MYTHS AND REALITIES ABOUT THE MEANING OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

THE CODIFICATION of rules and regulations under which managements prepare financial statements that are reviewed and frequently certified by accountants is known as Generally Accepted Accounting Principles, or GAAP. The primary users of statements prepared in accordance with GAAP are securities holders of all sorts—bank lenders, outside investors in common stocks, private-venture capital investors and property owners who lease facilities to users on a net, net, net basis.⁵⁷ However, virtually all other segments of our economy are readers of GAAP-prepared financial statements, including company customers, vendors, labor unions and even the Internal Revenue Service, which has some relatively precise (though not necessarily logical) rules as to when financial statements prepared in accordance with the Internal Revenue Code have to comport with those prepared in accordance with GAAP, and when the two need not have any discernible relationship to each other. Every investor interested in corporate reality ought to know what GAAP is, its uses and its limitations.

There are three prevalent myths about GAAP. The first is that GAAP tends to, or ought to, be rigidly codified with a series of well-articulated do’s and don’ts. Fortunately, GAAP is still not as highly rigid as is that other major United States accounting system, the Internal Revenue Code. It is to be hoped that GAAP never will become that way. If it does, it will no longer be useful for its principal purpose, which is to serve as an objective bench mark for those who appreciate its uses and limitations.

The second myth is that GAAP is all-encompassing and is, or should be, designed to measure all sorts of corporate events and phenomena. GAAP in fact measures only a limited number of events in limited ways.

The third myth about GAAP is the one expounded by its most vociferous critics, such as Abraham Briloff⁵⁸ and David Norr.⁵⁹ This myth is centered on a belief that GAAP ought to tell the Truth, that somehow it can be made more realistic for average investors while still becoming more informative and more useful for all of its users. The goal of reality-for-all through GAAP is a mirage. Corporate life is too complicated to expect any system of measurement to reflect more than a few pertinent objective bench marks; it cannot accurately—that is, realistically—report on all events and positions, especially since what is realistic frequently depends on the subjective interpretation of individual users of GAAP, as, for example, whether the first approach to valuation should be a going-concern approach or an asset-conversion approach. Within very wide limits, the way to make GAAP more useful is to make it more informative, regardless of whether it becomes more realistic. Fortunately, nearly all critics of GAAP, whatever else they disagree on, think it should be made increasingly informative. As a result of this, improvements in GAAP disclosures during the past ten years have been dramatic, as we pointed out in the previous chapter.

The formal definition of GAAP, as it appears in Accounting Principles, is as follows:

GAAP incorporates the consensus⁽¹⁾ at a particular time as to which economic resources and obligations should be recorded as assets and liabilities by financial accounting, which changes in assets and liabilities should be recorded, when these changes should be recorded, how the assets and liabilities in them should be measured, what information should be disclosed and which financial statements should be prepared.

(1) Inasmuch as GAAP embody a consensus, they depend on notions such as general acceptance and substantial authoritative support which are not precisely defined.⁶⁰

Opinions of the Accounting Principles Board (APB) and its successor, the Financial Accounting Standards Board (FASB), constitute substantial authoritative support. Theoretically, substantial authoritative support can exist for principles that differ from those of APB and FASB, but the burden of proof for departing from their dicta lies with the accountant preparing the financial statements in question. Such departures must be disclosed, but they are extremely rare.

Because GAAP is derived from general acceptability and substantial authoritative support, the emphasis has been on functionalism—whether particular rules will be useful and will work. The use of these standards has been fortunate in that it has enabled GAAP to reach its present status as an extremely useful tool for corporate analysis. However, the level of abstraction involved in deriving GAAP is not at all deep; rather, it is relatively superficial. There is very little in accounting literature that is deeply abstract, at least insofar as trying to explain why GAAP has developed the way it has or what GAAP is designed to do.

In the following pages, we review various underlying abstractions out of which GAAP evolved that we believe are important in helping investors understand how GAAP is useful and where it is limited. Because GAAP grew out of general acceptability, the assumptions underlying GAAP reflect the economic, legal and social mores that prevail in the United States. Indeed, because GAAP is based on commonly granted realities, it tends to be more useful than a code based upon abstract theorizing in a vacuum.

