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WORKING DRAFT - MAY 3, 2010

A Model Conceptual Framework for Private Company Accounting Standards

This working draft has been prepared for discussion purposes by Financial Executives International's Committee on Private Companies-Standards (CPC-S). CPC-S may make further changes to this working draft before it is finalized.

Andy Thrower, Past Chairman of CPC-S, served as the principal author of this working draft.

committee on private companies- standards

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WORKING DRAFT - MAY 3, 2010

A Model Conceptual Framework for Private Company Accounting Standards

Preface

To the Reader:

Financial Executives International (FEI) is a leading international organization of 15,000 members, including Chief Financial Officers, Controllers, Treasurers, Tax Executives and other senior financial executives from over 8,000 major companies throughout the United States and Canada. Approximately half of FEI’s members are from private companies. The Committee on Private Company Standards (CPC-S) is a technical committee of FEI which reviews and responds to research studies, statements, pronouncements, pending legislation, proposals and other documents issued by domestic and international agencies and organizations that impact private companies. This white paper represents the views of CPC-S. . Our committee is actively involved as a constituent in standard setting. Collectively, we review and publically comment on FASB and IASB exposure drafts and discussion documents. Current and former individual members of our committee have participated on various other constituent groups including the Private Company Financial Reporting Committee (PCFRC), the FASB’s Small Business Advisory Committee (SBAC), the Financial Accounting Standards Advisory Council (FASAC) , the IASB’s Small and Medium-sized Entities Working Group, the newly-formed AICPA/FAF/NASBA Blue-Ribbon Panel and various AICPA Committees. We have also worked on FASB project resource groups and we have participated in fatal flaw reviews of final FASB standards ballots.

Individual members of our committee have published and spoken on private company financial reporting issues, and have been quoted in the press on our views. Individual members have made formal presentations to the FASB’s User Advisory Group on stewardship accounting, and participated in the FAF and FASB 2008 Forum on High Quality Global Accounting Standards.

We have also available to us the resources of FEI’s Financial Executive Research Foundation (FERF) including its study on What Do Users of Private Company Financial Statements Want?

More importantly, each of our members is an experienced financial executive working directly within or on behalf of private companies. Our companies range in revenues from a few million dollars to over a billion. We are responsible for the financial affairs of our businesses including, but far from limited to, external financial statement preparation. Most of our members are also users of external financial statements of third party entities in our decision-making regarding our business relationships with these third parties.

Additionally, we are well versed in analyzing our own external financial statements, primarily in order to carefully explain to our users the contents of our statements along with the many diverse and increasingly complex financial reporting standards regarding recognition, measurement and disclosure. These users include owners, both active in and remote from our own companies, professional private company investors including venture capitalists and private equity groups and other investment companies, commercial lenders, and other users including general creditors, sureties and insurers.

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Many of our members are or have been CPAs, have a background in public accounting, and have worked in public companies preparing public financial statement fillings with the SEC including initial public offerings, and have prepared statutory filings for foreign regulatory bodies. Many of us are well versed in generally accepted accounting principles (GAAP). Some of us have been engaged in managing and operating private companies, have raised both equity and debt financing for private companies, have participated in merger and acquisition activities involving other private companies and have made investing and lending decisions regarding private companies on behalf of others. While we live in the U.S., many of us have responsibilities for the financial operations of foreign private companies, and among those many responsibilities is the financial reporting of these foreign companies.

Most of us have authority over and are responsible for engaging external auditors of our private company financial statements, including the selection, engagement, and dismissal of external auditors and for the negotiation of audit fees. Most of us would agree that we have experienced increasing costs for audited financial statements that our users tell us have decreasing usefulness to them.

As financial executives in our private companies, or as professional consultants for private companies, we each are directly responsible for assuring that our private company’s external financial statements are prepared in conformity with GAAP. Since our financial information is not regulated, our private company financial statements may just be a part of the total financial information that we provide to our users. Typically the nature of the information that we provide to our users or request from others in our own role as users is much more detailed and timelier than audited GAAP-based external financial statements. We members frequently communicate and share knowledge among ourselves that we have gained over many years on how users, including ourselves, make use of external GAAP-based financial statements. Accordingly, we are well positioned to know what our users like and do not like about external GAAP financial statements.

Based on our extensive user knowledge, we join the rising number of private company constituent voices who believe that it is now time for a separate uniform and comprehensive set of private company accounting standards in the U.S.

We noted the recent comment made by AICPA Board of Directors Chairman Robert R. Harris in the February 2010 issue of Chair’s Corner on behalf of CPA firms:

We CPAs know full well that the financial reporting needs of our private company clients or employers and their financial statement users are different from those of public companies. It’s time for accounting standards to reflect this difference.

We are those clients, and therefore, we are uniquely positioned and experienced to identify what those different needs are. Accordingly, we have prepared this document that we hope will serve as a model framework for a set of uniform and comprehensive set of private company financial standards.

Recommendation

After observing many fruitless efforts over several decades to address the needs of private company financial statement users, we believe that there is only one way to accomplish this with finality and effectiveness. We recommend the creation of an authoritative Private Company Accounting Framework (“Framework”). This Framework will guide and govern all Private Company Accounting Standards (“PCAS”). We have provided the model for this Framework.

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While we are recommending our model framework, we are not at this time commenting on who should maintain PCAS, nor are we commenting on the specific contents of either PCAS or on any existing set of private company accounting standards. However, we are recommending that an independent oversight body in the U.S. should have: (a) ownership of the Framework; (b) authority over any group of private company accounting standard setters responsible for PCAS; and (c) authority to require compliance with its Framework. For convenience, we are calling this oversight group the Private Company Accounting Foundation (“Foundation”).

Our use of the acronym PCAS in this document is a convenience for the phrase “private company accounting standards”, but it is not intended to promote a specific existing or potential set of such standards. However, we believe that the model for a conceptual framework contained in this document is an appropriate model on which any set of PCAS should be both based and governed. In our opinion, any proposed or existing private company accounting standards that lack the contents and governing force similar to this framework will ultimately be judged by users to be inadequate for their needs and, accordingly, will not be accepted by private company financial executives.

We define a private company as any legal entity organized for the purpose of making a profit that does not have any of its own debt or equity instruments trading in a public market regulated by a government, or by an agency appointed by a government to be the regulator. We leave it to others to fine tune this definition. We would also like to be clear that we are not advocating that any private company be required to use a set of private company accounting standards in lieu of GAAP. We forthrightly acknowledge that there are legitimate reasons that a private company may want to use GAAP, but those reasons are not addressed here by us.

Basis for Recommendation

We have prepared this document in this format for four reasons:

First, our long experience with standard setting has shown that the application of the concepts used by the FASB in developing GAAP have increasingly resulted in the issuance of standards focused on the needs of the public company equity investors, potential equity investors and their equity analysts. More and more, the basic underlying concepts of recognition, measurement and disclosure, and even the definitions of the elements of financial statements, are being used to incorporate forward looking, or fair value, financial information in public company financial statements. Revisions to the conceptual framework currently under consideration by the FASB and IASB continue to reflect this evolution of GAAP. Advances in academic research show the correlation between the inclusion of broader economic events and circumstances within public company financial statements and the valuations of public equity instruments. However, while we respect and support academic research, theoretical and academic views on how broader economic events and circumstances affect stock prices are not useful to the commercial banker reading our financial statements while considering lending money to our private companies.

Second, the process of setting GAAP follows a silo approach (i.e. “hot buttons” or emerging issues impacting regulated public companies are addressed as they arise). While we applaud the standard setters’ extensive efforts to reach out to private company constituents, the silo process many times results in the issuance of standards that private company constituents say interrupts a financial reporting system with changes for which many private company users say there is no demand. Indeed, some of us have received audit opinions containing multiple exceptions, not because of our misapplication of GAAP, but

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because our users request the exceptions. Some of our members do additional work for our users by taking audited GAAP private company financial statements and actually removing the impact of certain GAAP standards recognized and measured in these financial statements.

Thirdly, we believe that a proposed solution for private companies referred to as ”GAAP-Lite” is insufficient for our users in that GAAP-Lite addresses a list of perceived troublesome standards, primarily standards issued in recent years in response to public company equity investor and analyst requests. As a result, a GAAP-Lite approach leaves some remnants of these standards that originally had no relevance for a majority of private company users, and the process of the selection of which standards to include or not include in GAAP-Lite is generally a compromise because there is no underlying private company user-focused conceptual framework to provide guidance.

Fourthly, we believe that the criticism of GAAP by private company constituents has had its effect, and it is now time to put criticism of what is not liked in GAAP behind us and shift to actually putting something of substance on the table regarding what private company financial accounting standards should be in order to provide maximum decision usefulness.

Accordingly, our view is that the best way to determine the nature of accounting standards that will result in private company financial statements that satisfy users is for us first to provide a model private company framework. In our document we do this by identifying the ownership and authority of a Framework, the identity of who these private company financial statement users are, and how they use, or would like to use, private company financial statements for decision-making. We follow this by identifying (a) the twelve qualitative characteristics and the seven underlying principles of private company financial information, (b) then the definitions of the private company financial statement elements, and (c) the nature of the statements. It is not our intent to criticize GAAP in this document; our references to public entity accounting standards are only included where we believe such mention will assist the reader in comprehending the distinctions of private company accounting standards. Accordingly, we introduce references to GAAP with the phrase “by way of contrast . . .”.

Collectively, the contents of this document constitute a model for a separate conceptual framework for private companies. It is from this framework that we believe a set of private company accounting standards should be derived, or an existing set of private company accounting standards can be evaluated as to its usefulness. Accordingly, we have titled this document A Model Conceptual Framework for Private Company Accounting Standards.

In our extensive interaction with users and in our own use of private company financial statements, we were able to identify ten critical elements that, in our opinion, are desired by private company users in private company financial statements. In our opinion these critical elements were also identifiable in a careful reading of FERF’s study, What Do Private Company Financial Statement Users Want? It is our further opinion that any conceptual framework that forms the basis for the development and governance of private company financial standards should contain these ten critical elements. We have extensively incorporated these ten critical elements in developing our private company framework.

Ten Critical Elements in a Framework for Developing and Applying Private Company Accounting Standards

1) Incorporates the legal proprietary perspective of the entity, instead of the economic

perspective.

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2) Recognizes past accounting transactions only and excludes recognition of nontransaction-based economic events and circumstances under a capital maintenance view.

3) Excludes uncertainty in measuring private company financial statement elements (i.e., excludes the use of volatility, variability, and probability mathematics, and of course, efforts to re-tool the audit profession to audit these.)

4) Defines the recognition and measurement threshold as (a) a past occurrence of an accounting transaction has at least probably (i.e., more likely than not) occurred and (b) the transaction can be at a minimum reasonably estimated.

5) Focuses financial statements on operational performance ( i.e., the income statement) to reflect the operating activities by function that occurred in the period being reported on, and not on placing primarily focus on creating balance sheet amounts consisting of the present value of future cash flows ( i.e., a forecast), and the measurement of changes in those present values by nature.

6) Incorporates the matching principle – the recognition of expenses based on their association with revenues in the statement of operational performance.

7) Incorporates the needs of lenders for compliance with lender covenants, particularly cash flow coverage ratios indicating ability to service debt loads (i.e. lenders can find and understand EBITDA).

8) Incorporates the needs of owners for accountability of management for its use of actual invested capital by the owners (stewardship).

9) Uses a consistent measurement attribute -- the historical exchange rate of actual transactions (acquisition cost or historical cost) and retains the attribute in subsequent financial reports.

10) Contains constraints on application of standards, such as conservatism (in lieu of actual recurring testing of impairment), pragmatism, auditability of underlying transactions, user understandability, etc.

We do not intend to cover every conceivable concept for external private company financial reporting in this model framework, nor do we think it is necessary. We call attention to the fact that certain concepts are embedded in the accounting process by custom and tradition and need no further explanation. We also call attention to the constraints imposed by our model framework on excessive accounting standards development in an attempt to please all constituents by developing a “one size fits all” set of accounting standards.

We call attention to the definitions of accounting terms. Over time as GAAP has developed, the definitions of accounting terms used in GAAP have also changed, and will continue to change as the FASB and IASB make substantial changes in meaning to some basic terms in their proposed joint conceptual framework in order to accommodate the views of public company equity investors and analysts. There is a danger of financial statement users and even PCAS standard setters unknowingly miscommunicating with each other because of differing definitions of terms. For example, something as basic as the word asset, as proposed in the FASB/IASB new conceptual framework will have an entirely different meaning than its meaning to private company financial statement users. This is one of the primary reasons we believe that in order to have a separate uniform and comprehensive set of

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accounting standards for private companies, we must first have a separate and carefully constructed Framework. Accordingly, we have been careful to define accounting terms as we believe they traditionally and historically have been used by private company financial statement users. To assist the reader, we have added a Glossary of Private Company Accounting Terms. Terms defined in the glossary appear in bold print in their initial occurrence in the text of our document.

Our members also believe that there can be a level of finality in a set of private company accounting standards and that the development of accounting standards is not an ongoing evolutionary process. We also continue to believe and support the application of the common law to a set of private company accounting standards. Specifically, we believe that the application of a reasonable person test outweighs the usefulness of creating uniform and myriad rules designed in an attempt to create comparability of financial information for which there is limited demand for such comparability from private company users.

We also believe that a set of uniform and comprehensive private company accounting standards based on our proposed model framework will remove one of the many excessive and growing regulatory burdens on private companies. Large numbers of private companies currently resist the excessive cost of preparing a set of audited GAAP external financial statements. This resistance is growing. A more relevant set of private company accounting standards will result in a larger number of private companies in the U.S. being able to issue an affordable set of quality audited financial statements with the accompanying benefits to their owners and lenders.

While we are not recommending at this time a detailed structure of the private company standard setting process, we do recommend that the Foundation oversees an independent private company standard setter. However, more specifically and different from other standard-setting arrangements, we are calling for an authoritative Framework that once developed cannot be amended directly by a standard setter without authorization of the Foundation. We would also like to see the Foundation have a review and appeal process for proposed private company accounting standards that do not align with an authoritative Framework.

Our committee at this time does not express any opinion on the nature of non-profit entity financial reporting standards.

Finally, the members of CPC-S want to reiterate our longstanding support for the continuing independence of the FASB and IASB in their mission of providing transparent financial reporting for public and regulated entities. We believe that separation of private company accounting standards can only enhance the work of the FASB and IASB in providing high quality financial information for the public equity markets.

Our committee is willing to engage in dialogue with and provide further assistance to any independent organization in further efforts to provide and improve decision-useful financial information to users of private company financial statements.

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A Model Conceptual Framework for Private Company Accounting Standards

Table of Contents

INTRODUCTION ....................................................................................................................... 1

Authority of a Framework........................................................................................................ 1

Government by a Framework ................................................................................................. 1

Proprietary Nature of a Framework ......................................................................................... 1

THE SCOPE OF A CONCEPTUAL FRAMEWORK FOR PRIVATE COMPANY ACCOUNTING STANDARDS ............................................................................................................................ 2

THE PURPOSE OF A CONCEPTUAL FRAMEWORK FOR PRIVATE COMPANY ACCOUNTING STANDARDS ................................................................................................... 2

THE IDENTIFICATION OF PRIVATE COMPANY FINANCIAL STATEMENT USERS AND HOW PRIVATE COMPANY FINANCIAL STATEMENTS ARE USED ...................................... 3

Existing Private Company Owners ......................................................................................... 4

Potential Private Company Owners ........................................................................................ 7

Existing and Potential Bank and Other Commercial Lenders .................................................. 8

Asset-based Lending .......................................................................................................... 9

Lenders Seeking Personal Guaranties ................................................................................ 9

Disclosure to Lenders of Significant Events and Circumstances ........................................10

Other Users ...........................................................................................................................10

The Use of Private Company Financial Statements to Provide Periodic Assurance...............11

Private Company Financial Statements Prepared Under a Uniform and Comprehensive Set of Private Company Accounting Standards Compared to OCBOA ............................................11

The Limitations of the Use of Private Company Financial Statements ...................................13

THE OBJECTIVE OF PRIVATE COMPANY FINANCIAL STATEMENTS ...............................13

THE REPORTING UNIT TO WHICH PRIVATE COMPANY FINANCIAL STATEMENTS APPLY .................................................................................................................................................15

THE QUALITATIVE CHARACTERISTICS OF FINANCIAL INFORMATION CONTAINED IN PRIVATE COMPANY FINANCIAL STATEMENTS ..................................................................16

Relevance .............................................................................................................................17

Representational Faithfulness ...............................................................................................18

Relationship of Relevance and Representational Faithfulness ...........................................19

Constraining and Modifying Qualitative Characteristics .........................................................19

Principles-based Accounting ..............................................................................................20

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Pragmatism ........................................................................................................................21

Understandability and Simplicity ........................................................................................21

Materiality ..........................................................................................................................22

Cost Versus Benefit ...........................................................................................................22

Going Concern Concept .....................................................................................................22

Conservatism .....................................................................................................................22

Continuity ...........................................................................................................................23

Management’s Intention .....................................................................................................23

Mathematical Auditability ...................................................................................................23

Additional Considerations in the Qualitative Characteristics ..................................................25

THE SEVEN UNDERLYING PRINCIPLES THAT DETERMINE THE DISPLAY OF INFORMATION IN PRIVATE COMPANY FINANCIAL STATEMENTS ....................................25

The Realization Principle .......................................................................................................26

The Monetary Unit Principle ..................................................................................................27

The Recognition Principle ......................................................................................................27

Comparison of the Operational Activities View to the Capital Maintenance View in Recognition ........................................................................................................................30

The Measurement Principle ...................................................................................................31

Measurements of Contracts ...............................................................................................32

Comparison of Recognition and Measurement between Private Companies and Public Entities ..................................................................................................................................33

The Disclosure Principle ........................................................................................................34

Summary of Recognition, Measurement and Disclosure in Private Companies Versus Public Companies ..............................................................................................................35

The Matching Principle ..........................................................................................................35

The Time Period Principle .....................................................................................................36

THE ELEMENTS OF PRIVATE COMPANY FINANCIAL STATEMENTS ................................36

Assets ...................................................................................................................................36

Assets are Measurable and Probable ................................................................................38

The Measurement of Assets ..............................................................................................38

Cash Equivalents ...............................................................................................................39

Contrast of Private Company Assets Concepts with Public Entity Assets Concepts ...........40

Liabilities ...............................................................................................................................41

Liabilities are Measurable and Probable ............................................................................42

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The Measurement of Liabilities ..........................................................................................43

Contrast of Private Company Liabilities Concepts with Public Entity Liabilities Concepts ...43

Owners’ Equity ......................................................................................................................44

The Nature of Owners' Equity ............................................................................................44

The Recognition and Measurement of Owners’ Equity .......................................................46

Revenues ..............................................................................................................................46

The Nature of Revenues ....................................................................................................46

The Recognition of Revenues ............................................................................................47

The Measurement of Revenues .........................................................................................48

Contrast of Private Company Concepts of Revenues with Public Entity Concepts of Revenues...........................................................................................................................48

Expenses ..............................................................................................................................49

The Nature of Expenses ....................................................................................................49

The Recognition of Expenses ............................................................................................50

The Measurement of Expenses .........................................................................................51

Gains .....................................................................................................................................51

The Nature of Gains ...........................................................................................................51

The Recognition and Measurement of Gains .....................................................................52

Losses ...................................................................................................................................52

The Nature of Losses .........................................................................................................52

The Recognition and Measurement of Losses ...................................................................53

THE PRESENTATION OF PRIVATE COMPANY FINANCIAL STATEMENTS ........................53

Statement of Operational Performance ..................................................................................54

Statement of Financial Position .............................................................................................54

Statement of Owners’ Equity .................................................................................................55

Statement of Cash Flows.......................................................................................................55

The Notes to the Private Company Financial Statements ......................................................56

Glossary of Private Company Accounting Terms .............................................................. G-1

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INTRODUCTION

A conceptual framework for private company accounting standards (“Framework”) should be the property of a private company accounting foundation (“Foundation”) and should only be amended by the procedures contained in the Foundation’s by-laws. The Framework should provide the basis for the development and use of a set of uniform and comprehensive private company accounting standards (PCAS) used in preparing private company external-use financial statements. The Framework should have both authority over and government of all PCAS. Additionally, the Framework and PCAS should be considered, as a unit, proprietary. The definitions of Authority, Government, and Proprietary follow.

Authority of a Framework

The Framework and PCAS together should constitute the one and only hierarchy of accounting standards applicable to private company financial statements prepared under PCAS. Only the standard-setting board authorized by the Foundation should issue standards that constitute the official body of PCAS.

Government by a Framework

The Framework should require all private company accounting standards issued by the designated standard-setting body to conform to the contents of the Framework. Accordingly, PCAS issued by the designated standard setting body should require approval of the Foundation. The Foundation by-laws should require the Foundation in its oversight role to determine whether issued PCAS are in accordance with the Framework. Specifically, any standard determined not to be in accordance with the Framework should be declared non-binding by the Foundation. In addition the Framework should prescribe the development and application of PCAS under a principles-based methodology and not a rules-based methodology. External rules developed by other parties with the intent of applying, interpreting or modifying the application of the contents of the Framework and PCAS should not be a part of the Framework or PCAS. The Framework and PCAS should be a complete and intact set of accounting standards for private company financial statements.

