By Bob Schneider
Generally Accepted Accounting Principles (GAAP)
A key prerequisite for meaningful financial statements is that they be comparable to those for other companies, especially firms within the same industry. To meet that requirement, statements are prepared in accordance with Generally Accepted Accounting Principles (or, more commonly, GAAP), which "encompasses the conventions, rules and procedures, necessary to define accepted accounting practice at a particular time."
In the wake of the crash of 1929, the first serious attempt to codify GAAP was made by the AICPA (then the American Institute of Accountants) working with the New York Stock Exchange, which culminated in the creation of a Committee on Accounting Procedure. The Committee's resources were limited and in 1959 the Accounting Principles Board (APB) was established within the AICPA to take over the rule-making function. The APB was superseded in 1972 by the Financial Accounting Standards Board (FASB), an independent, not-for-profit organization with a governing board of seven members - three from public accounting, two from private industry, one from academia and one from an oversight body. (For more on GAAP visit the U.S. GAAP website.)
Current GAAP in the U.S. (or U.S. GAAP) includes rules from the FASB and these predecessors. Over time, standards are eliminated and amended as business conditions change and new research performed. Although in the U.S. the SEC has delegated the function of accounting rule-making to FASB, it is not the only source of GAAP. Research from the AICPA, best industry practices as defined by research and traditions, and the activities of the SEC itself all play a role in defining GAAP. (For more on the SEC read Policing The Securities Market: An Overview of the SEC.)
Further, within the FASB and AICPA themselves, there are various sources of GAAP. These include statements (of primary importance), interpretations, staff positions, statements of position, accounting guides, and so forth. Naturally, with so much documentation for GAAP, contradictions ensue. To eliminate the uncertainties, in 2008 the FASB issued FAS 162 to clarify the hierarchy in deciding which source of GAAP takes precedence over another. (For more on FASB, visit the FASB website.)
Accounting is how business keeps score, and business is no different than football when it comes to setting the rules of the game. Many accounting standards are firmly established, others continue to be debated vigorously among the players and a few are so highly controversial they get even people on the sidelines riled up. One example from the 2008 financial crisis is mark-to-market accounting, on which accountants, presidential candidates and pundits alike weighed in. Accounting standards setting then becomes part of the political process, and depending on the strength and commitment of the various forces, the rules are eliminated, amended or left alone.
One seemingly technical element in accounting standards that is of huge importance is disclosure. In any document, where you put information - in a screaming headline, or the 53rd footnote in Appendix Q - has a great deal to do with which readers view its relative importance. Financial statements are no different.
Besides the actual numbers on the balance sheet, P&L and statement of cash flows, a great deal of information is also provided in the notes to the financial statements. Some key financial information is put directly into the financial statements in parentheses (e.g. on the balance sheet and the number of shares authorized and issued for common stock). Notes contain information that should receive this favorable treatment but because the information may be considerable and include tables, it is included as a footnote instead.
The admonition to readers that "the accompanying notes are an integral part of these statements" alerts them to the notes' importance. But since they are at the bottom - and because they are often numerous, lengthy and, at times, impenetrable - more casual users ignore them. (To learn more see Footnotes: Start Reading The Fine Print.)
What's included in the notes? There's information on securities held, inventories, debt, pension plans and other key elements in determining the company's financial position. In addition, the notes will contain information about the company's accounting policies. Under GAAP, companies often do have discretion to use varying methods for valuing assets, and recognizing costs and revenue. This "Summary of Significant Accounting Policies" will appear as the first note to the statement or in a separate section.
There are other required disclosures external to the financial statements and notes, such as the Management Discussion and Analysis (MD&A), required by the SEC. In all, the list of required disclosures is long, detailed and complex. Although this exhaustive release of company information increases transparency, it does mean that financial statements become unwieldy. And the financial meltdown of 2008 - following the reforms implements in the wake of the Enron scandals a few years before - had observers once again wondering whether, despite all the disclosures, the necessary information for decision-making is being included in financial statements. (For further reading read An Investor's Checklist To Financial Footnotes.)
International Financial Reporting Standards (IFRS)
Outside the U.S., International Financial Reporting Standards (IFRS) have gained increasing prominence and are replacing the national GAAPs of many countries, including Australia, Canada and Japan; IFRS has been required for countries in the European Union since 2006. More than 100 nations have now adopted IFRS, although some continue to have elements of their own national GAAP in reporting standards. IFRS are set by the International Accounting Standards Board (IASB), which is the standard-setting body of the International Accounting Standards Committee Foundation (IASC Foundation). Just as the FASB incorporates the rules of former standards-settings bodies, IFRS includes the International Accounting Standards (IAS) that were issued by the International Accounting Standards Committee (IASC) from 1973 to 2000.
There has been much debate in the accounting profession of "principles-based" versus "rules-based" accounting. Principles-based systems offer broader guidelines in accounting treatment, within which accountants exercise their best judgment; rules-based systems are more prescriptive and specific. IFRS are considered more principles-based than U.S. GAAP, although there are certainly many specific rules included in IFRS as well (and some observers think they are trending in the rules-based direction).
To some extent, the different emphases reflect the differing business and legal cultures between U.S. and much of the world, notably Europe. There is concern that a principles-based system will simply give U.S. managers more freedom to tilt the numbers in their favor. Others argue that the rules-based system is overly complex and that it hasn't prevented U.S. corporate scandals.
The argument may eventually be moot, as the U.S. moves toward joining the world in adopting IFRS standards; the SEC has already issued a "road map" to that end. Nevertheless, IFRS adoption is hardly a done deal. And as has happened in other countries, the U.S., in adopting IFRS, may seek to retain various elements of U.S. GAAP.
It's a conundrum: uniform IFRS adoption worldwide would certainly make it easier to compare the financials of companies in different countries. On the other hand, national GAAPs were developed within the prevailing business, legal and social environments of each country. On both political and practical levels, it's difficult to eliminate all such individuality and some wonder if it is even desirable.
The operating environments of businesses and governments differ enormously. Companies compete with each other for customer revenue and constantly worry about becoming insolvent; governments are funded through the involuntary payment of taxes, and face no threat of liquidation. Governments do not have equity owners who demand profits; instead, they are accountable to citizens for the use of resources. Governments thus require much different financial reports, and hence different accounting standards.
The Federal Accounting Standards Advisory Board (FASAB) was established in 1990 as a federal advisory committee to develop accounting standards and principles for the
The Government Accounting Standards Board (GASB) was established in 1984 to provide standards for state and local governments. Like the FASB, the GASB is under the auspices of the Financial Accounting Foundation (FAF), a private, not-for-profit entity, which chooses the seven members of its board.
InvestingComparing financial numbers from corporations in different countries is possible with the adoption of IFRS.
InvestingThe International Financial Reporting Standards and the U.S. Generally Accepted Accounting Principles have some key differences.
InvestingLearn about the purpose of the IFRS, as well as its benefits, goals and fundamental difference from the U.S. GAAP.
InvestingInternational Financial Reporting Standards are accounting rules and guidelines governing the reporting of different types of accounting transactions.
InvestingThe term accounting principles refers to rules and guidelines companies use to help them record their business and financial transactions.
InvestingUnderstand four major reasons that financial statements published in 2016 are more complicated and difficult to read than they were in the past.
InvestingExamine the divergence of GAAP and adjusted earnings in the years leading up to 2015 to identify the factors causing the gap to widen.
InvestingRead about private equity accounting and how it is different than that of other investment vehicles. The nature of private equity makes a difference.
InvestingDiscover how to keep score of companies to increase your chances of choosing a winner.