We believe that there are eleven underlying, unarticulated assumptions, an appreciation of which gives creditors and investors good insights into the uses and limitations of GAAP.

UNDERLYING GAAP ASSUMPTION 1

Ownership of—that is, title to—tangible assets is the basis of value and the means of creating income.

Although it may seem to be a natural outgrowth of freeenterprise economics that value and income are created out of ownership of title to tangible property, there are no necessary reasons why an accounting system has to be based on such concepts. These concepts result in defining value or income as the excess of cash, receivables, inventory, investments and fixed assets over liabilities, with liabilities being defined strictly as obligations incurred to create assets, either tangible or intangible, that appear on a company’s balance sheet, where the only assets that normally appear are those to which the company has title.

Rather than basing a corporate accounting system upon title to tangibles, a system could be based on “rights to use” as a definition of assets, and “increases (or decreases) in rights to use” as a definition of profit (or loss). Because title to tangible assets is an underlying ownership concept of GAAP, any attempt to fit the right-to-use phenomena into it is awkward. Thus, there are various difficulties in accounting for leases by lessors and lessees.

GAAP could also have been grounded in other underlying assumptions. For example, one might argue that value and income are best measured by estimating future benefits for the corporation. This is the assumption underlying the capitalization of expenditures, which would otherwise be expensed by charges to income; the GAAP treatment or nontreatment of capitalized expenditures, especially for intangibles such as research and development, has always been awkward.⁶¹ Also, it would be logical in a mixed or nonfree enterprise system to base accounting rules on estimated social cost rather than on historic cost; many such proposals are extant today.

GAAP, as it must be, is a limited tool in measuring value and income, albeit an essential tool. It is limited in its measurements by economic data that fit into a bookkeeping cycle, which in turn is limited, by and large, to tangible assets to which a company has title. There are, however, all sorts of economic phenomena that create value and income that are not part of GAAP. Analysts, lenders and equity investors can ignore these non-GAAP variables only at their own peril, even though each and every one is an intangible. These key intangibles include the following:

• The first intangible involves debt finance. A lack of debt or an ability to create new debt is frequently a most important asset. In principal areas of corporate finance—such as underwriting, private placements, and mergers and acquisitions, as well as in the financial-integrity approach to fundamental analysis—a key variable almost all practitioners focus on is a lack of debt. The quality of the balance sheet tends to be a far more important consideration in corporate finance than the quantity of net assets on the balance sheet, or reported net worth, as is pointed out in Chapter 12, “Net Asset Values.” Yet lack of debt is largely ignored or played down in conventional fundamental security analysis, in part because, we suspect, unlike earnings and book value, GAAP does not measure an absence of obligations per se.

• The second intangible involves equity finance. The price at which its common stock sells can be a highly important company asset (or liability), especially to any company planning to issue its stock either to raise new money or to obtain additional assets via merger and acquisition. (An acquisition-hungry company using its stock when it is selling at one hundred times earnings and ten times book value to acquire a solidly financed, profitable firm selling at, say, close to book value is said to be trading with “Chinese dollars” or “funny money.”⁶²) The stock price conceivably can be important, too, to almost any company planning new financing, even if only short-term bank loans, since there is sometimes (though far from always) a tendency by outsiders to give considerable weight to the stock price in determining how much a company’s equity is worth.

