Most think of Accounting as this dry profession we only need to consider around tax time, but as an investor, understanding how accounting works on a basic level remains important if you want to analyze businesses on any level. GAAP accounting rules remain the primary force behind financial accounting, and today we will learn more about this exciting topic!
I took several semesters of accounting in college, and to be frank, I don’t recall much about the classes except for the pretty girl sitting at the desk right in front of me. In hindsight, I wish I had paid more attention to the teacher as it would have come in handy in my investing life.
Becoming a better investor includes understanding the business you want to buy. Part of learning the business is understanding the language business speaks, which is financial accounting—part of understanding the language is to have a foundation in GAAP accounting and the rules surrounding GAAP.
Buffett and Munger both have strong opinions on the understanding of businesses and the language of business, which is accounting.
“You need to know how figures are put together, but you also have to bring something else. Read a lot of business articles and annual reports. If I don’t understand it, it’s probably because the management doesn’t want me to understand it. And if that’s the case, usually there’s something wrong.”
“Asking Warren what good books he knows about accounting is like asking him what good books he has on breathing. You start with basic rules of bookkeeping, and then you have to spend a lot of time to really become knowledgeable.”
Topics we will discuss in today’s post:
- What is GAAP Accounting?
- What are the Four Principles of GAAP?
- Compliance with GAAP
- GAAP versus Non-GAAP: What’s the Difference?
- GAAP versus IFRS
Ok, let’s dive in and learn more about GAAP accounting rules.
What is GAAP Accounting?
According to Investopedia:
“Generally accepted accounting principles (GAAP) refer to a common set of accounting principles, standards, and procedures issued by the Financial Accounting Standards Board (FASB). Public companies in the United States must follow GAAP when their accountants compile their financial statements. GAAP is a combination of authoritative standards (set by policy boards) and the commonly accepted ways of recording and reporting accounting information. GAAP aims to improve the clarity, consistency, and comparability of the communication of financial information.”
GAAP accounting contrasts with non-GAAP accounting, which we will discuss in a little bit. Another contrast to GAAP accounting is the International Financial Reporting Standards (IFRS); more on that in a moment.
GAAP accounting helps govern the world of financial accounting according to standardized rules and guidelines. GAAP attempts to regulate and standardize the definitions, methods, and assumptions used in all financial accounting across all industries.
GAAP topics include items such as:
- Revenue recognition
- Balance sheet classifications
- Materiality
The ultimate goal of GAAP accounting is to ensure a company’s financial statements are complete, comparable, and consistent, all of which makes it easier for investors to compare companies across industries. GAAP also makes it easier to analyze companies and extract any possible useful information.
Ten general concepts can help us remember the main goal of GAAP:
- Principle of Regularity
- Principle of Consistency
- Principle of Sincerity
- Principle of Permanence of Methods
- Principle of Non-Compensation
- Principle of Prudence
- Principle of Continuity
- Principle of Periodicity
- Principle of Materiality/Good Faith
- Principle of Utmost Good Faith
The basic gist of all the above principles is that accountants must be truthful, honest, and consistent in all their financial document preparations.
The above rules and regulations began during the Great Depression to counter all the shady dealings that officials believed helped worsen the Great Depression.
Investors believed companies misled investors during the time with some less than forthright financial reporting practices. With the establishment of GAAP accounting, the Federal government hoped to avoid the issue going forward.
GAAP started in 1933 with the Securities Act of 1933 and the Securities Exchange Act of 1934.
GAAP governs accounting rules by the FASB (Financial Accounting Standards Board), and the GAAP accounting rules face scrutiny constantly, and different rules change periodically.
What Are the Four Principles of GAAP?
GAAP has four basic principles:
- Costs
- Revenues
- Matching
- Disclosure
Costs
The cost principle requires that the actual cost of assets be recorded instead of recording the cost based on market values or adjusting for inflation. The cost principle ensures that inventories and other purchases are reflected accurately in the accounting ledger. Another bonus in regards to this principle ensures recording costs at the time of purchase, as opposed to recording them later, which might require estimations or adjusting those costs.
