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Accounting Rules
by WealthEffect Staff

 
 

Consistency and objectivity are the goals
 
  Historical, accrual accounting is the result  
  Some shortcomings in a World According to GAAP  
 
1.

Accounting would seem to be just a simple matter of recording products sold, supplies bought, assets owned, and liabilities owed. The problem — and it is a huge problem — is in presenting a fair picture of a company's operations and putting a fair value on its assets and liabilities. To be valuable, accounting rules must be consistent and objective. Investors must have confidence in the truth behind the numbers.

In the U.S., we rely on Generally Accepted Accounting Principles (GAAP). To be consistent and objective, GAAP requires companies to account for their operations based on historical, accrual figures.

 
 
2.

Historical accounting says that the assets a company owns will be valued at cost. Although this is somewhat illogical — some assets rise in value over time, others decline — cost accounting eliminates the ability of companies to manipulate their figures based on subjective valuations.

Accrual accounting requires that revenues and costs be recorded when the company's products are sold, not when they are actually paid in cash. When a product is sold — whether for cash or credit — the sale is recognized in the financial statements when a cost is incurred — whether paid or not — the expenditure is recorded in the books.

 
 
3.

Historical, accrual accounting doesn't provide an accurate picture of the cash that flows into and out of a business. Capital expenditures for the building of factories and the purchasing of equipment, for example, are not recorded in the income statement when they are incurred. Instead, a portion of the total expense is recognized each year over the useful life of these factories and equipment — this expense item is known as depreciation.

Goodwill amortization, often created when one company buys another, is treated as an expense when it should be ignored while company options are ignored when they should be treated as an expense.

GAAP is flawed, certainly, but by striving to be consistent and objective, it provides a valuable starting point for the serious investor. You could say of GAAP what Churchill said of democracy — it's the worst approach, except for all the others.

Suggestion: Go to Company Reports