The FASB s New Definition of a Public Business Entity and the Private Company Decision-Making Framework

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1 A Closer Look Discussion and Analysis of Current Accounting and Audit Issues ACCOUNTING RESEARCH MANAGER ISSUE JANUARY 21, 2014 The FASB s New Definition of a Public Business Entity and the Private Company Decision-Making Framework Introduction In December 2013, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No , Definition of a Public Business Entity: An Addition to the Master Glossary. The ASU amends the Master Glossary of the FASB Accounting Standards Codification (Codification) to include a new definition of a public business entity to be used in future financial accounting and reporting guidance. The new definition will be used by the FASB, the Private Company Council (PCC), and the Emerging Issues Task Force (EITF) in specifying the scope of future financial accounting and reporting guidance. The Codification currently includes multiple definitions of the terms nonpublic entity, public entity, and publicly traded company (see Appendix A: Existing Definitions in the FASB Accounting Standards Codification for a discussion of these terms). The amendment in ASU provides a single definition of a public business entity for use in the next update to accounting standards that uses that term. The amendment does not affect existing guidance (see Appendix A). In December 2013, the FASB and the PCC also issued the Private Company Decision-Making Framework: A Guide for Evaluating Financial Accounting and Reporting for Private Companies (Decision-Making Framework). The Decision- Making Framework will be used by the FASB and the PCC to determine whether and when to provide alternative recognition, measurement, disclosure, effective date, or transition guidance for private companies. The new public business entity definition will determine which entities may apply any alternative guidance. Public Business Entity ASU added a new Master Glossary term Public Business Entity to the Codification that defines a public business entity as follows: A public business entity is a business entity meeting any one of the criteria below. Neither a not-for-profit entity nor an employee benefit plan is a business entity. a. It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements, Visit Accounting Research Manager on the web at

2 or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose financial statements or financial information are required to be or are included in a filing). b. It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations promulgated under the Act, to file or furnish financial statements with a regulatory agency other than the SEC. c. It is required to file or furnish financial statements with a foreign or domestic regulatory agency in preparation for the sale of or for purposes of issuing securities that are not subject to contractual restrictions on transfer. d. It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or an over-the-counter market. e. It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law, contract, or regulation to prepare U.S. GAAP financial statements (including footnotes) and make them publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions to meet this criterion. An entity may meet the definition of a public business entity solely because its financial statements or financial information is included in another entity s filing with the SEC. In that case, the entity is only a public business entity for purposes of financial statements that are filed or furnished with the SEC. The new public business entity definition differs from some of the existing definitions of a public entity in the Codification (see Appendix A). As stated in the public business entity definition, not-for-profit entities (within the scope of Topic 958, Not-for-Profit Entities) are not business entities and are not included in the definition. The FASB has stated that it will no longer make a public vs. nonpublic distinction between not-for-profit entities in future standard setting. The FASB also states that it will consider, on a standard-by-standard basis, whether a not-forprofit entity should apply financial accounting and reporting alternatives. In addition, employee benefit plans (within the scope of Topic 960, Plan Accounting Defined Benefit Pension Plans, Topic 962, Plan Accounting Defined Contribution Pension Plans, and Topic 965, Plan Accounting Health and Welfare Benefit Plans) are not business entities and are not included in the definition. The FASB states that it will consider, on a standard-by-standard basis, whether an employee benefit plan should apply financial accounting and reporting alternatives. Criterion e. (above) in the new definition is a criterion that current Codification definitions do not include. The existing definitions do not consider an entity to be public unless it meets one of the other criteria included in the definition (e.g., if it has debt or equity securities that trade either on a stock exchange or an over-the counter market). Criterion e. was added because of the changing nature of the markets and is intended to include securities other than those on an exchange or an over-the-counter market. A private company that controls and consolidates a public company is not a public business entity. As a result, such an entity should be able to apply financial accounting and reporting alternatives for private companies in its own financial statements. A consolidated subsidiary of a public company is not a public business entity for purposes of its standalone financial statements (other than those included in an SEC filing by its parent or by other registrants or those that are issuers and are required to file or furnish financial statements