Revenue
The revenue principle requires recording the company’s earnings, not when the payment is received. Recognizing revenues in this manner helps eliminate errors in accounting caused by payment delays and serves as the basis for accrual accounting.
Accrual accounting, for those unfamiliar with the term, is the method of accounting where the revenue or expenses post when the actual transaction occurs rather than when receiving the payment. Accrual accounting follows the matching principle, which we will discuss next.
Matching
The matching principle requires expenses to match the revenues related to them. The matching principle states the recording of expenses until the revenue causes the cost to occur. The matching principle allows the profitability of goods and services to be understood easily and illustrates the connection between revenues and expenses.
Disclosure
The disclosure principle requires all financial information be clear and easy to understand for all individuals. The disclosure needs to balance against the costs associated with producing said disclosures. Any information required to understand all financial statements needs inclusion in the body of statements, notes, or any supplemental information.
In each financial report, such as a 10-K or 10-Q, you can find information regarding how a company records its costs, revenues, matching, and disclosures below the main financial statements. We can find the information in the notes section of the reports. Most of it is legal jargon, but you can pull a tidbit or two out; it is good to skim in case revenue recognition has changed, for example.
Compliance with GAAP
Why focus on GAAP? If a company’s stock trades publicly, the company’s financial statements must conform with GAAP accounting rules, as established by the SEC (Securities and Exchange Commission).
The SEC requires that all companies on the stock exchanges file GAAP-compliant financial statements on a timely basis, every three months. This is required if the company wishes to trade on stock exchanges.
GAAP compliance is monitored and ensured by auditors, who are third-party accounting firms hired to audit the company’s financial statements to ensure they meet all GAAP accounting guidelines. These CPA firms audit the financial statements of outsiders to ensure no funny business goes on within the company and the company doesn’t try to mislead investors.
Although GAAP accounting doesn’t exist for non-public companies, it is standard practice for firms to adopt these accounting rules. If the company ever wishes to go public, it helps ease the transition and makes it easier for auditors or investors to analyze and extract any useful information.
And last but not least, if any company wishes to raise financing via a bank loan, most financial institutions require GAAP accounting as part of their debt covenants whenever they issue business loans. Therefore, most companies adhere to GAAP accounting rules.
If a company prepares its financial statements without GAAP accounting rules, you should beware. Without GAAP, it is much more difficult to assess the financial situation of said company, and any comparisons to companies using GAAP accounting would be borderline impossible.
Some companies may report GAAP and non-GAAP financial results, which is more common in quarterly earnings reports such as a 10-Q.
GAAP accounting rules require that a company report any figures as the non-GAAP state in its financial statements or press releases.
Let’s move on to GAAP versus non-GAAP.
GAAP versus Non-GAAP: What’s the Difference?
As GAAP is strictly adhered to and monitored constantly, non-GAAP is the opposite of those requirements.
Companies are allowed to display their financial figures in a non-compliant way, referred to as non-GAAP, but it must list those figures as non-GAAP, and there must be a reconciliation presented as well.
Non-GAAP figures usually exclude rare items associated with acquisitions, restructuring, and one-time adjustments to balance sheets. The reasoning for allowing these exceptions remains a smoothing out of earnings volatility that results from temporary situations, such as a one-time tax payment.
Non-GAAP accounting has risen recently, especially using earnings calls or quarterly statements. We see them in press releases designed to present the companies in the best light.
Most companies report their quarterly earnings in non-GAAP figures, and many will lead with those numbers to present the company in a more flattering light.
Investors need to understand non-GAAP figures and interpret them, but it is important to understand where GAAP accounting rules remain more appropriate. Successfully understanding the differences or the ability to weed out the misleading or incomplete non-GAAP numbers becomes more important as those results diverge from the GAAP figures.
