This Blog is written by Mr. Abbas Shahid, Associate Taxation Advisory Services. Please read this blog and provide your valued comments.
GAAP (Generally Accepted Accounting Principles)
Generally accepted accounting principles, or GAAP, are a set of rules that encompass the details, complexities, and legalities of business and corporate accounting. The Financial Accounting Standards Board (FASB) uses GAAP as the foundation for its comprehensive set of approved accounting methods and practices. The acronym is pronounced “gap.”
GAAP specifications include definitions of concepts and principles, as well as industry-specific rules. The purpose of GAAP is to ensure that financial reporting is transparent and consistent from one organization to another.
There is no universal GAAP standard and the specifics vary from one geographic location or industry to another. In the United States, the Securities and Exchange Commission (SEC) mandates that financial reports adhere to GAAP requirements. The Financial Accounting Standards Board (FASB) stipulates GAAP overall and the Governmental Accounting Standards Board (GASB) stipulates GAAP for state and local government. Publicly traded companies must comply with both SEC and GAAP requirements.
Many countries around the world have adopted the International Financial Reporting Standards (IFRS). IFRS is designed to provide a global framework for how public companies prepare and disclose their financial statements. Adopting a single set of world-wide standards simplifies accounting procedures for international countries and provides investors and auditors with a cohesive view of finances. IFRS provides general guidance for the preparation of financial statements, rather than rules for industry-specific reporting.
HISTORY OF GAAP:
Without regulatory standards, companies would be free to present financial information in whichever format best suits their needs. With carte blanche to portray a company’s fiscal standing in the most ideal light, investors could be easily misled. The Great Depression in 1929, a financial catastrophe which caused years of hardship for millions of Americans, was primarily attributed to faulty and manipulative reporting practices among businesses. In response, the federal government, along with professional accounting groups, set out to create standards for the ethical and accurate reporting of financial information.
According to Stephen Zeff in The CPA Journal, GAAP terminology was first used in 1936 by the American Institute of Accountants (AIA). Federal endorsement of GAAP began with legislation like the Securities Act of 1933 and the Securities Exchange Act of 1934, laws enforced by the U.S. Securities and Exchange Commission (SEC) that target public companies. Today, the Financial Accounting Standards Board (FASB), an independent authority, continually monitors and updates GAAP.
Today, all 50 state governments prepare their financial reports according to GAAP. While a little less than half of U.S. states officially require local governments to adhere to GAAP, the Governmental Accounting Standards Board (GASB) estimates that approximately 70% of county and local financial offices do anyway.
U.S. law requires businesses that release financial statements to the public and companies that are publicly traded on stock exchanges and indices to follow GAAP guidelines, which incorporate 10 key concepts:
- Principle of regularity:
GAAP-compliant accountants strictly adhere to established rules and regulations.
- Principle of consistency:
Consistent standards are applied throughout the financial reporting process.
- Principle of sincerity:
GAAP-compliant accountants are committed to accuracy and impartiality.
- Principle of permanence of methods:
Consistent procedures are used in the preparation of all financial reports.
- Principle of non-compensation:
All aspects of an organization’s performance, whether positive or negative, are fully reported with no prospect of debt compensation.
- Principle of prudence:
Speculation does not influence the reporting of financial data.
- Principle of continuity:
Asset valuations assume the organization’s operations will continue.
- Principle of periodicity:
Reporting of revenues is divided by standard accounting time periods, such as fiscal quarters or fiscal years.
- Principle of materiality:
Financial reports fully disclose the organization’s monetary situation.
- Principle of utmost good faith:
All involved parties are assumed to be acting honestly.
BASIC PRINCIPLES OF ACCOUNTING:
Beyond the 10 principles, GAAP compliance is built on three rules that eliminate misleading accounting and financial reporting practices. These rules create consistent accounting and reporting standards, which provide prospective and existing investors with reliable methods of evaluating an organization’s financial standing. Without these rules, accountants could use misleading methods to paint a deceptive picture of a company or organization’s financial standing.
These three rules are:
- Basic accounting principles and guidelines:
These 10 guidelines separate an organization’s transactions from the personal transactions of its owners, standardize currency units used in reports, and explicitly disclose the time periods covered by specific reports. They also draw on established best practices governing cost, disclosure, going concern, matching, revenue recognition, professional judgment, and conservatism.
- Rules and standards issued by the FASB and its predecessor, the Accounting Principles Board (APB):
The FASB issues an officially endorsed, regularly updated compendium of principles known as the FASB Accounting Standards Codification. The compendium includes standards based on the best practices previously established by the APB. These organizations are rooted in historic regulations governing financial reporting, which were implemented by the federal government following the 1929 stock market crash that triggered the Great Depression.
- Generally accepted industry practices:
There is no universal GAAP model followed by all organizations across every industry. Rather, particular businesses follow industry-specific best practices designed to reflect the nuances and complexities of different areas of business. For example, banks operate using a different set of accounting and financial reporting methods than those used by retail businesses.
Limitations of GAAP:
While GAAP strives to alleviate incidents of inaccurate reporting, it is by no means comprehensive. Companies can still suffer from issues beyond the scope of GAAP depending on their size, business categorization, location and global presence.
