Industry diversity and vast differences between corporate financial strategies make standardizing accounting difficult. The complexity and fluidity of financial markets, asset securitization and accounting cast a certain shadow over the effectiveness of generally accepted accounting principles. GAAP are faced with numerous regulatory obstacles such as the intended goal of merging with international financial reporting standards, complications in asset valuation and exploitation of accounting practices that allow corporations considerable leeway and latitude.
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Problems with Generally Accepted Accounting Principles
1. Moneycation
Published by Moneycation™
Newsletter: September 16, 2014
Volume 2, Issue 8
Problems with generally accepted accounting
principles
Generally accepted accounting principles are a set of standards
that apply to non-governmental legal entities in the United States. They are authorized by the U.S.
Securities and Exchange Commission and maintained, updated and organized by the Financial
Accounting Standards Board. GAAP serve a legitimate and beneficial function by adding
consistency to financial reporting practices; otherwise would likely prove haphazard to investors
and be non-beneficial to the economy. Nevertheless, there are unique discrepancies within GAAP
that do not completely clear the way for corporate transparency. These problems with GAAP add to
the adage “investor beware” as not all accounting techniques are carried out and/or disclosed in a
way that would be easy for users of financial statements to understand.
Statutory law
Statutory accounting laws are legislative mandates that are often embodied within the U.S. Code, a
simplified but expansive reference of multiple legislative acts. Examples of statutory laws that
govern specific areas of accounting and finance are Title 26 of the U.S. Code, which pertains to
taxation, and Title 15, which encompasses commerce and trade. An instance of statutory law that
has been codified and concerns accounting rules is the Sarbanes-Oxley Act or the Public Company
Accounting Reform and Investor Protection Act.
The Sarbanes-Oxley Act requires greater accountability from corporate managers. However, the
extent of that financial responsibility extends only as far as generally accepted accounting
principles require them to do so. Since GAAP are not designed to account for every single
accounting scenario, the underlying principles serve as guidelines that allow room for interpretation
in some instances. Corporate objectives and the nature of business make taking advantage of that
regulatory wiggle room a more likely outcome in many cases.
The tax accounting rules governed by Title 26 of the U.S. Code also differ from financial
accounting that is codified by GAAP. Moreover, according to Mississippi College, this sometimes
leads to a discrepancy between income tax expense and income tax payable, making the income
statement a more accurate representation of financial position in terms of money owed and paid.
These differences are not permanent, but if the amount due on a balance sheet is not payable until
after a financial statement is issued, the income statement will not necessarily reflect the actual
payable amount.
2. Statutory banking rules authorized by legislation are found in Title 12 §1831n of the U.S. Code.
Examples of derivative regulations of U.S. Code or legislation include the Volcker rule under the
Dodd-Frank Act. This law specifically affects financial practices and therefore the accounting of
investment banks for the protection of the financial system and investors. However, while some
banking rules aim to reduce banking risk, they do not necessarily do so as not all financial activities
are explicitly included in the scope of the Volcker rule per a Harvard Law School Forum
publication by David M. Lynn. He states the following:
“...certain trading and fund activity is expressly permitted—notably, underwriting activities,
market-making related activities, and risk-mitigating hedging activities...The Volcker Rule
legislation covered the area with a broad brush, leaving many significant issues open to
regulatory interpretation. The Final Rule is complex in scope and has elicited significant
commentary and questions from the banking industry and the public at large.”
These points are reiterated by Lee Sheppard of Forbes magazine. What is more, Sheppard states
even though hedging is permitted for the purpose of mitigating risk under the Volcker rule, the
activity is not standardized in accordance with GAAP's ASC 815-20-25. This standard requires
periodic testing and repositioning of hedging activity to account for changes in fair value.
Statutory accounting principles
Another instance in which GAAP is not entirely useful is in the assessment of insurance company
solvency according to the National Association of Insurance Commissioners. This is because
GAAP pertains to and is designed to standardize financial reporting. Moreover, the NAIC utilizes
another set of accounting principles called statutory accounting principles or SAP. SAP does not
conflict with the rules of GAAP, but it does focus on areas of accounting that GAAP does not.
