IFRS and Privately-Held Companies

Gregory J. Millman

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Many have heard about something new, something different happening in the realm of accounting, but few have a clear picture of what that is, or how it will affect them. In this well researched, concise report on international financial reporting standards (IFRS), Greg Millman has provided the critical information that key players will need to know as they begin the process of determining how and when to respond to these important developments. This balanced presentation provides perspectives from key constituents with important knowledge of the areas you will need to consider in the near term, and beyond. Gary Illiano National Partner-in-Charge International and Domestic Accounting Grant Thornton LLP

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IFRS and Privately-Held Companies

TABLE OF CONTENTS Purpose and Executive Summary Research Methodology What is IFRS? Definition Growing Acceptance of IFRS in the United States Relevance to Private Companies in the United States IFRS vs. IFRS for Private Entities Why IFRS for Private Entities? How Does IFRS for Private Entities Differ from Full IFRS IFRS vs. GAAP: Implications for Private Companies Principles vs. Rules The LIFO Tax under IFRS Other IFRS-GAAP Issues Important for Private Companies The Bankers Perspective Mary Ann Lawrence, Key Bank Dev Strischek, SunTrust Mike Cain, Frost Bank The Private Company Executive Perspective George Beckwith, National Gypsum William D. Koch, Development Dimensions International Inc. Arthur Neis, Alliance Minerals North America LLC Andy Thrower, Naviscent Summary and Conclusion About the Author and Financial Executives Research Foundation, Inc. 1 2 3 3 3 3 5 5 5 7 7 7 9 11 11 12 13 14 14 15 16 17 19 20

IFRS and Privately-Held Companies

Purpose The purpose of this report is to give executives of private companies a basic introduction to the implications of International Financial Reporting Standards (IFRS). In November 2008, the SEC proposed a roadmap for the use of IFRS by publicly held companies. Privately held companies are not subject to SEC reporting requirements, but should be aware that IFRS represent an alternative to GAAP that they may want to consider. Unlike public companies, private companies face a choice not only between GAAP and IFRS, but between full IFRS and IFRS for Private Entities. Therefore, this report addresses both sets of standards insofar as they may affect private companies. The report does not limit itself to discussions of accounting differences, but discusses the impact of those differences on financial reporting, tax reporting, the raising of capital, and other activities. Executive Summary Here are the key findings of this report, based on interviews of bankers, financial executives, and other experts: Principles-based IFRS may supplant rules-based GAAP for public companies in the United States by 2014, according to a roadmap proposed by the Securities and Exchange Commission (SEC). Although there will be no regulatory requirement that private companies adopt IFRS, there are sound reasons for private companies to consider it. There will soon be two options for private companies interested in adopting IFRS: full IFRS and IFRS for Private Entities. Even if privately held, companies that are accountable to the public because they issue publicly traded debt securities, or have fiduciary responsibilities (such as banks and mutual funds) must use full IFRS and follow the same rules as publicly held companies. Private companies that are not accountable to the public may opt for IFRS for Private Entities. IFRS for Private Entities is expected to be approved in the first quarter of 2009. The AICPA already recognizes IFRS as a legitimate alternative to GAAP. So private companies should be able to adopt either full IFRS or IFRS for Private Entities as early as next year, if they choose. For some companies, full IFRS or IFRS for Private Entities may offer clear advantages, but for others, these methods may entail potentially steep tax and audit costs. IFRS for Private Entities represents the International Accounting Standards Boards attempt to, in its words, provide a simplified, self-contained set of accounting principles that are appropriate for smaller, non-listed companies. It could mean that private companies will have lower costs for financialstatement preparation and auditing.

However, neither full IFRS nor IFRS for Private Entities permits LIFO. This means that under current U.S. tax law, companies on LIFO could face steep tax penalties for adopting IFRS. Many U.S. banks say they currently are not equipped to deal with IFRS. Their credit analysts do not understand it, and their analytical software, credit ratios, etc. do not address IFRS statements. Most accountants in the United States have little or no training in IFRS. Accounting schools have not prepared the profession for IFRS. Although the IASB claims that IFRS for Private Entities represents a simplification of full IFRS, critics say that the simplicity is only apparent, and that private companies adopting the standard will still have to do much of the measurement and reporting that is of little relevance or utility to the users of their financial statements.

