Accounting and Financial Reporting Standards
The authoritative standards and rules that govern financial accounting and reporting by businesses in the United States are called generally accepted accounting principles (GAAP). When you read the financial statements of a business, you’re entitled to assume that the business has fully complied with GAAP in reporting its cash flows, profit-making activities, and financial condition — unless the business makes very clear that it prepared its financial statements by using some other basis of accounting or deviated from GAAP in one or more significant respects.
If GAAP isn’t the basis for preparing its financial statements, a business should make very clear which other basis of accounting it’s using and avoid using titles for its financial statements that are associated with GAAP. If a business uses a simple cash-receipts and cash-disbursements basis of accounting (which falls way short of GAAP), for example, it shouldn’t use the terms income statement and balance sheet. These terms are part and parcel of GAAP, and their use as titles in financial statements implies that the business is using GAAP.
You’re lucky that there’s no room here for a lengthy historical discourse on the development of accounting and financial reporting standards in the United States. The general consensus (backed by law) is that businesses should use consistent accounting methods and terminology. General Motors and Microsoft should use the same accounting methods; so should Wells Fargo and Apple. Businesses in different industries have different types of transactions, of course, but the same types of transactions should be accounted for in the same way. That’s the goal.
There are upwards of 7,000 public companies in the United States and more than 1 million privately owned businesses. Should all these businesses use the same accounting methods, terminology, and presentation styles for their financial statements? Ideally, all businesses should use the GAAP rulebook. Privately owned companies aren’t required to follow GAAP rules, although many do. The rulebook permits alternative accounting methods for some transactions, however. Furthermore, accountants have to interpret the rules as they apply GAAP in actual situations. The devil is in the details.
In the United States, GAAP constitute the gold standard for preparing financial statements for business entities. The presumption is that any deviations from GAAP would cause misleading financial statements. If a business honestly thinks that it should deviate from GAAP to better reflect the economic reality of its transactions or situation, it should make very clear that it hasn’t complied with GAAP in one or more respects. If deviations from GAAP aren’t disclosed, the business may have legal exposure to those who relied on the information in its financial report and suffered a loss attributable to the misleading nature of the information.
Unfortunately, the mechanisms and processes of issuing and enforcing financial reporting and accounting standards are in a state of flux. The biggest changes in the works have to do with the push to internationalize the standards, as well as the movements toward setting different standards for private companies and for small and medium-size business entities.
Financial accounting and reporting by government and not-for-profit entities
In the grand scheme of things, the world of financial accounting and reporting can be divided into two hemispheres: for-profit business entities and not-for-profit entities. A large body of authoritative rules and standards called GAAP has been hammered out over the years to govern accounting methods and financial reporting of business entities in the United States. Accounting and financial reporting standards have also evolved and been established for government and not-for-profit entities. This book centers on business accounting methods and financial reporting. Financial reporting by government and not-for-profit entities is a broad and diverse territory, and full treatment of it is well beyond the scope of this book.
People generally don’t demand financial reports from government and not-for-profit organizations. Federal, state, and local government entities issue financial reports that are in the public domain, although few taxpayers are interested in reading them. When you donate money to a charity, school, or church, you don’t always get financial reports in return. On the other hand, many private, not-for-profit organizations issue financial reports to their members — credit unions, homeowners’ associations, country clubs, mutual insurance companies (owned by their policy holders), pension plans, labor unions, healthcare providers, and so on. The members or participants may have an equity interest or ownership share in the organization; thus, they need financial reports to apprise them of their financial status with the entity.
Government and other not-for profit entities should comply with the established accounting and financial reporting standards that apply to their type of entity. Caution: Many not-for-profit entities use accounting methods different from business GAAP (in some cases, very different), and the terminology in their financial reports is somewhat different from that in the financial reports of business entities.
Getting to know the U.S. standard-setters
Okay, so everyone who reads a financial report is entitled to assume that GAAP has been followed (unless the business clearly discloses that it’s using another basis of accounting). The basic idea behind the development of GAAP is to measure profit and to value assets and liabilities consistently from business to business — to establish broad-scale uniformity in accounting methods for all businesses and to make sure that all accountants are singing the same tune from the same hymnal. The authoritative bodies write the tunes that accountants have to sing.
Who are these authoritative bodies? In the United States, the highest-ranking authority in the private (nongovernment) sector for making pronouncements on GAAP and for keeping these accounting standards up to date — is the Financial Accounting Standards Board (FASB). Also, the SEC has broad power over accounting and financial reporting standards for companies whose securities (stocks and bonds) are publicly traded. Actually, the SEC outranks the FASB because it derives its authority from federal securities laws that govern the public issuance and trading in securities. The SEC has on occasion overridden the FASB, but not very often.