Proprietary Nature of a Framework

The system of accounting standards known as PCAS, along with the Framework, should constitute in total a single unit that is proprietary to the Foundation. Individual standards and applications that are contained within the PCAS should not by themselves be proprietary. They may be, and in many circumstances will be, generically used, and may also be incorporated as part of other systems of accounting standards issued by other standard-setting bodies. The Foundation should grant both the use of PCAS for the preparation of private company financial statements, and the right to make representations that those private company financial statements are prepared in accordance with PCAS, but only for use as a single, intact unit. The Foundation should prohibit use of any written or verbal reference to PCAS or the Framework in accompaniment to financial statements if not used in the preparation of those financial statements as a complete and single unit; except, the Foundation should grant the use if departures from any component to PCAS are indicated in a writing that accompanies any distribution of financial statements purporting to be prepared under PCAS. In no circumstances should any set of financial statements reference PCAS if it also contains standardized financial reporting rules imposed by any other party including trade organizations, professional associations, other standard

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setting organizations, or external accounting firms engaged to compile, review or audit these financial statements. However, this should not prohibit voluntary disclosures.

THE SCOPE OF A CONCEPTUAL FRAMEWORK FOR PRIVATE COMPANY ACCOUNTING STANDARDS

The Framework and PCAS should be designed for entities, referred to throughout this document as private companies, whose financial statements are not regulated by a government or agency designated by a government, nor have issued public exchange ownership or debt instruments, including those entities that do not currently intend to : (a) become subject to such regulation; (b) issue public exchange ownership or debt instruments; or (c) be acquired or controlled by entities that are required to use another set of accounting or financial reporting standards than PCAS. The determination of which private companies actually use PCAS, or may be compelled to use PCAS, should be outside of the scope of the Framework. Nothing in the Framework should compel any private company to use PCAS, nor prevent a private company, however defined, from adopting another set of accounting standards. While the scope of application to private companies should not be determined in the Framework, the Framework should require that any private company that purports to use PCAS and identifies either verbally or in writing that it has used PCAS in preparing a set of financial statements, must apply all the standards contained in PCAS.

THE PURPOSE OF A CONCEPTUAL FRAMEWORK FOR PRIVATE COMPANY ACCOUNTING STANDARDS

The purpose of the Framework should be to provide authority and governance to the development and use of PCAS. The purpose of PCAS is to provide certain specified financial information, namely organized financial statements, to those who use private company financial information (“users”), in a manner that meets their needs. Unlike users of financial information of regulated and public entities, private company users obtain financial information in a variety of ways. Private company financial statements are one component of the varied financial information obtainable from private companies.

By contrast, one of the concepts impacting the establishment of financial reporting standards for regulated and public entity financial reporting is to provide financial information to external users who lack the authority to compel information they want. Standards for these regulated and public entities attempt to obtain information from these entities that private company users are usually able to obtain in a manner other than, or in addition to, their private company financial statements. Accordingly, the scope and amount of information needed in financial statements is narrower for private company users than for regulated and public company users. In addition, in general the nature of private company users is different than the nature of regulated and public entity financial statement users. In order to achieve the purpose of the Framework and PCAS, the private company financial statement users and their needs must be identified.

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THE IDENTIFICATION OF PRIVATE COMPANY FINANCIAL STATEMENT USERS AND HOW PRIVATE COMPANY FINANCIAL STATEMENTS ARE USED

Private company financial statements are a part of the financial information made available to or obtainable by interested parties external to private companies, referred to as users, for the purpose of making financial decisions. Unlike regulated and public entities, releases of financial information by private companies are not specified by public law, particularly with regard to forward-looking information.

Private company financial statements are prepared to meet the needs of users of the financial statements, and the needs of the private company. They may be prepared in accordance with: (1) the FASB Accounting Standards Codification established by the Financial Accounting Standards Board (“FASB”) in the U.S. (“GAAP”); or (2) International Financial Reporting Standards and International Financial Reporting Standards for Small and Medium-sized Entities established by the International Accounting Standards Board (“IASB”); or (3) an Other Comprehensive Basis of Accounting (“OCBOA”), explained further later in this paper. In addition to the private company financial statements, there may be other separate releases of financial information to users, either formally or informally. This other private company financial information may consist of some or all the following:

• Detail of asset-based loan collateral. Examples include accounts receivable detail by customer and age, inventory detail by component and turns, cash balances, detail of capital expenditures, and detail of appraised values of fixed assets and other assets.

• Detail of liabilities. Examples include accounts payable detail by vendor and age, detail of leases, detail of payroll obligations, and detail of other obligations.

• Details of owners’ equity. Examples include a detailed listing of equity ownership, and agreements or plans for dilution, succession, or redemption of ownership.

• Income tax returns.

• Monthly internally prepared operating results and performance metrics.

• Updated forecasts, projections, budgets and other forward-looking information. These may take different forms and may be prepared on the same accounting standards as external financial statements, or may instead be cash based, may only be focused on future operating results, and may have unit of accountability (i.e., cost center, department, division, etc.). Start-up or newer private companies seeking initial capital may be asked to provide a formal business plan.

• Various financial, operational and contractual data as requested by users. Examples include such items as financial details of contracts, schedules of construction in progress, financial guarantees, insurance arrangements, owners’ personal financial information, owners’ personal guarantees, financial information of related companies, detail of lawsuits, environmental information, employment agreements, deferred compensation plans, retirement and post employment plans, share-based payment plans affecting dilution or alteration of existing ownership, and financial information required to support a private company financial statement user’s due diligence process.

Some of the above information may also be prepared and presented to external users in graphical format. In addition, actual contents of the private company financial statements are frequently reformatted by

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private companies at external users’ requests to provide metrics to satisfy user needs. Examples of reformatting of private company financial statements include presentation of covenant ratios, presentation of revenue and expense per unit of product, supplemental schedules of non-cash expenses, supplemental schedules of non-recurring financial transactions, extended disclosures such as details of cost of goods manufactured and sold, presentation of EBITDA with normalization for nonrecurring items or removal of owners’ compensation, presentation of economic value added (EVA), and graphical displays.

The nature and volume of financial information released by a private company depends on many variables, including the financial strength of the private company, the type and amount of external capital, the private company and the private company’s industry risk factors, the capital provider’s financial strength and risk profile, the regulatory requirements imposed on the capital provider, the competitiveness of capital providers, and the general condition of the economy. Occasionally, based on these variables, a user may ask for only a minimum of additional information beyond periodic private company financial statements. Private company financial statements provide structured and consistently prepared financial information to users.

The specific users and uses of private company financial statements follow.

Existing Private Company Owners

Existing owners not active in a private company’s operations use private company financial statements to hold management accountable for the use of the owners’ resources in causing the company to achieve operational performance. This accountability, also called stewardship, includes enabling owners to see, on a periodic basis, whether or not the management of the private company has achieved the owners’ personal goals for the company. These goals, under a going concern concept, are primarily two-fold:

1) To determine if the historical cash flow generated by the private company’s operations is in

accordance with the owners’ desire. This is frequently referred to as operational performance. 2) To determine if the historical cash flow generated by the private company’s operations is

sufficient to provide the owner(s) with the personal goal of building wealth. This is frequently referred to as a return on investment.

These primary goals – indicators of operational performance and return on investment - would also encompass using the private company financial statements to show owners how much cash profit there is to pay out in dividends to shareholders. These goals also incorporate the principle of determining the stewardship of the non-owner managers to the owners, and include the determination of the managers’ compensation. These two goals may or may not be related. Some owners of private companies may view as most important cash flow in the form of distributions in order to have cash available for personal use within a period of time, exceeding even the importance of building personal wealth. To these owners, valuation of net assets and returns on invested capital may have no importance. Additionally, for both goals the owners use private company financial statements based on past or historical operating results of the company. This is because private company owners usually have access to additional, broader and more meaningful information for other purposes such as predicting the future. While the owners may and do use historical financial statements as a basis to project the future – not only to mathematically predict

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future cash flows, but to set future expectations of management performance -- the owners usually have the ability to compel forward-looking financial information from the company’s management in addition to the private company financial statements.

Unlike public and regulated entities, in private companies the distinction between owners who participate in management and owners who do not participate in management may be narrow. External private company owners have the choice of directing the operations of the company through a board of directors or not, and have the choice of how much authority to give to a board, if any. Within private family-owned businesses and private closely-held businesses with detached ownership, both the equity structures and the narrow distribution of ownership allow certain family members, or a small and close group of owners, to either maintain control of the private company or amass control of the private company. These ownership structures are frequently able to determine the “voice" of the ownership in private entities. Under federal law, private companies are not subject to providing financial statements to the public. Privacy laws apply to the distribution of private company financial statements, but securities laws do not. The rights of minority interests to obtain private company financial statements prepared under a uniform set of accounting standards such as GAAP are determined contractually. Several states have laws that give minority interests the rights to receive financial statements.

The two goals, (1) operational performance and (2) return on investment, of private company owners also impact the behavior of the private company’s CEO and executive management. Under the stewardship concept, the owners look to the CEO to execute the operations necessary to achieve whatever mix of the two goals that the owners desire. There is no uniform “rule” for a private company CEO to follow. For example, the owners of one private company in a particular industry may desire to maximize the current year’s cash distribution, while owners in a similar company in the same industry may desire to maximize the equity value of the company. Competition occurs, but it may not be based on who can create the most equity value. A private company CEO very likely will never see a competitor’s financial statements.

This variation in the goals of individual private company owners, in turn, determines the nature of the financial information that these owners desire from the private company in order to hold the CEO accountable. While reporting externally, the private company CEO looks internally to his staff in guiding them to achieve the mix of goals (1) and (2). By way of contrast, the public entity CEO, as directed by the entity’s board may first look outwardly to potential investors and analysts to ascertain what creates enhanced equity value for the public entity, and then look inwardly to guide his staff in creating that equity value. For example, all public entity CEOs within a specific industry may have a “rule” imposed on them by equity analysts seeking to find the particular company within that industry that has the most potential to maximize common stockholder equity value.

The financial reporting of value creation by the public entity focuses external financial reporting on estimating the future cash flows (and resulting fair value) created in the current reporting period by the CEO’s activity. Both the public entity’s financial reports and the private company’s financial statements may be “right” from the perspective of relevance to their respective users; however, a single financial reporting framework that combines or compromises what is reported may be less useful to both the public entity and private company users.

Regardless of whether owners give higher weight to goal (1) or goal (2), most owners are interested in understanding the results of their private company’s operational performance during a reporting period and how much cash flow was generated by this operational performance. There is a trade-off between reporting a totally pure amount of cash flow from operations (i.e., subtracting the actual cash expended during the period on operations from the actual cash generated in the period by operations) and reporting operational performance results that may have been achieved not only by the current period’s actual cash

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flow, but by past cash flows and committed future cash flows. The net income reported on the statement of operational performance typically balances these goals by including accruals and deferrals.

Many private company owners also prefer a second measurement of operational performance, EBITDA, that isolates from the reported net income certain non-cash items allocated under the matching principle that are a portion of separate one-time cash expenditures for tangible and intangible long term assets and liabilities (i.e., depreciation and amortization). In addition, these owners would isolate from the reported net income any non-cash gains and losses resulting from certain non-transaction revaluations and other events. Furthermore, these owners desire that this second measurement exclude the costs of financing the operations and exclude the amount of income tax assessable on the operational performance. EBITDA retains the balance between pure cash flow from operations and measuring operational performance, but by isolating certain components of net income, EBITDA serves a very useful proxy for cash generated by the operational performance of a private company. As a result, many private company users view EBITDA as a key, or the key, measure of the statement of operational performance.

Owners may also consist of professional investors. These may be institutional investors (e.g., venture capitalists and private equity groups) or non-institutional investors (e.g., individual or angel investors). Professional investors usually seek to achieve a return on their invested capital at pre-determined targeted levels. These targeted levels of return incorporate the amount of capital invested, the periodic rate of return on the investment, and the final realization of the investment (exit value) at a planned future date. External private company financial statements prepared under an accepted set of accounting standards may be used in evaluating the initial acquisition price, annual return on investment, and exit price.

The statement of operational performance (the income statement), contained in external private company financial statements, is frequently used as a basis for determining EBITDA (or other similar measures) which in turn is used to calculate the periodic return on investment. However, EBITDA as determined from private company financial statements is frequently adjusted by the impact of certain transactions, in order to provide, in the judgment of the private company investor, a better representation of the return on investment achieved from the company’s normal operations. While a statement of operational performance may be a starting point, these investors will have access to the private company’s internal records and may either use the records to adjust the statement of operational performance, or alternatively, use the company’s internal records in order to construct an EBITDA number in accordance with their own investment metrics and on a more timely basis.

A professional private investor rarely makes a decision to invest in a private company -- including buy, sell and hold decisions -- based predominantly on external private company financial statements. Instead, the private company investors have the ability to perform, or have performed on their behalf, needed “due diligence” and ongoing monitoring of a private company’s operating results and use of invested capital.

Some professional investors take minority equity interests in both private companies and public companies and hold these companies in the same portfolio and may even compare the financial statements of these companies. Depending on the nature of the minority interest, the question may arise as to whether the private company should use private company accounting standards or the generally accepted accounting principles (GAAP) used by public companies. Ultimately, regardless of any private company user demands, the selection is determined by the majority vote of the owners unless there is an intervening statute or regulation. In these circumstances, nothing in the scope of private company accounting standards should require or prevent the selection by a private company of using either private company accounting standards or GAAP.

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This stewardship view of private company financial statements also leads to a view that all financial activity during a reporting period and the financial position at the start and end of a reporting period is presented from the existing owners’ perspective and not from the perspective of non-owners who may have an interest in becoming owners. Private company owners typically hold their ownership interests for a significant period of time; they also generally know and interact with each other, as well as with the management of their own companies. Presenting the financial statements from the view of these existing owners is referred to as the legal proprietary perspective. By way of contrast, investors in public companies, particularly large public companies, are widely dispersed and frequently acquire and sell (i.e. “turn”) their investments in public companies. The public company common equity investor and potential common equity investor may not have a relationship with lenders, other investors, or even management, and in many cases do not desire to have a relationship. Accordingly, the public company investor and potential investor view the entity as an economic unit distinct from management and its other individual owners, and they are more focused on how to value the entity. This public entity perspective is called the economic perspective of the entity.

Potential Private Company Owners

While the structure of private company accounting standards focuses on the needs of existing owners, potential owners of private companies use financial information generally in the same manner as existing private company owners. Potential owners may intend to keep the existing management of the private company intact. Accordingly, potential owners may be interested in the past stewardship of the existing management and may use current or prior financial statements to evaluate existing management’s use of capital. The two goals above, (1) operational performance and (2) return on investment, of existing private company users are not incompatible with potential owners. Like existing private company owners, potential owners may place different weight on these two goals. By way of contrast, while public entities do acquire private companies, private company accounting standards should not be designed to be solely relied upon by potential public entity equity investors and their representatives. This is because potential private company investors can call upon the private company to make disclosures of desired information directly to them. The potential investor in a public entity may do identical analysis as a potential investor in a private company; however, for public entities the nature of the potential investor, the intention of the potential investor, and the marketability of a company’s equity impacts a decision to buy, sell or hold an equity share in a public entity. Additionally, the starting point for preparing financial analysis is different for a potential owner in a private company because a private company has not had its financial disclosures subject to regulations, and by its nature the distribution of its financial information is highly restricted and proprietary. That information is likely to remain confidential since virtually all investments in private companies are accompanied by an extensive due diligence process and not by reference to financial information available in the public domain. This is not normally the case for public entity ownership interests, typically shares of common stock, traded in public markets where it is the role of a government securities regulator to ensure that a carefully defined set of financial disclosures, and no others, are made available on an equal footing at the same time to all potential investors. Furthermore, the public company investor has to place greater reliance on general purpose external financial reports due to the nature of public company markets, regulation, and legal restrictions on forward-looking financial information. A private company might desire to position itself to be acquired by a public entity. The scope of private company accounting standards should not prohibit a private company from selecting and using another comprehensive set of financial reporting standards in order to facilitate such an acquisition.

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Existing and Potential Bank and Other Commercial Lenders

Existing and potential bank and other commercial lenders (“lenders”) use private company financial statements, along with other available, obtainable financial information, to determine the amount and terms of loans to private companies. Lenders use private company financial statements, along with other available financial information, to determine if the private company has complied with, or is capable of complying with, existing or proposed loan covenants and other loan terms during the reported period and the margin over (or under) compliance requirements. Collectively these uses of private company financial statements are referred to as determining and monitoring a private company’s liquidity. Loan covenants and other loan terms are based primarily on operational performance, cash flow or representations of cash flow, and invested costs in assets in relationship to committed costs of debt (referred to as asset-to-liability ratios), and committed costs of debt in relationship to owner invested capital (referred to as debt-to-equity ratios). The source of this data is contained in the historical operational performance in the period covered by the private company financial statements and the financial position on the reporting date. Included in measuring performance is the use of the statement of operational performance (the income statement) to determine EBITDA. Just like private company owners, lenders often view EBITDA as a proxy for cash generated by a private company’s operations. In many cases, the importance of EBITDA is likely to be equal to or greater than the importance of net income. Implicit in the lenders’ use of the above financial information is an evaluation of the private company’s ability to remain a going concern and its ability to repay its debt. Lenders may use information contained in the private company financial statements, along with financial history derived on other companies contained in commercially available databases, to predict the probability of a private company filing for bankruptcy protection. The Altman Z score is an example of one such probability calculation. The concept of stewardship also applies to existing lenders in that measurement of financial performance in the private company financial statements assists lenders in holding both management and owners accountable for achieving contractual loan terms including covenants, and to evaluate management’s achievement of, or progress toward achieving, previously submitted financial projections in financial statement format. The amount of credit extended by a lender to a private company is based on, among other factors, the level and nature of the owners’ equity, more specifically, the owners’ contributed capital in the private company and the deployment of that capital and the resulting operational performance and cash flows disclosed in the financial statements. Lenders, while not indifferent to external economic events and circumstances impacting the private company, prefer the recognition and measurement of the effect of these activities be separated from the results of deployment of capital. This enables the lender to have confidence that liquidity ratio calculations (e.g., asset-to-liability and debt-to-equity ratios) contain values originated and maintained at their historical exchange rate and not distorted by non-cash, non-transaction valuation changes. Accordingly, lenders prefer the measurement of the elements of private company financial statements to be based on actual input values observed in transactions (usually referred to acquisition cost or historical cost) as the capital is deployed. The stewardship concept also impacts how the lender views the operations of a private company in its relationship with its owners. Ownership changes in private companies occur infrequently and the ownership interest is usually not widely dispersed. Accordingly, the financial strength of the owners and their personal character also impact the willingness of a lender to lend to a private company as well as the amounts and terms of loans. Even though the private company may be a separate legal entity, the lender may view the private company as an extension of the owners’ financial strength and personal character. Under the stewardship concept, private company financial statements are used by a lender to

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determine if the owners have kept, during the period reported, commitments given to the lender not just in a legal contract, but both verbally and in the owners’ personal conduct of the relationship with the lender. This view is consistent with the legal proprietary perspective of the entity.

Asset-based Lending

While there are large private companies that obtain unsecured debt and make private placements of debt, the majority of lenders to private companies, particularly to smaller private companies, are asset-based lenders. These lenders frequently supplement the private company financial statements with additional information prepared and obtained outside of the financial statements. In some cases this information is more detailed, and may be independently appraised and audited at the direction of the lender and is obtained by the lender on a much more timely and frequent basis than a set of private company financial statements prepared according to a uniform set of accounting standards. The most common example of supplemental information is a liquidation value appraisal of an entity’s tangible assets prepared by an independent appraiser for an asset-based lender. Asset-based lenders may also require private companies under “borrowing base agreements” to provide specific detail of its current assets and liabilities (i.e., working capital) in a more timely fashion and in more detail than periodic external-use private company financial statements. Asset-based lenders also focus on both the potential shortfall in cash that may occur in a private company’s’ operations and on the potential shortfall in liquidation values of private company’s assets. As a result, private companies are often conservative in the assumptions used, in that a conservative approach would favor understating (vs. overstating) asset amounts disclosed on a private company’s statement of financial position, and favor overstating (vs. understating) expenses on a private company’s statement of operational performance. This concept has traditionally been referred to as conservatism. Additionally, asset-based lenders typically over-collateralize both the private company financial statement’s working capital and the externally appraised real estate and tangible property values. An asset-based lender is likely to secure 100% of the liquidation value of the collateral and base the loan on a lesser percentage of this liquidation value. These lenders are not looking for fair value, because in a liquidation, they receive liquidation value, not fair value. Accordingly, the use of fair value measurements and subsequent re-measurements of fair value of collateralized items contained in private company financial statements are less important than applying conservatism to historically reported amounts in order to prevent the lendable percentage of liquidation values from being below, or falling and remaining below, related outstanding loan amounts. Finally, while asset-based lenders do find usefulness in private company financial statement disclosures of long-term intangible assets, and may lend against such intangibles in larger private companies, a bias is placed on disclosure of long-term tangible assets over long-term intangible assets since a liquidation value of a tangible asset is both more measurable and more likely to have a market in the case of a forced liquidation.

