GAAP Limitations

Countries such as the U.S., India, Australia and many European countries have their own Generally Accepted Accounting Principles, or GAAP, that provide rules and standards for financial reporting within their countries. In the U.S., GAAP guidelines are established by the Financial Accounting Standards Board, or FASB. Due to the inherent limitations in GAAP and the widespread investment in international companies that cross national boundaries, many accounting and financial professionals are advocating for the worldwide adoption of the International Financial Reporting Standards, or IFRS, used in over 100 countries.

Financial statements provide a snapshot of the financial health of a company. Accounting standards are essential for companies making decisions on the allocation of their resources, as well as for investors who rely on clear, credible and transparent financial statements. GAAP treats several major accounting issues involving inventory valuation, revenue recognition and financial instruments differently than the IFRS. This means that international companies must prepare costly and cumbersome reconciliation reports that compromise transparency and clarity.

In some areas, such as treatment of derivatives and securitizations, GAAP provides specific rules instead of guiding principles. This means that GAAP is not sufficiently flexible to accommodate changes in the marketplace. In addressing this issue, the FASB acknowledges making political compromises to gain acceptance of a rules-based standard. These compromises include making exceptions for transactions based on scope that limit the volatility of reported earnings and attempt to make allowances for the transition effects to the new standard, which can compromise clarity and consistency.

Under GAAP, assets are reported using their historical cost, or initial acquisition cost. However, “fair value” may be a more accurate representation of an asset’s value. Fair value is the price that a seller would be willing to sell and a buyer would be willing to pay for the asset. While this can sometimes be difficult to measure, fair value is arguably a more accurate representation of the asset’s worth. The FASB acknowledges the relevance of fair value measurement and allows for its use for certain types of assets while not requiring it for other assets. The rules on how to accomplish this, however, are complex and can be inconsistently interpreted.

The FASB intends GAAP to apply to all American companies, big and small, public and private. While the level of complexity and detail of financial reporting required by GAAP may be appropriate for large public companies, it is not relevant for small privately held companies. Privately held companies prepare their financial statements primarily for lenders, vendors and boards of directors who do not require the burdensome and costly GAAP reporting standards. Lenders particularly evaluate a company’s performance using non-GAAP criteria such as liquidity ratios, cash flow information and Earnings Before Interest, Taxes, Depreciation and Amortization, or EBIDA. As GAAP reports earnings after calculating these factors, they must be added back in.