Q: Accounting scandals seem to form the core of corporate malfeasance in the USA. Is there something wrong with the GAAP - or with American accountants? A: Accounting is based on some fundamental principles.
As I say at the beginning of my textbook, the accountant "records and interprets variations in financial position ... during any period of time, at the end of which he can balance net results (of past operations) against net resources (available for future operations)".
Accountancy includes the designing of financial records, the recording of financial information based on actual financial transactions (i.e., bookkeeping), the production of financial statements from the recorded information, giving advice on financial matters, and interpreting and using financial data to assist in making the best management decisions.
Simple as these principles may sound, they are, in practice, rather complicated to implement, to interpret and to practice. About 80% of the transactions require only about 20% of the effort because they are straightforward and obvious to a book-keeper, once the rules are learned.
But - and it is a big but - the other 20% or so of transactions require 80% of the intellectual effort. These transactions are most likely to have major impacts on the profit and loss account and the balance sheet.
My colleagues and I, all qualified accountants, have heated discussion over something as simple as the definition of a debit or a credit. Debits can be records of either expenses or assets. The former counts against income in the statement of profit and loss. The latter is treated as a continuing resource in a balance sheet. It is sometimes gradually allocated (expensed) against income in subsequent years, sometimes not.
A fundamental problem with the financial reporting of WorldCom, for example, was that huge quantities of expenses were misallocated in the accounts as assets.
Thus, by reducing expenditures, profit appeared to be increased. The effect of this on stock values and, thereby, on executive rewards are secondary and tertiary outcomes not caused directly by the accountancy.
Another example concerns interest on loans that may have been raised to finance capital investment, while a large asset is under construction, often for several years.
Some argue that the interest should be accounted for as part of the capital cost until the asset is operational. Others claim that because the interest is an expense, it should be charged against that year's profits. Yet, the current year's income includes none of the income generated by the new asset, so profit is under-stated. And what if a hydro- electric power station starts to operate three of its ten turbines while still under construction? How does one allocate what costs, as expenses or assets, in such cases? Interestingly, the Generally Accepted Accounting Principles (GAAP) require that "interest during construction" be capitalized, that is included in the cost of the asset. The International Accounting Standards (IAS) prefer expensing but allow capitalization. From an economic viewpoint, both are wrong - or only partially right! The accountancy profession should get together to establish common practices for comparing companies, limiting the scope for judgment. Accountants used to make the rules in the USA and elsewhere until the business community demanded input from other professionals, to provide a more "balanced" view.