Some of the differences between GAAP and SAP are described in the following excerpt from the
International Risk Management Institute:
“...statutory accounting rules do not allow the inclusion of certain non-admitted assets on the
balance sheet; require that certain loss reserves be set by conservative formulas instead of
the insurer's estimates; require the insurer to immediately recognize the expenses associated
with writing new business instead of amortizing them over the policy period; and do not
allow premiums for reinsurance placed with unauthorized reinsurers to be recognized as an
asset.”
This is relevant to investors who have grown accustomed to financial reports such as 10-Ks that
have been audited in accordance with GAAP. Not being aware of the difference in auditing and
filing standards used for publicly traded corporations could mean the difference between a good
investment, and a flawed, if not failed retirement plan, especially if private insurance companies are
a primary managed fund holding.
The problem with SAP also extends to regulators per a letter sent by four U.S. Senators to the
Chairwoman of the Federal Reserve Bank. This letter states that federal regulation of the banking
industry is designed in accordance with GAAP, but not SAP, therefore the efficacy of resulting
regulations are jeopardized. They state it as follows:
3. "…the Federal Reserve has signaled that it wishes to mandate the uniform use of GAAP for
all companies, including insurers that presently do not perform such accounting. Such a
mandate would impose extraordinary costs on insurers totaling hundreds of millions of
dollars without improving the prudential supervision of such companies. Moreover, there are
alternative mechanism the Federal Reserve could employ to obtain a "consolidated" picture
of insurance holding companies at a fraction of the cost of imposing GAAP."
The concerns of the senators in this letter seem to echo what might be a managerial issue for
insurance companies seeking to skirt or find an alternative to statutorily mandated federal
regulation. Essentially, by leveraging the power of senators, insurance companies have an
opportunity to reduce their regulatory compliance costs and boost shareholder interests via
persuasion. In essence, this matter reflects the limits of regulations to standardize accounting in a
way that lowers systemic financial risk.
Regulatory limitations
Generally accepted accounting principles are not required universally. Some companies are exempt
from having to follow these standards, partly because statutory law set out by the Securities Act of
1934 and codified in GAAP pertains to public companies. Moreover, according to Legal Zoom,
small companies do not have to employ GAAP in their financial statements even though the FASB
states GAAP “are to be applied” to non-governmental entities in the preparation of financial
statements.
“Although it is not written in law, the U.S. Securities and Exchange Commission (SEC)
requires publicly traded companies and other regulated companies to follow GAAP for
financial reporting. Although smaller companies are not required to use GAAP, there are
certain situations, such as obtaining credit or seeking investors, which require, by contract,
those companies to also follow GAAP when preparing their financial statements.“
For equity investors in private industry, the non-obligation of businesses to utilize GAAP leaves
room for misleading creative accounting. This should be a concern for venture capital investors,
crowd-fund equity investors and new partners or shareholders. However, some legislative
requirements are set out in the U.S. Code in reference to banking practices, specifically Title 12,
Section 183. This places some limitations on financial misinformation in so far as it pertains to the
banking activity of privately owned businesses and corporations. The incapacity of accounting
regulations to handle less than transparent, fraudulent or dubious accounting practices is apparent in
the existence of creative accounting.
Creative accounting
Creative accounting encompasses a wide range of accounting techniques that enable corporations to
boost shareholder value, share prices and the appeal of reported financial data. Sometimes this is
done with some legal basis via aggressive interpretation of accounting principles, and other times it
done illegally with fraudulent financial reporting. According to Brijesh Yadav in a Standard
International Journal publication, creative accounting is an industry wide problem.
4. “Creative accounting is a challenge for the accounting profession. In practice, situations
emerge under the pressures of the management, in which the accounting professionals apply
a certain accounting treatment provided by laws and regulations; this shows different images
of organizations than true and fair ones, which are countless. The accounting professional is
forced to balance ethics accounting principles and their job.”
Numerous forms of creative accounting exist, the motivations for which vary. Executives may seek
to maintain their high salaries or community clout via creative accounting or corporate staff
themselves may seek to personalize the accounting process for individual gain at the expense of the
corporation. Sometimes, these practices go undetected or unnoticed by investors and regulators or
they are legal enough to pass minimum standard requirements. Nevertheless, an adverse result of
earnings management is an impression of stability and consistency that may not be reflective of
reality.
