Question

Generally accepted accounting principles (GAAP) fail to capture all the transactions that are relevant for the valuation of a firm. Discuss the main areas where GAAP is deficient for the purposes of valuation.

Answer 1

The main areas where GAAP is deficient for the valuation purposes are as follows:

1. Measurability: Financial statements show what can be reliably measured. This results in non-recognition of some assets, often internally developed assets, the very assets that are most likely to confer a competitive gain and create value. Examples are a superior management team, brand name, employee skills, and a reliable supply chain.

2. Non-capitalized costs: The concept of measurability is the expensing of costs relating to “assets” which are difficult to be identified with enough precision to warrant capitalization. Examples are research and development costs relating to future products, and brand equity costs from advertising and promotional activities.

3. Historical costs: The Company’s assets and liabilities are often recorded at original acquisition or issuance costs. The subsequent rise in value is not recorded until realized, and fall in value are only recognized if deemed permanent. Therefore, GAAP balance sheets omit valuable and important assets

Thus, GAAP balance sheets omit valuable and important assets. The analysis of ROE and liquidity and solvency assessment need to consider that assets can be underreported and that ratios can be distorted.