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University of Massachusetts Amherst

Family Business Center

Egad! Gaps in GAAP

by Shel Horowitz

Rudy D'Agostino, of FBC sponsor Meyers Brothers, came to the September '02 gathering to shed light on "Gaps in GAAP."

GAAP stands for Generally Accepted Accounting Principles, and as corporate scandals fill the news, his presentation was timely and well-received. "Obviously, the GAAP leaves some room for judgment, and the Enrons and WorldComs have taken liberties with that," he commented.

D'Agostino made it very concrete: some documents, he said, can conform with GAAP but still neglect crucial information that might not be indicative of the true value of a business.

For example, a balance sheet lists assets, liabilities, net worth, and from this information key ratios may be determined.

But a balance sheet may overstate the apparent value of certain aspects of a business. For example the paper value of an investment in a private company recorded at cost may not reflect the risk that the other company may go bankrupt, or the balance sheet may not factor in stockholder debt that is expected to be repaid via bonuses-what if your company's performance falls and those earnings aren't there?

On the other side, parts of the balance sheet may not be indicative of a higher value of the company compared to their real worth. Fixed assets are valued at their historical cost less accumulated depreciation, which may be far less than their current value. And Last In First Out (LIFO) inventory valuation may not reflect the true replacement value of the inventory.

Similarly, an income statement will itemize net income, total sales, taxes, debt service, and other factors. It will show you the paper profit, but actual cash flow may be quite different. The impacts of such items as management perks or the effect on a business of losing a large customer may not be readily apparent from the income statement.Until recently, stock compensation plans didn't have to be reported on income statements, but new laws will change that.

Enron and its ilk have are caused other changes in the accounting profession, as well. Two of the biggest changes include: An accounting firm that provides consulting services will not be allowed to audit its own clients, and the SEC will now regulate accounting firms auditing publicly traded companies.

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