What are the 4 principles of GAAP?

Accounting is often thought of as this dry profession that we only need to consider around tax time, but if you are an investor, understanding how accounting works on a basic level is important if you are going to analyze businesses on any level. GAAP accounting rules are 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 that sat in the desk right in front of me. In hindsight, I wish that I had paid more attention to the teacher as it would have come in handy in my investing life.

Part of becoming a better investor is understanding the business that you want to buy, and part of learning that business is understanding the language that business speaks, which is financial accounting. Part of understanding that language is having 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 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.”

Warren Buffett

“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.”

Charlie Munger

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 IRFS

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 is contrasted by non-GAAP accounting, which we will discuss in a little bit. Another contrast to GAAP accounting is the international version referred to as IFRS (International Financial Reporting Standards), more on that in a moment as well.

GAAP accounting helps govern the world of financial accounting according to rules and guidelines that are standardized. 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 that 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, as well as 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 of their preparations of financial documents.

All of the above rules and regulations were established during the Great Depression as a counter to all the shady dealings that officials believed helped worsen the Great Depression.

It was believed that companies misled investors during that time with some less than forthright financial reporting practices. With the establishment of GAAP accounting, the Federal government hoped to avoid that going forward.

GAAP was established in 1933 with the Securities Act of 1933 and the Securities Exchange Act of 1934.

GAAP accounting rules are governed by the FASB (Financial Accounting Standards Board), and the GAAP accounting rules are scrutinized on a constant basis, and different rules change periodically.

What Are the Four Principles of GAAP?

GAAP has four basic principles:

• Costs
• Revenues
• Matching
• Disclosures

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 that costs are recorded at the time of purchase, as opposed to recording them at a later date, which might require estimations or adjusting those costs.

Revenue

The revenue principle requires that revenues be recorded at the time they are earned, not when the payment is received. Recognizing revenues in this manner hleps eliminate errors in accounting caused by payment delays, and also serves as the basis for accrual accounting.

Accural accounting, for those not familiar with that term, is the method of accounting where the revenue or expenses are recorded when the actual transaction occurs, rather than when the payment is received. It follows the matching principle, which we are going to discuss next.

Matching

The matching principle requires that expenses need to be matched with the revenues related to them. It states that expenses are not recorded until such time as the revenue causes the cost to occur. The matching principle allows the profitability of goods and services to be understood easily, plus it illustrates the connection between revenues and expenses.

Disclosure

The disclosure principle requires that all financial information be clear and easy to understand for all individuals, and the disclosure must be balanced against the costs associated with producing said disclosures. Any and all information required for the understanding of all financial statements must be included 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; found below the main financial statements and included in the notes section of the reports. Most of it is legal jargon, but you can pull a tidbit or two out, and it is good to skim in case revenue recognition has changed, for example.

Compliance with GAAP

Why focus on GAAP? Well, if a company’s stock is publicly traded, 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 traded on the stock exchanges have to file GAAP-compliant financial statements on a timely basis, every three months. All of this is required if the company wishes to be traded on stock exchanges.

GAAP compliance is monitored and ensured by auditors, who are third-party accounting firms hired by the company to audit the company’s financial statements to ensure they meet all GAAP accounting guidelines. These CPA firms audit the financial statements to ensure there is no funny business going on within the company and that the company is not trying to mislead investors.

Although using GAAP accounting is not required for non-public companies, it is a standard practice among those firms to adopt these accounting rules. If the company ever wishes to go public, it helps ease the transition, plus it 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 utilizing GAAP accounting rules, you should beware. Without using 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 in both GAAP and non-GAAP when reporting its financial results, which is more common in quarterly earnings reports such as a 10-q.

GAAP accounting rules require that a company that is reporting any figures as the non-GAAP state that in its financial statements or press releases.

Let’s move onto GAAP versus non-GAAP.

GAAP versus Non-GAAP: What’s the Difference?

As GAAP is strictly adhered to and is 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 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 irregular items such as those associated with acquisitions, restructuring, and one-time adjustments to balance sheets. The reasoning for these exceptions is it allows for a smoothing out of earnings volatility that results from temporary situations, such as a one-time tax payment.

Non-GAAP accounting has risen in recent years, especially in the use of earnings calls or quarterly statements. Plus, they are very prevalent in press releases, all of which are designed to present the companies in the best light.

Investors need to be aware of non-GAAP figures and be able to interpret them, but it is important to understand where GAAP accouting rules are 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, in an attempt 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 Dow reported non-GAAP earnings.
• 14 out 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, all of which were up from 59% in 1996.

Tech companies are the biggest proponents of non-GAAP figures, as these companies usually don’t report high earnings from GAAP, because of the nature of its business.

Some companies such as Uber remove items such as recurring items related to costs that the company incurs to grow, which can make comparisons to Uber difficult.

Some companies use adjusted earnings as a means of reporting 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, and as investor sentiment increases, look for the rise in said adjustments. Not all of the metrics are bad, and many can be helpful in smoothing out the earnings over a period to help you analyze the company better.

But when they are presented as a method of deceiving the investor that results are better than they actually are, then that is a problem.

The use of non-GAAP figures is prevalent on any quarterly report such as a 10-q, but must be presented with GAAP reconciliations. But all annual reports are reported in GAAP figures, so all the non-GAAP figures must be reconciled at the end of the fiscal year. That is why it is best to go to annual reports as a guide for the financial condition of the company. Keep in mind that quarterly reports are not audited, thus the use of non-GAAP figures.

Along those lines, several companies only report their financial condition according to GAAP accounting rules, among them Berkshire Hathaway and Markel Corporation.

In fact, 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 are focused on U.S. companies, the alternative for international companies is the use of 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 that these costs be recorded as they are incurred, where IFRS allows the costs to be capitalized and amortized.
• Reversing write-downs – GAAP requires that any write-down is permanent regardless of 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 was in 2007, which removed the requirement for foreign companies who were 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 both nationally and internationally will gain more importance, and the increase of 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 the reputation of being tired and stuffy. While there might be a tinge of truth to that, to be an investor, it is critically important to understand the language of business, and that 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. 

Charlie Munger

To be an investor of 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 gather more 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.

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