- Diverse Type of Companies:
Oftentimes, GAAP seems to take a “one-size-fits-all” approach to financial reporting, however this can do little to reduce issues faced by distinct industries. For example, state and local governments have struggled with implementing GAAP due to their unique environments. This has resulted in new GAAP hierarchy proposals to better accommodate these government entities.
Small businesses have also struggled with implementing GAAP. These standards may be too complex for their accounting needs and hiring personnel to create GAAP reports can be expensive. As a result, the FASB has been working with the Private Company Council to update the GAAP with private company exceptions and alternatives.
- Time Frame:
Due to the extremely thorough standards-setting process of the GAAP policy boards, it can take months or even years to finalize a new standard. These wait times may not work to the advantage of companies complying with GAAP, as pending decisions can affect their reports.
- Global Vs. Domestic:
GAAP is not the international accounting standard; this is a developing challenge as businesses become more globalized. The International Financial Reporting Standards (IFRS) is the most common set of principles outside the United States and is used in places such as the European Union, Australia, Canada, Japan, India, and Singapore. To reduce tension between these two major systems, the FASB and International Accounting Standards Board are working to coverage standards.
Ungarbling the Garbling in GAAP:
Garbling occurs to some degree in practically all media, but in financial accounting it’s both intentional and very intense.
The U.S. GAAP/IFRS approach to measuring assets (and liabilities) is frequently and far too simplistically described as a “mixed attribute” system. Historic cost may be mistakenly considered to be an attribute, but that is a digression. (Historic cost is merely an attribute of a past transaction, as opposed to the asset itself.) A legitimate reportable “attribute” is generally understood to be either: a measure of value if sold (e.g., “fair value”); cost to replace; or present value of future benefits.
But, in my humble opinion (IMHO), too few understand that some (the majority of? an increasing number of?) assets are “measured” with algorithms, which cannot possibly produce a “faithful representation” of any of the aforementioned financial attributes. That is because there is only one way to describe the numbers generated with these algorithms: by nothing more than the algorithms themselves. I will refer to the numbers produced by these algorithms as “garblings.”
One of my favorite examples of a garbling — is the “translation” of land that is held by a foreign subsidiary. (I’ll explain why I put “translation” in quotes later.) According to U.S. GAAP (and IFRS), the algorithm that produces the number reported on the consolidated balance sheet would be historic cost in the foreign currency multiplied by the current exchange rate. SFAS 52 even states that this process of “translating” the land into the reporting currency is nothing more than a mechanical process (therefore, leading to a translation “adjustment” as opposed to a gain or loss).
Other examples abound, with leases and loans being two recent examples. Together, they reveal that GAAP is not even a “mixed attribute” information system that, at its very best, adds together the historic cost of some assets (non-attributes) with the fair value of an interest rate swap; and presents the apples/oranges summation as “total assets.” It is even less than that. U.S. GAAP and IFRS are largely collections of garblings.
It seems to me that this is unique among what I might call language-based reporting systems, e.g., newspapers, radiological reports. Statements from these systems could require specialized knowledge to be accurately understood, but it is clear that within these systems intentional garbling is seen as an act of bad faith. The defenders of garbling in financial accounting argue that garbled numbers are informative nevertheless, because they approximate, or are correlated, with attributes. Moreover, garbling could be excused because the cost of estimating an attribute is too high, and/or its reliability is too low. To these arguments, I have the following responses:
- Even under the best of circumstances, there is no way to evaluate the deviation or degree of correlation between a garbling and an attribute. U.S. GAAP could even require a garbled cash balance.
- Algorithmic garblings have ZERO representational faithfulness, which is purportedly one of the two fundamental qualitative characteristics of financial accounting (the other being relevance).
- It is costly to learn all of the garbling algorithms, and few (zero?) users of financial statements actually do. On the other hand, reading a listing of assets/liabilities reported using one consistent attribute is not much more challenging than reading the newspaper.
Translating land held by a foreign subsidiary at current exchange rates actually provides two instances of garbling. Thus far, we have considered the garbling of a number, but U.S. GAAP garbles words as well, and “translation” is a prime example. That term would ordinarily imply that there is an attempt to retain meaning (e.g., translating from Spanish to English); but, as I already mentioned, the FASB admits that by reporting an amount for land by multiplying an historic cost in a foreign currency by a current exchange rate is nothing more than a mechanical process.
In addition to translation, here is a sampling of term garblings and that Statement of Financial Activities (SoFA) will not permit:
- “Goodwill” is rarely goodwill.
- “Probable” being defined as “likely to occur” is a sham (False) definition.
- “Impairment” has little or nothing to do with an asset’s capacity to function.
- “Fairly Presented” is anything but.
- No balance sheet prepared in accordance with U.S. GAAP/IFRS could be legitimately considered a ”Statement of financial position”.
Three Golden Rules of Accounting:
- Personal A/c which states the rule; Debit the receiver and credit the giver.
- Real A/c the rule; Debit what comes in and Credit what goes out.
- Nominal A/c were Debit all expenses and losses and Credit all incomes and gains.