Companies are deviating from the Generally Accepted Accounting Practices (GAAP) when reporting their financial performance. Here's why.
For investors, the most important piece of paper available to them about a company they’re interested in investing in is a balance sheet.
The old saying, numbers don’t lie, used to mean that you could comfortably rely on the company’s health, as it’s depicted in the quarterly and annually reported earnings they file.
Unfortunately, this is proving to be less and less true.
The Generally Accepted Accounting Practices (GAAP) for reporting quarterly financial performance is starting to slip away as companies look for ways to better report major, one-time expenditures in light of their impact on the short-term pricing of a stock; especially if they miss their earnings forecasts.
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How Do Companies Report Their Earnings?
Every quarter, publicly traded companies release their earnings for the previous three-month period (commonly referred to as a quarter).
To understand whether a company is performing well, stock analysts compare the quarterly reports to the forecasted earnings.
The largest banks in the country have analysts on staff that forecast the projected earnings of a company, based on the data provided by the company’s internal analysts.
Broader market trends are also taken into account in order to understand how an individual company will perform within the context of the broader market climate.
For example, a company in the tech space will be held to a higher growth curve standard than a high-end jewelry company.
Tech products are easy to access (whether they’re mobile apps or corporate software), while jewelry requires massive production infrastructure and additional resource in order to sell a physical item.
Deviations from GAAP
The Generally Accepted Accounting Practices (GAAP) provide loose guidelines for companies in how they report their financial performance.
However, in order to appear as appealing to investors as possible, many companies are veering away from the GAAP reporting standards and beginning to offer alternative reports.
According to an article published by Yahoo Finance, companies are creating reports that vary wildly from the GAAP reports they’re required to release.
How can one company issue two separate financial reports? Well, the answer is simple.
The GAAP rules require that companies provide an accounting of every dollar spent within a quarter.
However, companies make bulk purchases, or commit to buyouts of other companies that show up as massive one-time expenditures on their books.
To keep from appearing weaker than they are, they choose to spread these one-time or annual charges across multiple quarters.
This allows for companies to save on long-term costs without paying a short-term penalty in the performance ratings of their stock.
Sounds confusing? Let’s simplify it. In your household you have massive expenditures that only hit your checking account every few years.
For example, let’s say your water heater broke and you ended up replacing it. While it might appear to an outside observer that you blew your monthly budget that month, you would instead report to them that this was just a one-time cost, and in reality the cost would be spread out over years of use.
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So, did you really break that month’s budget? No, you ended up dipping into an emergency fund in order to keep things on track.
Companies are doing similar things with their balance sheets. They’re still reporting the expenditure, but classifying it in ways that help reflect the true performance of their organization over the long-term.
The problem, though, is when companies begin abusing this in order to hype up their brand on the street.
Many executives receive compensation and bonuses directly tied to the performance of their company’s stock, so there’s unfortunately an incentive to misrepresent the company’s financial health in order to secure bonuses.
I’m not saying this is happening, but there’s certainly potential for it to happen, which is why GAAP is such an important topic. But if you’re a small, private company, does this really affect you?
Small Business Finances
For most mom and pop businesses, GAAP isn’t something that’s going to come up.
Keeping the books straight is a fairly straightforward task, and you aren’t really going to be reporting your finances to an outside agency.
But, if you ever seek outside funding, you might need to make sure your financial accounts are in line with the GAAP’s that your potential investors will require.
Maintaining a database of financial transactions and customer records can be a massive undertaking, especially if past years have only been loosely reconciled.
But this information becomes incredibly important for making informed business decisions, which is why most companies should keep strong records of both accounting and client-related information.
For working professionals, like local dentists, it’s important to understand how the books are being managed.
Professional Corporations (P.C.’s) have to worry about paying down student loan debt and other training costs associated with managing a practice.
These costs, if accounted for incorrectly, can damage the financial health of a company, or unintentionally misrepresent it to outside shareholders.
Even if a company isn’t taken public through an IPO, consolidating debt and bringing on strategic partners requires records that can be relied upon.
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Take the time to take care of bookkeeping every week. It’ll pay dividends down the road.