3 3 with the SEC). A consolidated subsidiary should be able to apply financial accounting and reporting alternatives for private companies in its own financial statements. Private Company Decision-Making Framework In December 2013, the FASB and the PCC issued the Decision-Making Framework, which will be used by the FASB and the PCC in making user relevant and cost effective evaluations for private companies. The Decision- Making Framework discusses factors that may differentiate the financial reporting considerations of private companies from public companies. The Decision-Making Framework also sets forth areas where financial accounting and reporting guidance might differ for private and public companies. Significant Differential Factors The FASB and the PCC have identified certain factors that differentiate the financial reporting considerations of private companies and public companies: The number of primary financial statement users and their access to management; The investment strategies of primary users; The ownership and capital structures; Accounting resources; and The manner in which preparers learn about new financial reporting guidance. The number of primary financial statement users and their access to management. The types of financial statement users are generally the same for private and public companies. A private company, however, may have fewer financial statement users and those users may have access to management and may receive information throughout the year. There are fewer restrictions on sharing financial information with users of private company financial statements as compared to public companies. Private company users may receive monthly unaudited financial information from a private company. The FASB and the PCC have identified certain factors that differentiate the financial reporting considerations of private companies and public companies. This factor is more relevant to disclosure matters than recognition and measurement matters. The investment strategies of primary users. Private company investors have little or no access to public markets to divest their investments in private companies. As a result, these investors may have a greater focus on cash that can be realized from their investments. Financial statement users tend to focus on earnings before interest, taxes, depreciation, and amortization (EBITDA), with some additional company-specific noncash adjustments. Many private company investors focus on accounting and disclosure requirements affecting cash (for dividend payments) and adjusted EBITDA for purposes of applying a valuation multiple to estimate a value for their securities. Most private company investors in nonfinancial companies indicate that they are more interested in accounting guidance that affects reported cash amounts or probable future cash flows. They also are less interested in accounting guidance that produces or results in volatility in reported earnings and asset and liability values resulting from underlying changes in fair value

4 4 that are expected to reverse contractually in the future if the company has the intent and ability to hold the related instrument to maturity or term (e.g., an investment in debt securities, the asset or liability associated with an interest rate swap agreement, or the entity s own debt). The ownership and capital structures. The capital structure and capital funding of private companies vary from those of public companies. Common private company ownership structures include: (a) S-corporations; (b) limited liability companies; (c) general, limited, limited liability, or family limited partnerships; (d) sole proprietorships; and (e) trusts (i.e., employee stock ownership plans). Many private companies also have multiple entities under common ownership, which often results in transactions with affiliates and other related parties, as well as guarantees and cross-collateral arrangements with lenders. In contrast, the most common form of public company structure is the C-corporation. The types of ownership and capital structures of private companies vs. public companies should be considered when evaluating the applicability and the consequences of certain accounting guidance (e.g., income taxes, consolidation, and equity). Accounting resources. The Decision-Making Framework states that private companies (and public accountants that serve private companies) generally have resource constraints resulting in fewer and less specialized accounting personnel when compared to public companies. These resource constraints should be considered when effective date and transition guidance is established. The manner in which preparers learn about new financial reporting guidance. Private companies have stated that they generally learn about new guidance from their public accountants when planning for the year-end financial statements. They also generally receive educational updates in the second half of the calendar year. This situation should be considered when effective dates are established. Areas of Potential Differences The Decision-Making Framework is intended to assist the FASB and the PCC in determining whether and when to provide alternative guidance for private companies. Private companies may select the alternatives that they believe are appropriate to apply. The Decision-Making Framework sets forth specific areas where financial accounting and reporting guidance might differ for private and public companies: Recognition and measurement; Disclosure; Presentation; Effective date; and Transition method. Recognition and measurement. The Decision-Making Framework states that the FASB and the PCC should first determine whether the recognition or measurement guidance being evaluated provides relevant information to users of private company financial statements at a reasonable cost. That analysis should focus on: The relevance of the information in meeting the objective of financial reporting for typical users of private company financial statements; The characteristics that differentiate users of private company financial statements from users of public company financial statements; and The cost and complexity of applying the guidance. If the guidance being evaluated is relevant, the FASB and the PCC should consider whether

5 5 the use of practical expedients could satisfy the needs of the financial statement users. If the guidance being evaluated is not relevant to the user and is costly or overly complex for the preparers, the FASB and the PCC should analyze the benefits and costs of alternative recognition and measurement guidance for private companies. Disclosure. The Decision-Making Framework states that disclosure alternatives should generally not be considered for private companies when disclosures provide relevant information to the most common types of users at a reasonable cost. When deciding to provide disclosure alternatives for private companies, the primary considerations include: The typical needs and areas of focus of lenders, other creditors, and investors; and The relevance of the measurement attribute required by the current guidance to typical users of private company financial statements. When considering disclosure alternatives, the financial statements users access to management should be considered. However, disclosure alternatives should not be permitted unless input from users indicates that a disclosure does not provide relevant information to typical users or is provided to a narrow set of those users. In certain circumstances (i.e., distributions paid to owners, related party relationships, and income tax sharing agreements), additional disclosures beyond those required of public companies may be required for private companies. Presentation. The Decision-Making Framework states that private companies and public companies should generally apply the same presentation guidance. However, alternative presentation guidance may be considered for private companies if: Private companies already have an exception for providing related or similar types of information; There is a basis to support alternative recognition and measurement or alternative disclosure requirements; or The information does not affect amounts and metrics that financial statements users use. Effective date. The Decision-Making Framework states that new guidance should generally be effective for private companies one year after the first annual reporting period for which public companies are to adopt the new guidance. In addition, private companies generally should not be required to adopt new guidance during an interim period within the initial fiscal year of adoption. Private companies should generally be allowed to apply the new guidance before the deferred private company effective date, but no earlier than the required or permitted effective date for public companies. If the FASB and the PCC determine that new guidance should be adopted as soon as possible, the effective date for private companies should be the same as public companies. In certain circumstances (e.g., the new guidance is complex or requires a retrospective method of application), the FASB and the PCC may establish an effective date more than one year after the first annual reporting period for which public companies are to adopt the new guidance. Transition method. The Decision-Making Framework discusses transition when retrospective application is required. If retrospective application is not required, the transition method should be the same for private and public companies.

