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Generally Accepted Accounting Principles
US law requires all publicly traded companies, as well as any company that publicly releases financial statements, to follow GAAP principles and procedures.
Established in the United States, GAAP originated as a result of the stock market crash of 1929, and subsequent Great Depression. Poor and inconsistent financial reporting and oversight was identified as a contributing cause of the meltdown. GAAP is not a law, an important distinction. Its origins began with The Securities Act of 1933 and the Securities Exchange Act of 1934.
GAAP is controlled by the Financial Accounting Standards Board (FASB) in Connecticut, US.
It is an alternative, or addition to, the International Financial Reporting Standards (IFRS) framework that governs how most companies outside of the US report their financial statements.
GAAP is set forth in 10 primary principles, as follows:
- Principle of consistency: This principle ensures that consistent standards are followed in financial reporting.
- Principle of permanent methods: Closely related to the previous principle is that of consistent procedures and practices being applied in accounting and financial reporting.
- Principle of non-compensation: This principle states that no entity is to expect any compensation for providing full and accurate financial reporting.
- Principle of prudence: All reporting of financial data is to be factual, reasonable, and not speculative.
- Principle of regularity: This principle means that all accountants are to consistently abide by GAAP.
- Principle of sincerity: Accountants should perform and report with basic honesty and accuracy.
- Principle of good faith: Similar to the previous principle, this principle asserts that anyone involved in financial reporting is expected to be acting honestly and in good faith.
- Principle of materiality: All financial reporting should clearly disclose the organisation’s genuine financial position.
- Principle of periodicity: This principle refers to entities abiding by commonly accepted financial reporting periods, such as quarterly or annually.
GAAP further set out specific rules and principles governing elements such as standardised currency units, cost, and Revenue Recognition, financial statement format and presentation, and required disclosures. For example, it requires precise matching of expenses with revenues for the same accounting period.
GAAP allows investors to more easily understand financial statements and make valid comparisons.
CAUTION: It should always be remembered that any set of financial statements, IFRS or otherwise, are merely ‘snapshots’ or ‘photographs’ of a company on a given day. A day that is typically flagged far in advance, and one which the business has had plenty of notice to prepare for.
At TEAM we are acutely aware of this activity. Any time spent reviewing financial statements should be undertaken cynically, and with an inquisitive mind.
Much of IFRS serves purpose for lenders or creditors such as banks. Banks in particular prefer to examine “smoothed” out finances, with little volatility in the numbers. IFRS allows flexibility, in that accounting methods for depreciation, tax deferral and amortisation can be altered to achieve this “smoothing”. This “smoothing” effect is less relevant to shareholders in the TEAM view.
In the real-world, businesses do not operate this way. Companies are in a constant state of flux, and subject to changing circumstances and conditions that include, but are not limited to, consumer demand, external economic fundamentals, pandemics, and other calls and constraints on capital. As a result, IFRS accounting is limited, in that the ‘snapshot’ doesn’t necessarily present an accurate reflection of the company’s economic reality.
Adoption of IFRS can persuade companies to prepare financial statements that appeal to creditors, such as banks, rather than shareholders. For equity investors, IFRS accounting should be viewed with a healthy dose of skepticism, not necessarily accepted as an accurate snapshot of a company’s financial position and performance.
Financial Statements overly simplify. They look to reduce complex data down to one single number. Examples being the valuation of intangible assets, illiquid assets, derivatives and liabilities or contingencies.
“The Shipman’s Tale”, is one of The Canterbury Tales by Geoffrey Chaucer, written between 1387 and 1400.
It tells the story of a merchant, his wife and her lover, a monk. The rich merchant is too occupied with his accounts to notice his wife is being wooed by the monk. The monk who is also a friend of the merchant borrows money from the merchant and gives the money to the merchant’s wife. Thus, settling her debts and buying her “affections”, using the merchant’s own money. Later the merchant asks the monk to repay the debt. The monk tells the merchant he has repaid the debt and to ask his wife where the money is. Her response:
“The devil take all such reckonings”
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