Utility of GAAP Financial Statements in the Assessment of Value Creation
This discussion covers the utility of GAAP financial statements in the assessment of value creation and the advantages and disadvantages of financial statements prepared using GAAP. This topic has been given due consideration before especially by people who want to increase the value of companies. The discussion starts with the explanation of GAAP and mechanics of valuation. The utility of GAAP financial statements in assessment of value creation is discussed later on. Finally the advantages and disadvantages of using GAAP financial statements are explained.
GAAP – Generally Accepted Accounting Principles
GAAP is the guideline of principles, rules and procedures used by accountants in recording and interpreting business transactions and preparing financial statements such as the income statement, balance sheet and statement of cash flows. These principles are also helpful to the users of financial statements as they help in the transparency and integrity of financial statements. The values in financial statements differ when different techniques of calculations and recording transactions are used under GAAP specially the methods of calculating depreciation and the usage of accruals concept.
Mechanics of Value Creation
Companies today tend to focus on ways that can increase their economical or financial value. This desire for the increment in value is to gain a competitive edge on other companies for the purpose of financing and improving the overall image. Shareholders require a good return on their investment in the company; higher value means higher return on investment. There are a lot of tools and techniques available to these companies to achieve enhancement of value. Ratio analysis is one of the means of value creation and specially the ratios indicating the investment returns such as P/E ratio, EPS, Dividend payout ratio etc. The two most popular techniques for assessment of value are the EVA-Economic Value Added and ROI-Return on Investment (Damodaran, 1999). As mentioned above GAAP tend to change values of financial statements which in turn would change values achieved under the techniques mentioned as they are directly linked to the financial statements.
Utility of GAAP financial statements in assessment of value creation
The importance of GAAP financial statements cannot be ignored as they are directly linked to the value creation of a firm. The ratios calculated using the values in the financial statements would be highly affected if the principles of GAAP are followed or ignored. Most investment and profitability ratios are based on the values in the income statement and the cash flows available to the company. As these ratios are a major indicator of a company’s value; this value would change considerably. The main objective of financial statements prepared utilizing GAAP is the matching of expenses and revenue in a period. The results of this objective are the concept of accrual method and depreciation which are important as they change the values in financial statements and eventually the net income and free cash flows (Alexander, 2007). The accruals method and the concept of depreciation both affect all of the financial statements. Supposing a company has 5 million worth of fixed assets and the average life of these assets is 10 years then theoretically the annual average depreciation charge on these assets would be 500,000. If we use or neglect this amount there would be a difference of 500,000 when calculating the different ratios.
Benefits of using GAAP financial statements in assessing value creation
The major benefit of using GAAP financial statements for any purpose is the transparency and integrity of these statements and the confidence people have in these statements as compared to those prepared under the absence of GAAP. Particularly after the ENRON and WorldCom scandals the shareholders are insecure about the proper disclosure of financial statements and the ratios derived from these statements. The principles of GAAP help in the accurate and complete disclosure of values which helps build up the confidence of the shareholders and eventually the value of the company. GAAP procedures also help in the financial juggling of values through various methods of depreciation and doubtful debts.
Pitfalls of using GAAP financial statements in assessing value creation
One shortfall of using GAAP financial statements is that the principles under GAAP are based on the business environment of U.S.A and might be misinterpreted in other countries. One article suggests that the users of financial statements are using other means to get the required information as the current business environment has considerably changed since the development of GAAP (Rimerman, 169). The use of GAAP historical cost principle also results in a considerable change of estimated values. Consider a machine that was purchased 5 years ago and is lying idle in the factory premises. The real value might be far different from the original cost and the machine would not have depreciated considerably.
As we have seen the GAAP financial statements help in manipulating values of the financial statement and in turn manipulating the ratios and value of the company. Value creation is of utmost importance in this era of corporate competition. As more and more companies go public the value of a company becomes more important as the shareholders now have to choose from a wide array of investment options in different companies and the value of a company would be significant. The utility of GAAP financial statements would help build a better picture before the prospect investors of the company and would be a confidence building measure but we should be careful as the business environment has changed significantly in recent times.
Alexander, J. (2007). Performance Dashboards and Analysis for Value Creation. New Jersey: John Wiley & Sons Inc.
Damodaran, A. (1999, February 2). Value Creation and Enhancement: Back to the Future. Retrieved May 18, 2009, from Ideas.repec.org: http://ideas.repec.org/p/fth/nystfi/99-018.html
Rimerman, T. (169). The Shanging Significance of Financial Statements. Journal of Accountancy , 1990.