An important note regarding non-GAAP: studies have shown in recent years that companies are more willing to back out losses than gains to foster investor optimism, as opposed to adhering to GAAP measures and their corresponding consistency.
Some stats along these lines:
- In Q3 2019, 67% of all companies in the Dow reported non-GAAP earnings.
- 14 of the 20 companies reporting non-GAAP reported higher non-GAAP earnings than GAAP earnings.
- In the case of net income, non-GAAP utilization has grown 33% from 1998 to 2017.
- In 2019, 97% of all companies in the S&P 500 used non-GAAP adjustments, up from 59% in 1996.
Tech companies are the biggest proponents of non-GAAP figures as they usually don’t report high earnings from GAAP because of the nature of their business.
Some companies, such as Uber, remove recurring items related to costs that the company incurs to grow, making comparisons to Uber difficult.
Some companies use adjusted earnings to report their financial results, but other adjusted metrics have come into being in the last twenty years. Items such as:
- EBIT – Earnings Before Interest and Taxes
- EBITDA – Earnings Before Interest, Taxes, Depreciation, and Amortization
- Adjusted revenues
- Core earnings
- Funds from Operations
- Revenue per user
- User per click
The adjustments go on forever; as investor sentiment increases, look for the rise in said adjustments. Not all metrics are bad, and many can help smooth out the earnings over a period to help you analyze the company better.
But when they present them as a method of deceiving the investor that results are better than they are, then that is a problem.
The use of non-GAAP figures remains prevalent on any quarterly report, such as a 10-Q, but they must have GAAP reconciliations. But all annual reports contain GAAP figures, so all the non-GAAP figures must reconcile at the end of the fiscal year, which is why annual reports remain the best guide for the company’s financial condition. Remember that quarterly reports don’t get audited and thus use non-GAAP figures.
Along those lines, several companies only report their financial condition according to GAAP accounting rules, including Berkshire Hathaway and Markle Corporation.
Buffett and Munger hate any of the non-GAAP figures, including EBITDA. Munger refers to EBITDA as b**s**t earnings and completely dismisses any use of such a figure.
GAAP versus IFRS
While GAAP accounting rules focus on U.S. companies, the alternative for international companies remains using IFRS (International Financial Recording Standards). The accounting bodies that both govern GAAP and IFRS have been working on merging the two accounting standards since 2002.
There has been progress, but a few items that remain different include:
- LIFO Inventory – GAAP allows companies to use the Last in, First Out (LIFO) inventory cost method, while IFRS prohibits its use.
- R&D Costs – GAAP requires recording these costs as they incur, whereas IFRS allows the capitalization and amortization of costs.
- Reversing write-downs – GAAP requires that any write-down is permanent regardless if the market value of the asset increases in value. IFRS allows write-downs to be reversed if the asset’s value increases.
One big achievement in 2007 removed the requirement for foreign companies registered in the U.S. to utilize GAAP accounting rules if their financial statements were already compliant with IFRS accounting rules.
As the globalization of markets continues, work on the accounting rules nationally and internationally will gain more importance, and the increased standards that allow investors to understand all financial statements from around the world will increase investor sentiment.
Final Thoughts
As I mentioned in my intro, accounting has a reputation for being tired and stuffy. While the statement might have a tinge of truth, to be an investor, it is critically important to understand the language of business, which is accounting.
…Accounting is the language of practical business life. It was a very useful thing to deliver to civilization. I’ve heard it came to civilization through Venice, which of course, was once the great commercial power in the Mediterranean. However, double-entry bookkeeping was a hell of an invention.
To be an investor in publicly traded companies, you don’t need to be a CPA-level accountant, but you do need to understand the differences between a credit and a debit and understand how financial statements flow together. All the other information will come as you read through more financial statements and gain experience.
That is going to wrap up our discussion for today.
As always, thank you for taking the time to read this post, and I hope you find something of value on your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,
Dave