Research Methodology This report is based on interviews with accounting professionals, policymakers, bankers, private-company executives, and other experts. The interviews were conducted during the second and third quarters of 2008. The intention was to identify the issues most important for private companies, but not to compile an exhaustive catalog of accounting treatments under U.S. GAAP, full IFRS, and IFRS for Private Entities. This report distills what some of the leading authorities in private-company accounting have to say about IFRS as it relates to private companies. It aims to reach a general-management audience, and is not primarily addressed to accounting specialists. As this report was going to press, the International Accounting Standards Board was in the process of finalizing IFRS for Private Entities (formerly IFRS for Small and Medium Enterprises). Although some outstanding issues would affect the details of reporting under the new standard, their disposition would neither substantially alter the main findings of this report, nor affect the interviewees concerns about the impact of IFRS convergence on private companies.

What is IFRS?
Definition International Financial Reporting Standards are issued by the International Accounting Standards Board (IASB), a 14-member organization appointed by the trustees of the International Accounting Standards Committee Foundation. The IASB defines its mission as to develop, in the public interest, a single set of high-quality, understandable and international financial reporting standards (IFRS) for general-purpose financial statements. Growing Acceptance of IFRS in the United States In October 2002, the Financial Accounting Standards Board (FASB) of the United States and the IASB announced a memorandum of understanding known as the Norwalk Agreement. The memorandum was a step toward convergence of U.S. generally accepted accounting principles (GAAP) with international standards. Subsequently, the U.S. Securities and Exchange Commission (SEC) made several decisions that led many to wonder whether IFRS might replace GAAP altogether. The most notable of these decisions were: November 15, 2007 The SEC voted unanimously to eliminate the requirement that foreign issuers of securities in the United States reconcile their IFRS financial statements with GAAP, provided that they use IFRS as adopted by the IASB, and not a local adaptation of IFRS. August 27, 2008 The SEC announced a plan to propose a roadmap for adoption of IFRS by U.S. public companies. The roadmap would identify conditions under which the SEC might permit or require public companies to report using IFRS. Relevance to Private Companies in the United States Unlike most other jurisdictions, the United States does not require private companies to provide general-purpose financial statements (or have those statements audited) as a matter of course. Unless companies access the public capital markets, or operate in certain regulated industries, they need not provide financial statements (other than tax returns) to any government entity. Thus, U.S. private companies do not and very likely will not face any regulatory requirement that they prepare their financial statements in accordance with either GAAP or IFRS. That said, many private companies will sooner or later find themselves facing the decision of whether to adopt IFRS. At present, although regulators do not require them to prepare audited financial statements, other constituencies may. Thus, private companies often prepare audited financial statements according to GAAP for bankers, customers, suppliers, management and other constituencies. The process of convergence launched by the FASB and the IASB, and the roadmap defined by the SEC, suggest that IFRS will not only influence but may even supplant GAAP for public

companies within the next decade. As IFRS becomes more widely accepted, and possibly even required, as an accounting standard for publicly held companies, it should behoove private companies to be aware of how they may or may not benefit from adopting it. IFRS offers clear advantages to many private companies in the United States. For example, some U.S. private companies may have subsidiaries outside of the United States that are already using IFRS to comply with the law in those jurisdictions. Such companies could well find it simpler to adopt IFRS at the parent level than to reconcile to U.S. GAAP. For these and other private companies, the transition to either full IFRS or IFRS for Private Entities may and we emphasize may -- mean simpler financial statements and lower audit costs. Yet IFRS may also impose new and onerous costs on some private companies. For example, companies that use the last-in-first-out (LIFO) method may find that adopting IFRS carries a steep tax penalty. Many of these companies have substantial LIFO reserves. IFRS does not permit the use of LIFO (in contrast with GAAP). The U.S. Internal Revenue Service requires companies to be consistent in their use of LIFO or FIFO: that is, they must use the same method for tax reporting as they do for financial reporting. Converting from LIFO to FIFO would mean a tax hit because the LIFO reserves would become taxable. Some interviewees expect to see congressional or regulatory relief to encourage companies to make the transition to IFRS. However, not all interviewees expect relief. In fact, some suggest just the opposite that the IFRS transition could represent a stealth tax increase on businesses. There is some evidence for the latter, pessimistic view: some Congressional members have proposed increasing tax revenues by repealing LIFO. The transition to IFRS will have unique consequences for government contractors because of the regulatory environment in which they operate, notes William Keevan, senior managing director of Kroll, Inc. He explains that virtually all government contractors are subject to the "cost principles in Part 31 of the Federal Acquisition Regulation ("FAR") and most contractors are subject to the Cost Accounting Standards ("CAS") promulgated by the Cost Accounting Standards Board, which is part of the Office of Federal Procurement Policy. The CAS set forth the rules contractors must follow for measuring costs, assigning costs to accounting periods and allocating costs to government contracts. The FAR cost principles determine whether a cost is or is not reimbursable. Both the CAS and FAR cost principles incorporate GAAP to a certain degree, while differing from GAAP in other respects. Adoption of IFRS may require that costs and prices of contracts be adjusted. "Depending on how the regulators view these accounting changes, contract costs and prices could be adjusted both upward and downward, or only downward. Other complications are also likely to result," says Keevan.

