Lower Valuations for Private Companies?

The CFA Institute recently released a report about investor apprehensions concerning separate accounting standards for private companies. The report reflects the results of a survey of investment professionals in the CFA Institute. The separate accounting standards include differing accounting rules for SMEs (small or medium sized entities) under IFRS and for private companies under GAAP (as advanced by the Private Company Council). On balance, while investors seem to think the initiative will reduce companies’ compliance costs, they believe the benefits are unlikely to outweigh the costs.

When asked about the impact of private company accounting standards, the results of the survey indicated the following:

• 82% believe comparability between private and public companies would be jeopardized
• 65% said the standards would result in the loss of information typically useful in financial analysis
• 73% said the new standard would generate greater complexity for investors.

The CFA Institute report noted:

“Establishing separate standards for non-public companies will add complexity and cost to other dimensions of financial reporting. For example, differential accounting standards will make it more costly for users to understand, standards setters to develop and maintain, educators to teach, and assurance providers to obtain proficiency in financial reporting.”

A specific instance of added complexity and costs would be for a private company preparing to go public, or if a public company is interested in acquiring a private company. In both of these cases, the financial statements would not be comparable and the private company would incur time and costs to translate historical financial statements to public company accounting standards.

Investors are also worried about the quality of financial statements under a private company version of GAAP.  The requirements for footnote disclosure are likely to be less rigid; specifically, less quantification in favor of more qualitative description. The majority of those polled (78%) agreed that investors would perceive private company accounting standards to be of lower quality than regular U.S. GAAP.

The study also suggests that the loss of information resulting from private company accounting standards may actually lead to lower valuations for private companies. When assessing the value of a firm, investors consider a firm’s lack of transparency in different ways, including adjusting the cash flows, discount rate, or expected growth rate. The report suggests that the loss of decision-useful information “will likely lead to an increase in risk premium and cost of capital for non-public companies.”

Will the use of alternative accounting standards actually impact private company valuations? That remains to be seen. But a lack of transparency regarding one’s investment is certainly a valid rationale for applying a bit more skepticism in valuation. We will continue to monitor the development of these standards as well as the responses from the investor and preparer community.

Related Links

• Investors Unhappy with FASB Simplification of Accounting Standards for Private Companies
• FASB Endorses GAAP Exceptions for Private Companies
• Purchase Price Allocations and the PCC
• FASB Releases Another Elective Exception to GAAP for Private Companies