Lenders Seeking Personal Guaranties

Existing and potential bank and other commercial lenders may also seek guarantees of private company loans from owners and other entities with related ownership and may or may not request separate financial statements from these sources as a condition of making or maintaining a loan to the private company. However, the separation of the private company’s financial statements from financial statements of related entities is generally preferred by lenders in order to evaluate the operational

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performance and coverage ratios of the private company separately from any guarantors. This separation is also consistent with the knowledge that lenders have of owners and management and is consistent with the legal proprietary perspective of the entity. Disclosure of an entity (or entities) related to the private company is important to the lender. However, automatic financial statement consolidation based solely on a definition of “control”, or even based on majority legal ownership, can create less useful information about a private company to a lender, particularly where the nature of the operations of the related entity is different than that of the private company. By way of contrast, public company investors may have an interest in a public company consolidating all related entities that have an economic impact on the entity’s fair value.

Disclosure to Lenders of Significant Events and Circumstances

Finally, lending agreements may also require private companies to provide separate and more timely notification to lenders of events and circumstances that may impact a private company’s financial condition or its ability to comply with lending terms and covenants (sometimes referred to as material adverse events), but are not probable (i.e., more likely than not) of occurring nor capable of being reasonably estimated, and therefore are not recognized and measured in financial statements prepared under private company accounting standards. Lenders are aware that there are always risks of varying degrees and undeterminable sources to a private company but have expressed a preference that private company financial statements not incorporate present values of estimated future cash flows for every potential risk that may affect the economic or fair value of the private company, in contrast to those major events that will likely affect liquidity.

Other Users

Entities and individuals, other than existing and potential owners, and existing and potential bank and commercial lenders, may need financial information from a private company in order to establish and monitor a financial or operational relationship with a private company. These financial and operational relationships may be that of a supplier to or customer of a private company. The parties to such relationships may also be that of an insurer or guarantor of a private company, or may be agencies of governments who issue grants, tax credits or other benefits to private companies. The information contained in private company financial statements may be used as follows:

• To underpin and monitor compliance with contractual arrangements

• To determine general creditworthiness or viability

• To determine the amount of credit to extend

• To provide a basis for governments to issue grants and tax credits

• To assist in determining the amount of insurance coverage and level of risk

• To determine the amount and terms of obligations to be guaranteed

Typically, these users are not the primary reason that private companies prepare a set of external-use financial statements under a set of established accounting principles. In most cases these users may accept other available financial information from a private company when external-use financial

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statements prepared under an established set of accounting standards do not exist. Accordingly, these users are referred to as secondary users. Two of the desired constraining qualitative characteristics of private company accounting standards, pragmatism and simplicity, point to a need to avoid creating a set of accounting standards that, over time, drift into an attempt to become “one size fits all” with the result of adding too much information or too much complexity to private company financial statements.

The Use of Private Company Financial Statements to Provide Periodic Assurance

Private company financial statement users look to the consistent application of a set of accounting standards as a means of assurance that all other financial information received and relied upon is free from material error from period to period. Private company users are interested in consistency in reporting operating results of a company from period to period. Many private companies that provide external-use financial statements prepared according to a set of accounting standards do so only once a year. These annual financial statements are often delivered to the user many months after the end of the reporting year. While in the regulated or public entity environment, such a lag in reporting is prohibited by laws or regulations and would cause the statements to be viewed by users as “stale”, this is not the case with many private company financial statement users. Private company users generally accept and rely on interim (monthly or quarterly) statements prepared from the books and records of the private company, based solely on recorded accounting transactions in the underlying accounting systems, without necessarily having a full set of accounting standards applied, particularly in regards to disclosures. A uniform set of accounting standards used in preparing private company financial statements once a year, and externally audited or reviewed, increases the users’ confidence that the likelihood of a material error in a given period’s financial statements, including interim statements, is reduced. This practical observation of the widespread acceptance of the length of time allowed by users for the delivery of annual audited or reviewed private company financial statements prepared in accordance with a set of accounting standards leads to the view that many private company users look at a set of annual audited or reviewed private company financial statements as a “truing-up” of the historical earnings and financial condition of the company. Since these users have a greater access to different types of financial information above and beyond annual private company financial statements, the usefulness of having consistency in annual financial statements extends far beyond the statements themselves.

Private Company Financial Statements Prepared Under a Uniform and Comprehensive Set of Private Company Accounting Standards Compared to OCBOA

Historically, many private companies have issued external-use financial statements prepared, and frequently audited or reviewed, according to the comprehensive set of general purpose financial reporting standards used by public company investors and analysts (i.e., GAAP). However, many other private companies have issued financial information to their users prepared under some other basis of accounting. Examples of these other types or bases of preparing private company financial information include:

• Income tax returns.

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• Cash-basis financial information prepared from the cash receipts and disbursement records of a private company.

• Basic financial statements (typically a balance sheet and an income statement) prepared directly from the underlying double-entry accounting system which usually includes some accruals.

• Form-based financial information required by statue or by individual user-based requirements.

• FDIC call reports for private company banks.

Collectively, these methods of preparing and providing information to private company users are called OCBOA, or Other Comprehensive Bases of Accounting. However, OCBOA is an informally used term and is in no way “comprehensive” in the same sense as GAAP nor in the same sense as a uniform and comprehensive set of private company accounting standards. OCBOA financial information is prepared by private companies for several reasons including:

• The cost of preparing GAAP statements – including the costs of external review or audit – is too high relative to the perceived benefits.

• Private company financial statements prepared under GAAP may not be perceived as relevant to the user’s needs, or may be viewed as containing some information that is a hindrance to the user’s needs (e.g., the determination and use of EBITDA as a cash proxy).

• The size of and simplicity of operations of a private company may not warrant the need for much financial information.

• There may be simply no demand for GAAP statements by the private company user.

On the other hand, many private company users find OCBOA financial information to be inadequate for their needs. Among these users concerns about OCBOA information are:

• Critical financial information needed for decision-making may be left out.

• A private company may not consistently apply OCBOA from period to period.

• A lack of, or a less comfortable level of, external assurance regarding the reliability of the information being free of a material error.

• Incompatibility when comparing OCBOA information to other private companies’ financial information and to benchmarks.

• There is no meaningful definition of some types of OCBOA.

While much concern has been raised by many private company users regarding the inclusion of non-relevant information in private company financial statements prepared according to GAAP, and the manner in which some information is recognized, measured and disclosed, for many private company users OCBOA falls at the other end of the relevance spectrum and leaves the user wondering about what might be left out.

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Private company financial statements prepared under a uniform and comprehensive set of accounting standards designed specifically for private company users could be an option to fill this gap. PCAS are based on the qualitative characteristics of the primary users of private company financial statements, and it is these characteristics which determine the uniform and comprehensive system of recognition, measurement and disclosure of private company financial statement elements.

The Limitations of the Use of Private Company Financial Statements

Private company financial information is by definition unregulated. Users may have the ability and right to obtain additional financial information beyond a set of private company financial statements prepared in accordance with private company accounting standards. Some private company financial statement users deliberately pass up opportunities to obtain additional financial information. This can be due to a user competing against another provider of capital and being willing, as part of such competition, to accept the risk of not having additional information that he would otherwise be able to obtain. PCAS should not be designed to compensate for these user actions.

In addition, PCAS should be explicitly designed for non-regulated entities. Some private company financial statement users may be regulated by third parties, including governments and agencies and quasi-agencies of governments. PCAS should be designed to provide transparency of the financial information contained therein, but not designed to provide or incorporate regulatory tools for these third parties. Therefore, throughout PCAS, the term “user” should refer to, and should intend to address the needs of primary users.

THE OBJECTIVE OF PRIVATE COMPANY FINANCIAL STATEMENTS

The objective of private company financial statements (“Objective”) is to satisfy the needs of the primary users. Primary users are existing and potential owners, existing and potential bank lenders and commercial lenders, and sureties. Accordingly, the development of a stand-alone, uniform and comprehensive set of private company accounting standards is directed to satisfy these primary users. Secondary users may find that private company financial statements prepared under PCAS do not address all of their needs. However, in order to achieve the qualitative characteristics of financial information contained in private company financial statements, PCAS should not attempt to create “one-size fits all” statements. The words “general purpose” are not applicable to private company external-use financial statements.

The primary way in which private company financial statements satisfy the Objective is to provide the results of the company’s past operational performance of the reporting periods presented and the cash generated or expended by the operational performance through a process of realization. The results of operational performance include not only cash generated and expended on operations in the reporting period, but also the measurement of the effects on operational performance during the period of previous disbursements or receipts of cash from periods preceding the reporting period and commitments based on past accounting transactions to disburse or receive cash in periods beyond the reporting period. These are referred to as deferrals and accruals.

The secondary way in which private company financial statements satisfy the Objective is to provide users with the nature of the operational resources, operational obligations, and the owners’

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investments of the private company measured primarily at their input values recognized at the date of the exchange, less the using up of the input values in the periods benefited. This is commonly referred to as the financial position of the private company. Included in the secondary purpose is the measurement and recognition of how cash was used or obtained in managing the operational resources, operational obligations, and investments by the owners of the private company. Also included in the secondary purpose is the identification of the relationship of the operational resources, operational obligations, and owner’s investments to each other on the reporting date, and changes between them during the reporting period.

There is a trade-off of between balancing of the needs to measure and report operational performance and the actual cash flow generated from operational performance during a specific reporting period. There is also a trade-off between measuring and reporting operational performance during a time period and measuring and reporting the financial position as of a specified date. A financial statement showing only the cash receipts and disbursements incurred during the reporting period may provide the clearest picture of cash flow from operations, but at the cost of sacrificing a complete view of operational performance resulting from past actual and future committed expenditures or receipts of cash. Likewise a statement of financial position incorporating only those operational resources and operational obligations existing on a specified date and solely as a result of past cash transactions excludes operational resources and operational obligations created or dissolved by past financial transactions. Private company accounting standards governing the preparation of private company financial statements recognize this trade-off by providing articulation. Articulation is the design of the relationships among the private company financial statement elements in such a manner that allows the user to ascertain and reconcile cash to accrual accounting transactions within a set of financial statements and also to associate the financial activity occurring within a specific time period to the financial position of the private company at the starting and ending points of that time period. The goal of PCAS should be to minimize and simplify these articulations while satisfying the primary and secondary order of the private company financial statements. This simplification should be accomplished in PCAS by

• The identification and layout and relationships of the private company financial statements and their elements with a view that the ultimate focus over time is to measure the net cash generated by the operations of the company, and to show the process of realization.

• The selection and consistent use of a common and unchanging measurement attribute – an input

value consisting of acquisition or historical cost (as modified by the constraining qualitative characteristics of private company financial statements).

• The design of accounting standards that gives the elements in a statement of operational

performance precedence over the elements contained in a statement of financial position.

• The design of the statement of operational performance to faithfully represent measurements of the key operational activities (i.e., by function) of the private company during a reporting period matched to the revenue generated during that period.

• The definition of both the recognition and measurement of private company financial statement

elements being generally limited to past accounting transactions. • The design of PCAS that allow the user to ascertain transaction-based cash flows and avoids

attempts to measure and value uncertain and nontransaction-based future cash flows.

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While past operational performance and the financial position of a private company as reported in its financial statements are used in projecting future operational performance and future financial condition, this projection is done only in two very limited ways.

First, the private company financial statements are used in the general sense of the past being an indicator of the future. This general sense is better described as the “momentum” of the entity. The effectiveness of this momentum vanishes over time at varying rates from entity to entity, and due to economic forces external to the entity. Therefore, the ability to create “rules” for predictability in private company financial statements prepared on the basis of historical data is extremely limited.

Second, private company financial statements are used as just one component of a package of financial information that is available to the private company user. As a result, the private company financial statements may be used to form a baseline from which future and formal projections of financial performance and financial condition are prepared. Private company users possess and can elect to retain the capability to obtain these projections. However, apart from this generalization, private company financial statements primarily include historical information about an entity, and the role of users who make projections of uncertain future cash flows and entity valuations is outside the scope of the objective of financial statements prepared according to PCAS.

THE REPORTING UNIT TO WHICH PRIVATE COMPANY FINANCIAL STATEMENTS APPLY

In order to develop a uniform and comprehensive set of private company accounting standards for private company financial statements, the entity unit to be reported on must be determined. For private company financial statement purposes the reporting entity is determined and presented in financial statements from the legal proprietary perspective. In simple terms, private company financial statements reflect the perspective of the existing common shareholders (or other legal term that describes the existing voting interests of the common owners) rather than the economic perspective of the entity.

By way of contrast, under the economic perspective public company equity investors and analysts desire the consolidation of any additional entities controlled by management that affect the economic value of the primary entity. While the legal proprietary perspective still views a private company as a separate legal entity, meaning that it is separate from its common shareholders, the private company is viewed as that which is legally controlled by its proprietors and not as the economic sphere that may be controlled by the entity itself. For private company financial statement users, the application of the legal proprietary perspective leads to several fundamental concepts:

• The default boundary of the reporting private company is circumscribed by the legal boundary of the private company, and not by the private company’s economic boundaries.

• The ownership equity element in the private company’s statement of financial position incorporates recognition, measurement and disclosure of only those net income, distributions of net income, and net investment transactions of the entity that pertain to the owners.

• Compound instruments containing elements or potential elements of legal ownership are not separated into different elements in the private company financial statements nor revalued from their initial recorded values.

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• Contractual agreements between a private company and its owners for future redemptions of some or all of the owners’ equity interests in exchange for cash or instruments that contain options for redemption in cash, regardless of whether the redemption is initiated by the private company, or by the owners, are not liabilities of the private company, but are potential (i.e., unrecognized until realized) equity withdrawals.

• The primary boundary for consolidation of other entities into the reporting private company is determined by legal ownership of a minimum of a majority of another entity by the reporting private company. Financial or operational control of another entity is not a basis, per se, for consolidation of a controlled entity by the reporting private company. Additionally, for entities that are more than majority owned by the reporting private company, the compatibility of the majority or more owned entity must be such as to enhance, as opposed to obscure, the disclosure of measurements of operational performance of the reporting entity in order to consolidate these entities. Management, including owners who are actively involved in management, are in the best position to determine this compatibility. In such circumstances, the potential perceived enhancement of a statement of financial position is subservient to the presentation of operational performance. In addition, consolidation for income tax purposes should not constitute a requirement to consolidate under PCAS.

• The default disclosure in private company financial statements for less than majority legal ownership of an entity, and for more than majority ownership of entities that are not compatible in measuring operational performance, consists of either: (a) disclosure only; or (b) the investment at cost method of accounting; or (c) the equity method of accounting. The selected method should be based on the percentage of legal ownership as guided by PCAS. However, the guiding concept is the legal proprietary perspective which usually views such arrangements as investments.

• For unconsolidated entities where the reporting private company exercises financial or operational control, the default method of accounting is by disclosure in the notes to the private company financial statements. The major class of such relationships is usually in the form of financial guarantees by the reporting private company. Additional disclosures in the notes of a private company’s financial statements might include relationships between the private company and an unconsolidated entity whereby the private company provides subordinated debt or equity and above or below market value arrangements regarding lease, service, or management contracts.

THE QUALITATIVE CHARACTERISTICS OF FINANCIAL INFORMATION CONTAINED IN PRIVATE COMPANY FINANCIAL STATEMENTS

The qualitative characteristics are those non-quantifiable characteristics of financial information present within private company financial statements that aid the user in determining the decision usefulness of the statements. The qualitative characteristics, while not necessarily visible to the eyes of the private company financial statement reader, are nevertheless not abstract concepts, nor are they merely a compilation of traditionally recognized observations about accounting practices. Their enumeration and description here is intended for four purposes.

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• To inform and educate the private company financial statement user of the specific characteristics of the structure, contents and limitations of private company financial statements that the user may rely on in interpreting and applying the information contained in these statements for decision-making purposes.

• To both actively guide and limit the development of PCAS by the PCAS standard setters in a

manner that best aids the user. More specifically, the guiding and limiting functions of the qualitative characteristics are designed to focus the PCAS standard setters on developing standards within a commonly and traditionally accepted “knowledge base” (i.e., custom and tradition), which the qualitative characteristics describe, and to select from the components of various alternative systems of recognizing, measuring and disclosing financial information in private company financial statements those components that conform to the qualitative characteristics and to reject those components that do not conform to the qualitative characteristics. The guiding and limiting functions of the qualitative characteristics also assist the PCAS standard setters in achieving uniformity and comprehensiveness of the overall system of private company accounting standards. Therefore, these qualitative characteristics are used, front and center, in determining both the development and application of PCAS.

• To guide the preparer and issuer of private company financial statements in making application of

the principles contained in PCAS. The qualitative characteristics provide the preparer and issuer with an ultimate intent of a PCAS standard and also provide the ultimate authority over how to apply a specific principle of a PCAS standard to an accounting transaction where the PCAS is silent on detail application requirements.

• To both determine and act on the definitions and applications of the underlying principles of

information incorporated into the financial statements. The underlying principles are provided in a separate section of this document.

The qualitative characteristics of financial information contained in private company financial statements consist of the primary qualitative characteristic of relevance, the secondary qualitative characteristic of representational faithfulness, and the ten constraining and modifying qualitative characteristics.

Relevance

The primary qualitative characteristic of financial information contained in private company financial statements is the relevance of the information to its primary users. Relevance is defined as the usefulness of the information contained in the private company financial statements to those who use the information. Relevance affects the selection of what is recognized from the universe of financial information (referred to as recognition), how it is measured from a selection of alternative ways to measure (referred to as measurement), and how what is recognized and measured is displayed for the user (referred to as disclosure). As the primary characteristic, relevance comes first in the development of PCAS. It is entirely a primary user-based determination and attempts to answer the question: What, among available information, does a primary user want to see in a set of private company financial statements in order to satisfy the user’s needs? Guidance to the PCAS standard setters in answering the above question should be found in a user-focused Framework, such as the model framework contained in this document. Within the Framework, overall guidance of what financial information is relevant to a private company financial statement user

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should be provided by a section, Objective of Private Company Financial Statements (“Objective”). The Objective in this model framework is very clear in establishing a foundation for what is relevant to the private company users: primacy is given in the Objective on providing the private company user with the results of past operational performance of the private company, by recognizing and measuring past accounting transactions. Secondary importance is given on identifying the operational resources and operational obligations that existed on a reporting date, as a result of past accounting transactions, that have been used, and will be used in the future to enhance operational performance. The relationship of performance and position (i.e., their articulation) is provided by the application of accrual accounting within a transactions-based system, or model, of accounting. Since the rest of the contents of the Framework should focus, refine, and constrain development of a private company accounting model according to the Objective, the Framework should further guide the standard-setter in determining what is relevant in developing PCAS that builds out this accounting model. There are multiple accounting and financial models that have been proposed and used over many years for external financial reporting purposes. Relevance along with the other qualitative characteristics and the underlying principles of information that should be included in the Framework, constrain the PCAS standard setter from focusing on other accounting or financial reporting models, or portions thereof, that contradict the Objective. This is one of the reasons that the Framework should be authoritative.

Representational Faithfulness

The secondary qualitative characteristic of financial information contained in private company financial statements is representational faithfulness. Representational faithfulness is defined as the consistent, verifiable and neutral development and application of PCAS to the financial information which relevance first determines should be recognized, measured and disclosed in private company financial statements, resulting in the financial statement users having a high degree of reliability in what the presentation purports to represent.

• Consistency is defined as the similar application of accounting standards to private company financial statements over time. The objective of consistency is to give confidence to the private company financial statement user that the basis on which the statements have been prepared has not been changed from period to period.

• Verifiability is defined as that quality of private company financial information that may be demonstrated by securing a high degree of consensus among independent measurers using the same measurement method. A high degree of consensus means there is a preference towards recognizing and measuring information in private company financial statements that is observable in past transactions over information that projects uncertainty of the future. This definition of verifiability based on past observable transactions establishes an easily understandable threshold and consistent level of accuracy for the measurements incorporated into private company financial statements.

• Neutrality means that the application of private company accounting standards is free from any bias to attain a predetermined result or to induce a particular mode of behavior.

• Reliability is the outcome of applying the qualitative characteristic of representational faithfulness. It is defined as the level of correspondence between the captions, amounts and relationships of

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what is displayed in private company financial statements and the underlying operational activities captured by accounting transactions in the current reporting period and over time.

Relationship of Relevance and Representational Faithfulness

As the primary qualitative characteristic, relevance takes precedence over representational faithfulness in private company financial statements. This hierarchy is important in developing PCAS for three reasons. First, relevance gives guidance to the selection of a measurement attribute from alternative choices. A single accounting transaction by a private company may result in observation of more than one measurement attribute, each of which might be faithfully represented by a consistent, verifiable and neutral observation. However, it is not the ability to make a faithful representation of one or more of those attributes that determines the selection; instead, it is the relevance of the measurement attribute to the private company financial statement users that makes the determination. Second, but more fundamental and preceding recognition, relevance would determine whether or not a financial event or other circumstance is even recognized. Third, custom and tradition are important for the private company users, and as a result, some user-desired components of private company financial statements may not necessarily be compatible with each other within private company financial statement recognition, measurement and disclosure. Relevance has precedence over a theoretical, consistent application of accounting standards within a set of private company financial statements. Thus, for example, the recognition in private company financial statements of a benefit to a company obtained by a mutually unfulfilled executory contract for the commitment to use a tangible item (such as a contract for the lease of equipment where the equipment has been delivered to and placed in service by a private company ) may be, in theory, inconsistent with not recognizing in the private company financial statements a benefit to a company under a mutually unfulfilled executory contract for an intangible item (such as a long-term employment contract). However, even though the benefit of both contracts may be measurable with representational faithfulness, it is the relevance of the information to the user that should determine the nature and extent of private company accounting standards. Notwithstanding this hierarchy of giving preference to relevance in private company standard setting, PCAS should not be developed solely on a narrow issue-by-issue approach in an attempt to address a standalone “hot-button” issue identified as having relevance by a user. This approach, referred to as standard setting by silos; that is to say, without giving consideration to the broader purposes of private company financial statements as expressed above, should be avoided in the development of PCAS. Thus, constraints on relevance and representational faithfulness are needed in developing private company financial statements.