6 6 If retrospective application is required, the FASB and the PCC should consider whether a private company could apply practical expedients, a limited or modified transition method, or the prospective method. In making this determination, the FASB and the PCC should consider primarily: Whether the amendments affect reported cash balances, cash flows, or adjusted EBITDA; and Whether the amendments affect other important amounts or metrics, including total debt, liquidity, or leverage ratios. If an alternative method of transition is allowed, a private company would be required to disclose qualitative information about the comparison of its current period and prior period financial statements. A private company may also be required to disclose quantitative information about the comparison of its current period and prior period financial statements. If an alternative method of transition is not allowed, the transition method should be the same for private and public companies. Next Steps The term public business entity was initially used in ASU No , Investments Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects (a consensus of the FASB Emerging Issues Task Force), issued by the FASB on January 15, The term will also be used in future updates to accounting standards that use that term.

7 7 Appendix A: Existing Definitions in the FASB Accounting Standards Codification The Codification currently includes multiple definitions of the terms nonpublic entity, public entity, and publicly traded company. The definitions are listed below along with the Codification topics that use the definition. In December 2013, the FASB issued ASU , which added a new term, Public Business Entity, to the Master Glossary. The new definition will be used by the FASB, the PCC, and the EITF in specifying which entities will apply future financial accounting and reporting guidance. The new definition is to be used in the next update to accounting standards that uses that term. When completing ASU , the FASB decided not to amend the existing terms in the Codification. The FASB may amend the existing terms in the future after reviewing any implementation issues that may arise from the use of the new definition. Nonpublic Entity The term Nonpublic Entity as used in Topic 105, Generally Accepted Accounting Principles, Topic 220, Comprehensive Income, Topic 350, Intangibles Goodwill and Other (Subtopic ), Topic 360, Property, Plant, and Equipment, Topic 405, Liabilities, Topic 715, Compensation Retirement Benefits (Subtopic ), Topic 820, Fair Value Measurement, Topic 830, Foreign Currency Matters, and Topic 954, Health Care Entities, is defined as follows: Any entity that does not meet any of the following conditions: a. Its debt or equity securities trade in a public market either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally. b. It is a conduit bond obligor for conduit debt securities that are traded in a market, including local or regional markets). c. It files with a regulatory agency in preparation for the sale of any class of debt or equity securities in a public market. d. It is required to file or furnish financial statements with the Securities and Exchange Commission. e. It is controlled by an entity covered by criteria (a) through (d). The term Nonpublic Entity as used in Topic 718, Compensation Stock Compensation, is defined as follows:

8 8 Any entity other than one that meets any of the following criteria: a. Has equity securities that trade in a public market either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally b. Makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market c. Is controlled by an entity covered by the preceding criteria. An entity that has only debt securities trading in a public market (or that has made a filing with a regulatory agency in preparation to trade only debt securities) is a nonpublic entity. The term Nonpublic Entity as used in Topic 350, Intangibles Goodwill and Other (Subtopic ), and Topic 715, Compensation Retirement Benefits (Subtopic ), is defined as follows: Any entity other than one with any of the following characteristics: a. Whose debt or equity securities trade in a public market either on a stock exchange (domestic or foreign) or in the over-the-counter market, including securities quoted only locally or regionally b. That is a conduit bond obligor for conduit debt securities that are traded in a market, including local or regional markets) c. That makes a filing with a regulatory agency in preparation for the sale of any class of debt or equity securities in a public market d. That is controlled by an entity covered by a., b., or c. Conduit debt securities refers to certain limited-obligation revenue bonds, certificates of participation, or similar debt instruments issued by a state or local governmental entity for the express purpose of providing financing for a specific third party (the conduit bond obligor) that is not a part of the state or local government s financial reporting entity. Although conduit debt securities bear the name of the governmental entity that issues them, the governmental entity often has no obligation for such debt beyond the resources provided by a lease or loan agreement with the third party on whose behalf the securities are issued. Further, the conduit bond obligor is responsible for any future financial reporting requirements. The term Nonpublic Entity as used in Topic 825, Financial Instruments, is defined as follows:

9 9 Any entity that does not meet any of the following conditions: a. Its debt or equity securities trade in a public market either on a stock exchange (domestic or foreign) or in the over-the-counter market, including securities quoted only locally or regionally. b. It is a conduit bond obligor for conduit debt securities that are traded in a market, including local or regional markets). c. It files with a regulatory agency in preparation for the sale of any class of debt or equity securities in a public market. d. It is controlled by an entity covered by the preceding criteria. The term Nonpublic Entity as used in Topic 715, Compensation Retirement Benefits (Subtopics and ), and Topic 740, Income Taxes, is defined as follows: An entity that does not meet any of the following criteria: Public Entity a. Its debt or equity securities are traded in a public market, including those traded on a stock exchange or in the over-the-counter market (including securities quoted only locally or regionally). b. It is a conduit bond obligor for conduit debt securities that are traded in a market, including local or regional markets). c. Its financial statements are filed with a regulatory agency in preparation for the sale of any class of securities. The term Public Entity as used in Topic 280, Segment Reporting, Topic 350, Intangibles Goodwill and Other, Topic 805, Business Combinations, Topic 954, Health Care Entities, and Topic 958 Not-for-Profit Entities, is defined as follows: A business entity or a not-for-profit entity that meets any of the following conditions: a. It has issued debt or equity securities or is a conduit bond obligor for conduit debt securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets). b. It is required to file financial statements with the Securities and Exchange Commission (SEC). c. It provides financial statements for the purpose of issuing any class of securities in a public market.

10 10 The term Public Entity as used in Topic 740, Income Taxes, is defined as follows: An entity that meets any of the following criteria: a. Its debt or equity securities are traded in a public market, including those traded on a stock exchange or in the over-the-counter market (including securities quoted only locally or regionally). b. It is a conduit bond obligor for conduit debt securities that are traded in a market, including local or regional markets). c. Its financial statements are filed with a regulatory agency in preparation for the sale of any class of securities. The term Public Entity as used in Topic 470, Debt, and Topic 718, Compensation Stock Compensation, is defined as follows: An entity that meets any of the following criteria: a. Has equity securities that trade in a public market, either on a stock exchange (domestic or foreign) or in an over-the-counter market, including securities quoted only locally or regionally b. Makes a filing with a regulatory agency in preparation for the sale of any class of equity securities in a public market c. Is controlled by an entity covered by the preceding criteria. That is, a subsidiary of a public entity is itself a public entity. An entity that has only debt securities trading in a public market (or that has made a filing with a regulatory agency in preparation to trade only debt securities) is not a public entity. Publicly Traded Company The term Publicly Traded Company as used in Topic 220, Comprehensive Income, Topic 270, Interim Reporting, Topic 325, Investments Other, and Topic 825, Financial Instruments, is defined as follows: A publicly traded company includes any company whose securities trade in a public market on either of the following: a. A stock exchange (domestic or foreign) b. In the over-the-counter market (including securities quoted only locally or regionally), or any company that is a conduit bond obligor for conduit debt

11 11 securities that are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local or regional markets). Additionally, when a company is required to file or furnish financial statements with the SEC or makes a filing with a regulatory agency in preparation for sale of its securities in a public market it is considered a publicly traded company for this purpose. Conduit debt securities refers to certain limited-obligation revenue bonds, certificates of participation, or similar debt instruments issued by a state or local governmental entity for the express purpose of providing financing for a specific third party (the conduit bond obligor) that is not a part of the state or local government s financial reporting entity. Although conduit debt securities bear the name of the governmental entity that issues them, the governmental entity often has no obligation for such debt beyond the resources provided by a lease or loan agreement with the third party on whose behalf the securities are issued. Further, the conduit bond obligor is responsible for any future financial reporting requirements. The term Publicly Traded Company as used in Topic 932, Extractive Activities Oil and Gas, is defined as follows: A business entity that has any of the following characteristics: a. Whose securities are traded in a public market on a domestic stock exchange or in the domestic over-the-counter market (including securities quoted only locally or regionally) b. That is a conduit bond obligor for conduit debt securities that are traded in a market, including local or regional markets) c. Whose financial statements are filed with a regulatory agency in preparation for the sale of any class of securities in a domestic market. To discover how Accounting Research Manager can help you stay in compliance with recently issued standards and developments, contact your CCH Account Representative. A Closer Look was written by the Chicago-based staff of CCH s Accounting Research Manager s expert editorial team and is part of our extensive collection of unique thought leadership content. It is published with the understanding that the publisher is not engaged in rendering legal, accounting, tax, or other professional services. If legal, accounting, tax advice, or other professional assistance is required, the services of a competent professional should be sought.