An example of creative accounting that has led to scandals in the past is earnings management, a
process by which participants stand to earn private gain at the expense of unknowing shareholders
and tax recipients. This is accomplished with estimates and timing of transactions per the American
Institute of CPAs. An instance of earnings management is income smoothing, which is a sub-category
of earnings management that has the effect of hiding large movements in company income
from period to period. Income smoothing is carried out by delaying expense recognition and by
deferring revenue. Moreover, according to the Accounting Review, empirical evidence exists that
supports the claim income smoothing has a greater informational impact on future company
performance as reflected in stock price.
Asset valuation
The authors of “Principles versus rule based accounting standards” argue that the FASB's GAAP
are too focused on principles and not rules as this allows for unrealistic quantitative truth weaving
via a literal interpretation of standards that are already ambiguous and vague to start with. They
state this in the following way:
“The FASB continues to permit and may well extend the fair measurement of assets and
liabilities even though those valuations are often not based on relevant (applicable) and
reliable (objectively determined) market prices.”
A reason why fair measurement of assets is considered to be unreliable in some circumstances is
because there are three measures of value called level 1, level 2 and level 3 assets. The latter of
these pertains to assets that are immeasurable by conventional market means and therefore are
ambiguous by there very nature. The problem is many corporate assets fall under this category of
valuation that is used in financial reporting. FASB Statement 157 defines level 3 assets as follows:
“This Statement expands disclosures about the use of fair value to measure assets and
liabilities in interim and annual periods subsequent to initial recognition. The disclosures
focus on the inputs used to measure fair value and for recurring fair value measurements
using significant unobservable inputs (within Level 3 of the fair value hierarchy), the effect of
the measurements on earnings (or changes in net assets) for the period. This Statement
encourages entities to combine the fair value information disclosed under this Statement with
5. the fair value information disclosed under other accounting pronouncements, including FASB
Statement No.107, Disclosures about Fair Value of Financial Instruments,where
practicable.”
Thus, “unobservable inputs” that are “encouraged” to be used with other fair value information
after “initial recognition” with “highest and best use” in mind leaves a substantial amount of leeway
provided that no liquid or observable market exists for the asset. For instance, the securitization of
art derivatives are based on the value of art, each of which are subjectively valued on a case per
case basis making derivatives of such assets difficult to value with any certainty, especially if the art
is not well known or recognized. Investopedia states, “Even though they are hard to value, Level 3
assets are held at large investment shops and commercial banks by the billions” and that these
assets were scrutinized as suspect following the credit crunch of 2007.
Off-balance-sheet items
Currently, GAAP appears to have room for improvement in terms of accounting for of risk by
partial owners of off-balance-sheet items. Off-balance-sheet items include securitization of assets,
joint venture investments, special purpose entities and pension assets and liabilities per Tracy
Byrnes of the New York Stern School of Business. Section 85-10-35-3 of the FASB's GAAP
Codification refers to off-balance-sheet items as follows:
“Off-balance-sheet financial instruments refers to off-balance-sheet loan commitments,
standby letters of credit, financial guarantees, and other similar instruments with off-balance-
sheet credit risk except for instruments within the scope of Subtopic 815-10”
According to Byrnes, these items are reported in financial statements such as quarterly SEC filings,
but they are done so in a less than transparent manner since they are confusingly mentioned in
footnotes under cash flow statements. What is more, since off-balance-sheet items are only listed in
the financial statements of the consolidating owner and not partial owners, these items may not
even be in the footnotes of corporations that are pass-through or partial owners. The Risk &
Compliance Journal cites William Fellows, a partner at Deloitte & Touche LLP on the matter.
“If a securitization entity must be consolidated, all of its assets and liabilities to third parties
are included in the consolidated balance sheet of the party that consolidates, not just their
proportionate ownership share. Accounting equity in a consolidated securitization entity held
by a third party investor is shown as a non-controlling interest in the consolidated financial
statements,”
According to the Risk & Compliance Journal, there is some uncertainty surrounding the
implementation of these rules. Specifically, the attribution of variable interest as this affects which
organization is responsible for consolidating securitization on financial statements. The possible
problems concerning variable interest rest in section 85-10-45-1 of codified GAAP “
“In the preparation of consolidated financial statements intra-entity balances and
transactions shall be eliminated. This includes intra-entity open account balances, security
holdings, sales and purchases, interest, dividends, and so forth. As consolidated financial
statements are based on the assumption that they represent the financial position and
6. operating results of a single economic entity, such statements shall not include gain or loss
on transactions among the entities in the consolidated group. Accordingly, any intra-entity
profit or loss on assets remaining within the consolidated group shall be eliminated; the
concept usually applied for this purpose is gross profit or loss (see also paragraph 810-10-
45-8).”