Full IFRS vs. IFRS for Private Entities

Why IFRS for Private Entities? There will soon be two separate sets of IFRSs. Full IFRS applies to public companies and to private companies that are publicly accountable because they access the public debt markets or hold assets as fiduciaries (such as banks, insurance companies, securities broker/dealers, pension funds, mutual funds, investment banks, etc.). However, in February 2007, the IASB published an exposure draft of a proposed IFRS for Small and Medium-sized Entities. In May 2008, the board changed the title to IFRS for Private Entities. Full IFRS fills approximately 2,700 pages. By contrast, the exposure draft of IFRS for Private Entities was approximately 250 pages long. The IASB explained: Because full IFRSs were designed to meet the needs of equity investors in companies in public capital markets, they cover a wide range of issues, contain a sizeable amount of implementation guidance, and include disclosures appropriate for public companies. Users of the financial statements of private entities do not have those needs, but rather are more focused on assessing shorter-term cash flows, liquidity and solvency. Also, many private entities say that full IFRSs impose a burden on them a burden that has been growing as IFRSs have become more detailed and more countries have begun to use them. Thus, in developing the proposed IFRS for Private Entities, IASBs twin goals were to meet user needs while balancing costs and benefits from a preparer perspective. (source: http://www.iasb.org/Current+Projects/IASB+Projects/Small+and+Mediumsized+Entities/Small+and+Medium-sized+Entities.htm)

The objective of the project is to develop a set of standards that meets the needs of entities that are not publicly accountable but that do publish financial statements for external users, including providers of capital, credit rating agencies, owners who are not active in management, etc. How Does IFRS for Private Entities Differ from Full IFRS? Full IFRS applies to publicly accountable companies. The IASB claims to have made five kinds of changes to full IFRS in order to develop a standard for private entities: 1. Topics deemed not relevant to private entities are eliminated. 2. Where full IFRS allow accounting policy options, IFRS for Private Entities includes only the simpler option. 3. Many simplifications of the recognition and measurement principles that are in full IFRS. 4. Many reductions in disclosures. 5. Simplified drafting. The abbreviated, private-entity standard eliminates topics not relevant to most private entities. Whereas full offers a choice of accounting treatment, IFRS for Private Entities provides only the simple option. Recording and measurement is also simpler. For

example, there are only two categories of financial assets, instead of four, and private entities are permitted to expense all research and development costs, instead of capitalizing development after viability of the innovation. However, private entities may choose to use the more complex accounting treatment by cross-referencing to full IFRS. Yet critics say that the simplification apparent in IFRS for Private Entities is misleading. Andy Thrower, former national chairman of the Standards Subcommittee of FEIs Committee on Private Companies, says, Simplification is not there, and I dont believe that private companies will experience any meaningful difference between whats in IFRS for Private Entities and what theyre doing now. Thrower says that IFRS for Private Entities looks simple because it is a short, clearly written document but still requires private companies to do the same kind of extensive and expensive measurement and disclosure required by U.S. GAAP.