GAAP also include minimum requirements for disclosure, which refers to how information is classified and presented in financial statements and to the types of information that have to be included with the financial statements, mainly in the form of footnotes. The SEC makes the disclosure rules for public companies. Disclosure rules for private companies are controlled by GAAP.
Internationalization of accounting standards (maybe, maybe not)
Although it’s a bit of an overstatement, today the investment of capital knows no borders. U.S. capital is invested in European and other countries, and capital from other countries is invested in U.S. businesses. In short, the flow of capital has become international. U.S. GAAP doesn’t bind accounting and financial reporting standards in other countries. In fact, significant differences exist that cause problems in comparing the financial statements of U.S. companies with those in other countries.
Outside the United States, the main authoritative accounting standards setter is the International Accounting Standards Board (IASB), which is based in London. The IASB was founded in 2001. More than 7,000 public companies have their securities listed on the several stock exchanges in European Union (EU) countries. In many regards, the IASB operates in a manner similar to that of the FASB in the United States, and the two have very similar missions. The IASB has already issued many standards, which are called International Financial Reporting Standards.
For some time, the FASB and IASB have been working together to developing global standards that all businesses would follow, regardless of the country in which a business is domiciled. Political issues and national pride come into play, of course. The term harmonization is favored, which sidesteps difficult issues regarding the future roles of the FASB and IASB in the issuance of international accounting standards. The two rulemaking bodies have had fundamental disagreements on certain accounting issues. It seems doubtful that they’ll agree on a full-fledged universal set of standards. But stay tuned; it’s hard to predict the final outcome.
Divorcing public and private companies
Traditionally, GAAP and financial reporting standards were viewed as being equally applicable to public companies (generally, large corporations) and private companies (generally, smaller companies). Today, however, we’re witnessing a growing distinction between accounting and financial reporting standards for public and private companies. Although most accountants don’t like to admit it, there’s always been a de facto divergence between the actual financial reporting practices of private companies and the more rigorously enforced standards for public companies. A surprising number of private companies still don’t include a statement of cash flows in their financial reports, for example, even though this statement has been a GAAP requirement since 1975.
Although it’s hard to prove one way or the other, my view is that the financial reports of private businesses generally measure up to GAAP standards in all significant respects. At the same time, however, there’s little doubt that the financial reports of some private companies fall short. In May 2012, the FASB established an advisory committee for private-company accounting standards. In setting up the council, the FASB said, “Compliance with GAAP standards for many for-profit private companies is a choice rather than a requirement because private companies can often control who receives their financial information.” The council advises the FASB on the appropriate accounting methodology for private companies when changes in GAAP are being considered.
Private companies don’t have many of the accounting problems of large public companies. Many public companies deal in complex derivative instruments, issue stock options to managers, provide highly developed defined-benefit retirement and health benefit plans for their employees, enter into complicated intercompany investment and joint venture operations, have complex organizational structures, and so on. Most private companies don’t have to deal with these issues.
Following the rules and bending the rules
An often-repeated story concerns three people interviewing for an important accounting position. The candidates are asked one key question: “What’s 2 plus 2?” The first candidate answers, “It’s 4.” The second candidate answers, “Well, most of the time the answer is 4, but sometimes it’s 3, and sometimes it’s 5.” The third candidate answers, “What do you want the answer to be?” Guess who gets the job. This story exaggerates, of course, but it does have an element of truth.
The point is that interpreting GAAP isn’t a cut-and-dried process. Many accounting standards leave a lot of room for interpretation. Guidelines would be a better word to describe many accounting rules. Deciding how to account for certain transactions and situations requires seasoned judgment and careful analysis of the rules. Furthermore, many estimates have to be made. Deciding on accounting methods requires, above all else, good faith.
A business may resort to “creative” accounting to make profit for the period look better or to make its year-to-year profit less erratic than it really is (which is called income smoothing). Like lawyers who know where to find loopholes, accountants can come up with inventive interpretations that stay within the boundaries of GAAP. These creative accounting techniques are also called massaging the numbers. Massaging the numbers can get out of hand and become accounting fraud, also called cooking the books. Massaging the numbers has some basis in honest differences in interpreting the facts. Cooking the books goes way beyond interpreting facts; this fraud consists of inventing facts and good old-fashioned chicanery.