Apr 04

Introduction to Financial Statement Analysis. Part 1b: GAAP

by David Harper, CFA, FRM, CIPM

FinStatements |

This is a textual summary of the second half of our 19-minute movie: An Introduction to Financial Statement Analysis. Chapter 1: Who's in charge.

Previously, we saw that the Securities and Exchange Commission (SEC) governs the preparation of financial statements in the United States (Question: Who's in Charge? Answer: the SEC, when you get down to it).

SEC governs, FASB is independent, both inform GAAP

The SEC, a regulatory (governmental) body, delegates responsibility to the Financial Accounting Standards Board (FASB), a seven-member nongovernmental organization. FASB conducts the heavy work of revising and updating all of the accounting standards. The idea is that FASB should be independent, and truly they have a remarkable if imperfect record of immunity to political pressure, though recently there has been a bit of a controversy surrounding FASB's independence (as an operating group of the Financial Accounting Foundation) in relation to the SEC.

In this way, both the SEC and FASB inform the principles that apply to the presentation of financial statements, called Generally Accepted Accounting Principles (GAAP).

We compare GAAP to a constitution because it evolves with the times. It must morph over time, if for no other reason than business models and transactions evolve. An simple transaction is to pay cash for a tangible asset. This is becoming less common as transactions become more complex. Nowadays, companies securitize receivables, enter into multi-year performance contracts, finance with debt-equity hybrids, routinely hedge with futures contracts, and increasing acquire and sell intangible assets. New transactions and asset types require new principles and/or rules. The average corporate balance sheet has changed dramatically over recent decades. When eBay bought Skype, a whopping $300 million dollars was allocated to intangibles; this included, presumably, a valuable customer list and the the trademark.

To prove that the whole thing is in evolutionary flux, consider that FASB is currently re-considering the entire foundation of GAAP, known as the Conceptual Framework. The underlying foundation of GAAP is called the Conceptual Framework and FASB is working to develop "standards that are principles-based, internally consistent, internationally converged." The key motive is to work with the International Accounting Standards Board (IASB) to converge toward a consistent international framework. This is more important than it used to be: corporations operate across borders. If you want to analyze the average S&P 500 corporation, you invariably are dealing with international jurisdictions, multi-national operations and foreign currency risk.

The Conceptual Framework

At first blush, the conceptual framework might seem too metaphysical. But it's really important to understanding financial statements. If you understand the trade-offs implied in any reporting framework, it is easier to understand some of the thornier accounting debates. The top of the framework looks like this:

The diagram above stops at the so-called Primary Qualities and does not include Secondary Qualities (e.g., it omits materiality and comparability. Comparability, as in comparing a company to its peers, is really important to an investors. Some believe it should be a Primary Quality. The current IASB framework elevates comparability; recently, FASB suggested that comparability is important but "logically follows both relevance and faithful representation").

If you look at the Primary Qualities, your initial reaction might be, those all look like good things. Let's do all of them! But relevance and reliability are sort of like truth and beauty: both are good, but sometimes you need to prefer one over the other (e.g., the ugly truth, or a beautiful illusion)!

Relevance - is it useful to me as an investor?

In the Conceptual Framework, Relevance includes three ingredients: Predictive Value, Feedback Value (might be relabeled Confirmatory Value), and Timeliness. We like to say that relevance means "useful." Recently, FASB referred to relevance information as "capable of making a difference in the decision of [financial statement] users." The three sub-qualities loosely refer to the idea that, in order to be relevant (useful), financial data should be "predictive" of future cash flows, received in a "timely" enough manner to be useful, and able to "feedback" correctly about previous transactions.

Reliability (Faithful Representation) - is it a "knock on wood" objective picture of reality?

Reliability includes three ingredients, too: Verifiable, Neutrality, and Representational Faithfulness. We like to summarize these into the word "objective." Or, if you like, FASB says this is when the data "depicts the economic substance of the underlying transaction or event."

Take real estate, for example, today's market value is what's relevant to us. Market value is useful. But, short of a transaction, it's hardly objective; three different appraisers will generate three different current market values. The historical cost (i.e., the purchase price originally paid for the real estate) is not so relevant but highly reliable. It is an objective number, it doesn't matter who measures it. So, historical cost is reliable but less relevant. Market value is relevant but less reliable.

Many new instruments/transactions cannot simultaneously relevant and reliable, as measured!

That's a key trade-off that informs many accounting trade-offs. For example, consider stock option expensing. The old method (APB 25) required companies to expense the intrinsic value at grant; i.e., the difference between the stock price and strike price. This was perfectly reliable; we can all agree that a plain vanilla option has no intrinsic value on the day it is granted. But, at the same time, zero is not a relevant number for the cost of that option. So, the new rule favors relevance over reliability. Understandably (and in our view, appropriately). But the price of this is less reliability. There is no single, perfectly objective measurement of this option's cost.

A final note in regard to FASB's current deliberations. FASB's preliminary views, in regard to convergence with IASB, include a modest reorganization of Reliability into Representational Faithfulness (and the introduction of the notion of "complete"). Basically, they felt this better captures the objectivity concept: that reports depict the economic, real-world substance of a transaction.

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