Financial strength does not arise solely out of a lack of existing debt or an ability to create new debt, but may also exist because of the presence of low-cost long-term debt. For example, one of Madison Square Garden’s principal assets is the ownership of an 80 percent interest in 2 Penn Plaza, an office building in New York City financed by the issuance of a twenty-five-year (or three-hundred-month) level-debt-service mortgage loan bearing 5¾ percent interest. (Level debt service refers to a method of loan repayment, under which total monthly payments are a constant amount and include both interest and debt repayment. In the early months, most of the payments constitute interest, while as time passes interest payments decrease and principal repayments increase.) If such a mortgage were to be issued under current conditions, the interest rate probably would be at least 9 percent. Since Madison Square Garden can sell its interest in 2 Penn Plaza subject to the 5¾ percent mortgage loan, the buyer would be willing to pay much more to acquire the building than would otherwise be the case, because a major part of the purchase price involves the assumption of a 5¾ percent mortgage loan. Based on this mortgage-rate factor, the net value of 2 Penn Plaza, using an asset-conversion analysis, is understated on Madison Square Garden’s books—that is, liabilities are overstated based on present values for the 5¾ percent mortgage. On a going-concern basis, though, assuming the mortgage will someday have to be refinanced and earnings are currently being overstated because of the need to replace the existing 5¾ percent mortgage, interest charges against income are too low.

By the adoption of an asset-conversion type of present-value accounting, a 5¾ percent loan could be reflected in Madison Square Garden’s books so that the mortgage liability, instead of being in the balance sheet at its face value of $25 million, might be reflected in the balance sheet at 90 percent of face value, or $22.5 million, equal to a yield to maturity of 9 percent. But under GAAP this raises all sorts of problems. Should the amount of the mortgage liability be changed periodically to reflect changes in interest rates? Should other accounts—the building itself, for example—also be adjusted to present value, even though there may be only very imprecise measures of present value for other accounts? We fear the widespread adoption of present-value accounting would get too far away from GAAP’s underlying assumptions and would result in more confusion than it is worth. Present values, by and large, are something for creditors and investors to determine themselves, using GAAP disclosures as objective bench marks. Present-value accounting has thus far been made part of GAAP in only those limited areas where it seems to have elements of objectivity—in pension accounting and accounting for certain long-term real estate receivables. We do not think present-value accounting should be extended much further.

One concept that pervades this book is the importance, in the appraisal of any corporation or any investment situation, of financial integrity, which is, of course, an intangible that is more or less outside the GAAP scheme of things. There are myriad other intangibles that are not part of GAAP but that are frequently important and even crucial in security analysis and corporate finance. In brief, these other intangibles can include the following:

1. Long-term, favorable (or unfavorable) contracts with key employees, customers and vendors

2. Trade names and patents

3. Distribution channels, such as dealer organizations

4. Manufacturing know-how

5. Licenses to do business

6. Tax-loss carry-backs (worth cash) and tax-loss carry-forwards (which we believe tend to be worthless unless they are usable in clean, or relatively debt-free, shells; see Chapter 16)

There is a final point about intangibles that is almost an aside. GAAP becomes increasingly less descriptive of phenomena in our economy as intangibles become more important as the principal elements of value and the principal sources of income. Intangibles are becoming increasingly prevalent as more and more of the United States’ Gross National Product is derived from personal services. GAAP provides good objective bench marks to value the output of steel mills; GAAP does not provide equally good bench marks at all to value the worth of a citizen’s medical degree.

UNDERLYING GAAP ASSUMPTION 2

Corporate asset items have independent values unmodified by their inclusion as but one small part of a going concern.

This is the one underlying assumption of GAAP that appears to be at wide variance with reality for going concerns. Indeed, it appears to be in conflict with the pervasive principle of GAAP that financial statements reflect the operations and position of a going concern.

As a practical matter, there are few assets that are part of a going concern that have values independent of the going concern. Independent values for classes of assets exist only in asset-conversion, not going-concern, contexts. No business can have title to or rights to use assets without at the same time assuming substantial encumbrances, de jure or de facto, that involve obligations that might include some liabilities recognized as such by GAAP, but almost certainly will include many others that are not part of GAAP. For example, a company, through ownership of assets, assumes obligations to pay property taxes, to treat its employees fairly, to avoid default in servicing its creditors, to deliver on time to its customers, to not pollute the environment and so on. As a matter of fact, the ownership of or right to use assets can give rise to such onerous non-GAAP liabilities as to bankrupt a business: witness the Chicago, Rock Island and Pacific Railroad’s bankruptcy in 1975, caused in great part by the Road’s legal obligations to continue operating unprofitable branch lines that it either owned or operated under long-term leases.

