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Accounting Principles Explained: How They Work, GAAP, IFRS

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Accounting Principles Explained: How They Work, GAAP, IFRS

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What Are Accounting Principles?

Accounting principles are the rules and guidelines that companies and other bodies must follow when reporting financial data. These rules make it easier to examine financial data by standardizing the terms and methods that accountants must use.

The International Financial Reporting Standards (IFRS) is the most widely used set of accounting principles, with adoption in 167 jurisdictions. The United States uses a separate set of accounting principles, known as generally accepted accounting principles (GAAP).

Key Takeaways

  • Accounting standards are implemented to improve the quality of financial information reported by companies.
  • In the United States, the Financial Accounting Standards Board (FASB) issues generally accepted accounting principles (GAAP).
  • GAAP is required for all publicly traded companies in the U.S.; it is also routinely implemented by non-publicly traded companies as well.
  • Internationally, the International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS).
  • The FASB and the IASB sometimes work together to issue joint standards on hot-topic issues, but there is no intention for the U.S. to switch to IFRS in the foreseeable future.

The Purpose of Accounting Principles

The ultimate goal of any set of accounting principles is to ensure that a company’s financial statements are complete, consistent, and comparable.

This makes it easier for investors to analyze and extract useful information from the company’s financial statements, including trend data over a period of time. It also facilitates the comparison of financial information across different companies. Accounting principles also help mitigate accounting fraud by increasing transparency and allowing red flags to be identified.

The ultimate goal of standardized accounting principles is to allow financial statement users to view a company’s financials with certainty that the information disclosed in the report is complete, consistent, and comparable.

Comparability

Comparability is the ability for financial statement users to review multiple companies’ financials side by side with the guarantee that accounting principles have been followed to the same set of standards.

Accounting information is not absolute or concrete, and standards are developed to minimize the negative effects of inconsistent data. Without these rules, comparing financial statements among companies would be extremely difficult, even within the same industry. Inconsistencies and errors also would be harder to spot.

What Are the Basic Accounting Principles?

Some of the most fundamental accounting principles include the following:

  • Accrual principle
  • Conservatism principle
  • Consistency principle
  • Cost principle
  • Economic entity principle
  • Full disclosure principle
  • Going concern principle
  • Matching principle
  • Materiality principle
  • Monetary unit principle
  • Reliability principle
  • Revenue recognition principle
  • Time period principle

The most notable principles include the revenue recognition principle, matching principle, materiality principle, and consistency principle. Completeness is ensured by the materiality principle, as all material transactions should be accounted for in the financial statements. Consistency refers to a company’s use of accounting principles over time.

When accounting principles allow a choice among multiple methods, a company should apply the same accounting method over time or disclose its change in accounting method in the footnotes to the financial statements.

Generally Accepted Accounting Principles (GAAP)

Generally accepted accounting principles (GAAP) are uniform accounting principles for private companies and nonprofits in the U.S. These principles are largely set by the Financial Accounting Standards Board (FASB), an independent nonprofit organization whose members are chosen by the Financial Accounting Foundation.

A similar organization, the Governmental Accounting Standards Board (GASB), is responsible for setting the GAAP standards for local and state governments. And a third body, the Federal Accounting Standards Advisory Board (FASAB), publishes the accounting principles for federal agencies.

Although privately held companies are not required to abide by GAAP, publicly traded companies must file GAAP-compliant financial statements to be listed on a stock exchange. Chief officers of publicly traded companies and their independent auditors must certify that the financial statements and related notes were prepared in accordance with GAAP.

Privately held companies and nonprofit organizations also may be required by lenders or investors to file GAAP-compliant financial statements. For example, annual audited GAAP financial statements are a common loan covenant required by most banking institutions. Therefore, most companies and organizations in the U.S. comply with GAAP, even though it is not a legal requirement.

Accounting principles differ around the world, meaning that it’s not always easy to compare the financial statements of companies from different countries.

International Financial Reporting Standards (IFRS)

The International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS). These standards are used in more than 120 countries, including those in the European Union (EU).

The Securities and Exchange Commission (SEC), the U.S. government agency responsible for protecting investors and maintaining order in the securities markets, has expressed interest in transitioning to IFRS. However, because of the differences between the two standards, the U.S. is unlikely to switch in the foreseeable future.

However, the FASB and the IASB continue to work together to issue similar regulations on certain topics as accounting issues arise. For example, in 2014, the FASB and the IASB jointly announced new revenue recognition standards.

