Research Paper

docx

School

Georgia Southern University *

*We aren’t endorsed by this school

Course

7400

Subject

Accounting

Date

Apr 3, 2024

Type

docx

Pages

Uploaded by CommodoreNewtPerson1079

GAAP and Economic Balance Sheets Robert Stinson Georgia Southern University Dr. Chuck Harter October 9, 2023

GAAP provides an excellent framework for financial reporting. Standardization of reporting provides greater trust in the financial reporting process. Analysts, investors, and company personnel can place trust in audited GAAP financials. However, the strict reporting standards of GAAP can fail to tell a complete story. Certain market conditions may fall outside the bounds of conventional reporting and certain balance sheet accounts may not be properly valued at historical cost. In these cases, an economic balance sheet can provide greater insight into a company’s current performance and valuation. While there are similarities between the two documents, there are notable differences. This paper will discuss the purpose of the documents, methods of valuation, intangible assets, contingent liabilities, use of reserves, and presentation. Economic valuations can be based on different criteria than GAAP valuations. While GAAP balance sheets focus on specific valuation standards, particularly historical cost, economic balance sheets emphasize true economic conditions. GAAP valuations tend to be more conservative, while their economic counterpart can be more aggressive if appropriate. For example, a contingent liability, which will be discussed in greater detail later, is presented on a GAAP balance sheet if the negative outcome is “probable” to occur (greater than 50% chance) and reasonably estimable ( 23.4 contingencies 2022). However, an economic balance sheet may not show this liability. A reason for this may be the time frame for potential penalties or obligations. For example, a fuel station with a leased location will likely require remediation efforts at the end of the lease. If the lease is 30 years, it does not do much for the economic value of the station to place this contingent liability on the financial reports. However, since it is more than 50% likely that environmental remediation efforts will be required at lease end, this item

would appear on a GAAP balance sheet. An economic balance sheet will likely reflect a smaller or no liability for this item. Market valuations also feature another key difference. Valuations under GAAP are typically handled at historical cost. Under the economic model, current economic conditions set the value. This can provide large variances between GAAP and economic balance sheets. There may also be a difference in how the information is used by investors and analysts. Economic balance sheets can provide a more realistic short-term snapshot of a company ( Economic balance sheet - KPMG 2016). Long-term investments are an example of an asset that can be undervalued at historical cost. A noted increase in investment value can lead to the asset being undervalued on GAAP financials. Commodities with fluctuating prices can also lead to variances between the two balance sheets. If a company has stockpiles of potatoes, and the price of potatoes increases, the company’s potato inventory is undervalued under GAAP standards. Intangible assets are assets that lack a physical structure. These can include customer lists, market share, goodwill, copyrights, trade secrets, and many others. These items have value because they help provide revenue for the company. Valuing these intangibles can be tedious ( 4.2 intangible assets: Identifiable criteria 2023). It is important to remember that valuations of intangibles may vary from a GAAP to economic balance sheet. It is important to recognize the differences in intangibles across the two documents. Under GAAP, historical cost is the valuation tool used to assign a proper value to an intangible. For example, a company may have spent $1 million dollars developing a process for a new beverage. After going to market, the company realizes the new process makes this product the best in the beverage market.

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version

Access to all documents
Unlimited textbook solutions
24/7 expert homework help

The process is an intangible and would be valued at $1 million. This process is assigned a useful life and amortized over the useful life. Further, the company will need to test for impairment annually to ensure the stated value of the intangible asset is not above its recoverable value (Puka and Zyla 2021). In the case impairment occurs, an adjusting entry must be made to correct the asset’s value. By the end of the assigned useful life of the process, the value will drop to zero due to amortization. The above intangible valuation situation would likely be different in an economic balance sheet. Say the process revolutionized the Company’s industry. Other production processes are clearly inferior, and the company is able to make and sell more product than any competitor. Luckily, economic balance sheets use market conditions to value intangibles. As such, even though this process cost $1 million to create, it can be valued at a much higher number. Economic balance sheets may consider future cash flows generated by the process and similar industry transactions ( Valuing intangible assets 2023). As this new process is revolutionizing the company’s production it can be valued at a much higher cost than the aggregate expenses incurred to create the process. As such, it is important to understand the method of intangible valuation on an economic balance sheet. As stated previously, contingent liabilities are also handled differently on an economic balance sheet. Per GAAP, contingent liabilities must be considered on the balance sheet if the negative outcome is 50% more likely to occur, and the occurrence is reasonably estimable ( 23.4 contingencies 2022). In the event a contingent liability meets the 50% threshold but is not reasonably estimable, it may be excluded from the face of financials. However, it must still appear in the disclosures. Economic balance

