Monday, February 19, 2007

US GAAP versus Indian GAAP

US GAAP versus Indian GAAP
If you thought I am going to give you a lecture on the basics of GAAP principles, then I am sorry to disappoint you. What, in fact, I would like to share with you is the dilemma, we as ordinary investors face these days when we come across a company's financials - one prepared in accordance with the Indian GAAP and another in accordance with the US GAAP. Some times it looks quite surprising when we find that a company which made profits as per the Indian accounting standards, is a loss making company from the standpoint of US GAAP. Who can forget the classic case of Daimler Benz which was a healthy profit making company according to German Standards, but just before its ADR issue realized that it was making losses under US GAAP. Isn't it really perplexing? Now the question arises in the mind of a layman like you and me is what the hell all this is. Is the company in question a profit making company or a loss making one? Is there money inside the wallet of the company or these guys are just making a fool of me by enjoying my hard money that I put in the stocks of their company?

It's true that the accounting jargon is giving enough heartburn for ordinary investors to cope with. But what is the root problem is not the availability of such kind of divergent but detailed information, but the ignorance and, in fact, the lack of investor education initiatives on behalf of the companies as well as the regulatory bodies. In such a scenario, it's the right time for us, the naive investors, to start with such initiatives before we actually get lost in the maze of information that is pouring on our desk day and night - courtesy Internet and Satellite TV.
Definitely you as an investor need to understand a little bit of these things. The most important thing to look at while analyzing a company's performance is to look at the provisions on account of items like ESOPs (Employee Stock Option Schemes) costs, deferred taxes, important write-offs on account of bad investments, doubtful trade receivables etc., made by the companies in their annual, half yearly or quarterly results. You may remember this month on January 9, 2001, Infosys declared its quarterly results, wherein the management had provided for stock option costs and written off some amounts for its investments in a dotcom company. Recently in Wipro's quarterly results too you would find that under US GAAP accounting, the company had written off some of the bad investments and had provided for deferred taxes. Therefore, if you read the management's discussion and analysis part of the result reports of the companies carefully, you would not only learn many useful things but also emerge as a street smart and well-informed investor. So, make it a habit to read between the lines.

U.S. generally accepted accounting principles

Generally accepted accounting principles (GAAP) are the accounting rules used to prepare financial statements for publicly traded companies and many private companies in the United States. Generally accepted accounting principles for local and state governments operates under a different set of assumptions, principles, and constraints, as determined by the Governmental Accounting Standards Board (GASB).
In the United States, as well as in other countries practicing under the English common law system, the government does not set accounting standards, in the belief that the private sector has better knowledge and resources. The GAAP is not written in law, although the U.S. Securities and Exchange Commission (SEC) requires that it be followed in financial reporting by publicly traded companies.

Basic objectives

Financial reporting should provide information that is:
  • useful to present and potential investors and creditors and other users in making rational investment, credit, and other financial decisions.
  • helpful to present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts.
  • about economic resources, the claims to those resources, and the changes in them.

Fundamental qualities

To be useful and helpful to users, financial statements must be:
  • Relevant: relevant information makes a difference in a decision. It also helps users make predictions about past, present and future events (it has predictive value). Relevant information helps users confirm or correct prior expectations (it has feedback value). It must also be available on time, that is before decisions are made.
  • Reliable: reliable information is verifiable (when independent auditors using the same methods get similar results), neutral (free from bias), and demonstrate representational faithfulness (what really happened or existed).
  • Comparable: information must be measured and reported in a similar manner for different enterprises (allows financial statements to be compared between different companies).
  • Consistent: the same accounting methods should be applied from period to period and all changes in methods should be well explained and justified (allows financial statements of the same company to be compared between different periods).

Basic concepts

To achieve basic objectives and implement fundamental qualities GAAP has four basic assumptions, four basic principles, and four basic constraints.

Assumptions

  • Economic Entity Assumption assumes that the business is separate from its owners or other businesses. Revenues and expenses should be kept separate from personal expenses. This applies even for partnerships and sole proprietorships. The entity concept does not necessarily refer to a legal entity.
  • Going Concern Assumption assumes that the business will be in operation for a long time. This validates the methods of asset capitalization, depreciation, and amortization. Only when liquidation is certain is this assumption not applicable.
  • Monetary Unit Assumption assumes a stable currency is going to be the unit of record. The FASB accepts the nominal value of the US Dollar as the monetary unit of record (unadjusted for inflation).
  • Periodic Reporting Assumption assumes that the business operations can be recorded and separated into different periods (most common periods are months, quarters and years). This is required for comparison between present and past performance.