This intra-entity accounting for profit means corporations with off-balance sheet interest recorded
in the consolidated financial statements of a subsidiary can record their liabilities from the
formation of special purpose entities on the financial statements of that subsidiary per Frank
Partnoy of the Roosevelt Institute. Furthermore, he states this facilitates a lack of transparency
because they allow companies to hide debt in off-shore corporate subsidiaries.
“Complex institutions increase their use of off-shore subsidiaries and swap transactions to
avoid disclosing liabilities, as they did during both the 1920s and the 2000s. Over time, the
exceptions eat away at the foundations of financial statements, and the perception of the
riskiness of large institutions becomes disconnected from reality. Without transparency,
investors and regulators can no longer accurately assess risk. Finally, the entire edifice
collapses. This is the story of both the 1920s and today.”
Considering that off-balance sheet items often involve a great deal of money, an unclear footnote on
a financial statement is less than revealing, but is still an on-financial statement item making it less
of a disclosure issue and more of a transparency issue that is not necessarily in investors' interest,
which is the SEC's and consequently the FASB's role to protect. In addition, since securitization of
assets implies an underlying derivative obligation, in some instances, the ownership of assets may
be questionable if not evident via financial reporting under GAAP.
Tax reporting
Another area of off-balance sheet accounting that is not necessarily misleading to investors, but
evasive to tax authorities is the reporting of subsidiary corporation income taxes. Furthermore, if a
business with controlling interest in a revenue generating project over its subsidiary records the
income tax of non-controlling subsidiary interests, then the amount of tax recorded on consolidated
income statements of the controlling corporation may not reflect that actual amount of income
earned in addition to lowering total expenses. This is because the tax incurred by the subsidiary
differs based on corporate structure per PricewaterhouseCoopers LLP:
“The financial statement amounts reported for income tax expense and net income
attributable to non-controlling interest differ based on whether the subsidiary is a C-corporation
or a partnership. The tax status of each type of entity causes differences in the
amounts a parent company would report in its consolidated income tax provision and net
income attributable to non-controlling interest.”
Non-controlling businesses such as partnerships are flow-through entities meaning the shareholders
report the business' income as their own respective percentage share of that income on their
individual tax filings. This poses an additional problem per PWC. Specifically, there are differences
of opinion in the accounting community about how deferred taxes are reported in some instances:
7. “Exceptions to the general guidance have been made in practice. Specifically, different views
exist regarding if and when deferred taxes should be provided on the portion of an outside
basis difference attributable to nondeductible goodwill.”
So what does this mean? Outside basis refers to the pass-through portion of deferred taxes that are
payable by the partner. Non-deductible goodwill is an intangible asset that if sold, is taxed based on
its value, which is open to interpretation if it is a level 3 asset. Moreover, even though goodwill
should be valued under its highest and best use, this is essentially an unenforceable quantification
of valuation due to its inherent ambiguity. Thus, parent corporations have the advantage of
underreporting income tax using off-balance sheet subsidiaries that are partnerships. A comment
within a public SEC letter concerning the matter states as much:
“We have read your response to comment 7 in our letter dated September 18, 2012. We are
not clear on your basis for recording a deferred tax asset for an outside basis difference that
GAAP presumes is essentially permanent in duration. In this regard ASC 740-30-25-9 does
not make a distinction between a corporate or non-corporate subsidiary. Accordingly we are
not clear that promulgated GAAP requires you to record a deferred tax asset on an outside
basis difference unless, possibly, your plan is to sell it within the foreseeable future”
The underreporting of taxable income by corporations subject to GAAP is considered a tax
avoidance mechanism that should be eliminated per Mitchell L. Engler in the Columbia Business
Law Review. Moreover, since tax accounting differs from book accounting, both tax sheltering and
tax avoidance represent numerical opportunities to businesses seeking to present their financial data
to investors. For example, according to Phil Kenkel of Oklahoma State University, deferred
compensation is not deductible from income until payment is made whereas it is under GAAP.
Thus, the financial statements issued under GAAP are more likely to reveal a more favorable tax
scenario than with tax accounting.
