General Purpose Financial Statements
‘Big GAAP Versus Little GAAP’ Obscures the Issue

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APRIL 2005 - FASB currently creates standards for “general purpose financial statements” for public companies, private businesses, and not-for-profit organizations. Much of the recurring concern about “Big GAAP and Little GAAP,” or, as currently characterized by an AICPA task force report, “GAAP for Public and Private Companies,” reflects differences in understanding of “general” and “purpose” in the context of financial statements. In addition, because “purpose” itself implies human use, to discuss general purpose financial statements without considering their most frequent, or general, use is virtually impossible.

Although the formalization of general purpose financial statements in the U.S. began in earnest after World War II, accounting thought-leaders of the early years of the 20th century were presenting papers at the monthly meetings of the NYSSCPA and elsewhere, arguing that financial statements intended for use in negotiations for debt and equity should incorporate practices reflecting that purpose. In other words, accountants have recognized for at least a century the difference between internal accounting information developed for management use and how that information is transformed in various ways for external use or for management’s negotiations with external parties.

General Purpose Accounting

In the broadest sense, the general purpose for standardized external financial statements centers around two concerns. First, standards reduce the costs of specific negotiations over the form and content of financial statements. Standards for general purpose financial statements facilitate contracting because they constrain insiders from producing financial statements that reflect only inside concerns. Imagine the cost of negotiating the form and content of financial statements with each equity and debt provider! Second, publication of such general purpose financial statements dramatically reduces the costs of searching for financial information about a company, which benefits potential equity, debt, and credit suppliers as well as company management.

Users of accounting information over the past several thousand years have focused on three general uses, two of them ancient, the third very modern. The two ancient purposes, albeit unrelated in intent, have been addressed through similar approaches. FASB’s conceptual framework refers to them as “the stewardship” purpose. But the framework really focuses on the third purpose, analysts’ use of accounting information to value the equity of public companies.

Accountability and Interim Settling-Up

The two ancient purposes reflect the use of accounting information in hierarchical organizations and in commercial contracting, with evidence of both arising in approximately 3500 B.C. They continue to be relevant today. The first concerns accountability. Are managers expending money for appropriate purposes, or for private inurement? Accountability has been, and continues to be, the most frequent external purpose for financial statements in the government and not-for-profit sectors.

The second ancient purpose of accounting, interim settling-up, concerns periodic distributions to owners and managers and the amount of capital left in the enterprise for creditor settlements and working capital. Sometimes referred to as the “contracting” purpose, it gained importance during the growth of the capital markets in order to curtail corporate organizers from paying themselves dividends from capital rather than from earnings. The revenue-recognition and expense-matching approach to standards that focused on realized transactions promoted capital maintenance to protect external capital providers, minority shareholders, and creditors from unreasonable risk of loss. The contracting purpose continues to be relevant for nearly every organization that receives capital or credit from more than one individual.

Equity Valuation

The modern general purpose for financial statements supports analysts’ valuation of the equity of a corporation, as articulated in FASB’s conceptual framework, and has led to asset-and-liability-recognition accounting and fair value measurement, both appropriately oriented toward the future rather than the past. For most U.S. entities, however, equity valuations occur only rarely, while contracting and accountability occur continuously. For companies whose equities are traded in the public capital markets, however, equity valuations are continuous. Moreover, external parties to such public companies also have intense accountability interests (e.g., the Foreign Corrupt Practices Act, and section 404 of the Sarbanes-Oxley Act) and complex interim settling-up issues (e.g., stock options and post-retirement benefits).

Conceptual Framework

Rather than separate accounting standards for public companies and private companies, it would be far preferable for FASB’s conceptual framework to explicitly integrate all the general purposes for financial statements. Such integration would benefit external users of public company financial statements because income attributable to realized transactions and to the three types of fair value measurements would be apparent. It would also recognize in GAAP accounting measures that are more routinely used in other sectors of the economy.

Robert H. Colson, PhD, CPA





















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