IFRS vs. GAAP: Implications for Private Companies

Principles vs. Rules The acronym GAAP stands for "generally accepted accounting principles. The word principles is a bit misleading, because in practice, U.S. GAAP is a rulebook with more than 20,000 pages of detailed prescriptions, industry-specific applications, variations, exceptions, and provisions. By contrast, even full IFRS is only about 2,700 pages long and, as mentioned above; the simpler IFRS for Private Entities is only about one-tenth the length of full IFRS. There is a cost to this simplicity: a greater range of variations in accounting practice. Paul Pacter, director of standards for private entities, IASB, says, "Obviously, at 10 percent of the size of full IFRS, there are fewer issues covered in the private entities standard, which will mean more diversity in practice than with full IFRS or U.S. GAAP." A panel addressing a gathering of bankers at the Risk Management Association's annual conference in October 2008 advised that two CPAs working with the same data could produce quite different reports, both in accordance with IFRS. Consequently, footnotes to financial statements will be indispensable to explain the preparer's logic and provide context for users. U.S. GAAP offers quite detailed and industry-specific rules for revenue recognition. IFRS does not. The principle under IFRS is to recognize revenue when it is probable that future economic benefits will flow to the entity and these benefits can be measured reliably. Press reports suggest that, internationally, companies switching from their local GAAP to IFRS have generally been able to report higher revenues. See, for example: http://www.cfo.com/article.cfm/10919122/c_3395216 Even if IFRS is simple and clear now, some question how long it may remain so after its adoption in the United States. More than one interviewee described IFRS as "GAAP 25 years ago, and suggested litigiousness in the United States will lead inexorably to detailed application guidance and blur the distinction between "principles" and "rules. Arthur Neis, president of Alliance Minerals North America LLC and a member of the Standards Subcommittee of FEI's Committee on Private Companies, says, "We are going back to the old days, when the auditors had to stand tall and individually take responsibility and say, 'This fairly represents the entity'. They can no longer hide behind page 892, paragraph 3."

The LIFO Tax under IFRS LIFO (last-in-first-out) is a method of calculating the cost of goods sold that assumes the last items to enter inventory are the first to be sold. The opposite of LIFO is FIFO (firstin-first-out), which assumes that the first items to enter inventory are the first sold. In inflationary periods, LIFO accounting reports a higher cost of goods sold, and therefore a lower net income. The opportunity to reduce tax liabilities by using LIFO was attractive

to many companies. The inflationary gains in the value of their inventory went not to the bottom line, but to a special LIFO reserve account. Over the years, those LIFO reserves have become quite substantial. In fact, in 2006, the Senate Republican leadership proposed getting rid of LIFO in order to raise revenues to pay for a $100 gas tax rebate for every American family. Associated Equipment Distributors, a trade group, reported that, Assuming a 35 percent tax rate, LIFO repeal could mean an $870 million tax increase for AED members alone! [Source: http://www.aednet.org/government/aed-washington-insights.cfm?id=07/01/2006#ref2] George Plesko, a professor at the University of Connecticut School of Business, testified that according to the most recent data available at that time, the LIFO reserves of U.S. publicly traded companies totaled $60 billion. He estimated that, assuming a 30percent tax rate, repealing LIFO could bring in $18 billion in tax revenues, before credits. [Source: http://www.senate.gov/~finance/hearings/testimony/2005test/061306testgp.pdf]. Of course, financial statements of privately held companies are not publicly available, and some critics disputed Pleskos calculations for publicly held companies. A broad coalition of trade associations and industry groups opposed the proposal to repeal LIFO, and it did not move forward. However, in 2007, U.S. House Ways and Means Committee Chairman Charles Rangel of New York proposed a tax reform bill that included repeal of LIFO to raise an estimated $107 billion over 10 years. A report by Credit Suisse indicated that basic materials and energy companies would be particularly exposed. [Source: http://emagazine.creditsuisse.com/index.cfm?fuseaction=OpenArticle&aoid=206991&lang=EN&coid=177883] Under current U.S. tax law, private companies that use LIFO and have accumulated substantial LIFO reserves would face a substantial tax penalty if they were to adopt IFRS, which does not permit LIFO. George Beckwith, controller of National Gypsum, says, Many private companies are S-corporations and are very attuned to the tax consequences of transactions. Giving up LIFO would be a big deal if it lands on the owners personal tax return. They wont be able to change their financial reporting model if its going to cost them cash. There have been reports of meetings and discussions with IRS officials about this issue. However, the requirement that companies be consistent in their use of LIFO or FIFO for both financial and tax reporting is not a matter of regulatory interpretation, but of tax law. Congressional action may be necessary to address it. Given the history of proposals to repeal LIFO advanced by both Republican and Democratic legislators specifically in order to raise tax revenues, it is far from certain that Congress would act to protect companies from the tax impact of the IFRS transition.