Revenue recognition
Revenue recognition is a vast section of GAAP that pertains to the recording of money from sales.
Since there are numerous types of products and services that are rendered and transacted in multiple
ways, having an accurate set of principles to account for reporting of that revenue makes sense. The
FASB issues new standards each year to account for changes in the accounting world and address
previously unattended or inadequately dealt with reporting matters. However, despite the many
definitions and guidelines the FASB has issued on the matter, problems persist.
To illustrate and example of a revenue recognition problem, consider Update No. 2014-09—
Revenue from Contracts with Customers (Topic 606). This was one of over a dozen new standards
issued by the FASB in 2014 and it aims to improve disclosure requirements, reporting of financial
changes from contract modifications, and determination of what contracts actually are from a
financial reporting perspective. However, in doing so, the bar is also raised for public companies
that engage in frequent contactual arrangements that change often.
Ken Tysiac of the Journal of Accountancy states that in effect, this places a resource burden on
those companies in order to properly manage the new standard adjustments. So in this case, the
problem may not be the accuracy of the standards as much as the difficulty of implementing the
8. new rules.
This is not the only problem of revenue recognition per Larry Perry CPA of Accounting Web. More
specifically, Perry states:
“Recognition of revenue assumes the amount is measurable and that there is reasonable
assurance of collection. When uncertainty exists as to collectibility, a separate provision
should be made for the doubtful collectibility.”
This is a similar issues to fair value measurement of assets. For instance, the delivery of a
contracted service that changes as the work-in-progress changes cannot be adequately valued until
the work is complete and paid for. This makes revenue recognition at the time of the initial
transaction somewhat misleading if not inaccurate if that value of an account receivable is used in
financial statements without disclosure about the nature of that contract.
Globalized standards
The International Accounting Standards Board along with the Financial Accounting Standards
Board have a goal of globalizing the rules of accounting. This objective has been in place for some
time and helps facilitate global commerce by adding consistency and removing financial reporting
obstacles that waste time and money. The problem is global accounting standards have not been
adopted in the United States as GAAP is still considered the rule of thumb by U.S. Corporations.
Even though the FASB has sought to make GAAP synchronous with IFRS, the result has been less
than that. An Accounting Web report on the subject cites the IASB Vice Chairman as saying the
following about the matter:
“Global standards are not only achievable, but an inevitable consequence of continued
economic globalization. More than four-fifths of countries now mandate the use of IFRS,
while momentum toward IFRS adoption continues in many of the remaining countries, as
evidenced by recent developments in India, Japan, and Singapore. IFRS has become the de-facto
global language of business, and over time, the IFRS map of the world will be
complete.”
The large accounting firm Ernst & Young made a similar claim in its 2012 publication titled, “US
GAAP versus IFRS: The Basics”. Even though both the FASB and the IASB seek to globalize
standardized accounting rules, the reality is that only the most substantial and far reaching of rules
have been made similar. The U.S. Is apparently not in a rush to give up control of its accounting
rules, and with a nearly $17 trillion economy in terms of annual gross domestic product, there is
good reason to not jump in to things too quickly.
“...the convergence process is designed to address only the most significant differences
and/or areas that the Boards have identified as having the greatest need for improvement.
While the converged standards will be more similar, differences will continue to exist between
US GAAP as promulgated by the FASB and International Financial Reporting Standards
(IFRS) as promulgated by the IASB.”
Differences in global accounting standards leave room for misinterpretation of financial statements
9. and inefficiency in international commerce. For example, in a comparison between IFRS and
GAAP, KMPG states “Unlike IFRS, the objective of financial statements is fair presentation in
accordance with US GAAP”. IFRS on the other hand, is more representative of accounting reality
rather than principles based actuality. “The overriding requirement of IFRS is for the financial
statements to give a fair presentation (or true and fair view).” This differences in accounting
terminology lend an ear to financial misinformation and have the potential to distort the liquidity,
value and debt of GAAP regulated corporations to the tune of billions of dollars if not more.
Disclosure requirements
The disclosure requirements under GAAP do not overwhelmingly facilitate corporate transparency.
As previously mentioned, one area where this is evident is in the ambiguous footnoting of off-balance
sheet items. However, an additional aspect of GAAP accounting reveals further issues with
disclosure. In particular, the reporting of errors during interim periods is done separately per the
following Securities and Exchange Commission excerpt.
