Gaps in GAAP

Generally accepted accounting principles (GAAP) offer companies and their auditors a consistent set of rules to follow in their reporting of company income statement and balance sheet information. GAAP also offers a measure of "quality control" that assures investors that reported numbers have been consistently derived from a set of uniform principles applied to all companies. This makes it possible for investors to compare reported results over time and across firms and industries. At least, this is how GAAP works in theory. Sometimes, accounting practice falls far short of the ideal. In some instances, it seems as if companies and their auditors come up with the numbers the companies want, irrespective of actual economic performance.

Common accounting tricks that managers and investors must be on the lookout for include

• Misleading focus on pro-forma results. Some firms seek to minimize poor operating performance by encouraging investors to overlook standard accounting charges.

• Excessive one-time R&D charges. These one-time charges are taken at the time of an acquisition to cover expenses for research and development that is ''in process'' but not yet commercially viable. By separating these expenses from revenues that might be gained in the future, future earnings can be overstated.

• Extravagant one-time "restructuring reserves." When normal expenses are written off ahead of time, future earnings are overstated.

• Aggressive revenue recognition. When service contracts stretch out for years, booking revenue too early inflates sales and earnings.

The Securities and Exchange Commission (SEC) has become concerned that the quality of financial reporting is eroding. It should be. If basic accounting practices ever lose credibility with investors and the general public, financial markets and economic performance would suffer greatly.

See: Alen Mattich, "Accountants Under the Microscope Post Enron," The Wall Street Journal Online, January 18, 2002 (

continuously with increases in output. AC and AVC also decline as long as they exceed MC, but increase when they are less than MC. Alternatively, so long as MC is less than AC and AVC, both average cost categories will decline. When MC is greater than AC and AVC, both average cost categories will rise. Also note that TFC is invariant with increases in output and that TVC at each level of output equals the sum of MC up to that output.

Marginal cost is the change in cost associated with a one-unit change in output. Because fixed costs do not vary with output, fixed costs do not affect marginal costs. Only variable costs affect marginal costs. Therefore, marginal costs equal the change in total costs or the change in total variable costs following a one-unit change in output:

MC AQ aq

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