Other IFRS-GAAP Issues Important for Private Companies Asked to note some of the differences between GAAP and IFRS, Paul Pacter, director of standards for private entities at the International Accounting Standards Board, indicated the following: Investments in real estate: full IFRS allows fair-value reporting, i.e., revaluing the investment at each reporting date. The change in value goes to the P&L. Provisions, such as liabilities of uncertain amounts: in U.S. GAAP, when a liability, such as a lawsuit, might have a range of possible outcomes, accountants accrue the minimum and disclose the potential excess. Under IFRS, accountants accrue the expected amount, which is a probabilityweighted estimate. Borrowing costs: GAAP requires capitalization of borrowing costs relating to construction of a long-lived asset, but under IFRS for Private Entities, borrowers may either capitalize or expense these costs. Research and development (R&D): GAAP expenses all R&D. Full IFRS expenses research costs but capitalizes development costs, defined as those costs incurred after the product is commercially viable. IFRS for Private Entities follows the GAAP approach of simply expensing all R&D costs, but allows the option of capitalizing development costs (with a cross-reference to full IFRS). Impairment: full IFRS requires calculating impairment based on the discounted cash flows. U.S. GAAP, by contrast, does not require an impairment calculation as long as the present value of future payments equals or exceeds the carrying amount of the asset. Pacter offers the example of a strip mall that is half empty. If gross expected rental payments equal or exceed the carrying amount, there is no need to calculate impairment under U.S. GAAP, but there is under IFRS. Income taxes: IFRS requires accrual of deferred taxes on non-deductible goodwill; U.S. GAAP may or may not. IFRS also requires accrual of deferred tax on undistributed earnings of consolidated subsidiaries.

Companies may find their income statements more volatile under IFRS, says Karine Benzacar, president of KnowledgePlus, a consulting firm based in Toronto. She explains, Reported income tends to be higher under IFRS but also tends to be a lot more volatile. Under current Canadian or U.S. GAAP, when there is asset impairment, the asset gets written down but not back up. Under IFRS, if circumstances change, the asset will have to be written up. She notes that IFRS also requires disclosure of constructive obligations. If a company has an expectation that it will make a payment, it has to disclose that in its financials. For example, suppose a company promises publicly to clean up an oil spill, even if it doesnt have to by law. Since it has made a public announcement, its expected to incur those expenses. Under IFRS, its required to show that liability in the financials. Banks are the primary source of capital for privately held companies, and IFRS is stricter than GAAP with respect to waivers of covenant issues. Mary Ann Lawrence,

senior vice president, credit risk review, at Key Bank, says that under U.S. GAAP, a company technically in default on a covenant at the end of a reporting period can go back to the bank and ask for a waiver. If the waiver is granted, the company need not report the default as a current liability. However, under IFRS, if the company has not already obtained a waiver before the end of the period, it must report the liability as current. The large companies have financial staffs that can project and track these issues. But a lot of small, private companies will run into a real problem with this because they dont realize theyre in default until the accountants do the books. Now theyll be in default, not just technically, but really in default, and thats a big distinction in the banking world, she says.

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The Bankers Perspective

This section of the report presents reflections on IFRS by bankers who provide capital to privately held companies. Mary Ann Lawrence Senior Vice President, Credit Risk Review Key Bank Were a large enough bank that we do public companies, but we also do a lot of private companies, and we get the entire gamut of small-enterprise statements. I think most people dont know and dont realize the effect of accounting convergence. It means, number one, everybody will have to be retrained and, number two, covenants are going to have to be rewritten and models to rate credit redone. Anything that relies on accounting data is going to have to be redone. It is going to be a massive change and will cost lots of money. Banks will need training for credit analysts and new software to get financial statements and ratios. They will have to rethink what ratios are and what they really mean, so they can figure out how to set covenant levels. It will be a brave new world for a whole bunch of people, not just the banks but also the bank regulators. It will be a big cost to the economy, and given the current conditions, Im not sure we have the extra economic power to provide the training necessary. Its a hidden cost that people dont think about. Theres no place to get really good training. The schools are not teaching IFRS. Academics will not start making changes in academic programs until there is clear guidance from the SEC for large companies and some guidance on what will happen with private companies. Lenders are not actually so concerned about what the rules are, but we want consistent application of those rules, so that when were looking at statements for two companies we can make an informed decision. Frequent changes in GAAP have hurt the consistency of accounting for private companies. Im not saying accountants are not doing the right thing, but there are many changes, and not a lot of lead time, so accountants arent always up-to-date. If youre a sole practitioner accountant doing primarily small private companies, you depend on continuing education to keep you abreast of the latest changes. The foundation of a principles-based system is that the accountant is a professional and understands the principles. I can see, in our litigious society, the legal system having a field day. So I think it will morph into more rules. The reason many people think IFRS is more principles- than rules-based is that IFRS hasnt been around long enough. When IFRS has been around as long as GAAP, youll see the same volumes of interpretations and rules. Its a cultural thing.

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I think there is going to have to be some kind of governing body in this country to oversee accounting for private companies. Who it should be is an interesting question. One could make an argument that it should be some new group that is an amalgamation of the FASB and the AICPA, a group that could speak both for the profession and for users.