Principles

  • The historical cost principle requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities. This principle provides information that is reliable (removing opportunity to provide subjective and potentially biased market values), but not very relevant. Thus there is a trend to use fair values. Most debts and securities are now reported at market values.
  • The revenue recognition principle requires companies to record when revenue is (1) realized or realizable and (2) earned, not when cash is received. This way of accounting is called accrual basis accounting.
  • The matching principle. Expenses have to be matched with revenues as long as it is reasonable to do so. Expenses are recognized not when the work is performed, or when a product is produced, but when the work or the product actually makes its contribution to revenue. Only if no connection with revenue can be established, cost can be charged as expenses to the current period (e.g. office salaries and other administrative expenses). This principle allows greater evaluation of actual profitability and performance (shows how much was spent to earn revenue). Depreciation and Cost of Goods Sold are good examples of application of this principle.
  • The full disclosure principle. Amount and kinds of information disclosed should be decided based on trade-off analysis as a larger amount of information costs more to prepare and use. Information disclosed should be enough to make a judgment while keeping costs reasonable. Information is presented in the main body of financial statements, in the notes or as supplementary information.

Constraints

  • Cost-benefit relationship states that the benefit of providing the financial information should also be weighed against the cost of providing it.
  • Materiality states that the significance of an item should be considered when it is reported. An item is considered significant when it would affect the decision of a reasonable individual.
  • Industry practices states that accounting procedures should follow industry practices.
  • Conservatism states that when choosing between two solutions, the one that will be least likely to overstate assets and income should be picked.

Setting GAAP

These organizations influence the development of GAAP in the United States.
U.S. Securities and Exchange Commission (SEC)
The SEC was created as a result of the Great Depression. At that time there was no structure setting accounting standards. The SEC encouraged the establishment of private standard-setting bodies through the AICPA and later the FASB, believing that the private sector had the proper knowledge, resources, and talents. The SEC works closely with various private organizations setting GAAP, but does not set GAAP itself.
American Institute of Certified Public Accountants (AICPA)
In 1939, urged by the SEC, the AICPA appointed the Committee on Accounting Procedure (CAP). During the years 1939 to 1959 CAP issued 51 Accounting Research Bulletins that dealt with a variety of timely accounting problems. However, this problem-by-problem approach failed to develop the much needed structured body of accounting principles. Thus, in 1959, the AICPA created the Accounting Principles Board (APB), whose mission it was to develop an overall conceptual framework. It issued 31 opinions and was dissolved in 1973 for lack of productivity and failure to act promptly. After the creation of the FASB, the AICPA established the Accounting Standards Executive Committee (AcSEC). It publishes:
  1. Audit and Accounting Guidelines, which summarizes the accounting practices of specific industries (e.g. casinos, colleges, airlines, etc.) and provides specific guidance on matters not addressed by FASB or GASB.
  2. Statements of Position, which provides guidance on financial reporting topics until the FASB or GASB sets standards on the issue.
  3. Practice Bulletins, which indicate the AcSEC's views on narrow financial reporting issues not considered by the FASB or the GASB.
Financial Accounting Standards Board (FASB)
Realizing the need to reform the APB, leaders in the accounting profession appointed a Study Group on the Establishment of Accounting Principles (commonly known as the Wheat Committee for its chair Francis Wheat). This group determined that the APB must be dissolved and a new standard-setting structure be created. This structure is composed of three organizations: the Financial Accounting Foundation (FAF, it selects members of the FASB, funds and oversees their activities), the Financial Accounting Standards Advisory Council (FASAC), and the major operating organization in this structure the Financial Accounting Standards Board (FASB). FASB has 4 major types of publications:
  1. Statements of Financial Accounting Standards - the most authoritative GAAP setting publications. More than 150 have been issued to date.
  2. Statements of Financial Accounting Concepts - first issued in 1978. They are part of the FASB's conceptual framework project and set forth fundamental objectives and concepts that the FASB use in developing future standards. However, they are not a part of GAAP. There have been 7 concepts published to date.
  3. Interpretations - modify or extend existing standards. There have been around 50 interpretations published to date.
  4. Technical Bulletins - guidelines on applying standards, interpretations, and opinions. Usually solves some very specific accounting issue that will not have a significant, lasting effect.
In 1984 the FASB created the Emerging Issues Task Force (EITF) which deals with new and unusual financial transactions that have the potential to become common (e.g. accounting for Internet based companies). It acts more like a problem filter for the FASB - the EITF deals with short-term, quickly resolvable issues, leaving long-term, more pervasive problems for the FASB.
  • Governmental Accounting Standards Board (GASB)
Created in 1984, the GASB addresses state and local government reporting issues. Its structure is similar to that of the FASB's.
  • Other influential organizations (e.g. American Accounting Association, Institute of Management Accountants, Financial Executives Institute)



Collected & Compiled by
Saktishree

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