GAAP Gets A Bad Rap

There’s a growing push to replaceGenerally Accepted Accounting Principles with an accounting system that better reflects companies’ finances.

Generally Accepted Accounting Principles (GAAP), the accounting framework US companies must follow for financial reporting, is coming under increasing criticism for being inadequate. It has reached a point where some companies are finding other ways to communicate their finances, rather than follow the guidelines of the Financial Accounting Standards Board (FASB). Hans Hogervorst, chairman of the International Accounting Standards Board says, “More than 88% of the S&P 500 now currently disclose non-GAAP metrics in their earnings release.”

But that strategy can be risky, as demonstrated by New York–based marketing company MDC Partners, which ran afoul of the Securities and Exchange Commission (SEC) and paid penalties to the tune of $1.5 million for using non-GAAP metrics.

MDC presented a non-GAAP measure called “organic revenue growth” that excluded the impact of acquisitions and foreign exchange. From the second quarter of 2012 to year-end 2013, MDC also added a third item that boosted its organic revenue-growth numbers. This was done without informing investors. The firm also came under fire for failing to give GAAP metrics equal or greater prominence compared to non-GAAP metrics in its earnings releases.

Commenting in a press release, G. Jeffrey Boujoukos, director of the SEC’s regional office in Philadelphia said, “The lack of equal or greater prominence for GAAP measures is a practice that we will continue to focus upon.”

GAAP Accounting money

So why are so many closely followed companies engaging in such accounting practices, given the risks and increased scrutiny? The answer is simple: Investors seem to want it. 

A survey by investor-relations firm Clermont Partners found that 74% of active investors on the buy side rely less on GAAP reporting and more on what purists dismiss as “fuzzy math.”

Bahnson and Miller urge financial-statement preparers to produce “comprehensive, and comprehensible, non-GAAP financial statements that actually reduce users’ uncertainty and risk,” and warn the analyst community to beware “the abundant defects in GAAP financial statements.”

For example, the authors suggest reporting appreciation of assets as well as GAAP-required impairment losses, and excluding outdated gains and losses that GAAP recognizes as pension costs.“Most of GAAP is counterproductive,” says Boise State University accounting professor Paul R. Bahnson. “There’s a lot of politics in standard-setting.” Bahnson, along with retired colleague Paul B.W. Miller, wrote a recent piece for Accounting Today that criticizes GAAP for its limited usefulness. They highlight the need for a new financial-reporting system that’s more transparent and accurate.

Bahnson tells Global Finance that if he could change one GAAP directive, it would be “reporting financial instruments at fair value.” Currently, he says, companies have a great deal of latitude in how they value their investments in other companies, regardless of degree of control or influence. Held-to-maturity, held-for-trading and available-for-sale are all GAAP-compliant methods, as well as the equity method for valuing investments in associated enterprises.

Bahnson also would like to see depreciation schedules better reflect the useful life of underlying assets as well as the speed with which they lose value—or gain value, as is sometimes the case. “When you see new buildings go up in New York,” he says, “they depreciate over 20 years. But [in that time] they go up in value, not down.” He says the imperative for depreciation rules should be to “reflect the change in the net wealth of the company.”

Bahnson isn’t sanguine about how quickly, or even if, GAAP will undergo the drastic change he would like to see. He expects continued resistance from, say, preparers who don’t want to be forced to disclose anything that could be interpreted as a competitive advantage and analysts whose careers are built on interpreting byzantine disclosures.

The FASB seems to recognize that changes are needed. “The FASB is currently tackling the issue of disclosure effectiveness head-on,” a spokesperson says, indicating that a disclosure framework is currently in the works, although no rollout date has yet been set.