Constraining and Modifying Qualitative Characteristics

In addition to, and constraining and modifying the application of the primary and secondary qualitative characteristics of private company financial statements, are ten qualitative characteristics.

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Principles-based Accounting

The phrase “the decision usefulness of private company financial statements” is an inherently subjective construct. While types of private company financial statement users, within the primary users, and types of decisions made by those users can be broadly identified and classified by their common traits, the specific methods of making decisions, and the selection of analytical processes to perform on the private company financial data selected in order to make decisions, and even the selection of the financial data itself, is a subjective mental process performed by an individual user. In the field of law in the western hemisphere, the longtime and still functioning “reasonable person” application of the common law serves well as the foundation of what is called principles-based accounting contained in private company financial statements. The reasonable person concept asks, what is the nature and amount of information that a reasonable user would like to have in private company financial statements in order to satisfy a set of decision useful objectives? This concept points to the need to find commonality in the principles and characteristics of private company financial statements. The reasonable person concept and commonality are somewhat vague from the competing perspective of a detailed set of laws or rules governing all possible human actions. However, too much detail in a set of private company financial statements can inhibit commonality (as, of course, can too little detail). In addition, too much rules-driven information in private company financial statements can create complexity that hinders the initial underlying purpose or principle and even over time obliterates the principle, leaving only the rules behind. The rules then become an end in themselves, and therefore, meaningless to the primary users for decision-making. Accordingly, the qualitative characteristic known as principles-based accounting is defined as follows: Private company financial statements should contain a collection of related information based on common user-accepted principles necessary to satisfy a reasonable user’s needs that in turn are identified by the Objective and by other common characteristics of private company financial statements that are enumerated and described in the Framework and in PCAS. In order to achieve this qualitative characteristic of principled-based accounting in private company financial statements, the responsibility is placed on the PCAS standard setters for the following:

• The development of private company accounting standards is based on the commonality, determined by the reasonable person concept, of the primary users in their decision-making processes.

• The commonality, determined by the reasonable person concept, defines an area for developing PCAS that has a threshold of providing a minimum amount of information and an upper boundary prohibiting too much information.

• PCAS is to be principles-based.

• PCAS is to be uniform. This means that the principles should generally be internally consistent with each other and not in conflict with each other, but subject to the interaction of the other qualitative characteristics.

• PCAS is to be comprehensive. This means that PCAS should cover all needed principles to

achieve commonality.

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• PCAS should recognize that there can be rare instances where commonality to primary users is not achieved in the application of a standard to a specific private company resulting in those private company financial statements having less usefulness or even being misleading to primary users. Accordingly, in such rare instances PCAS should allow for an override of the standard or a selection of another standard within PCAS that achieves the objective of private company financial statements, but in a manner consistent with the Framework even if the specific standard is not specified in PCAS.

Pragmatism

Private company accounting standards should attempt to incorporate practical, observable accounting principles into standard setting, as opposed to theoretical or “what should be” standards. Therefore, PCAS should attempt to incorporate accounting practices acceptable to the primary user needs, or customs and traditions, even if inconsistencies occur. PCAS should avoid attempting to implement “policy making”. While not to be used as a mechanism to avoid satisfying user needs, pragmatism overrides the need to provide theoretical unity in a body of private company accounting standards.

Understandability and Simplicity

Understandability and simplicity mean that private company financial statements and PCAS should be understandable to the average reader. The average reader is defined as any individual with general business knowledge, but without a financial or investing background. Understandability and simplicity incorporates, among other things:

• Use of “plain English” in the text for PCAS. • The general use of a common measurement attribute in making measurements. • The preference for making written, qualitative disclosures of financial events and circumstances

that do not result from accounting transactions, as opposed to incorporating these other financial events and circumstances into the elements displayed on the face of the financial statements.

• Avoiding the application of uncertainty tools (e.g. mathematical calculations of volatility, variability,

and probability) in measurements. • Avoiding the creation of rules-based artificial filtering mechanisms for determining what

information is, or is not, recognized and measured in financial statements. • In the development of PCAS, a willingness and predisposition to reject requests from users for (a)

specific applications of standards, (b) implementation guidance of a standard for uncommon or out of the mainstream application scenarios (c) creation of a numeric threshold for determining when to apply a standard,(d) exceptions to standards based on the uniqueness of a private company or industry, and (e) creation of a standard or interpretation in order to satisfy a unique use of information by a specific user that is not that of the majority needs of primary users.

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Materiality

Materiality is defined as the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information taken as a whole would have been changed or influenced by the omission or misstatement. Materiality is rooted in the “reasonable person” principle found in the common law. While materiality considers both the qualitative characteristics and quantitative amounts of the financial information, the threshold for recognition, measurement, and disclosure is not a specific quantitative value -- neither a raw number nor percentage -- and private company accounting standards should not incorporate mathematical determinations of materiality. Numerical adjustment of any amounts recognized, measured, or disclosed in private company financial statements otherwise prepared according to PCAS, solely to match numerical thresholds of materiality applied in the audit of the financial statements, renders the financial statements to not be in accord with PCAS.

Cost Versus Benefit

The cost versus benefit of financial information contained in private company financial statements is a qualitative judgment and is rarely able to be numerically expressed. In order to justify requiring a particular disclosure in private company financial statements, PCAS should require that the perceived benefits to be derived from that disclosure must exceed the perceived costs associated with it. By way of contrast the cost versus benefit threshold for public entities is almost always lower than for private companies. The practical reason is that private companies are usually smaller, have lower access to capital, have a higher cost of capital, and do not have other imposed regulations that let the marginal cost of implementing new accounting standards to be spread out over the fixed costs of regulatory compliance structures. The functional reason is that public entity equity investors and equity analysts perceive a higher benefit to recognition and measurement of uncertain future cash flows than do private company financial statement users. Accordingly, the development of PCAS should recognize this different threshold for private companies.

Going Concern Concept

The going concern concept is a concept under which a private company’s financial statements are prepared under the assumption that the private company’s operational performance, and use of its resources and obligations (collectively, net assets) in achieving operational performance, will continue indefinitely, and that the private company will have sufficient liquidity. Additionally, the going concern principle incorporates into private company financial statements the legal proprietary view that the existing owners will continue on, without material change, as owners. As a result, there is a propensity for private company financial transactions to be originally measured at their input value of exchange and not re-measured in subsequent periods at exit values such as liquidation value or at the present values of probability adjusted future cash flows (fair value), unless a failure to do so would be misleading to the primary private company financial statement users.

Conservatism

Conservatism, sometimes referred to as prudence, is a practical application of skepticism to the elements of private company financial statements. In operation, it serves as a constraint on the presentation of

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measured data that may otherwise be governed by the secondary qualitative characteristic of a faithful representation. Conservatism arises from customs and traditions in both the preparation and use of private company financial statements. Conservatism usually results in displaying the lowest of several possible values for the asset and revenue elements and the highest of possible values for liability and expense elements. However, its application is passive, particularly to the asset element, where it is applied in the format of observable impairment principles. Observable impairment is a result of a passive observation and not a result of the active testing of the underlying circumstances of the underlying element. The principle of “wasting” is sometimes incorporated into the characteristic of conservatism. Wasting is more appropriately associated with the consuming of historical costs in the generation of operational performance, and is usually described as a type of allocation under accrual accounting and the matching principle, and has precedence in measurement of an element over other potentially observable attributes such as fair value or replacement cost. PCAS development should incorporate all of these components of conservatism.

Continuity

Continuity is a constraint on the development or evolution of PCAS beyond a core set of standards. It serves as a brake on the continual issuance of both new standards and application/implementation rules that, by way of contrast, has been prevalent in the development of public company financial reporting standards. Continuity is a view that the application of a stable body of private company accounting standards over long periods of time is more useful than frequent and ongoing issuance of new standards. Continuity is a rebuttable argument that there can be finality and permanence in a set of private company accounting standards.

Management’s Intention

Management’s intention in the use of a private company’s resources and obligations is a reasonable basis to classify transactions in private company financial statements in the absence of the availability of clearly observable and verifiable information. For example, in absence of clearly observable and verifiable information regarding the holding period of a cash equivalent, management’s intention is to be relied upon in private company financial statement disclosures. Management’s intention also recognizes that a private company’s management may change its mind in a current reporting period from a position taken in a previous reporting period, and a change in any relevant private company financial statement classification always follows management’s change of intention.

Mathematical Auditability

PCAS should develop recognition, measurement and disclosure of the elements contained in private company financial statements in a manner that allows, encourages, but also restricts an external audit of private company financial statements in the following manner:

• Each account in a private company financial statement can be verified with a reasonable degree of assurance, by use of common statistical methods without resorting to underlying accounting systems and controls over financial reporting.

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• The overall private company financial statements can be demonstrated, as a whole, to be free from material bias.

• The notes to the private company financial statements can be verified with a reasonable degree

of assurance without the application of tests of uncertainty that may be inherent in the qualitative disclosures.

• Disclosures in private company financial statements do not include alternative ranges of future

realizations or settlements. • The development of principles-based accounting standards is not influenced by audit procedures

that may be reliant on rules or mathematical attest processes.

The mathematical auditability characteristic is sufficient when the above audit procedures are capable of being performed on the private company financial statements themselves. While systems and controls over external private company financial statements may enhance the assurance of the private company financial statements, they are not a part of PCAS and are not necessary to achieve the qualitative standard of mathematical auditability.

Many private companies, particularly smaller private companies, view external financial statements prepared according to a set of accounting principles, and subsequently independently audited or reviewed, to be a product to be purchased once a year in order to satisfy an external user’s request for information. This view is typical for private company financial statements required by bank lenders. Many of these private companies prepare, or engage outside resources to prepare, these private company financial statements only once a year. Management of private companies, and in many cases the owners of private companies who have access to more timely and useful data, may not use or have the need to use these external private company financial statements. Internal systems and controls of these private companies are likely to be foremost designed to help management assure the day-to-day accuracy of internal financial information used in decision-making and operational control. The development and application of PCAS should avoid the need to impose operational constraints or the need to create controls within private companies that would result in the audit or review function relying on controls over external financial reporting other than those needed to (a) maintain underlying systems that collect and summarize financial transactions, and (b) allow attest functions that use only those normal statistical methods of testing the collection and summarizing of these financial transactions within normal statistically determined confidence levels.

Additionally, audit processes that make adjustments that cause private company financial statements not to conform to the concepts contained in the Framework result in the statements not being in conformity with PCAS. The reason is that the Framework should form a part of PCAS and is therefore should be authoritative in its constructs and applications. The selection by a private company of a standards “override” provided by the qualitative characteristic of principles- based accounting in the Framework or by PCAS does not render the private company financial statements to not be in conformity with PCAS. On the other hand, the failure to follow the override principle in those rare circumstances when the private company financial statements would have less usefulness or be misleading to a primary user, renders the private company financial statements to not be in conformity with PCAS.

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Additional Considerations in the Qualitative Characteristics

Transparency and comparability are not qualitative characteristics of financial information contained in private company financial statements. Instead they are considered to be one of many outcomes of private company financial statements prepared under PCAS. Transparency is the ability to observe the outcome of the proper application of the qualitative characteristics and the underlying principles applied in a set of private company financial statements. By way of contrast, users of public entity financial statements use the term transparency to include not only the outcome of applying qualitative characteristics, but also to expand the amount of and nature of what is disclosed. This concept is not applicable to private company users, since these users, unlike public entity users, have other sources of financial information about a private company, and are not restricted by regulation to the amount of or timing of the release of financial information. Comparability is the ability to use financial statements of unrelated entities in order to compare the two entities’ operational performance and financial position. For private company financial statement users this may be one of the purposes for obtaining and using financial statements, but it is not a separate characteristic that governs the development of PCAS. Many users of private company financial statements are not able to obtain financial information of similar private companies in order to make comparisons. By way of contrast, many public entity users primarily use public entity financial statements to compare similar entities within an industry for the purpose of determining the relative market values (i.e., valuations) of the entities and the entities’ equity instruments. For public entity financial reporting, an emphasis on comparability may result in individual rules, bright lines, interpretations, applications and illustrations being embedded into public entity financial reporting standards (i.e., GAAP) contrary to the principles-based characteristic that private company financial statements contain. This typically manifests itself in the public entity financial reporting environment as “principles versus rules” discussions. In cases where private company users desire to make similar comparison of entity valuations, the circumstances invariably involve due diligence situations, and therefore, access to additional financial information needed for valuation purposes is readily obtainable. Organizations representing U. S. lenders, such as RMA, do collect and share summarized financial information by industry or other business codes. However, approximately 80% of reporting companies in RMA publications do not provide audited GAAP financial statements.

THE SEVEN UNDERLYING PRINCIPLES THAT DETERMINE THE DISPLAY OF INFORMATION IN PRIVATE COMPANY FINANCIAL STATEMENTS

The seven underlying principles are the principles that determine the display of information contained in private company financial statements and the structure of the statements themselves. The underlying principles determine what the private company financial statement user actual sees with his eyes. These principles not only determine the numerical display, but also the narrative display of financial information contained in the financial statements. These principles determine what gets measured, when it gets measured, and in what amounts. The nature of the underlying principles are influenced and shaped by the guidance and limits of the qualitative characteristics.

The purposes of the underlying principles are the same as the first three purposes identified in the section on qualitative characteristics. However, the underlying principles should be much more specific in guiding and limiting the development of PCAS because they affect the actual amounts that appear on the private

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company financial statements. The underlying principles of financial information displayed in private company financial statements consist of a primary underlying principle and six secondary underlying principles that each eventually lead back to the primary underlying principle. The primary underlying principle is the realization principle. The seven secondary underlying principles are the monetary unit principle, the recognition principle, the measurement principle, the disclosure principle, the matching principle, and the time period principle.

The Realization Principle

Realization is the process of converting noncash resources and rights into money and the settlement of obligations by payment of money or other assets that could be converted into money. Money includes cash and cash equivalents. Associated with this broader definition of realization is the term realizable which is defined as capable of realization, and the term realized which is defined as the completion of the realization process. Cash flow associated with realization can be either an inflow or outflow; however, inflows are usually referred to as realized and outflows are usually referred to as settlements. Over the life of a private company, from inception to dissolution, the amount of cash or other net assets in lieu of cash that will be distributed to the owners is equal to the sum of the operational performance, i.e., the accumulated net income, reported in time intervals. Final realization occurs upon dissolution of the private company. Under the going concern concept, however, dissolution is not the basis for preparing private company financial statements in the intervening time periods. The realization principle is applied to the recognition of private company financial statement elements on a reporting date. On reporting dates realization is used in private company financial statements to refer to sales of goods and services for cash or claims to cash and recognition that liabilities will be settled by cash or by assets that could be converted to cash. The term realization is used even more precisely at the transaction level by grouping a series of transactions that constitute an accounting cycle that ends in realization. So, for example the group of accounting transactions to recognize the purchase of inventory, its sale in exchange for a receivable, and cash collection of the receivable is a realization cycle and the cycle is referred to as the process of realization. The inventory and the accounts receivable and even the revenue can be said to be realizable. All three are said to be realized when final cash payment is received. Likewise, the associated accounts payable liability to make a cash payment for the inventory and for any related expenses incurred in making the sale and the final payment of the liabilities is a realization cycle.

Private company financial statements satisfy the Objective of private company financial statements by making a faithful representation of the process of realization. The principle of realization is the incorporation of the process of realization from a private company’s operational activities into what is presented in a set of private company financial statements. The application of the principle of realization is accomplished by the application of the principles of monetary unit, recognition, measurement, disclosure, matching and time periods. For this reason realization is referred to as the primary underlying principle and these next six are referred to as the secondary underlying principles.

The term realization is sometimes loosely applied in other ways such as its association with revenue recognition. However, realization should not be used in this sense within PCAS and revenue is said to be recognized. The revenue that has been recognized and the resulting asset in the form of a receivable are realizable and both become realized when cash is collected.

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The Monetary Unit Principle

Since the realization principle focuses on making faithful representations of the process of converting private company financial statement elements into cash, it then follows that amounts displayed in private company financial statements are measured in monetary units, i.e., a local currency. As a result, an assumption is made in private company financial statements that the monetary unit used is stable, and no adjustments to the purchasing power of the monetary unit are performed unless extreme conditions, such as hyperinflation, make the use of a stable monetary unit misleading.

The Recognition Principle

A private company’s elements resulting from past accounting transactions are recognized in its financial statements. Past accounting transactions consist of the following three specific operational activities of a private company:

1. External Operational Exchanges (Exchange transactions)

a) A binding or otherwise enforceable or equitable transfer of an asset from the private company to one or more third parties in which the private company receives in exchange an asset or settles a liability.

b) A binding or otherwise enforceable or equitable transfer of an asset to the private company from one or more third parties in which the private company gives up in exchange an asset or incurs a liability.

2. External Operational Transfers (Transfer transactions)

a) A one-way transfer of the private company’s asset, or the incurrence of a liability by the private company to make a one-way transfer of an asset, to one or more third parties made under compulsion or other obligation, in order to prohibit additional adverse effects to the private company’s operational performance.

b) A one-way transfer of an asset to the private company, or the assumption of the private company’s existing liability, by one or more third parties made for the private company’s benefit, in order to satisfy prior adverse effects on the private company’s operational performance.

c) A one-way transfer to a private company from its owners in the form of an owners’ equity investment, or a one-way transfer from a private company to its owners in the form of an owner’s equity withdrawal or dividend.

3. Internal Operational Transfers (Internal transactions)

a) Conversion costs of operating activities.

b) Consumption and other losses of assets in internal operational activities.

c) Incurrence of liabilities in internal operational activities

A private company’s general operating activities are the ordinary and usually recurring business activities, observable to an onlooker, of obtaining, altering, combining, converting, enhancing, consuming, investing, lending, renting, selling or otherwise using of goods and services for the purpose of creating net income

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(operational performance), and the acquisition, use and disposal of assets and the incurrence and settlement of liabilities needed for these recurring business activities.

Not all of a private company’s general operating activities are recognized in private company financial statements. Only those general operating activities that are combined with either, an external operational exchange, an external operational transfer transaction, or an internal operational transfer, and are realizable or realized, are recognized, and are referred to as recognized operating activities. For convenience, these three types of accounting transactions are referred to, respectively, as exchange transactions, transfer transactions, and internal transactions; however, the use of these shortened terms does not change their definition. Additionally, for convenience, the term operational activities is used in place of the phrase recognized operating activities.

In a perfectly efficient environment all activities of a private company would contribute to creating net income. However, the combination of general operating activities with these three specific accounting transactions results in net income (i.e., operational performance) reported as a result of past accomplishments rather than reported as an expectation of accomplishments.

“Past”, as used in past accounting transactions, means that an operational activity, i.e., the accounting transaction, has happened either prior to or on the private company’s reporting date in its financial statements. As noted above accounting transactions are realizable or realized. Transactions that are not part of the process of realization are not accounting transactions.

Included in item 1, exchange transactions, are mutually fulfilled executory contracts, or portions thereof fulfilled; mutually unfulfilled portions are excluded. A mutually unfulfilled executory contract is a contract between a private company and a third party that is equally unfulfilled by both parties, in part or whole. Included in this definition of a mutually unfulfilled contract would be a legally binding contract between two parties, but where binding is contingent on future performance by both parties to the contract, and the contract is, in form, prospective in nature. However, when a third party makes a commitment of a tangible asset to a private company, for immediate use by the private company, in an otherwise mutually unfulfilled contract, the qualitative characteristic of pragmatism considers the commitment to be a fulfillment and an exchange transaction has occurred.

In its simplest and generic definition, the term exchange means something is given in order to receive simultaneously something in return. Exchange transactions primarily include those normal exchanges with customers and vendors as part of the private company’s operational activities. These exchanges of assets or incurrence or settlement of liabilities normally result in the recognition of revenue and expense elements and may be accompanied by or preceded by an internal transaction. For example, if the asset exchanged by a private company is inventory, the internal transaction consisting of conversion costs may have recognized the inventory. The flow of the product to the customer in the exchange resulted in the recognition of revenue and its relinquishment results in recognition of an expense.

Exchange transactions also include exchanges by the private company to acquire those assets needed by the entity in its operational activities and to satisfy liabilities incurred to obtain those assets. An exchange transaction does not mean that an equal amount of values are exchanged.

