With the recent FAF Board of Trustees vote to establish the Private Company Council (PCC), the next step in this process of developing rules for private companies is for the PCC (together with the FASB) to develop a framework that will determine when it is justified to have GAAP exceptions and modifications for private companies.  With that as the goal, the fundamental question is what are the needs of private company financial statement users?  We know these users are fundamentally different from public company financial statement users, but do they actually have different needs?  And if so, why?

A premise used by supporters of a separate standard-setting board for private companies is that users of private company financial statements have different needs relative to users of public company financial statements.  Several comment letters to the FAF on its proposal to establish the Private Company Standards Improvement Council (PCSIC) refer to this notion when they urged the FAF to re-consider establishing a separate private company standard-setting board.  The Blue Ribbon Panel (BRP) report on standard setting for private companies states, “users of private company financial statements have different needs than users of public company financial statements” (p. 8).  This statement was based on a conclusion from an AICPA task force report issued in February 2005 (referred to as the Castellano Report).  However, this viewpoint is difficult to understand both from an economic theory standpoint and from the evidence on which the conclusion is based.

A primary objective of financial reporting is to provide information about the amount, timing, and uncertainty of future cash flows.  The assessment of future cash flows is not only important for capital providers to public companies, but it is also paramount for lenders to private companies.  Similarly, other constituents of both public and private companies should be primarily concerned about future cash flows.  Thus, in its deliberations, the FASB’s focus is on creating standards that provide financial statement users with better information about future cash flows.  I believe this focus should be relevant whether the financial statements are issued by a public company or a private company.

In 2006, the Financial Executives Research Foundation (FERF) issued a report entitled, “What do users of private company financial statements want?”  The report showed that bankers, investment bankers, and investors in private companies all want audited annual GAAP financial statements.  The FERF report also indicated that private company financial statement users want information beyond what is provided in the financial statements that would facilitate their assessment of future cash flows.  Nowhere did the report indicate that the users of these financial statements had different needs than users of public company financial statements.

The Castellano Report concludes from survey evidence that users of private company financial statements have different needs than users of public company financial statements.  However, based on what the survey evidence actually reveals, it seems like a giant leap to draw that conclusion.  The survey evidence shows that private company financial statements prepared in accordance with US GAAP are of high value.  Even when compared to the costs of preparing the reports, the survey respondents indicated the reports were of medium to moderately high value.  The only significant piece of evidence from this report that would perhaps support the notion that the needs of private company financial statements users are unique is that respondents indicated that some GAAP requirements are of little relevance for private companies.  However, these responses might merely capture the fact that some components of GAAP do not have a material effect on most private company financial statements.  Further, the survey did not ask whether these same requirements were of high, medium, or low significance for public companies.  Thus, the report cannot rule out the possibility that the users surveyed simply did not have a high opinion of the GAAP requirement, and that their response had nothing to do with their needs relative to the needs for users of public company financial statements.

Finally, the Castellano Report indicated that a majority of each constituency that had an opinion believe that differences between private and public company GAAP could be useful.  Again, this result says nothing about the needs of the user, and it might merely reflect the practicalities faced by smaller firms with limited resources.

In short, I am not aware of evidence that can unambiguously support the inference that users across private and public companies have different needs, and there is plenty of theoretical support for the notion that all users are primarily concerned about future cash flows.  But, this is not my area of research expertise either, and perhaps somebody out there can provide this evidence.  I would be interested to hear alternative views.