About 'us gaap accounting standards'|Evolution of US Generally Accepted Accounting Principles - 1930 to 2004
I am sure you have all heard tales of accountants "cooking the books". You've also heard tales of management, along with accountants, playing "numbers games" by reorganizing accounting records to smooth earnings. In some cases, the changes are blatantly illegal. A good example of this is the WorldCom scandal in which the company capitalized line expenses. This fraudulently boosted their balance sheet by increasing assets. In addition the move also fraudulently boosted their income statement because there were less expenses reported. What if I told you that companies and accountants can play numbers games and make changes that boost profits regularly? Would you be surprised? (Probably not.) Would you also be surprised if I told you there are ways of playing these number games that are totally LEGAL? Yes, you heard me right. Sometimes a company can just make some changes in they way they handle their transactions. As long as the changes they make are in accordance with generally accepted accounting principles, they are completely legal. Think about it: if accounting was straight forward and cut and dry, we would have no need for CPAs. I have a vested interest in the need for CPAs, because I am one. The truth of the matter is that many transactions are not cut and dry. You actually need all these accounting rules and disclosures. United States GAAP is also among one of the world's more conservative set of accounting standards. This means that typically a company's profits will be lower when they report under our standards than they would reporting under other sets of standards. Take Bank of America. Last week, the US Government told them that they needed to raise $34 BILLION in capital. This directive came after the results of the Bank Stress Test which tested how banks would fare with 10% unemployment and a 22% further decline in home prices. However, Bank of America posted a $4.2 Billion first quarter profit. This means that, at least on paper, Bank of America earned $4.2 billion during the first three month period in 2009. Seems like they are doing pretty good. Are they really doing as good as they say? Probably not. A vast majority of these profits are due to accounting changes. Basically, the profits are illusionary profits. I like to equate this to smoke and mirrors. Reuters had a really good article this morning that explained in greater detail the accounting changes that banks are using to boost their profits. Basically, the banks are using "credit value" adjustments to book gains. Using an example in the Reuters article, a bank could have a $100 debt that currently trades for $60. They can reduce the value of their debt to the amount it currently trades for - and book a gain as an offset. How can they do this? If you have basic accounting knowledge you know that at the very basic level, expenses and assets are debit balances, whilst revenues and liabilities are credit balances. You also know that debits = credits. Your books must balance. To make the accounting entry to reduce the value of the debt from $100 to $60, you would need to debit the liability (debt) account by $40. You would also need to have a credit entry for $40 to make the entry balance. Your choices for a credit are: revenue or liability. Hmm. I wonder which one the bank will choose! What can we learn from this? Simple. If you are invested in the stock market you need to know how to read a financial statement. You also have to have a basic understanding of accounting principles and what information you can get from reading the financial statement disclosures. You can't just take a press release stating "XYZ company earned $40 billion last year" and then invest in them without knowing the entire situation. I don't think people understand the lesson I just mentioned. As of Friday, bank stocks were trading up despite the fact that our government feels many of them are ill-prepared to weather the storm. Resources: Bank of America Press Release Reuters |
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