Dev Strischek Senior Vice President and Senior Credit Policy Officer SunTrust We bankers are always a little bit reserved when it comes to changes in accounting, and particularly a change as large as this one is going to be. IFRS has been totally focused on global publicly traded companies. The puzzle is how in the world you can focus only on a few thousand globally traded companies and put off until tomorrow the vast majority of corporations. My first thought is theres an equity analyst focus on IFRS, which seems to ignore the vast majority of corporations in the United States. The second interesting item is that most companies would report an increase in income under IFRS. Given that most privately held companies generally try to avoid paying additional taxes, they are not going to be very excited about that. Third, consider IFRS a Trojan horse for fair-value accounting: now your income statement is reflecting not just the cost and revenues associated with products or services you have sold, but also changes in value from time period to time period. Is that what we really want? Fourth, IFRS does not permit LIFO accounting, but many auto dealers and manufacturers use LIFO, so suddenly they have to push out their LIFO reserves into their income statements. Its an incredibly embarrassing time to show higher income when you probably dont have the cash flow to pay the taxes. A fifth item is that under IFRS, all leases would be treated as capital leases; there will be no offbalance-sheet operating leases. But for tax purposes theyre likely to continue to permit operating leases, so you have another deferred item popping up on balance sheets. In banking well accommodate just about anything. Many of our borrowers provide us with cash-based accounting that is not GAAP, or with tax statements. The amount of effort necessary to get onto a fair-value basis is big. For example, if you have an airplane, you cant just have a value for the plane, but you have to break it down into component parts. And how do you value nonfinancial assets anyway? The SEC itself seems to have slowed down its embrace of IFRS because of the financial crisis. If you were to look at the tenor of SEC pronouncements and guidance three or four months ago, IFRS was the way we were going to go. Now, in the financial crisis, fair value begins to look a little more challenging to implement. We in banking are grateful for the rethinking.

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Mike Cain Senior Executive Vice President Frost Bank It will really come down to cost-benefit. From my perspective, I get no real benefit. Most of our customers are middle-market companies with total sales from $1 million to $100 million. We have a few that do business internationally, but very few have reporting entities that are on IFRS. So in terms of making their accounting life easier, IFRS isnt really a factor. Most of these business users do not provide financial information to international grantors of credit but instead use letters of credit. So the biggest downside I see is that private companies are going to have to change their accounting with no benefit. The private sector is left with the cost of changing systems, familiarizing the internal staff with the new approach, working with preparers, and so on. Maybe theres an undefined long-term benefit, but most of our clients are looking at todays cost and revenue and arent too worried about two years from now. The LIFO issue will have a huge impact on private companies. Large numbers of our customers have a LIFO position, and I can think of several whose LIFO reserve is as big as their net worth. It was done that way for tax reasons. Although their profits have looked smaller, their cash flows have been better because of the tax subsidy theyve gotten for LIFO accounting. From a practical standpoint, thats probably the biggest direct cost. We have a financial analytic software package that serves us well, but it would not necessarily deal with a new basis of accounting. The system is not really going to map. An updated version of that will cost half a million bucks, plus who knows how many more dollars in training costs and reeducation. Those are the negatives. Most of the private companies I deal with perceive that accounting, whether its U.S. GAAP or IFRS, is really built for public companies and not for private companies. Im seeing a lot of statements these days that have opinions with qualifications or exceptions from GAAP. Ten years ago that would have been the kiss of death, but now its fairly commonplace. IFRS for Private Entities may be a middle ground, possibly a bit too light for a lot of our customers, but there are probably a lot for whom it would fit well. For us, cash flow is obviously paramount. Verification of numbers is important. But for most of the people we deal with, the more esoteric things like derivatives and fair-value accounting are not issues.

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The Private Company Executive Perspective

