Generally Accepted Accounting Practices (GAAP)

Beyond GAAP

Traditionally, the accounting profession has followed the principles laid down by Generally Accepted Accounting Practices (GAAP) when they prepare the financial statements of the company. GAAP, however, is not necessarily a means to present a representative or fair picture since it has several vague definitions of important terms like materiality. GAAP also creates room for judgments on the treatment of special items besides the scope it allows for estimates of a variety of items.

Under U. S. GAAP, an item is considered material if it has the potential to influence the judgment of a financial statement reader. Since the term material has not been rigorously defined, it is often hard to pin down just when creative accounting has a material impact. Typically, auditors look at quantitative measures; for example, an item that does not change net income by any more than a tiny percentage is considered immaterial. Similarly, it is hard to tell the threshold for the materiality of changes in the policies towards estimates.

The rising numbers of incidents of earnings management in the 1990s were indicative of the significance that executives attached to the weaknesses in GAAP. The percentage of Industrial companies reporting special items climbed from 48% in 1989 to 71% in 1998. Reports of special items among Mid-Caps and Small-Caps moved from 31% to 53% and from 32% to 42%, respectively. On an average, among companies with positive earnings before special items, 68.4% of special items reported were negative. The corresponding statistic for companies with negative earnings before special items was 82.9%.

SEC's Accounting Bulletin No. 99, issued to clarify operative aspects of Sarbanes Oxley, requires that accountants take both quantitative and qualitative considerations into account before making a judgment on the materiality of an accounting policy. The facts sourrounding the circumstances and the total mix of information has to be assessed before coming to a decision just as the Supreme Court mandated in several landmark cases.

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