An exchange transaction could be simultaneously identified as meeting the criteria of both Items 1a and Item 1b. For example, a cash payment for equipment to be used in operational activities is a transfer of an asset (cash) from a private company in exchange for another asset (equipment), meeting the definition of 1a. At the same time, the transaction could be viewed as a transfer to the private company of an asset (equipment) in exchange for the private company giving up an asset (cash), meeting the definition of Item

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1b. While the intention of Item 1 is to focus on the operational activities of the private company, the definition allows a practical capture of the transaction from both a giving and receiving perspective of an exchange.

In its simplest and generic definition, the term transfer means the receiving or relinquishing of something without receiving or relinquishing something in return. In a transfer transaction, a private company may transfer an asset to a third party or assume a liability to transfer an asset to a third party in the future without receiving a benefit in return. Additionally, in a transfer transaction an asset may be received by the private company from a third party or a liability of a private company may be assumed or settled by a third party without the private company providing a benefit in return.

In an transfer transaction, Item 2 above, a private company may need to make, or be forced to make, a one-way or non-reciprocal transfer to a third party or may be the recipient of a one-way transfer made to it by a third party. The obvious example is a requirement of a private company to pay taxes on its income or on its other operational activities. Other examples would be non-reciprocal payments of cash or transfer of other assets due to the private company’s failure to perform under a contract, settlement of product or service deficiencies, environmental issues, and other legal obligations incurred as a result of its operational activities. A third party’s actions towards a private company may result in similar non-reciprocal transfers of cash or other assets to the private company. A non-reciprocal transfer has to be realizable prior to recognition and otherwise satisfy the requirements of the underlying principles of recognition and measurement.

A private company may transfer assets internally as part of its internal operational activities in order to create a new asset. As part of the process of creating a new asset, the asset used in the internal operational activity may be physically transformed or consumed. This type of internal transaction is referred to as a conversion, and in measurement of the conversion the input values of the assets transformed or consumed are transferred to and become the input values of the new assets. The transferred input values are called conversion costs. The most common example is the transfer of the input values of materials, labor and overhead to finished goods inventory as a result of a manufacturing activity. No revenue or gain is recognized on the transfer.

In some internal operational activities the consumption of an asset may not give rise to a new asset and an expense is recognized in an internal transaction for its consumption. Additionally, in some internal operational activities an asset may be discovered to have no capability to enhance future operational performance and a loss is recognized in an internal transaction for the net realizable input cost of the asset.

A clarification is needed for the incurring of expenses. The input value of an asset obtained in a previous accounting transaction and subsequently sold to a customer as a good or service is transferred to expense as part of the exchange transaction. Other assets may be directly used or consumed in the exchange transaction. The input costs of these other assets are transferred to expense as part of the exchange transaction under the matching principle. An example of this is the acquisition of supplies and subsequent consumption. The initiating activity of obtaining the supplies may have occurred in an exchange transaction in Item 1b that first created an asset. The asset is then consumed in the exchange transaction and becomes an expense. However, an asset received in an exchange transaction may be immediately consumed in an internal transaction and become an expense. An asset recognized under Item 1a may be immediately consumed under Item 1b. An example would be a wage paid or due to an employee who provided a service to a customer. Accordingly, in the practical process of recording accounting transactions within the same reporting period, the recognition under Item 1a is ignored.

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Some assets may be consumed in internal operational activities because their consumption cannot be directly associated with the creation of other assets or the creation of revenue. The matching principle assigns the costs to the reporting period in which the asset is used or consumed. In these instances an asset obtained by Item 1b may be transferred to an expense under Item 3b. Again, the time interval between the exchange transaction and the subsequent internal transaction does not change the nature of the transaction, but may affect the practical process of recording the accounting transaction within the same reporting period. For example, the right to use office space during the current period may result in recognition of an asset, but if the right is used in an internal operational activity, such as space rented for administrative personnel, the right is recorded directly in the accounting records as rent expense for the current period.

Additionally, in practice, the occurrence of a liability within a private company’s internal operational activities can be said to give rise to an expense or loss. In reality, recognition under Item 3c is a subset of Item 3b, and the recognition under Item 3c is the same as if recognized under Item 3b. Item 3c is included because of the practical application of accounting processes within a reporting period.

The general principle for initially recognizing an element in private company financial statements is that an accounting transaction has occurred during the financial statement reporting period and has created the element. This process of recognizing elements by accounting transactions is referred to as transaction-based accounting. The development of PCAS should incorporate these concepts of transaction-based accounting

The accounting transactions that recognize elements in private company financial statements are usually observable and in many cases are documented in some form. In some cases an accounting transaction that creates an element may not be completely discernable. Accordingly, in order to be recognized, the observance of an occurrence of an accounting transaction must be at a minimum probable of having occurred in order for associated elements to be recognized. Probable means more likely than not, so an accounting transaction must have been more likely than not to have occurred in order for its associated elements to be recognized.

Except as affected by the constraining qualitative characteristics of financial information, financial statement elements are not recognized as a result of non-accounting transactions, or as a result of other economic events and circumstances.

Comparison of the Operational Activities View to the Capital Maintenance View in Recognition

In a private company framework the recognition principle is based on that subset of general operating activities that are recognized in transaction-based accounting, i.e., the operational activities view. Accordingly, in the development and application of PCAS, emphasis should be placed on recognizing accounting transactions that faithfully represent operational performance and resulting cash flow. In the operational activities view, the statement of operational performance has priority over the statement of financial position. The primary manner in which the operational activities view is applied in private company financial statements is to determine a private company’s periodic operational performance by the recognition of its flow of product and the application of the matching principle to the use of its resources in obtaining its flow of product. The secondary manner in which the operational activities view is applied in private company financial statements is the recognition by accounting transactions of the assets, liabilities, and owners’ net investments used in operational activities for the purpose of enhancing operational performance.

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By way of contrast, public company investors/analysts prefer the recognition principle to be based on the financial capital maintenance of an entity. Under this view, a return on financial capital results, in the words of the FASB’s Conceptual Framework, “only if the financial (monetary) amount of an enterprise’s net assets at the end of a period exceeds the financial amount of the net assets at the beginning of the period after excluding the effects of transactions with owners”. The reporting period’s change in net assets reflects a measurement of change in wealth, or well-offness, and is dependent on determining an acceptable beginning and ending valuation (usually at exit prices) of net assets. Accordingly, in public entity financial statements the statement of financial position has priority over a statement of operational performance. For public company investors and analysts financial capital maintenance is also dependent on the appropriate definition of what “events” to include, i.e. recognize, in the financial statements. Accordingly, the investors and analysts desire public company accounting standards (GAAP) to recognize not only transactions, but also “other events and circumstances”. Events are defined broadly in the FASB’s Conceptual Framework as “a happening of consequence to an entity”. Circumstances are defined as “a condition or set of conditions that develop from an event or series of events”. The source of these different views of recognition is, of course, how financial statements are used. The influence of the public company investor and analyst needs for forward-looking information in order to make equity valuations has resulted in their views dominating the development of GAAP in recent years under the financial capital maintenance concept.

The Measurement Principle

In private company financial statements, an element must first be recognized before measurement can occur. Measurement is expressed as an observable attribute, referred to as a measurement attribute, in monetary terms. Cash and cash equivalents are measured as money. Other elements that are recognized in private company financial statements are initially measured at input values expressed in monetary terms. An input value is the exchange price that is present in the accounting transaction. For assets and liabilities the input value is usually referred to as either the acquisition cost or the historical cost.

The purpose of the use of input values is to enable the private company financial statement user to maintain accountability of externally provided financial resources (capital and debt financing) over time and to account for the operational performance achieved by use of these financial resources. Accordingly, the input value of assets and liabilities is not normally changed over time, except where the application of the matching principle results in a portion of the input value being used to measure operational performance. In subsequent reporting periods an unmatched portion of the input value measurement attribute remains and assets and liabilities are said to be measured at amortized cost. However, no change in measurement attribute has occurred and the amortized cost is still input value. An exception to maintaining amortized costs is made in applying the qualitative characteristic of conservatism.

In an exchange transaction, an element’s input cost is not changed, but is exchanged externally at a different measurement attribute, an exit price. This is also expressed in the measurement of periodic net income as recognizing the difference between an element’s input value and its exit price. This recognition only occurs as a result of an exchange transactions.

Costs that become conversion costs in an internal transaction are a summation of the input values of the elements that combine to form the new element. The conversion costs may be collected from several

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sources, but the combined cost is a sum of its component costs, nor more or no less, and the measurement attribute is not changed.

In a transfer transaction resulting in a one-way transfer from a private company of cash or other assets to a third party or to the private company’s owners, the measurement of the transfer transaction is the amount of cash or the input value of the other assets transferred. If instead of transferring cash or other assets to the third party, the private company incurs an obligation to the third party, the measurement of the transfer transaction is the present value of the future obligation to make the transfer.

In a transfer transaction resulting in a one-way transfer to a private company of cash or other assets by a third party or by the private company’s owners, the measurement of the transfer transaction is the amount of cash or the fair value of other assets received. If instead of transferring cash or other assets to the private company, the third party assumes an obligation of the private company, the measurement of the transfer transaction is the private company’s input value of the obligation.

In summary, the default initial and subsequent measurement attribute in all PCAS, except for cash equivalents, should be input value. Subsequent measurement may result in some of the input cost of assets and liabilities being assigned to the measurement of operational performance. However, the remaining input value is not re-measured but may be referred to as amortized cost. The application of the qualitative characteristic of conservatism may result in the decrease in the input value of an asset and an increase in the input cost of a liability.

Input value is usually observable within accounting transactions. However, in some instances input value is not clearly observable. In such instances, in order for an element to be measured, it must meet the minimum threshold for measurement. The minimum threshold for measurement means that the input value within the accounting transaction is measurable. Measurable is defined as a reasonable minimum single amount that may be estimated (referred to as the best estimate) without incorporating variability, probability, volatility or other numerical techniques for measuring uncertainty, and will result in a faithful representation in a transaction-based accounting system.

While recognition occurs before measurement, these two principles work together in determining the minimum threshold for inclusion of an accounting transaction in private company financial statements by combining probable and measurable. The minimum threshold for recognition and measurement is defined as follows:

• It is probable that an accounting transaction has occurred and it is probable that the accounting transaction has benefitted operational performance in the reporting period or will benefit future operational performance (recognition principle)

• The accounting transaction is measurable (measurement principle)

If an accounting transaction does not meet the minimum recognition threshold of probable and measurable, then it is not recognized on the face of private company financial statements until such time information regarding the accounting transaction becomes available to meet the minimum threshold.

Measurements of Contracts

For the execution of contracts that result in an accounting transaction, the input value is not always readily viewable. Some contracts may only specify a series of future cash payments. In this case the

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input value is ascertained by separating the cost of cash – i.e. interest -- from the total series of cash payments. Typically, this is done by discounting the series of cash flows to a present value. However, the portion of the future cash flows assigned to the input value of an element should be ascertained, where possible, from the contract. Therefore, the use of an interest rate should be the rate stated in the contract or implicit in minutiae of the contract, and not the private company’s external incremental borrowing rate which is more commonly used in public company financial statements for the purpose of re-measuring fair values of contracts instead of expressing the true acquisition costs of elements. For private companies the use of contracted future cash flows is used solely to determine input cost; it is in no way an attempt to project future cash flows. Additionally, for private company accounting, the series of cash flows used in determining the input value should follow the recognition principle of being both probable and capable of being reasonably estimated. Uncertainty and contingent cash flows are not incorporated into the measurement of input values.

These concepts are applicable to either legal side that the private company holds in a contract; i.e., the cash payer or cash receiver party to a contract and the resulting creation of elements whether assets or liabilities. A resulting element measured at input value may be more or less that an observable market rate; however, that means nothing more than the facts: As a lessee the private company has either obtained a bargain contract or made a poor business decision relative to the market. For assets obtained at an input value materially in excess of an observable market price, the qualitative characteristic of conservatism may mean that the input value should be written down.

Comparison of Recognition and Measurement between Private Companies and Public Entities

While private company financial statement users are concerned with risk to a company’s cash flows, they recognize that many risks to a private company’s future cash flows are external to the company. In addition, private company financial statement users prefer that measurements of past operational performance remain separate from potential changes in the present values of future cash flows. The use of measurement attributes, including the nature of and threshold for measurement and recognition, by private company financial statement users differs from the use made of public entity financial statements by equity owners and equity analysts.

By way of contrast, one of the primary purposes of public entity financial statements is to allow the user to attempt to value a public entity’s equity instruments or to attempt to value the entity as a whole. Valuations of a public entity’s equity instruments are impacted by, among other things, future cash flows of the entity adjusted for uncertainty using a variety of mathematical techniques. Many public entity financial statement users have expressed that the goal of financial reporting for public entities should be to recognize and measure assets and liabilities, initially and in subsequent reporting periods at the present value of the expected future cash flows of the entity adjusted for uncertainty. These public entity financial statement users desire that the statement of financial position be a tool to predict future cash flows of the entity. Their view is that disclosing the uncertain quality of a possible (or even remotely possible) future cash flow is more useful than not recognizing a present value at all. The measurement attribute that incorporates both recognizing a possible cash flow and applies techniques to adjust the uncertainty of these cash flows is collectively referred to as either an exit price attribute or the fair value attribute.

The use in private company accounting of the input value as the default initial and subsequent measurement attribute grounds the measurement in an observable transaction and improves the neutrality and verifiability components of the qualitative characteristic of representational faithfulness. No system of accounting is perfectly aligned to the views of any one user, and over time certain elements

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measured at input value can lose relevance to some users. Updated measurements based on another measurement attribute, in addition to the original acquisition measurement attribute can be voluntarily disclosed in the notes to the financial statements as matter of pragmatism. For example, the most recent externally appraised value of a private company’s real estate holdings, along with the date of the appraisal, can be disclosed in the notes.

The Disclosure Principle

Disclosure is display of the captions and numerical amounts in private company financial statements and the explanatory notes to the financial statements. Disclosure is determined by the application of the qualitative characteristics, other underlying principles, and the definitions of the elements. While the disclosure principle can in some cases determine the visual appearance of contents within private company financial statements, the disclosure principle is also limited to only influencing the nature of the statements themselves and some of the classifications of the contents. This is because custom and tradition acceptable to and preferred by users define the individual private company financial statements themselves along with some of the classifications. The disclosure principle more freely determines the nature and contents of the notes to private company financial statements. Without overriding the constraints imposed by custom and tradition, the disclosure principle consists of applying the three qualitative characteristics of materiality, understandability and simplicity, and management’s intention to: (a) the display of clarifying captions; narratives or amounts within the four individual private company financial statements; (b) the ordering of inclusion of contents within the four financial statements; (c) the determination of the nature and contents of the notes, all for the purpose of improving decision making by the primary private company financial statement users. In application to the disclosure principle, materiality includes the display of information that a reasonable private company primary user would expect to see in private company financial statements for decision-making purposes, and also the display of any additional information that would keep the private company financial statements from misleading the user. In applying understandability and simplicity, the notes would provide additional information that would better enable a user to understand standardized captions, the identity of accounting standards and policies that have a major impact on recognition and measurement of the elements, and unusual items and amounts appearing within the private company financial statements. In applying management’s intention, the notes would include clarifications of the purpose of the classification of items in the private company financial statements from among available choices, and the reasons for selection of a certain application of a standard from the available choices allowed by PCAS or the Framework. However, the disclosure principle contains constraints. First, disclosure is limited to information contained within the four financial statements. The notes are not a substitute for or an elaboration of private company financial information available from other sources. Second, since private company financial statements contain information from transaction-based accounting, disclosures of uncertainties and alternative amounts, or ranges of amounts, or percentages of uncertainties would undermine the probable and reasonably measurable basis of private company financial statements. Finally, management’s intention does not include a discussion and analysis format.

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Summary of Recognition, Measurement and Disclosure in Private Companies Versus Public Companies

By way of contrast, the table below summarizes the key differences in recognition, measurement and disclosure between private company financial statements and public entity financial statement.

Recognition Principle Private Company Accounting Standards

Public Company GAAP

What is the basis, or view, of recognition?

Operational activities view Financial capital maintenance view

What is the key financial statement?

Statement of Operational Performance

Statement of Cash Flows and Statement of Financial Position

What gets recognized? Accounting transactions Present or future cash flows When does recognition occur? In the past In the present What is the key threshold for recognition?

Probable None; any measurable probability that is material

What are the parameters for elements to be included?

Limited to operational activities combined with accounting transactions

Transactions, other events and circumstances

How does representational faithfulness affect measurement?

Verifiability and neutrality are satisfied by using transaction exchange price as input value

FASB proposes to reduce verifiability to an “enhancing” characteristic only

What is the default for initial measurement?

Input values Input and exit values

What is the default for subsequent measurement?

Input value is amortized according to the matching principle

Exit values

How is periodic income, or earnings, measured?

Revenues and gains less expenses and losses from transactions

Comprehensive income including holding gains and losses from re-measurement of exit values

What is the primary purpose of disclosure in notes?

Clarification of financial statements by applying materiality, understandability and simplicity, and management’s intention

Supplemental financial information, information not recognized in the statements, account reconciliations, and analysis

What is the basis of measurement of amounts disclosed in footnotes?

Same as financial statements Alternative measurement amounts of the elements based on variability and uncertainty

Does disclosure include management’s discussion and analysis?

Not permitted since the analysis can be obtained elsewhere

Acknowledged as a type of disclosure in the FASB framework

The Matching Principle

The development of PCAS should incorporate the matching principle. The measurement of operational performance in private companies is the excess of revenues reported in a time period over the expenses reported during the same time period. The recognition of revenue in a reporting period is the starting point for measuring the period’s operational performance. The matching principle is the recognition of expenses based on their association with revenues. This association may be a direct association. For example in recognizing a private company’s flow of product, the input costs of the flow of product (i.e., the input costs of the goods and services) are recognized as expenses and matched against the exit price of the flow of product (the revenue).

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The association of expenses to revenues may also be indirect. The total of flows of product over a time period may result in an observable use of an asset that cannot be associated with any one flow of product. These indirectly associated expenses may be matched to revenues by means of an allocation process – assigning a faithfully representational portion of an asset’s input cost to expense during the reporting period in which the revenues are recognized. The matching principle also supports the concept of recognizing expenses under an accrual basis. The recognition of revenue may point to the need to accrue an expense with a resulting recognition of a liability. In reality the accrual points to the existence of an operational resource (an asset) that is immediately consumed; the accrued liability points to the need to settle the obligation associated with the consumed resource.

The Time Period Principle

The time period principle determines that all amounts displayed in a private company’s financial statements issued during regular intervals over the life of the private company, referred to as periodic financial statements, reasonably and meaningfully provide a faithful representation of the financial activities and financial condition of the private company during the dates covered by these statements. The demarcation of the time periods determine when elements are recognized in financial statements, and help determine the amounts of accruals and deferrals that are associated with the recognition principle and the matching principle. The time periods are referred to as reporting periods or accounting periods.

THE ELEMENTS OF PRIVATE COMPANY FINANCIAL STATEMENTS

Elements of private company financial statements are the classifications of items with common characteristics in the private company financial statements. They are considered to be the building blocks from which private financial statements are constructed in that accounting transactions recognized and measured are usually first organized in a double-entry accounting system into these elements. Elements are recognized only from accounting transactions. In private company financial statements there are seven private company financial statement elements. Three elements are displayed on the statement of financial position – assets, liabilities and equity. Four elements are displayed on the statement of operational performance – revenues, expenses, gains and losses. The three elements on the statement of financial position each have additional components or classifications. In the order of the element definitions below, the statement of financial position elements are presented first, not because they have a higher priority, but because the typical private company obtains its initial assets by debt or equity financing to use to enhance operational performance.

Assets

A private company’s assets are its measurable operational resources that exist on a reporting date, resulting from past accounting transactions, that are more likely than not expected to be used to benefit future reported operational performance.

The Nature of Operational Resources and the Recognition of Assets

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The category operational resources is an identifiable subset of a private company’s general resources. Operational resources are identified by the characteristic of being capable of enhancing the operational performance of a private company beyond the date on which they are first recognized. Specifically, a private company’s operational resources consist of any of the following seven items:

1. Cash and cash equivalents.

2. Investments in property and financial instruments to be used directly by the private company in achieving operational performance. Directly means that the resource is used in its essential form, and revenue derived from holding the property or financial instruments is a primary operational activity of the private company.

3. Discretely identifiable tangible or intangible items to be used or consumed in operational activities for the purpose of enhancing future operational performance.

4. Goods and services to be sold to customers in future periods for the purpose of enhancing operational performance.

5. Conversion items. Conversion items, usually referred to as conversion costs are those items that are associated with the production of inventory and those items associated to self-construction of long-lived assets, both of which are used to enhance future operational performance. The term conversion costs refers to the costs of these items that are collected and reassigned in total to the cost of the inventory produced or long-lived asset constructed.

6. Balances arising from the process of realization of sale of goods or services, or other operational resources into net income. This would include measurable balances arising from future realization of assets previously used but no longer used to enhance operational performance.

7. Rights to receive cash or other assets for recognized gains.

Each of the resources is, by definition, capable of being used to enhance a private company’s operational performance; more specifically their use can increase the net income reported in a private company’s future statements of operational performance. However, these items are not current measurements of the financial, economic, or other benefits of those future operational enhancements, nor are they measurements of future cash flows from such operational enhancements. They are resources discrete and separable unto themselves that can be used, and are intended to be used, to generate operational performance.