About the only situation where the ownership of assets seems to be purely passive and not giving rise to the assumption of material encumbrances is where public, noninstitutional security holders—that is, pure outside investors—hold small amounts of highly marketable securities or cash. Passivity and liquidity are highly interrelated. The more liquid the assets, the less the responsibilities for managing those assets. The speculator who buys egg-futures contracts is rarely looking for the responsibility that goes with owning eggs.

The fact that assets in going concerns do not have a value independent of their relationship to the going concern figures importantly in security analysis. For example, our valuation of deferred income taxes in Chapter 7 is based on a nonindependent, going-concern view of a depreciable asset, in contrast to the independent value assumed under GAAP. Under GAAP, if accelerated depreciation is taken on a piece of machinery for tax purposes, and on regular depreciation for stockholder purposes, income is charged with deferred income taxes, whereas actual tax payments are now reduced because of the accelerated depreciation. Over the life of the piece of machinery, the total tax bill will be the same regardless of the depreciation method used. Our analysis, on the other hand, assumes that it is probable or possible that the cash saved in the early years of use of the piece of machinery because of accelerated depreciation for tax purposes will be reinvested in other depreciable assets. As a consequence, the deferred tax charge is something less than the 100 percent expense GAAP makes it out to be, and indeed the deferred tax may never have to be paid at all. Rather, on a going-concern basis, deferred tax charges have elements of both profit and expense, with the percentage of breakdown between profit and expense best left to analysts rather than to accountants.

UNDERLYING GAAP ASSUMPTION 3

Changes in accounting rules should not be disruptive of important existing practices unless there is conflict among establishment members.

This underlying assumption was considerably more valid before the 1974 pronouncement of the FASB, under which a rule was promulgated requiring that all research and development expenditures be expensed. Nonetheless, it still remains true that GAAP is an establishment tool, and there is implicit recognition that its basic purpose is to aid, not to fight or alter, an existing economic system.

We may expect changes in GAAP to be evolutionary rather than revolutionary or radical. Revolutionary or radical changes rarely if ever reflect a consensus or have general acceptability, at least in the United States as it exists today. And consensus and general acceptability are the stuff out of which GAAP is made.

Thus, the great body of accounting-rule changes tends to be nondisruptive, and if they prove to be disruptive, such changes are either amended or ignored. When accounting rules change, harmful changes are virtually never retroactive, and important exceptions to the new rules tend to be made to accommodate sectors of the establishment that would be harmed if such changes had to be complied with. For example, Opinion 20 of the Accounting Principles Board, entitled “Accounting Changes” and issued in 1971, states that with one exception, when accounting principles are changed there should always be disclosure, in one fashion or another, of what the financial statement looked like before the accounting change and what it looked like after. The one exception is contained in Paragraph 29, “Special exemption for an initial public distribution,” which refers to companies going public for the first time, in which case there need be no disclosure of what reported net income was before the change in accounting principle. When companies are private, they tend to adopt accounting principles that minimize reported net income and therefore income taxes; when companies go public, they tend to opt for accounting principles that maximize reported net income and, it is hoped, the price at which new issues can be marketed to the public. It could put quite a damper on the new-issue market to require of companies going public for the first time the disclosure of their earnings as reported when the businesses were private. A good argument can be made that such disclosures would serve broad economic interests, either by discouraging certain new issues from ever seeing the public light of day or by making it likely that new issues would be priced lower than they now are. But GAAP tends to be an inappropriate vehicle through which to discourage the financial community’s underwriting of companies going public for the first time—which at times has been a significant Wall Street subindustry. This is discussed in some detail in Appendix I, where the F. & M. Schaefer public offering is described.