“...under U.S. GAAP, correction of errors that are material to the interim period but not to
the estimated income for the entire fiscal year or on earnings trends shall be separately
disclosed in the interim period.”
What this means for financial clarity is an accounting mistake is not necessarily evident on typical
financial reports investors are used to reviewing as part of their due diligence. This is the case
whether the accounting error(s) were made knowingly or un-knowingly, and apparently without
limit to the dollar amount. In an accounting scenario where materiality of a transaction, account
balance or revenue amount is detrimental to some other financial circumstance, the occurrence of
an error may or may not be influential to deal making or capital acquisition. Yet another instance
where disclosures leave room for misinformation is in the presentation of estimates.
“U.S. GAAP requires discussion of estimates when it is reasonably possible that the estimate
will change materially in the next year....Disclosure of factors that cause the estimate to be
sensitive to change is encouraged but not required.”
While the disclosure of estimates is required if there are likely to be changes in that estimate, the
magnitude of those changes is less likely to be known or understood if the merely suggested factors
that influence those estimates are not revealed.
Another recent example of limited disclosure requirements are those pertaining to business failure.
In August 2014, the FASB issued an accounting standards update ASU 205-40 to clarify when
corporations should reveal substantial doubt about a corporation's ability to perform in the future.
The principle states that substantial doubt about business continuity within a year of releasing a
specific financial statement within which that doubt should be revealed. Even though this rule is an
improvement, the notion of substantial doubt is premised on a business' ability to meet near-term
obligations such as debt, contractual services and equity issuances.
Companies with zero or low debt, but with adequate capitalization to continue for some time
despite unpredictable revenue streams may not be classified as probable failures under this
standard. This principle also excludes clarification of conditions that are probable to lead to a
10. company's mid-term or long-term demise. Moreover, technically, they do not apply to imminent
failures 366 days or a day or more after the literal interpretation of the standard. As with other
principles, the spirit of ASC 205-40 is neither emphasized nor required.
Liability reporting
Liability reporting is an area of accounting that has latitude in financial reporting requirements.
According to the Rose Foundation, even if a company subject to GAAP uses accrual accounting, it
does not have to accrue the full potential value of environmental liabilities if they are not known
with “probability”. Probability can mean a lot of things such as above 50% or above 95%
likelihood, and the evaluation of probability itself is riddled with actual and added statistical
hurdles of validity. Although environmental reporting is a limited aspect of accounting in terms of
some corporations, for large polluters and corporations with heavy carbon footprints, the
advantages of this loophole are substantial.
“If a liability is “probable” but not reasonably estimable, then the corporation does not have
to accrue the liability as a charge to income, but only must disclose the nature of the
contingency in the financial statement. However, if “information is available” that indicates
that the estimated amount of the loss is within a range, and a certain number within the
range that appears “at the time to be a better estimate than any other amount within the
range,” the corporation should accrue that amount.” If no amount within the range is a
better estimate than any other amount, according to GAAP, the minimum amount shall be
accrued.”
To illustrate the above scenario, a company that has not yet incurred debt, but in the course of
business such as later stages of project management, will incur debt, the lowest estimate of that
future debt may be used in financial reporting even though it may be unrealistic. The advantage of
using this accounting technique is that income in financial statements will appear higher than
reality might dictate.
The above environmental scenario is just one of many liability reporting problems within GAAP
per Sanford Lewis of the Investor Environmental Health Network. Moreover, in an IEHN
publication, Lewis details eight liability reporting loopholes that conceal financial conditions from
investors and protect corporations from having to fully disclose financial data in a transparent way.
He states it in the following way:
“Among other things, the regulatory flaws encourage companies to conceal damaging
scientific findings from investors, fail to disclose estimates of the range of potential liabilities,
and place undue reliance on litigators, in conflict with their obligations to protect privileged
information.”
So what exactly are these loopholes? In a nutshell, they all revolve around disclosure, estimation
and valuation of liabilities and use ambiguity, legal protection and reporting limitations to achieve
this end. For example, failure to disclose long-term, potential and maximum estimated liabilities is
a result of hiding information within attorney-client privilege, failure to use known industry
benchmarks and not allowing shareholders to vote on specific liability disclosures per the report.
The fact these things are possible do not necessarily indicate inadequacy of the intent of GAAP, but
11. rather the exploitation of ethical leeway made possible by GAAP. This is made more clear in the
use of numerous in-substance defeasance techniques that also hide debt from balance sheets.