Items 2, 3 and 4 usually result from a private company’s exchange transactions. Item 5 results from internal transactions. Item 7 arises from transfer transactions. Item 6 includes amounts from previous operational activities that will be converted into cash in the future, i.e., they are realizable items, and are typically classified as receivables. Item 6’s inclusion of balances of prior assets that no longer enhance operational performance may seem contradictory. However, the end of the process of operational performance is realization.

General resources is a broad term encompassing the many things that a private company can use, as perceived by an onlooker, in a positive way. However, only the above subset of general resources can qualify as operational resources. However, not all of these seven operational resources are assets. These seven operational resources become assets when their existence comes about by a past accounting transaction, and can be measured, and can be determined to probably (i.e., are more likely than not) enhance future operational performance.

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Assets are Measurable and Probable

Measurable is the definition of the underlying principle of measurement, which further includes the definitions of a reasonable estimate and of realization. The phrase “more likely than not” is the definition of probable provided by the underlying principle of recognition. As stated in the underlying principles, measurable and probable, in addition to working independently, can also work interactively; i.e., one does not necessary always precede the other.

Measurable and probable as used in the definition of an asset are not only initial judgments (i.e., applied only when an operational resource first becomes an asset), but these judgments are also applied on future financial statement reporting dates. An asset could at some point become un-measurable and/or less than likely to benefit future operational performance. Additionally, some discretely identifiable portion of an asset could likewise become un-measurable and/or become less than likely to benefit future operational performance. In such cases the asset or discrete portion thereof would no longer be recognized. However, the principle of observable impairment as defined in the qualitative characteristic of conservatism would apply to these judgments.

The fact that an operational resource is capable of being used to enhance the operational performance of a private company also implies that the seven operational resources may be used up or consumed, over time, in the process of being used.

The Measurement of Assets

Assets of private companies are initially measured at the input values of the accounting transactions. The input value of an asset is its acquisition cost, also referred to as historical cost, measured in monetary terms, observable in the accounting transaction that initially recognized the asset. Subsequent measurement of assets, except for cash equivalents, remains at the original input value less portions of the input value allocated or amortized to expense under the matching principle, less any observable impairment. This subsequent measurement is sometimes referred to as amortized cost. Since the primary objective of private company financial statements is to measure operational performance, the purpose of selecting input value for measuring assets is to obtain a basis for the computation of net income. The input value of asset, or portion of an asset, that becomes an expense in a transfer transaction is also assigned to the reporting period in which the accounting transaction is recognized.

An input value of a single asset can be transferred to another asset by the internal operational activity of the private company and is recognized by an internal transaction. For example, the conversion costs of manufacturing an item of inventory are a transfer of input values (material, labor and overhead). The input values are transferred and collected in a different place; i.e., in a different asset (finished goods inventory). However, no measurement alteration of the input values is made. For measuring operational performance (i.e., determining net income), only when subsequent operational activities result in an exchange transaction, is the input value exchanged for an exit value. In this example, the creating of valuable, saleable inventory by performing an internal operating activity (manufacturing) does not result in re-placing the input value with an exit value because an exchange transaction did not occur. The operational activity of selling the inventory is an exchange activity that changes the amount of realization, so the input value given up (the inventory) is matched to an exit value (the sales revenue), with the resulting difference reported as net income. The exit value is assigned as the new input value of the new asset recognized by the accounting transaction (accounts receivable).

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In a transfer transaction an input value of an asset may be transferred out of the private company and have none of its value replaced, because there is no exchange, and therefore the effect is to reduce net income by the amount of the input cost of the asset transferred.

An asset may be deliberately removed from service by a private company’s management; i.e., the asset is no longer used to enhance operational performance. In addition, the application of the qualitative characteristic of conservatism may result in observance of an asset, or portion of an asset, no longer enhancing future operational performance. An internal transfer accounting transaction recognizes management’s intention or the unanticipated reductions in usefulness of assets. The asset is measured at the lower of its amortized cost or realizable amount. These assets are presented separately in the financial statements.

Cash Equivalents

The use of monetary expressions in measuring elements results in a common unit of measure for all elements. While the ultimate end of financial reporting contained in the sum of all periodic private company financial statements is the netting of all cash flows over the life of an entity, an entity can substitute cash equivalents for actual cash. Cash and cash equivalents are measured at the value of money. However, the “value” of money changes over time. A cash equivalent is a type of financial instrument that has all of the following specific characteristics. The instrument,

• Has come into existence by an accounting transaction and meets the definition of an asset. • Is used by the private company temporarily as an investment for cash for the purpose of obtaining

a higher rate of return than from holding cash in deposit accounts or to protect the purchasing power of cash.

• Has an active market with a reliable volume of identifiable trading prices for the specific cash equivalent held by the private company.

• Can be converted into cash without delay, other than a holding period specified in a contract, during normal trading hours, except for the normal period of time required to execute and settle the transaction.

An active market, a reliable volume, and identifiable trading prices mean that the private company can readily obtain a quote for converting the financial instrument to cash at any time, and, except for the constraints of a holding period imposed by a contract, could actually convert the instrument to cash at the time of receiving the quote, without actually having to execute such a transaction, and that the cash proceeds that it would receive for such a transaction would be at the same price (subject to normal market price and settlement). While “temporary” means other than permanent, the period of time that a private company holds a cash equivalent is determined by management’s discretion.

Because cash equivalents are substitutes for cash, they are measured at their equivalent cash value. The initial measurement of the cash equivalent is the amount of cash originally exchanged or invested, less cash transaction costs. At each subsequent reporting period, the cash equivalent is re-measured at the amount of cash that could be obtained for the cash equivalent. This amount is the quoted fair value of the cash equivalent less specific trading costs that the private company would pay. This is the same as the cash equivalent’s liquidation value.

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Measuring cash equivalents at liquidation or exit value may appear to be inconsistent with the use of input values. However, the use of liquidation value is consistent with the cash realization principle. Transaction—based accounting measures transactions that, over time, are realized. Private company financial statements measure the amount of this cash. Realization can be in cash or cash equivalents. Cash equivalents are not considered a part of transaction-based accounting, but a temporary investment of cash. Accordingly, these cash equivalents should be valued at their equivalent amount of cash, and liquidation value is the best determination of this equivalence.

Financial instruments that do not have all of the above specifically defined characteristics are not cash equivalents and are measured both initially and subsequently at their input value. These financial instruments are subject to transaction-based accounting and follow recognition principles consistent with the measurement of operational performance.

Contrast of Private Company Assets Concepts with Public Entity Assets Concepts

By way of contrast, in the FASB’s proposed new conceptual framework for public companies, GAAP defines an asset as follows:

An asset of an entity is a present economic resource to which the entity has a right or other access that others do not have.

This proposed definition drops the word “past” from the FASB’s previous definition of an asset. This allows the new definition to include present or forward-looking information. In addition, the definition drops the phrase “transactions and events”, with the result that no restriction is placed in the definition on what can create an economic resource – either internally within the entity or externally by general economic circumstances. This intentional change allows the term “economic resources” to be defined by the FASB’s definition as “something that is scarce and capable of producing cash inflows or reducing cash outflows”. In addition, the definition drops the words probable (i.e., more likely than not) as a minimum threshold for recognition; the intention is to separate recognition from measurement. However, dropping “probable” from the definition allows the future cash flows to be measured at their present values, adjusted for probabilities, and then re-measured at exit values on all subsequent reporting dates. The asset definition, while still distinguishing an asset as “something” is nevertheless reported as equivalent to the present values of the probability adjusted future cash flows of that “something”.

The table below shows the differences between the proposed public entity concepts and the private company concepts of an asset:

Concepts of Assets Private Company Accounting Standards

Proposed Public Company GAAP

Type of resource Operational resource Economic resource Methodology for recognition of an asset

Created by an accounting transaction Something scarce and capable of producing a net cash inflow

When the asset is created In the past Exists on balance sheet date Minimum threshold for recognizing

Probable None; any measurable probability that is material

Distinguishing between the actual resource and its measurement

The resource is separate from future cash flows; instead a resource is used to enhance future operating activities

Present value of the future cash flows is equal to the resource reported – no real distinction

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Default initial measurement Input values Input values and exit values Default subsequent measurement

Input values amortized according to the matching principle

Exit values

Parameters for resources to be included

Limited to operational activities combined with accounting transactions

Any event or circumstance that creates an economic resource

Liabilities

A private company’s liabilities are its measurable operational obligations that exist on a reporting date, resulting from past accounting transactions, that are more likely than not expected to be settled in the future by conveying assets to or performing services for third parties other than the private company’s owners.

The Nature of Operational Obligations and the Recognition of Liabilities

The category, operational obligations, is a subset of a private company’s total obligations. Operational obligations are identified by the characteristic of arising from past operational activities including the obligation to pay for expenses previously recognized and the obligation to provides services in exchange for cash previously received, obligations from the past acquisition or creation of assets, and obligations to repay cash borrowed in the past. Specifically, a private company’s operational obligations consist of any of the following five items:

1. Obligations to pay cash or other assets for recognized expenses. 2. Obligations to provide future services that create a revenue element for the private company

when the services are performed. 3. Obligations to pay cash or other assets for assets acquired or created. 4. Obligations to repay cash borrowings. 5. Obligations to pay cash or other assets for recognized losses.

Obligations, herein referred to as general obligations, is a broad term encompassing all legal or equitable commitments of a private company, observable by an onlooker, to a third party. General obligations typically arise from the requirement to settle binding legal arrangements. However, general obligations may also arise from equitable responsibilities or duties to maintain good business relationships or in accordance with normal business practices. However, only the above subset of general obligations can qualify as operational obligations. However, not all of these five operational obligations are liabilities. These five operational obligations become liabilities when their existence comes about by a past accounting transaction, and can be measured, and can be determined to probably (i.e., are more likely than not) be settled in the future. Usually items 1 though 4 result from past exchange transactions. Items 1 and 3 may result from internal transactions activities. Item 5 arises from transfer transactions.

While a private company’s past accounting transactions create liabilities, these accounting transactions are generally those designed to create elements other than liabilities. As a result, recognition of a liability may be dependent on the recognition of another element. For example, the importance of the statement of operational performance leads to the application of the matching principle in recognizing expenses in

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the same period as associated revenues. The recognition of an expense under the accrual process determines the simultaneous recognition of an associated liability, even where the legal form of the obligation has not yet occurred. Likewise, the importance of recognizing a loss element in the statement of operational performance due to a one-way transfer of an operational resource in a transfer transaction, or unanticipated reduction of use of an asset in an internal transaction, results in the recognition of a liability. Item 2 above requires a liability to be recognized, not when legally incurred, but upon the recognition of an expense.

The recognition principle addresses mutually unfulfilled contracts. Where an unfulfilled portion of a contract exists, there is generally an unconditional right of setoff, and a liability is not recognized. However, where a third party has committed operational resources to the private company, there is no longer an unconditional right of set off and an exchange transaction has occurred. For example, leased property provided to a private company by a third party is a commitment of an operational resource. The private company recognizes the operational resource and the operational obligation in an exchange transaction.

The recognition principle also applies to a private company’s obligations under a long-term contract for receipt of a constructed tangible asset. A private company may receive the equivalent of a commitment if it receives identifiable portions of a constructed asset. Such identifiable portions are usually segregated clearly in construction contracts. In such cases, the private company would recognize both the tangible asset and the liability for the committed portion in an exchange transaction.

However, the primary qualitative characteristic of relevance and the constraining and modifying qualitative characteristic of pragmatism affect recognition of contracts for many intangible assets. Accordingly, while the act of a third party under an otherwise mutually unfulfilled contract in providing a tangible asset results in recognition, the commitment of an intangible asset under a mutually unfulfilled contract generally does not. The customs and traditions of pragmatism may determine recognition. For example, a contract in which a third party commits to lease employees over time, or even a long-term employment contract in which an employee commits his exclusive service to the private company, does not lead to recognition of a long-term asset or liability.

Liabilities are Measurable and Probable

Measureable and probable are applied to recognizing and measuring liabilities, both initially and subsequently, in the same manner as in recognizing and measuring assets, but with three differences.

First, in applying the definition of realization, the term is used in its settlement sense. A liability must have the characteristic of becoming settled at a future date by the transfer of cash, other identifiable assets or by providing identifiable future services that will create revenue.

Second, in applying the definition of probable, the qualitative characteristic of conservatism creates a bias towards recognizing liabilities at a lower threshold than in the application of probable to recognition of assets. The application of conservatism is a matter of judgment, and is also affected by the additional qualitative characteristics of pragmatism and materiality.

The qualitative characteristic of conservatism also applies to measurement of a loss related to mutually unfulfilled executory contracts and creates an exception to the matching principle under transaction-based accounting. Where there is an observable impairment under a contract, a loss is recorded in the statement of operational performance and a corresponding amount is recognized as a liability. For

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example, if a permanent decline is believed to have occurred in the price of raw materials to be received by a private company under a long range non-adjustable purchase contract, the obligation then exceeds the value of the raw materials and a loss and corresponding liability are recognized.

Third, where it is at least probable that a liability exists on a reporting date but a reasonable estimate of a measurement cannot be made, the nature of the liability should be disclosed in the notes accompanying the private company financial statements.

The Measurement of Liabilities

Liabilities of private companies are initially measured at the input values of the accounting transactions. The input value is the exchange price, also referred to as historical cost. In many accounting transactions, the amount of the liability is secondarily determined; that is, it is the amount first determined in measuring another financial statement element. For exchange transactions, the measurable amount of the obligation is usually stated, although this stated amount may be derived from the stated acquisition amount of an asset obtained in the transaction, or by the actual amount of cash loaned to the private company in a borrowing agreement. For internal transfers the amount of the liability is usually determined by the measurement of the related element in the accounting transaction. Consistent with the priority of the statement of operational performance the amount of a liability is derived by application of the matching principle in recognition of expenses.

For liabilities created in accounting transactions in which a private company receives cash and is obligated to repay cash, any amounts representing interest included in the exchange price, referred to as discounts or premiums, are measured separately from the amount of the original obligation under an effective interest rate yield method . However, the application of an effective yield measurement method is not for the purpose of re-measuring the amount of a liability based on its current market value or current settlement value, but only to distinguish between the original exchange price of the obligation and the subsequent obligation to pay interest at the actual amount of interest specified or implicit in a borrowing agreement.

Subsequent measurement of liabilities remains at the original input value less portions of the input value of any original advances recognized in the statement of operational performance. This subsequent measurement is sometimes referred to as amortized cost. For example, a portion of the amounts of cash or other assets received in exchange for an obligation to provide future services is transferred to the statement of operational performance under revenue realization measurement. Under the qualitative characteristic of a going concern, liabilities are assumed to be settled in the future under their original terms, including original maturity date, unless and until modifications are made and then the modified terms are substituted for the original. Therefore, a debt instrument issued by a private company is assumed to be held to maturity and measured at amortized cost.

Contrast of Private Company Liabilities Concepts with Public Entity Liabilities Concepts

By way of contrast, in the FASB’s proposed new conceptual framework for public companies, GAAP has the following definition of a liability:

A liability of an entity is a present economic obligation for which the entity is the obligor.

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As is the case with the definition of assets, the FASB’s proposed definition drops the words “past”, “transactions and events”, and “probable” from the definition. The proposed definition also replaces the previous language of “future sacrifices of economic benefits”, with the new phrase “present economic obligation”, which it defines as “an unconditional promise or other requirement to provide or forgo economic resources, including through risk protection. As a result, the recognition of a liability follows the broad recognition of economic resources. Measurement is determined without a probability threshold (other than materiality) and exit values are used initially and for subsequent reporting periods.

The table below shows the differences between the proposed public entity concepts and the private company concepts of a liability:

Concepts of Liabilities Private Company Accounting Standards

Proposed Public Company GAAP

Type of obligation Operational obligation Economic obligation Methodology for recognition of a liability

Created by an accounting transaction An obligation to provide or forgo an economic resource

When the liability is created In the past A neutral judgment of existence on a balance sheet date

Minimum threshold for recognizing

Probable None; any measurable probability that is material

Distinguishing between the actual obligation and its measurement

The obligation is separate from future cash flows; instead an obligation results from past operational activities.

Present value of the future cash flows is equal to the resource reported – no real distinction

Default initial measurement Input values Exit values Default subsequent measurement

Input values maintained with interest accretion or revenue recognition under the matching principle

Exit values

Parameters for obligations to be included

Limited to operational activities combined with accounting transactions

Any event or circumstance that creates an economic obligation

Owners’ Equity

A private company’s owners’ equity consists of the net amount of its accumulated earnings, accumulated distributions of those earnings, and the net amount of the owner’s capital invested and retained.

The Nature of Owners' Equity

From a mathematical perspective, the total amount of owners’ equity is the difference between the total amount of assets and total amount of liabilities displayed on a private company’s statement of financial position. This difference is sometimes loosely referred to as a residual interest in the assets. However, in private company financial statements one portion of this difference between assets and liabilities mathematically results from the articulation of the elements on the statement of operational performance with the statement of financial position and a second portion is due to financing (both debt and equity) within the statement of financial position. In financial statement articulation, amounts displayed as assets and liabilities may be secondarily determined by the recognition in the statement of operational performance of revenues, expenses, gains and losses since the measurement of operational performance on a transaction-based model has priority in private company financial statements. The total of owners’ equity (as distinct from the components of owners’ equity), may be viewed as mathematical balancing of the accounts.

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Accordingly, the use of the term “residual” does not represent a numerical amount of a claim by the owners against assets, amounts of assets that could be distributed to owners on the reporting date, an amount that could be distributed to owners in a current or future liquidation, or the owners’ fair value of their interests on the date of the statement of financial position.

Instead of being a residual interest of the owners, and in addition to being a balancing of accounts, owners’ equity in private company financial statements consists of three distinct components each of which contains its own definition, and each of which contains meaningful information for private company financial statement users.

The first component of owners’ equity displayed in a private company’s statement of financial position is the accumulated net income of the private company since its inception. This component, accumulated net income, is dependent on the accounting transactions that determine the amount of a private company’s net income measured under an operational performance view. The accumulated net income component is not the change in net asset values during a reporting period under a financial capital maintenance concept. Accumulated net income is a measure of operational performance of a private company since its inception and not a measure of wealth creation for the owners. Over time, and in accord with the realization principle, the accumulated net income represents a proxy for total net cash flow generated by operational performance including the cash cost of resources consumed and the cash costs of financing the operational performance.

The second component displays the distribution of net income to owners since the private company’s inception a result of a transfer transaction. The component, accumulated distributions or dividends, is actually a distribution of net assets created by operational activities over time. As a practical matter, these first two components are usually netted and referred to as retained earnings.

Retained earnings shows an amount of net assets (but not specific net assets) on the statement of financial position that potentially could be distributed to the owners equal to the amount of accumulated net income and the amount of accumulated distributions. However, an actual distribution is based on the private company’s ability to transfer assets, and the amount of cash or other net assets that would be realized in the event that the existing net assets must first be exchanged for other net assets prior to distribution. The amount of retained earnings is also useful in showing the history and pattern of past dividend to owners. The amount of retained earnings is also useful for showing the segregation and relationship of the amount of capital in a private company on the date of the statement of financial position attributable to operational performance distinct from the owners’ net capital investment.

The third component is the net amount of owners’ capital invested and retained in the private company at input values on the date of the statement of financial position as a result of past transfer transactions. The owners’ capital is the net of amounts originally and subsequently invested at their input values less amounts of these investments subsequently withdrawn by the owners. This component is primary used for stewardship purposes as this amount, in tandem with other sources of financing, is compared to the operational performance of the private company for evaluation of performance of the private company and its management by private company financial statement users. This component, either by itself or with retained earnings, is used with other financial statement metrics to evaluate the amount of debt that a lender may willing to loan, or maintain, as a loan to a private company.

In summary, while the total of owners’ equity equals assets minus liabilities, the total is actually the net of (a) the results of operational performance since inception, (b) less distributions of net assets to owners since inception resulting from operational performance, and (c) the net amount of investments of capital invested and withdrawn by the owners as of the date of the statement of financial position.

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To provide useful and relevant information to private company financial statements users, portions of the results of operational performance, amounts of distributions, and capital investments and withdrawals may be separated into accounting periods.

The Recognition and Measurement of Owners’ Equity

Accumulated net income is the result of the recognition and measurement of revenues, expenses, gains, and losses over time. Accumulated distributions and the investments and withdrawals of owners’ capital are recognized by transfer transactions. Most transfers are in the form of cash. Other net assets transferred to or from a private company are measured at the private company’s input value of the net assets. A mutually unfulfilled contract may contain commitments between the private company and an existing owner or third party that may result in the private company issuing or redeeming equity instruments. The issuance or redemption of equity instruments are not recognized in the private company financial statements until fulfillment or partial fulfillment by the existing owner’s or third party’s commitment or partial commitment occurs. Such unfulfilled contracts or partially unfulfilled contracts, if material, are disclosed in the notes.

Revenues

A private company’s revenues are the measurable flows of its products to customers, resulting only from exchange transactions that occurred during a past reporting period, and more likely than not favorably increased operational performance in that past reporting period.