sheets can take a more nuanced approach. Regulatory investigations may appear on a GAAP balance sheet but left off the economic counterpart. If a negative result is 51% likely to happen and estimable, it must appear on the financials. However, a regulatory investigation is not a quick occurrence. Long-term impacts, while estimable, are highly subjective with an equally high susceptibility to change ( 23.4 contingencies 2022). In this instance there are many arguments as to why this item should be included with contingent liabilities on the balance sheet. In these instances, the economic balance sheet provides an alternative view. Reserves are another management estimate that may impact balance sheet accounts. Reserves are used by management to offset future losses. Reserves are liabilities on the GAAP balance sheet. Reserves can cover future warranty claims, required remediation efforts, legal penalties, and other potential losses. GAAP has specific reporting criteria for reserves. The requirements are similar to contingent liabilities. The event the reserve is for must be likely to occur and estimable (Kenton 2021). The reserve also utilizes existing profits to fund the account. As such an expense is recorded in the income statement, reducing profitability when a reserve is formed. Economic balance sheets do not have the same strict reporting requirements. Reserve presentation can vary on an economic balance sheet. They may be presented in reductions to asset value as opposed to a liability. As such, there is no expense on the income statement, improving profitability over the GAAP document. The requirements for creating a reserve are also relaxed. A company can create a reserve that may not be required under GAAP to reflect a particular market environment.

Without standardization in financial reporting, a “wild west” environment would exist. Investors would have to rely upon financial statements that would not be tied to any sort of quality or accuracy requirement. Unregulated accounting can create all sorts of havoc. This is why GAAP is so important. The GAAP framework provides a clear set of reporting standards. Stakeholders of financial statements can typically trust the information they are given. Although GAAP provides detailed standards for a myriad of scenarios, it may not be perfect for every situation. The standardization can come at the cost of recognizing unique economic realities. This is where the economic balance sheet provides a better picture of a company’s current financial environment ( Economic balance sheet - KPMG 2016). However, it is important to note, economic balance sheets are rarely audited. While some firms offer advisory services that produce economic balance sheets, it is important to compare economic balance sheets to their GAAP counterparts. As discussed above, valuations at historical cost can be misleading regarding the current fiscal environment. While the documents have noticeable differences, utilizing both documents can provide the most information to all stakeholders.

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version

Access to all documents
Unlimited textbook solutions
24/7 expert homework help

References 23.4 contingencies . PWC. (2022, April 30). https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/financial_statement_/ financial_statement___18_US/chapter_23_commitmen_US/ 234_contingencies_US.html#pwc-topic.dita_1421044012150140 4.2 intangible assets: Identifiable criteria . PWC. (2023, June 5). https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/business_combination/ business_combination__28_US/chapter_4_intangible_US/ 42_intangible_assets_US.html Economic balance sheet - KPMG . KPMG. (2016, July). https://assets.kpmg.com/content/dam/kpmg/pdf/2016/07/ADV-Economic-Balance- Sheet.pdf Kenton, W. (2021, May 27). Balance sheet reserves: Definition, types, and example . Investopedia. https://www.investopedia.com/terms/b/balance-sheet-reserves.asp Puca, A., & Zyla, M. (2021, August 24). The Intangible Valuation Renaissance: Five methods . CFA Institute Enterprising Investor. https://blogs.cfainstitute.org/investor/2019/01/11/a-renaissance-in-intangible- valuation-five-methods/ Valuing intangible assets . Mauldin & Jenkins. (2023, August 21). https://www.mjcpa.com/valuing-intangible-assets/