The one area where there are likely to be radical changes in accounting rules is where one establishment group needs protection against another. The best example of this was the issuance in 1970 of Opinions 16 and 17 of the Accounting Principles Board, severely limiting, and in many cases eliminating, the use of pooling-of-interests accounting for acquisitions. Opinion 16 lays down nine criteria that have to be followed to use pooling accounting rather than purchase accounting. Opinion 17 requires amortization of purchase premiums over periods not to exceed forty years when purchase accounting is used. Acquisitions can be made using either pooling or purchase accounting. Pooling accounting is helpful to earnings-per-share-conscious acquirers whose stocks are selling at substantial premiums above book value and who issue stocks whose market prices represent a substantial premium over the acquired company’s book value. In a pooling, two companies merely combine their books; no premiums need be amortized by periodic charges against profit. In purchase accounting, however, a purchaser who issues stock in an acquisition has to account for that acquisition at a price related to the number of shares issued in the acquisition times the market price of the stock issued.

Insofar as that market-derived value exceeds the book value, or appraisal value, of the acquired company, the difference has to be set up in the balance sheet as purchase good will and must be amortized for financial-statement purposes—but not for income-tax purposes—by periodic charges to net income.

Insofar as reported earnings are the name of the game in the stock market, an inability to use pooling discourages many issuers from acquiring companies at values representing premiums over the acquired companies’ book values. Such a development has ensued since 1970 and has been warmly greeted by the managements of many staid, solid, conservative companies, which would rather not be taken over by a company run by aggressive financiers anxious to issue Chinese dollars in merger and acquisition transactions.

Opinions 16 and 17 have radically altered the arithmetic and structure of mergers and acquisitions by public companies, and the effects of 16 and 17 would no doubt have been even more dramatic if the 1971-75 bear market, which dropped many stock prices below book value, had not occurred. To us, it seems probable that had a sizable body of influential members of the corporate community—and the antitrust political community as well—not thought that the pace of mergers and acquisitions should be dramatically slowed, there would have been no 16 and 17. The FASB is now restudying 16 and 17 with a view to modifying these opinions, because many believe that they went too far in eliminating the use of pooling and thereby discouraging many mergers and acquisitions that would otherwise be feasible and desirable.

UNDERLYING GAAP ASSUMPTION 4

A puritan work ethic is desirable; hence achievements through going-concern operations are far more desirable than achievements through asset conversions—mergers and acquisitions, reorganizations or refinancings.

It seems implicit in financial accounting and its going-concern standards that businesses are run for the purpose of making profits from operations and that these results are reflected in successive income accounts. With the exception of investment trusts, businesses that attempt to create wealth by refinancing, reorganizing, acquiring, disposing of, or creating realized or unrealized capital gains are aberrational. In part, this is attributable to the fact that businesses that do not strive for operational profits are harder to fit into GAAP standards than those that do. However, there is a universality of the concept that the goal of businesses should be to produce profits from operations rather than to create wealth by fostering capital gains, realized or unrealized. Such a concept is central not only to GAAP, but also to virtually all the literature on security and corporate analysis, ranging from Dewing,⁶³ Bonbright,⁶⁴ and Graham and Dodd,⁶⁵ to Mauriello⁶⁶ and Bogen.⁶⁷ It is also an underpinning of our antitrust laws, which tend to deem that expansion by opening new operations is competitively good, whereas expansion by acquisition decreases competition and is ergo bad.

The final seven underlying GAAP assumptions are derived from the accountant’s views of what should be done in order to enable a fair presentation to be made to readers of financial statements. Most often, but not always, it is thought that a fair presentation ought to be made to average investors. Typically, “average investor” seems to be defined as someone who is (a) not too bright, (b) not trained in the uses and limitations of GAAP and (c) vitally affected by day-to-day fluctuations in stock market prices. We again emphasize that it is impossible, a will-o’-the-wisp, to even attempt to make GAAP comprehensible, much less fair, to an average investor or trader as defined.

UNDERLYING GAAP ASSUMPTION 5

The medium is the message.⁶⁸

Immediate stock market impact is what financial statements are directed to. What the numbers, especially the net-income figure, are reported as is more important than what the numbers mean. As a corollary to this, there are twin goals that most accounting critics desire—that is, that GAAP should represent Truth and be both realistic and informative. We disagree. We do not believe that much more should be asked of GAAP than that it be informative to people trained to use it.