The Nature of Revenues

A private company’s goods and services are created by its operational activities. The nature of a private company’s revenues is the flow of its goods, the flow of its rights to use its goods, and the flow of its services to customers. Collectively, these flows are referred to as a flow of product. The purpose of a private company’s flow of product is to make a profit for the private company. Revenues directly increase the measurement of a private company’s operational performance in a reporting period, and are favorable or positive numbers that increase the calculation of net income on the statement of operational performance. Some definitions of the term revenues disregard the flow of product, which is an outward flow, and focus on an inflow of assets or net assets received by a private company in exchange for goods and services. However, such definitions are either intertwining or substituting terminology more related to how to recognize and measure revenues than to the nature of revenues. Recognizing a flow of product to a customer is the starting point for measuring a private company’s operational performance. Accordingly, the application of the qualitative characteristic of representational faithfulness focuses representation in private company financial statements on the flow of products from the private company to the customer instead of the resulting inflow of net assets to the private company. While impossible to segregate the flow of product from a benefit expected to flow in to the private company in return, the private company definition of revenues does incorporate an enhancement to operational performance. This private company definition then allows focus on the recognition of the completion of the flow of product and on the exit price of the flow. It is the revenues that are earned and realized, with the result that new assets are obtained or settlements of liabilities occur. The additional benefit of the private company revenues definition is that the sacrifices incurred in order to create the flow of products (expenses) can be matched against the revenue recognized from the flow of product.

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Goods is a broader term used to encompass a private company’s inventory and any of its other assets that it normally intends to transfer in a recurring exchange, or intends to transfer its rights to use in a recurring exchange, to customers in order to enhance the private company’s operational performance. A private company’s revenues result from past exchange transactions that are recurring and part of its operational activities. Specifically, private company revenues can be created by the following three types of flows to customers:

• Flows of selling goods

• Flows of rendering services

• Flows of rights permitting customers to use its goods

Not all of these three items are revenues. In order to be revenues, these items had to be created by an exchange transaction that resulted from recurring operational activities. Flows of product created by operational transfers or by internal transfers are not revenues. Additionally, in order to be revenues an exchange transaction recognizing any of the three items must to be determined to have probably (i.e., more likely than not) occurred during the reporting period and probably enhanced operational performance during the reporting period, and the exit prices must be capable of being reasonably estimated. In determining the flow of rights in the third item, the creation of an agreement by a private company with a customer that will allow the customer the right to use a private company’s goods, but contains conditions affecting the customer’s access to the right, is not a flow of rights permitting use to the customer, and is therefore not revenue. This type of conditional right is usually created in a mutually unfulfilled executory contract. The flow of rights occurs when an exchange transaction takes place actually permitting the customer access to exercise the rights, and in the case of an executory contract creates fulfillment or partial fulfillment. The use of goods in item 3 means that the customer has the ability to receive any of its benefits from the private company’s goods without regards to whether the benefit creating event is acted upon the goods by the customer, private company, third party, or the passage of time, and regardless of whether the goods are located with the customer, private company, or third party. The revenue recognized by a private company for the flow of its rights permitting its customers to use its goods is expressed in such terms as rent, interest, dividends, royalties, and commissions.

The Recognition of Revenues

A private company recognizes revenues when both of the following circumstances have occurred within and as part of an exchange transaction:

• The private company has performed, i.e. substantially accomplished, what it must do to be entitled to the benefits of an exit price from a customer. This is also referred to as completion of the earnings process.

• The exit price of the private company’s flow of product has been realized or is realizable.

As a result of the above circumstances, a customer usually has receipt or substantial receipt of a good, the right of access to use a good, or has been rendered a service. However, a private company’s

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recognition of revenue is not dependent on the private company determining whether any subsequent benefit is obtained by the customer or whether an asset is created by the customer for the good, right to a good, or service outside of any guarantee of benefits by the private company.

The Measurement of Revenues

A private company measures revenues at the exchange prices observable in the exchange transaction. The exchange price is the exit price of the private company’s flow of product. The observation of the exit price is usually verifiable by its acceptance -- referred to as a price or fee -- by the customer agreeing to the exit price stated in a contract, quote, invoice, statement of accounts receivable or by the customer’s transference of money, or other measurable assets that are realizable, or by assumption of a measurable liability of the private company. However, the inflows of money, other assets, or assumption of a liability are not the revenues or the amount of the revenues, but usually are equal to the exit price, and the exit price becomes the input value of money or assets received or liabilities reduced.

The Recognition and Measurement of Revenues from a Long-term Contract

A long-term contract is a contract for performance of specific operational activities by a private company for more than one reporting period. For a long-term contract with a customer that specifies a series of performances by a private company, each of which can be substantially accomplished, flow of product and recognized revenue occur when each of the specified series of performances is substantially accomplished by the private company, provided at a minimum a realizable amount of exit price can be estimated. Each series of specified performances is viewed an exchange transaction by the partial fulfillment of an otherwise mutually unfulfilled contract. However, not all long-term contracts specify a series of performances. The qualitative characteristic of pragmatism provides a modification to the recognition and measurement of revenues under a long-term contract when the contract does not contain a specific series of performance requirements that would constitute a flow of product. When both the total exit price of a private company’s long-term contract and the input values of the operational activities required by the long term contract can at a minimum be reasonably estimated, a flow of product is recognized and measured by the private company by reference to the stage of completion of the contract’s required total operational activity.

Contrast of Private Company Concepts of Revenues with Public Entity Concepts of Revenues

By way of contrast, in the FASB’s proposed new revenue recognition standard for GAAP, revenue is defined as follows:

Revenue should be recognized on the basis of increases in an entity’s net position in a contract with a customer.

The proposed new standard is based on an asset and liability approach consistent with GAAP’s financial capital maintenance view. In the proposed GAAP standard an entity’s assets and liabilities on which revenue recognition is based are contained within an entity’s contracts with its customers. The assets are referred to as rights to receive consideration from customers and the liabilities as performance obligations of entity. Revenue is recognized as performance obligations are satisfied. A performance obligation is satisfied when a good or service becomes an asset of the customer. Revenue is not recognized by an entity on long-term contracts if control of an asset is not transferred to a customer. Revenue is not defined separately from its measurement.

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Measurement of the total of the contracts rights and obligations is based on total customer consideration, which is a measurement of potential inflows to the entity. Measuring revenue consists of allocating the total contract consideration to each of the contract’s performance obligations based on an estimate of the relative standalone prices of the goods and services underlying the performance obligations. The minimum measurement threshold is an estimate. Finally, associated performance obligations such as warranties and other post delivery services are recognized as revenues and not as accrued costs under the matching principle.

The table below shows the differences between the proposed public entity standard and the private company concepts of revenues:

Concepts of Revenues Private Company Accounting Standards

Proposed Public Company GAAP

Definition of revenue Private company’s flow of its goods, its rights to use its goods, and its services

Not defined separately from recognition

Methodology for recognizing revenue

Completion of earnings process and exit price is realized or realizable

Asset and liability approach

Method of recognition of a contract with a customer

No recognition Recognition of fully or partially offsetting asset and liability

Measurement attribute of a contract with a customer

No measurement Total customer consideration or inflow to be received

Recognition of delivery of a good or service

Substantial accomplishment of what must be done to receive a benefit

Recognition of the good or service as asset by the customer

Measurement of delivery of a good or service

Exit price of the good or service Allocation of total contracted customer consideration

Threshold for recognition and measurement

Probable of occurrence and measurement is reasonably estimated

Any estimate of a standalone market price

Recognition of associated performance obligations

Accrued as a cost under the matching principle

Recognized as revenue when the performance obligation is satisfied

Revenue recognition of long-term contracts

Pragmatic recognition based on stage of completion

Not recognized until control of asset passes to customer

Expenses

A private company’s expenses are the measurable sacrifices of its net assets incurred directly or indirectly in the creation of flows of its products to customers, resulting from accounting transactions that occurred during a past reporting period and more likely than not unfavorably decreased operational performance in that past reporting period.

The Nature of Expenses

In a private company’s operational activities leading to the flow of its product, the private company uses some of its assets in order to create flows of its product to customers. These assets are primarily the goods and services that the company relinquishes to a customer in order to be able to obtain revenues. These goods and services are said to be sacrificed because they are no longer operational resources of the company once the flow of product is recognized. They are direct sacrifices because these goods and services have flowed directly to the customer and have the potential to become assets of the customer. Other assets are used indirectly in the creation of the private company’s flow of product and become expenses in an accounting transaction. These assets can be observed as having an operational benefit

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in creating flows of product, but the assets either do not flow to the customer, or cannot be observed as flowing to the customer, but in both cases are observed to be used. Some of these assets are indirectly used in the creating of flows of product over time and their sacrifice is allocated over the time periods in which the flows are observed to occur. Some expenses result from assets that are observed to exist only momentarily and are sacrificed in the same period as the flow occurs. This is typical of the flow of services where the asset may be a salary of a private company’s employee used in the flow of the service. While an asset by definition enhances future operational performance, the sacrifice of the asset, i.e. the expense, is matched as best as can be reliably determined with the revenues that are recognized from the flow of product. The term sacrifice means that the asset was being used as intended in creating a private company’s flow of product. Sacrifice does not mean the asset was physically consumed in its use. Used does not mean used-up. While the consumption or physical disappearance of an asset may point to its sacrifice, the term sacrifice means that the asset was used for operational activities purposes instead of for other purposes. The asset that was or is being sacrificed to create a flow of product may have a value to a third party different from its transaction-based input value. Measuring alternative current or future values apart from the input values and exit prices of accounting transactions, except for the application of conservatism, is not an objective of private company financial statements. The information may be of interest to a private company financial statement user but is obtainable from other sources of private company information.

The Recognition of Expenses

Revenues directly increase the measurement of a private company’s operational performance in a reporting period, and are favorable or positive numbers that increase the calculation of net income on the statement of operational performance. Expenses directly decrease the measurement of a private company’s operational performance in a reporting period, and are unfavorable or negative numbers that decrease the calculation of net income on the statement of operational performance. The recognition of the expenses is derived from the recognition of the revenue. This is the application of the matching principle in determining periodic operational performance. In some cases the recognition of revenue is said to create a liability under the matching principle, and the accounting transaction usually directly records the expense and a liability. Under this accrual basis however, an asset is recognized and immediately expensed because it has immediately been used to enhance operational performance by the recognition of revenue associated with the asset. The liability is the accrual of the obligation associated with the asset that is immediately sacrificed. Nevertheless, the impetus for measuring the resulting liability may be the accrual process used in measuring operational performance. The liability associated with revenues in the matching principle may not arise because of a separate or stand alone contractual or other legal obligation, but may be a reasonable estimate of what needs to be matched against revenue in the current reporting period that may be confirmed at a later date by a contractual or legal commitment. For example, the need by a private company to engage a third party in the future to provide warranty work on a private company’s flow of product that occurred in a current period, may result in an accrual of an expense and liability in the current period under the matching principle, but the actual contractual requirement that results in an obligation to the third party who performs the warranty work may not occur until a future period, and the identity of the third party may be known until a future period. Unlike recognition of revenues, recognition of expenses can result from all three types of accounting transactions. In a flow of product to a customer, those direct expenses associated with the sacrifice of goods and services are recognized in an exchange transaction that matches the separate exchange

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transaction recording the revenue. An expense will also be recognized in a transfer transaction when a one-way transfer of net assets to a third party is indirectly associated with the total flows of product during a reporting period. These expenses are primarily in the form of taxes, fees or penalties that an entity may be compelled to make to a third party. These expenses are necessary in order to allow the entity to legally or contractually make or continue to make its flow of product. However, the relationship with any one flow of product is indirect and as a result, recognition is usually determined by the assigning of the expense to the reporting period or periods in which the transfer allowed the occurrence of operating activities that resulted in recognition of revenues. Finally, some internal transactions result in the using of assets that are indirectly associated with a flow of product, but cannot be reliably demonstrated to effect flow of product beyond the period in which the transaction occurred. Accordingly, the input costs of these activities are recognized as expense in the period in which the internal operating activities occurred. However, the collection of the input values of several assets and the re—assigning of the input values to another asset not yet used in the flow of product is the internal operational process of creating conversion costs. Conversion costs may be recognized as expenses when the associated flows of product occur. Where revenue is recognized on a long-term contract with a customer, expenses are recognized under the matching principle. However, in some long-term contracts, the relationship of the incurrence of periodic expenses to total estimated costs of the contract may serve as a more useful basis of measuring operational performance and may be acceptable under the qualitative characteristic of pragmatism.

The Measurement of Expenses

Since an expense is defined as the sacrifice of net assets, expenses are measured at the input costs of the specific assets sacrificed or specific liabilities settled that compose these net assets that are sacrificed. Practically, since under an accrual basis an asset may be simultaneously created and consumed, the measurement of the expense may be determined by looking at the acquisition cost within the accrual accounting transaction that in practice bypasses the asset recognition.

Gains

A private company’s gains are the measurable inflows of benefits, other than benefits associated with the recognition of revenues, and other than benefits in the form of owners’ net investments, resulting from accounting transactions that occurred during a past reporting period, and more likely than not favorably increased operational performance in that past reporting period.

The Nature of Gains

Gains and revenues are similar. Both directly increase the measurement of a private company’s operational performance in a reporting period, and are favorable or positive numbers that increase the calculation of net income on the statement of operational performance. Both gains and revenues result in the receipt of benefits. Benefits are inflow of assets or a settlement of a liability, and therefore are realized or realizable. The distinctions between gains and revenues, however, are for assistance to the private company user in better understanding operational performance of the private company. These distinctions are four-fold:

• Unlike revenues, gains do not result from the private company’s recurring flow of product.

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• While gains do result from a private company’s operational activities, they are not the primary focus of the operational activity, and may be considered incidental.

• Unlike revenues, gains may be recognized from transfer transactions, specifically a one-way transfer to a private company from a third party.

• Unlike revenues, gains are measured based on the input values of the inflow of benefits in the accounting transaction.

The Recognition and Measurement of Gains

A private company recognizes a gain from two types of accounting transactions – an exchange transaction and a transfer transaction in which the private company receives a one-way transfer of benefits. A private company recognizes the gain in the period in which it more likely than not has the right to obtain control of the benefits, and when the benefits can be reasonably estimated. In an exchange transaction a gain is measured as the difference between the input value of the private company’s net assets exchanged and the input value of the benefits received. In a transfer transaction a gain is measured by the input value of the benefits received. Gains are only recognized and measured in private company financial statements from the operational activities of a private company when transfer transactions and internal transactions have occurred. By way of contrast, in public entity financial reporting statements gains may be recognized due to changes in assets and liabilities under a capital maintenance view. In summary, a private company’s gains result from favorable accounting transactions from that portion of its operational activities that are not considered the normal operating activities of the private company.

Losses

A private company’s losses are the measurable outflows of net assets and unanticipated reductions in usefulness of assets, other than sacrifices of its net assets associated with the recognition of expenses, and other than outflows in the form of owners’ net withdrawals, resulting from accounting transactions that occurred during a past reporting period, and more likely than not unfavorably decreased operational performance of the past reporting period.

The Nature of Losses

Losses and expenses are similar. Both directly decrease the measurement of a private company’s operational performance in a reporting period, and are unfavorable or negative numbers that decrease the calculation of net income on the statement of operational performance. Both losses and expenses result in the reduction of net assets either from an outflow of sacrifice. The distinctions between losses and expenses, however, are for assistance to the private company user in better understanding operational performance of the private company. These distinctions are three-fold:

• Unlike expenses, losses do not result from the private company’s recurring flow of product.

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• While losses do result from a private company’s operational activities, they are not the primary focus of the operational activity and may be considered incidental.

• Unlike expenses, losses may be recognized by the unanticipated reduction in the usefulness of an asset. Reduction in usefulness means that an asset or portion of an asset may no longer enhance future operational performance.

The Recognition and Measurement of Losses

With the exception of unanticipated reductions in the usefulness of assets, the recognition of losses is the opposite of gains. A private company recognizes a loss from two types of accounting transactions – an exchange transaction and a transfer transaction in which the private company makes a one-way transfer of net assets. A private company recognizes the loss in the period in which it more likely than not becomes obligated to relinquish control of net assets, and when the amount of the relinquishment of net assets can be reasonably estimated. In an exchange transaction a loss is measured as the difference between the input value of the private company’s net assets exchanged and the input value of the benefits received. In a transfer transaction a loss is measured by the input value of the net assets to be relinquished. Losses are also recognized when an asset or portion of an asset is determined, other than in its normal and recurring use, no longer to enhance future operational performance. An asset may be intentionally removed from service, or may be observed in part or whole by the application of the qualitative characteristic of conservatism no longer to be enhancing operational performance. The input cost, i.e. the amortized cost, identified with the asset or portion of asset no longer enhancing operational performance, unless a portion is realizable in a separate transfer transaction, is transferred to a loss element in an internal transaction. The minimum threshold for recognizing a loss from an observable impairment is that the asset will probably not enhance future operational performance. Losses are only recognized and measured in private company financial statements from the operational activities of a private company when transfer transactions and internal transactions have occurred. By way of contrast, in public entity financial reporting statements losses may be recognized due to changes in assets and liabilities under a capital maintenance view. In summary, a private company’s losses result from unfavorable transactions from that portion of its operational activities that are not considered the normal operating activities of the private company.

THE PRESENTATION OF PRIVATE COMPANY FINANCIAL STATEMENTS

Private company financial statements are a collection of specified, structured displays of the elements, and are accompanied by structured explanatory notes. Each display other than the notes are referred to as a financial statement and collectively referred to as private company financial statements. The complete set of statements and their order of display are as follows:

• Statement of Operational Performance (also informally called an income statement)

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• Statement of Financial Position (also informally called a balance sheet)

• Statement of Owners’ Equity

• Statement of Cash Flows (also informally called a cash flow statement)

The order of these statements is based on the primary way in which private company financial statements satisfy the Objective of private company financial statement users which is to provide the results of the private company’s past operational performance. The order and relative importance of the statements also places primary emphasis on recognizing and measuring the elements of the statement of operational performance in a higher relationship to the elements of the statement of financial position.

Statement of Operational Performance (also informally called an income statement)

The statement of operational performance displays the elements of revenues, expenses, gains, and losses and their relationships in determining net income. Net income is the final measurement of a private company’s operational performance because it is the direct and fully dependent result of the application of the definition of the elements, the qualitative characteristics and the underlying principles, applied within the framework of the Objective. Accordingly, other concepts or views of net income are excluded from the statement of operational performance. Within the display of the four elements, additional disaggregations are displayed by function and not by nature. Function refers to the key operating activities of the private company that comprise operational performance. Examples of functions include, but are not limited to selling goods, providing services, manufacturing product, advertising, marketing, research, business development, and administrative. With a functional display the private company financial statement user can determine the actual costs (input values) of the various key operations of the private company that were used in obtaining the revenue (exit price) from the company’s flow of product; the result is net income under the matching principle. By way of contrast, many users of public entity financial reports prefer that the income statement display items by nature – a categorization that matches and links to all changes in net assets, other than with common stockholders. Under a capital maintenance view, an income statement is essentially a statement of changes in net assets during a reporting period. In the views of many public entity equity investors and equity analysts, the origination of financial statement articulation is the statement of financial position, and therefore, in order to understand articulation during a reporting period, the income statement accounts need to align with the asset, liability and equity accounts. Under this view Income from operating activities is just one component of the income statement and is captured, though not displayed, when all changes in net assets are recognized. For many private company financial statement users, the measurement of EBITDA in a reporting period is important. Optional display of EBITDA, or a similar singular amount derived directly from net income may be displayed below the display of net income.

Statement of Financial Position (also informally called a balance sheet)

The statement of financial position displays the elements of assets, liabilities and owners’ equity at the beginning and end of a reporting period. The display is the direct and fully dependent result of the

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application of the definition of the elements, the qualitative characteristics and the underlying principles, and the articulation of the financial statements applied within the framework of the Objective. The amounts are intended to faithfully represent the results of past accounting transactions that recognized assets and liabilities, under the legal proprietary or stewardship view, at their original input values and adjusted over time by that portion of the input values that has been used to enhance operational performance over the past reported time periods. Certain items and amounts of assets and liabilities may, from time to time, approximate fair values and may approximate a present value of a future cash flow, but the assets and liabilities are primarily the result of the deployment of capital, including both the owners investment and debt, and may indicate how that deployment was used to generate operational profit within past reporting periods and may be used in the future to generate both operational profit and cash flow. However, the displayed amount of assets, liabilities and owners’ equity are not the only indicators of or creators of future earnings and cash flows, nor collectively the present value of future earnings or cash flows; there will be other events and circumstances outside of accounting transactions that will likely have a future impact. However, the statement of financial position is designed to identify only those assets and liabilities recognized by past accounting transactions. The display of the elements on the statement of financial position is the order of assets, liabilities and owner’s equity with totals for each. Disaggregation of assets and liabilities is made based on their common characteristics and by either ascending or descending order of liquidation, but not by business and financing activities.

Statement of Owners’ Equity (also called a statement of changes in owner’s equity)

The statement of owners’ equity shows the components of owners’ equity at the beginning and end of a reporting period and the changes occurring during the period. The components displayed are:

• The accumulated net income

• The accumulated distributions of net income to the owners

• The total investments by the owners and the total of withdrawals of prior investments by the owners

The display for each component is in reconciliation format: The balance at the beginning of a reporting period is displayed and the activity during the reporting period is displayed in total and added to the beginning balances to agree to the balance at the end of the reporting period which is also displayed. The display of accumulated net income component may also include a secondary display of any changes in the reporting period to amounts of previously reported accumulated net income as a result of applying any requirements of PCAS.

