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Who's in Charge?
In the United States, a company that offers its common stock to the public typically needs to file periodic financial reports with the Securities and Exchange Commission (SEC). We will focus on the three important reports outlined in this table:
The SEC governs the content of these filings and monitors the accounting profession. In turn, the SEC empowers the Financial Accounting Standards Board (FASB)--an independent, nongovernmental organization--with the authority to update U.S. accounting rules. When considering important rule changes, FASB is impressively careful to solicit input from a wide range of constituents and accounting professionals. But once FASB issues a final standard, this standard becomes a mandatory part of the total set of accounting standards known as Generally Accepted Accounting Principles (GAAP).
Generally Accepted Accounting Principles (GAAP)
GAAP starts with a conceptual framework that anchors financial reports to a set of principles such as materiality (the degree to which the transaction is big enough to matter) and verifiability (the degree to which different people agree on how to measure the transaction). The basic goal is to provide users--equity investors, creditors, regulators and the public--with "relevant, reliable and useful" information for making good decisions.
As the framework is general, it requires interpretation and often re-interpretation in light of new business transactions. Consequently, sitting on top of the simple framework is a growing pile of literally hundreds of accounting standards. But complexity in the rules is unavoidable for at least two reasons.
First, there is a natural tension between the two principles of relevance and reliability. A transaction is relevant if a reasonable investor would care about it; a reported transaction is reliable if the reported number is unbiased and accurate. We want both, but we often cannot get both. For example, real estate is carried on the balance sheet at historical cost because this historical cost is reliable. That is, we can know with objective certainty how much was paid to acquire property. However,
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