This section of the report presents reflections on IFRS by executives of privately held companies and preparers of financial statements. Each of these executives is a member of the Standards Subcommittee of FEIs Committee on Private Companies. George Beckwith Controller National Gypsum Private companies need to know that IFRS is not completely different. Its not as if you change how you record receivables and payables and basic expenses. The main differences are things that private companies would find to be favorable. Its much more principles-based and focused on general-purpose financial statements, unlike GAAP, which has evolved to be a special-purpose financial statement. For example, there might be special-purpose financial statements made up just for a regulator. Utility regulators require a utility to list and account for assets differently; bank regulators require different disclosures from energy regulators. GAAP has moved [accounting] to be almost exclusively for publicly traded companies. IFRS takes it back to being what the general person wants to see. Many of the frustrations private companies have come from the fact that everybody has to play by the public-company rules; other than filing a 10-k and following proxy rules, private companies have the same disclosure requirements. IFRS is much more principles-based. Thats certainly a benefit. GAAP requires a $20or $50-million dollar construction company to go through with its auditors all the disclosures that would be required for some obscure thing that doesnt really apply to it. Getting away from that is going to be a big benefit to private companies. I think it would make our financial information more understandable to our owners and our creditors. We would have fewer carve-outs for debt covenants and so forth. Today we back out a lot of FASB accounting that banks and owners say is not relevant to them as users. We would have fewer of those. Wed have a better look into the financials of the organization. From an internal perspective, the preparer would find it simpler. I think our audit fees would go down. We hope to adopt it, but we have roadblocks in our way. Like many others, we would like to see LIFO addressed. LIFO doesnt have any good accounting theory behind it; its much more of a tax theory. Its not as if its good financial reporting to use LIFO. IFRS does not allow it. But many public and private companies are more attuned to the tax consequences of transactions. They wont want to change their financial reporting model if its going to cost them cash.

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William D. (Bill) Koch Vice President and CFO Development Dimensions International Inc. The train is moving to convergence: either jump on or get run over. I dont know whats going to happen with U.S. standards, but theyre going to converge at some point in time. Were a human resources consulting firm focusing on three things: 1) employee selection, 2) leadership development, and 3) execution of corporate strategy. Were about 50/50 U.S. and non-U.S., with a lot of pass-through subsidiaries. Many, if not most, jurisdictions use IFRS or a variant. We consolidate using U.S. GAAP at headquarters, and it turns out that for us, its close to being the same. There are some special cases where the rules are different. But when we did an analysis of IFRS for Private Entities a year ago, we walked away saying wed move to that someday. Wed have to do some work, but the fact that the rules wouldnt be changing every three weeks was very appealing. CFOs dont generate business value by spending time on accounting pronouncements; not one of my customers has asked me about what our position is on fair value, FIN 48 or FIN anything else. Owners of private companies are generally significant percentage owners, not minority shareholders. Theyre involved, know whats going on in the business, and are much more interested in cash flow than valuation. Analysts of public companies are looking for a piece of differential value that, when the world catches on, will drive up the price. Its a totally different motivation. We run a pretty simple business you have to get your cost to be nine when you sell for 10. If I were czar of all Russia, Id issue cash-flow statements. But we have to capitalize R&D software development and amortize it, because from a valuation standpoint its supposed to be better. We dont manage our business that way. Its one of the things we put up with because thats what GAAP says you must do, but we dont need that kind of profitless bookkeeping.

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Arthur Neis President, Alliance Minerals North America LLC Member of the IASB Working Group for Small and Medium-sized Enterprise Financial Reporting and of the FEI Standards Subcommittee The logic is pretty clear and compelling. We have in IFRS a set of standards, not rules, which can be applied rationally. The AICPA has said that IFRS is a recognized set of standards on which auditors can opine. Bank agreements that specifically reference GAAP are beginning to reference IFRS. IFRS seems to be very well field-tested and easily implemented, and the lenders have gone along, recognizing that private companies are different from public companies. In preparing IFRS for Private Entities, we started with all of the accounting and reporting principles for any given area and asked ourselves which of those accounting and reporting principles applied only to public entities. We eliminated a large percentage of the principles, and delineated the key accounting and reporting principles that apply to private entities. It seems to me that almost everyone in the world of business has a concept of the fundamentals of accounting and financial reporting. The problem is that we have deviated down the path of innumerable rules and nuances that were specific to situations and werent relevant to operating management. But every business person has been through at least a few courses at a business school and has had a basic introduction to financial reporting. IFRS for Private Entities is contained in 250 pages, and anybody can read that, understand it, take it away and hang on to it. Were going back to the old days, when the auditor had to stand tall and individually take responsibility and say, This fairly represents the entity. They can no longer hide behind page 892, paragraph 3. Thats where we were 50 years ago when I got into business. I got lectures on how my personal financial strength was dependent on my integrity and my auditing. The same applies to all preparers/CFOs.