In-substance defeasance
An example of liability reporting that affords corporations subject to GAAP some flexibility is
evident in the option to expense assets rather than capitalize them and vice versa. Moreover,
accounting principles allow the purchase of large business items to be recorded as assets without
cost other than depreciation expense on the income statement. In other words, the immediate cost of
expensive business expenditures can be incurred over time via straight line or accelerated
depreciation. This process is called capitalization of expenses and should not be confused with
"capitalization" which is equity investment within a company.
Expensing is different from capitalizing of expenses because items i.e. assets or services are not
depreciated in this method. Instead, with this accounting technique, when items are expensed
immediately the costs are realized as a reduction to revenue rather than an increase to the liabilities
of a company. If the expense is to be paid over a few months, all or part of it may become a short-term
liability but will usually quickly become expensed as the debt is paid.
Another method of removing debt from balance sheets is via transfer of loans to a trust. Also per
professor Brijesh Yadav of the Standard International Journal, doing this enables corporations to
increase profitability on paper in addition to improving the debt profile of a business. For the
corporation and parties of interest, this can incur lower costs of additional debt and facilitate the
leveraging of assets with greater ease.
Conclusion
Industry diversity and vast differences between corporate financial strategies make standardizing
accounting difficult. The complexity and fluidity of financial markets, asset securitization and
accounting cast a certain shadow over the effectiveness of generally accepted accounting principles.
GAAP are faced with numerous regulatory obstacles such as the intended goal of merging with
international financial reporting standards, complications in asset valuation and exploitation of
accounting practices that allow corporations considerable leeway and latitude.
Investors, corporate tax receipts and efficient financial analysis are all effected by limited disclosure
requirements, variance in accounting standards and costly one-size-fits all regulations. All these
factors represent a challenge for the Federal Accounting Standards Board and other standard setting
contributors such as the American Institute of CPAs, the Public Company Accounting Oversight
Board and the National Association of State Boards of Accountancy.
Economic, legislative and commercial interests challenge the use of, creation and implementation
of accounting regulations via divergence of financial intention, procedural difference of opinion and
strategic objectives, but GAAP provides a considerable amount of guidance and certainty regarding
a wide array of accounting practices that involve revenue recognition, presentation of financial
statements and asset accounting among other important and heavily used financial accounting
practices. As laws change, markets adapt and transactions evolve, the FASB continues to issue
statements, exposure drafts and updates to keep up with and facilitate the somewhat fluid nature of
12. accounting. This provides adequate, if not sufficient regulatory stability to the accounting industry
and those entities and persons it effects.
Sources:
1. “Cornell University Law School”; 12 U.S. Code § 183 – Accounting Objectives, Standards, and Requirements
2. “ U.S. Securities and Exchange Commission”; Securities Exchange Act of 1934
3. “Federal Accounting Standards Board”; Facts About FASB
4. “Legal Zoom”; Generally Accepted Accounting Principles or GAAP: What Does it Mean?; Stephanie Paul;
September 2009
5. “Cornell University Law School”; 15 U.S. Code Chapter 98 – Public Company Accounting Reform and Corporate
Responsibility
6. “Yale Law School: Yale Law School Legal Scholarship Depository”; Does the Sarbanes-Oxley Act Have a Future?;
Roberta Romano; January 1, 2009
7. “Gibson Dunn Lawyers”; The Sarbanes-Oxley Act: Rewriting Audit Committee Governance; Stephanie Tsacoumis,
Stephanie R. Bess and Bryn A. Sappington
8. “Seeking Alpha”; Danger Zone: Stocks With Most Misleading Non-GAAP Earnings; David Trainer; July 23, 2014
9. “AccountingDegree.org”; 10 Accounting Tricks the 1% Use to Dodge the Taxman
10. “The Daily Beast”; 8 Ridiculous Tax Loopholes: How Companies Are Avoiding the Tax Man; Josh Dzieza;
February 25, 2012
11. “New York Times”; Looking at Some Corporate Tax Loopholes Ordinary Citizens May Envy; Andrew Ross Sorkin;
April 14, 2014
12. “Investor Environmental Health Network”; Bridging the Credibility Gap: Eight Corporate Liability Accounting
Loopholes that Regulators Must Close; Sanford Lewis
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