Statement of Cash Flows (also informally called a cash flow statement)

The contents of the statement of cash flows are derived directly from the other private company financial statements. Its purpose is to provide information about the changes in cash occurring within a reporting period, primarily as a result of a private company’s operational performance, and secondarily, the private company’s investing and financial activities associated with supporting its operational performance. Accordingly, the starting point for the statement of cash flows is the net income for the period. The net

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income is then adjusted by the normal accruals and deferrals and non-cash gains and losses associated with operational performance in order to determine the cash provided by operational activities. The process by which this operational cash flow is determined and presented is referred to as the indirect cash flow method. The purpose of using the indirect cash flow method is to show the link between net income reported during a period and the related process of realization occurring during the period. PCAS should permit the option to use the direct cash flow method in addition to, but not in substitution for, the indirect cash flow method. After displaying cash flows for operational activities, cash flows from investing activities and then from financing activities are presented. Investing activities are the acquisitions and disposals of long-term assets. Financing activities are the changes in the amount and composition of owners’ investments and debt financing from sources other than operational performance and investing activities.

The Notes to the Private Company Financial Statements (also called footnotes or notes)

The notes to the private company financial statements contain information that satisfies the disclosure principle. The notes provide narrative descriptions and disaggregations of line item amounts that do not fit the form and content of the four private company financial statements. The nature of each of the specific disclosures would be determined within individual standards contained in PCAS. However, the list below should be included in the Framework to guide and limit the nature and number of disclosures. Deviations from this list of disclosures in the development of PCAS should be rare:

• Significant accounting policies that affect the recognition and measurement of operational performance.

• Selection of an accounting standard or application of an accounting standard from among choices offered in PCAS and management’s intentions in making the selection.

• Selection of a classification of contents in private company financial statements from among choices offered in PCAS and management’s intentions in making the selection.

• Significant changes in recognizing or measuring financial statement elements due to the application of a new accounting standard or a change application or interpretation of an existing standard.

• Significant changes in estimate and the reason for the change in estimate.

• Correction of errors in prior private company financial statements.

• Disclosure of related parties and significant activity with the related parties.

• Financial guarantees of third parties.

• Identification of overrides of PCAS or the Framework or the application of Framework where there is no PCAS. Management’s intention in the selection or application is included.

• The nature of any accounting transaction for liabilities, expenses, and losses meeting the recognition threshold, but not the measurement threshold.

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• Pledges of assets or other restrictions on the use of assets that are not otherwise recognized as

liabilities.

• Limited disaggregation of line items on the private financial statements based on custom and tradition and the application of materiality, understandability and simplicity. However, disaggregation is not based on rules or account reconciliations.

• Narrative explanation of standardized captions used within the private company financial statements.

• Future payment terms and interest rates on receivables and payables.

• Future redemption and conversion terms of compound financial instruments.

• Future redemption or issuance terms for equity or equity related instruments.

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A Model Conceptual Framework for Private Company Accounting Standards

Glossary of Private Company Accounting Terms Account: A subset of a private company financial statement element in which an accounting transaction is recorded by a double-entry accounting system. Accounting Transactions: The three types of realizable operational activities of a private company consisting of external operational exchanges, external operational transfers, and internal operational transfers. Accrual Accounting: The accounting process of recognizing, measuring and disclosing elements and changes in those elements in the financial reporting periods affected by past accounting transactions rather than only in the periods in which cash is received or paid by the entity. Accrual accounting consists of accruals, deferrals, and allocations. Accruals: The portion of accrual accounting associated with recognition, measurement and disclosure of expected future cash receipts and payments. Accumulated Distributions: The second component of owners’ equity. Accumulated distributions displays the distribution of net income to owners since the private company’s inception as a result of transfer transactions. Accumulated Net Income: The first component of owners’ equity. Accumulated net income displays the accumulated net income of the private company since its inception. Allocation: The portion of accrual accounting, usually associated with the matching principle, that initially and subsequently assigns or distributes a recognized and measured amount according to either the requirements of an accounting standard or an accepted accounting convention to either (a) a financial reporting period, or (b) to or from a conversion cost. Amortized Cost: The unmatched portion of the original input value measurement attribute remaining for assets and liabilities in subsequent reporting periods. Articulation: The design of the relationships among the private company financial statement elements in such a manner that allows the user to ascertain and reconcile cash to accrual accounting transactions within a set of financial statements and also to associate the financial activity occurring within a specific time period to the financial position of the private company at the starting and ending points of that time period. Assets: A private company’s assets are its measurable operational resources that exist on a reporting date, resulting from past accounting transactions, that are more likely than not expected to be used to benefit future reported operational performance. Cash equivalent: A cash equivalent is a type of financial instrument that has these specific characteristics: It has come into existence by an accounting transaction and meets the definition of an

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asset; it is used by the private company temporarily as an investment for cash for the purpose of obtaining a higher rate of return than from holding cash in deposit accounts or to protect the purchasing power of cash; it has an active market with a reliable volume of identifiable trading prices; it can be converted into cash without delay during normal trading hours, except for the normal period of time required to execute and settle the transaction. Conservatism: One of the constraining and modifying qualitative characteristics of private company financial statements. Conservatism is the practical application of skepticism to the elements of private company financial statements usually resulting in displaying the lowest of several possible values for the asset and revenue elements and the highest of possible values for liability and expense elements. Continuity: One of the constraining and modifying qualitative characteristics of private company financial statements. Continuity is the view that the application of a stable body of private company accounting standards over long periods of time is more useful than frequent and ongoing issuance of new standards. Conversion Costs: A type of internal accounting transaction in which measurement of the input values of the assets transformed or consumed, known as conversion items, become the input values of new assets. The transferred input values are called conversion costs. Conversion Items: Assets transformed or consumed in internal operational activities of a private company in order to create other assets. Cost versus Benefit: One of the constraining and modifying qualitative characteristics of private company financial statements. The cost versus benefit characteristic determines that in order to justify requiring a particular disclosure in private company financial statements, PCAS should require that the perceived benefits to be derived from that disclosure must exceed the perceived costs associated with it. Custom and Tradition: Part of the qualitative characteristic of pragmatism that guides and limits PCAS by a commonly and traditionally accepted “knowledge base” as opposed to application of theoretical concepts. Deferrals: The portion of accrual accounting associated with past cash receipts and payments. Disclosure: One of the seven underlying principles that determines the display of information in private company financial statements. Disclosure is the display of the captions and numerical amounts in private company financial statements and the explanatory notes to the financial statements. Disclosure is determined by the application of the qualitative characteristics, other underlying principles, and the definitions of the elements. Dividends: See accumulated distributions. EBITDA: The abbreviation for earnings before interest, taxes, depreciation, and amortization. The numerical amount of EBITDA is determined by adding the following line items in the statement of operational performance: net after-tax income (earnings), net interest expense, income tax expense, depreciation expense, and amortization expense of intangible assets. The amount may also be adjusted by judgmental determinations of nonrecurring transactions and events included in the net income. Economic Perspective of the Entity: A view of a public entity, or a view of a collection of economically related entities one of which is a public entity, from the perspective of a potential equity investor that

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results in the structure of public entity financial statements, the definition of the elements contained therein, and the concepts of recognition, measurement and disclosure of economic transactions, events and other circumstances, reflecting the needs of public company investors. Elements: The classifications of items with common characteristics in the financial statements. Elements are considered to be the building blocks from which private financial statements are constructed in that accounting transactions recognized and measured are first organized in a double-entry accounting system into the accounts that make up the elements. Expenses: A private company’s expenses are the measurable sacrifices of its net assets incurred directly or indirectly in the creation of flows of its products to customers, resulting from accounting transactions that occurred during a past reporting period and more likely than not unfavorably decreased operational performance in that past reporting period. External Operational Exchanges: One of the three types of accounting transactions. Specifically, a binding or otherwise enforceable or equitable transfer of an asset from the private company to one or more third parties in which the private company receives in exchange an asset or settles a liability; a binding or otherwise enforceable or equitable transfer of an asset to the private company from one or more third parties in which the private company gives up in exchange an asset or incurs a liability. External Operational Transfers: One of the three types of accounting transactions. Specifically, a one-way transfer of the private company’s asset, or the incurrence of a liability by the private company to make a one-way transfer of an asset, to one or more third parties made under compulsion or other obligation, in order to prohibit additional adverse effects to the private company’s operational performance; a one-way transfer of an asset to the private company, or the assumption of the private company’s existing liability, by one or more third parties made for the private company’s benefit, in order to satisfy prior adverse effects on the private company’s operational performance; a one-way transfer to a private company from its owners in the form of an owners’ equity investment, or a one-way transfer from a private company to its owners in the form of an owner’s equity withdrawal or dividend. Financial Capital Maintenance: A view of financial reporting in which, a return on financial capital results, in the words of the FASB’s Conceptual Framework, “only if the financial (monetary) amount of an enterprise’s net assets at the end of a period exceeds the financial amount of the net assets at the beginning of the period after excluding the effects of transactions with owners”. The reporting period’s change in net assets reflects a measurement of change in wealth, or well-offness, and is dependent on determining an acceptable beginning and ending valuation (usually at exit prices) of net assets. Financial Position: The nature of the operational resources, operational obligations, and the owners’ investments of the private company measured primarily at their input values recognized at the date of the exchange, less the using up of the input values in the periods benefited. Flow of the Product: The nature of a private company’s revenues consisting of the flow of its goods, the flow of its rights to use its goods, and the flow of its services to customers. Gains: A private company’s gains are the measurable inflows of benefits, other than benefits associated with the recognition of revenues, and other than benefits in the form of owners’ net investments, resulting from accounting transactions that occurred during a past reporting period, and more likely than not favorably increased operational performance in that past reporting period.

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General Obligations: A broad term encompassing all legal or equitable commitments of a private company, observable by an onlooker, to a third party. However, only a specified subset of general obligations can qualify as operational obligations. General Resources: A broad term encompassing the many things that a private company can use, as perceived by an onlooker, in a positive way. However, only a specified subset of general resources can qualify as operational resources. Going Concern: One of the constraining and modifying qualitative characteristics of private company financial statements. The going concern characteristics is a concept by which a private company’s financial statements are prepared under the assumption that the private company’s operational performance, and use of its resources and obligations (collectively, net assets) in achieving operational performance, will continue indefinitely, and that the private company will have sufficient liquidity. Goods and Services: A broad term used to encompass a private company’s inventory and any of its other assets that it normally intends to transfer in a recurring exchange, or intends to transfer its rights to use in a recurring exchange, to customers in order to enhance the private company’s operational performance. Indirect Cash Flow Method: The process by which operational cash flow is determined and presented in a private company’s cash flow statement in order to show the link between net income reported during a period and the related process of realization occurring during the period. Input Values: The exchange price that is present in an accounting transaction. For assets and liabilities the input value is usually referred to as either the acquisition cost or the historical cost. It is the default measurement attribute for both original and subsequent measurement in private company financial statements. Internal Operational Transfers: One of the three types of accounting transactions. Specifically, conversion costs of operating activities; consumption and other losses of assets in internal operational activities; incurrence of liabilities in internal operational activities. Legal Proprietary Perspective of the Entity: A view of a private company from the most basic level of private ownership in the entity, that results in the structure of the private company financial statements, the definition of the elements contained therein, and the concepts of recognition, measurement and disclosure of financial transactions, reflecting the needs of the primary users of private company financial statements. Liabilities: A private company’s liabilities are its measurable operational obligations that exist on a reporting date, resulting from past accounting transactions, that are more likely than not expected to be settled in the future by conveying assets to or performing services for third parties other than the private company’s owners. Liquidation Value: The probable net cash proceeds to a seller of an asset in either an orderly or a forced sale. Liquidity: The ability of a private company to convert its net assets disclosed in its financial statements into an amount of cash, or to use its net assets to generate or earn an amount of cash, that is sufficient to

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service an amount of existing or proposed debt extended or extendable to the private company with an margin of safety, measured in excess cash over debt, acceptable to the creditor. Losses: A private company’s losses are the measurable outflows of net assets and unanticipated reductions in usefulness of assets, other than sacrifices of its net assets associated with the recognition of expenses, and other than outflows in the form of owners’ net withdrawals, resulting from accounting transactions that occurred during a past reporting period, and more likely than not unfavorably decreased operational performance of the past reporting period. Management’s Intention: One of the constraining and modifying qualitative characteristics of private company financial statements. Management’s intention is the use of a private company’s resources and obligations as a reasonable basis to classify transactions in private company financial statements in the absence of the availability of clearly observable and verifiable information. Matching Principle: One of the seven underlying principles that determines the display of information in private company financial statements. The matching principle is the recognition of expenses based on their association with revenues. This association may be a direct or indirect association with revenues. Materiality: One of the constraining and modifying qualitative characteristics of private company financial statements. Materiality is the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information taken as a whole would have been changed or influenced by the omission or misstatement. Mathematical Auditability: One of the constraining and modifying qualitative characteristics of private company financial statements. Mathematical auditability is the development of recognition, measurement and disclosure of the elements contained in private company financial statements in a manner that allows, encourages, but also restricts an external audit of the statements in that each account can be verified with a reasonable degree of assurance, by use of common statistical methods without resorting to underlying accounting systems and controls over financial reporting; the overall statements can be demonstrated, as a whole, to be free from material bias; the notes to the statements can be verified with a reasonable degree of assurance without the application of tests of uncertainty that may be inherent in the qualitative disclosures; disclosures in the statements do not include alternative ranges of future realizations or settlements; the development of principles-based accounting standards is not influenced by audit procedures that may be reliant on rules or mathematical attest processes. Measurement Attribute: A monetary characteristic observable in an accounting transaction. Measurement: One of the seven underlying principles that determines the display of information in private company financial statements. Measurement is expressed as an observable attribute, in monetary terms. The default initial and subsequent measurement attribute in all PCAS, except for cash equivalents, should be input value. Monetary Unit Principle: One of the seven underlying principles that determines the display of information in private company financial statements. The monetary unit principle is the display in private company financial statements of elements measured in monetary units, i.e., a local currency, and the assumption, except in extreme conditions such as hyperinflation, that the monetary unit used is stable.

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Mutually Unperformed Executory Contracts: An executory contract unperformed by both parties. Included in this definition would be a legally binding contract between two parties, but where binding is contingent on future performance by both parties to the contract, and the contract is, in form, prospective in nature. Notes: The notes to the private company financial statements contain information that satisfies the disclosure principle. The notes provide narrative descriptions and disaggregations of line item amounts that do not fit the form and content of the four private company financial statements. Objective: The objective of private company financial statements (“Objective”) is to satisfy the needs of the primary users. The primary way in which private company financial statements satisfy the Objective is to provide the results of the company’s past operational performance of the reporting periods presented and the cash generated or expended by the operational performance through a process of realization. The secondary way in which private company financial statements satisfy the Objective is to provide users with the nature of the operational resources, operational obligations, and the owners’ investments of the private company measured primarily at their input values recognized at the date of the exchange, less the using up of the input values in the periods benefited. Observable Impairment: Observable impairment is the application of the qualitative characteristic of conservatism constrained to passive observations and not the active testing of the underlying circumstances of the underlying element. OCBOA: Abbreviation for Other Comprehensive Basis of Accounting. Operational Obligations: Five specific general obligations of a private company consisting of obligations to pay cash or other assets for recognized expenses; obligations to provide future services that create a revenue element for the private company when the services are performed; obligations to pay cash or other assets for assets acquired or created; obligations to repay cash borrowings; obligations to pay cash or other assets for recognized losses. Operational Performance: The reporting in a private company’s financial statements of realized or realizable enhancements of the private company’s cash resulting from those operating activities recognized by past accounting transactions. Specifically, the net of revenues, expenses, gains and losses during a reporting period, commonly referred to as net income. Operational Resources: Seven specific general resources of a private company consisting of cash and cash equivalents; investments in property and financial instruments to be used directly by the private company in achieving operational performance; discretely identifiable tangible or intangible items to be used or consumed in operational activities for the purpose of enhancing future operational performance; goods and services to be sold to customers in future periods for the purpose of enhancing operational performance; conversion items; balances arising from the process of realization of sale of goods or services, or other operational resources into net income; rights to receive cash or other assets for recognized gains. Override: The replacement of the application of a standard in PCAS with another method of recognition, measurement or disclosure in a rare instance where commonality to primary users is not achieved in the application of the PCAS standard to a specific private company, and such application of the PCAS standard would result in the private company financial statements having less usefulness or even being misleading to primary users.

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Owners’ Equity: A private company’s owners’ equity consists of the net amount of its accumulated earnings, accumulated distributions of those earnings, and the net amount of the owner’s capital invested and retained. Pragmatism: One of the constraining and modifying qualitative characteristics of private company financial statements. Pragmatism is the attempt to incorporate practical, observable, and commonly used accounting principles into private company standard setting, as opposed to theoretical or “what should be” standards. Primary Users: The primary users of private company financial statements are existing owners and potential owners and existing and potential bank and commercial lenders and sureties. Principles-based: One of the constraining and modifying qualitative characteristics of private company financial statements. Principles-based accounting is defined as follows: Private company financial statements should contain a collection of related information based on common user-accepted principles necessary to satisfy a reasonable user’s needs that in turn are identified by the Objective and by other common characteristics of private company financial statements that are enumerated and described in the Framework and in PCAS. Private Companies: For-profit entities whose financial statements are not regulated by a government or agency designated by a government, nor have issued public exchange ownership or debt instruments, including those entities that do not currently intend to: (a) become subject to such regulation; (b) issue public exchange ownership or debt instruments; or (c) be acquired or controlled by entities that are required to use another set of accounting or financial reporting standards than PCAS. Private Company External-use Financial Statements: Periodic financial statements issued by private companies in accordance to PCAS. Probable: Probable means an accounting transaction must have been more likely than not to have occurred in order for its associated elements to be recognized in private company financial statements. Qualitative Characteristics: The non-quantifiable characteristics of financial information present within private company financial statements that aid the primary users in determining the decision usefulness of the statements. Realization Principle: The primary underlying principle of the seven underlying principles. Realization is the process of converting noncash resources and rights into money and the settlement of obligations by payment of money or other assets that could be converted into money. Realizable: Capable of being realized. See the definition of realized. Realized: The completion of the realization process; the completed actual conversion or settlement of an element into cash or money. Recognition: One of the seven underlying principles that determines the display of information in private company financial statements. The general principle for initially recognizing an element in private company financial statements is that an accounting transaction has occurred during the financial statement reporting period and has created the element.

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Relevance: The primary qualitative characteristic of financial information contained in private company financial statements. Relevance is defined as the usefulness of the information contained in the private company financial statements to those who use the information. Representational Faithfulness: The secondary qualitative characteristic of financial information contained in private company financial statements. Representational faithfulness is defined as the consistent, verifiable and neutral development and application of PCAS to the financial information which relevance first determines should be recognized, measured and disclosed in private company financial statements, resulting in the financial statement users having a high degree of reliability in what the presentation purports to represent. Retained Earnings: The net of accumulated net income and accumulated distributions. Revenues: A private company’s revenues are the measurable flows of its products to customers, resulting only from exchange transactions that occurred during a past reporting period, and more likely than not favorably increased operational performance in that past reporting period. Rules- based: A contrast to the private company qualitative characteristic of principles-based accounting that emphasizes comparability of public entity financial statements to each other primarily for equity investors and equity analysts. Secondary Users: Private company financial statement users other than the primary users. Seven Underlying Principles: The principles that determine the display of information contained in private company financial statements and the structure of the statements themselves. Statement of Cash Flows: The statement of cash flows is a private company financial statement that provides information about the changes in cash occurring within a reporting period, primarily as a result of the private company’s operational performance, and secondarily, the private company’s investing and financial activities associated with supporting its operational performance. Statement of Financial Position: The statement of financial position is a private company financial statement that discloses the relationship of the private company’s assets, liabilities, and equity on a specified date. Statement of Operating Performance: The statement of operating performance is a private company financial statement that discloses the relationship of the private company’s revenues and expenses and gains and losses during a reporting period. Stewardship: The accounting by an agent (manager) for the use of resources that the principal (owner) has supplied directly or indirectly. Stewardship accounting attempts to answer the question: “How efficiently has the company used its resources to run its business on behalf of its existing owners and creditors?” Time Period Principle: One of the seven underlying principles that determines the display of information in private company financial statements. The time period principle determines that all amounts displayed in a private company’s financial statements issued during regular intervals over the life of the private company, referred to as periodic financial statements, reasonably and meaningfully provide a faithful

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representation of the operating activities and financial condition of the private company during the dates covered by these statements. Transaction-based Accounting: The general term applied to the process or system of recognizing private company accounting transactions. Underlying Principles: See seven underlying principles. Understandability and Simplicity: One of the constraining and modifying qualitative characteristics of private company financial statements. Understandability and simplicity means that private company financial statements and the private company accounting standards governing the statements should be understandable to the average reader. The average reader is defined as any individual with general business knowledge, but without a financial or investing or accounting background.