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Andy Thrower Partner, Naviscent If Im a small company on the European continent, Im required by law to have financial statements audited and filed. Here in the United States, Im not required to have that, but in the event I go out to seek capital, debt or equity financing, the party that may be willing to invest or lend may require me to have a set of audited financial statements. So its a market-based determination here in the United States. A database of the Risk Management Association lists 150,000 private companies. About 30,000 to 40,000 issue audited statements. Another 30,000 to 40,000 issue statements according to GAAP, and the rest either say they are tax-based, othercomprehensive based, or else dont disclose. So there are many more private companies issuing GAAP statements than public ones. If the AICPA says it will now accept IFRS for Private Entities, but the banks dont want it, then there isnt a demand. The preponderance of support for GAAP is market-driven, and by market I basically mean custom and tradition. We could end up adopting IFRS for Private Entities, or we could end up doing nothing. It appears to be a simpler version and perhaps a less costly option for U.S. companies, as it excludes some of those things that private-company users say are irrelevant. But my opinion is that IFRS for Private Entities is basically designed for companies with 50 employees, and I think it is still too complicated for the small company that needs GAAP statements only because it needs a bank loan. IFRS for Private Entities gives the impression of being simpler because there are fewer pages and it reads nicely. But some things are summarized by cross reference to full IFRS. That makes IFRS for Private Entities a lot smaller, but it does not take away the requirement. At some point, it may state a principle identical to full IFRS or GAAP, but leave out the implementation guidance. That doesnt mean you dont have to implement it or report it; the fact that IFRS for Private Entities doesnt tell you how doesnt mean you dont have to do it. The debate over GAAP for private companies has been around for a while, but now that we have convergence, it raises again whether its a convenient opportunity for private companies to do something different. We have had a lot of standards in recent years based less on accounting transactions and more on economic events. That adds a degree of difficulty for private companies. With no transaction, they have to hire an appraiser. Then the banker says I dont need that information; if I need to know the value of your fixed assets, Ill hire an appraiser.

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In 2005, the AICPA published the Private Company Financial Reporting Task Force Report. The report identified 12 GAAP requirements that were low either in relevance or usefulness for private companies. However, when the IASB issued its final exposure draft of IFRS for Private Entities, it included all 12. ** Well continue to hear the same complaint: that the information satisfies the needs of investors and potential investors, but not of users of financial statements of private companies, who are primarily bank lenders. I dont see any improvements. Moreover, in this country there is an insatiable demand for implementation guidance, interpretation of standards, etc. You wont change the U.S. cultural and legal environment. When we adopt IFRS, a void will be created, and somebody will step in and write rules and implementation guidance because our culture will require that. Then private companies, as long as theyre in the system, will be pulled along, and it will be business as usual. Just because somebody puts out a principles-based standard on leases doesnt mean my auditors are going to be comfortable. Legal exposures remain the same, secondguessing remains the same, so the idea that well magically drop all of these detail demandsyou tell me how in the world could that possibly happen?

**Note: in an article now under consideration for publication by The CPA Journal, Andy Thrower details the problematic standards and their treatment under IFRS for Private Entities.

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Summary and Conclusion

IFRS for Private Entities will offer privately held companies an alternative to GAAP. Principles-based rather than rules-based, this alternative promises to be simpler and more straightforward than GAAP. The IASB has also committed to put changes on a timetable, so the first release of IFRS for Private Entities will be unchanged for at least two years. Companies frustrated with the complexity of GAAP and the frequent changes from the FASB may find IFRS for Private Entities preferable. However, tax issues will be a deterrent for companies that use LIFO to calculate the cost of goods sold. Executives of private companies seem more receptive than bankers to the prospect of IFRS for Private Entities. Bank credit analysts do not, for the most part, have training or expertise in IFRS. Banks will need to upgrade software and human resources in order to cope with the change. Although bankers are decidedly unenthusiastic about making these investments, bankers who spoke on the subject for this report indicated that they would accommodate borrowers who opt to make the switch.

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About the Author Gregory J. Millman is a contributing editor to Financial Executive magazine and editor of IFRS Reporter (http://www.ifrsreporter.com ). He has also written for Forbes, Barrons, the Wall Street Journal, The Washington Post, and numerous other periodicals. He is the author of books of financial journalism including The Floating Battlefield: Corporate Strategies in the Currency Wars; The Vandals Crown: How Rebel Currency Traders Overthrew the Worlds Central Banks, and The Day Traders: the Untold Story of the Extreme Investors and How They Changed Wall Street Forever. His most recent book is Homeschooling: A Familys Journey. Prior to making a career shift to journalism, he worked in banking, consulting, and project finance in China. He earned an MBA at the Olin School and a Master of Arts (Asian Studies) from Washington University in St. Louis. He may be reached at gregmillman@gmail.com or by phone at (732) 926-1225.

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