Since accounting principles differ around the world, investors should take caution when comparing the financial statements of companies from different countries. The issue of differing accounting principles is less of a concern in more mature markets. Still, caution should be used, as there is still leeway for number distortion under many sets of accounting principles.

Who sets accounting principles and standards?

Various bodies are responsible for setting accounting standards. In the United States, generally accepted accounting principles (GAAP) are regulated by the Financial Accounting Standards Board (FASB). In Europe and elsewhere, International Financial Reporting Standards (IFRS) are established by the International Accounting Standards Board (IASB).

How does IFRS differ from GAAP?

IFRS is a standards-based approach that is used internationally, while GAAP is a rules-based system used primarily in the U.S. IFRS is seen as a more dynamic platform that is regularly being revised in response to an ever-changing financial environment, while GAAP is more static.

Several methodological differences exist between the two systems. For instance, GAAP allows companies to use either first in, first out (FIFO) or last in, first out (LIFO) as an inventory cost method. LIFO, however, is banned under IFRS.

When were accounting principles first set forth?

Standardized accounting principles date all the way back to the advent of double-entry bookkeeping in the 15th and 16th centuries, which introduced a T-ledger with matched entries for assets and liabilities. Some scholars have argued that the advent of double-entry accounting practices during that time provided a springboard for the rise of commerce and capitalism. What would become the American Institute of Certified Public Accountants (AICPA) and the New York Stock Exchange (NYSE) attempted to launch the first accounting standards to be used by firms in the United States in the 1930s.

What are some critiques of accounting principles?

Critics of principles-based accounting systems say they can give companies far too much freedom and do not prescribe transparency. They believe because companies do not have to follow specific rules that have been set out, their reporting may provide an inaccurate picture of their financial health. In the case of rules-based methods like GAAP, complex rules can cause unnecessary complications in the preparation of financial statements. These critics claim having strict rules means that companies must spend an unfair amount of their resources to comply with industry standards.

The Bottom Line

Accounting principles are rules and guidelines that companies must abide by when reporting financial data. Whether it’s GAAP in the U.S. or IFRS elsewhere, the overarching goal of these principles is to boost transparency and basically make it easier for investors to compare the financial statements of different companies.

Without these rules and standards, publicly traded companies would likely present their financial information in a way that inflates their numbers and makes their trading performance look better than it actually was. If companies were able to pick and choose what information to disclose and how, it would be a nightmare for investors.

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100% Equities Strategy

Written by admin. Posted in #, Financial Terms Dictionary

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What Is a 100% Equities Strategy?

A 100% equities strategy is a strategy commonly adopted by pooled funds, such as a mutual fund, that allocates all investable cash solely to stocks. Only equity securities are considered for investment, whether they be listed stocks, over-the-counter stocks, or private equity shares.

Key Takeaways

  • A 100% equities strategy involves only long positions in stocks.
  • Such a strategy is common among mutual funds that allocate all investable cash solely to stocks, forgoing higher-risk instruments such as derivatives or riskier strategies such as short selling.
  • With 100% equity strategies, a portfolio’s style can be further subdivided into capital appreciation, aggressive growth, growth, value, capitalization, and income, among others.

Understanding a 100% Equities Strategy

100% equities strategies represent portfolios that only select investments from the equities (i.e., stocks) universe. 100% equity strategies are predominant in the market and encompass a large majority of offerings.

Generally, very few funds would be able to deploy all available capital to equity market investments without holding some cash and cash equivalents for transactions and operating activities.

In practice, many 100% equity strategies will have an investment objective or mandate to invest at least 80% in equities. The 80% threshold is a formality used in regulatory or registration documentation for the majority of equity funds in the marketplace, with many funds deploying anywhere from 90% to 100% to equities.

100% equity means that there will be no bonds or other asset classes. Furthermore, it implies that the portfolio would not make use of related products like equity derivatives, or employ riskier strategies such as short selling or buying on margin. Instead, 100% equities implies a more focused, traditional approach to equity investment.

Special Considerations

Equities are generally considered a riskier asset class over alternatives such as bonds, money market funds, and cash.

A well-diversified portfolio of all stocks can protect against individual company risk, or even sector risk, but market risks will still persist that can affect the equities asset class. Thus, both systemic and idiosyncratic risks are important considerations for aggressive equity investors. As a result, most financial advice recommends a portfolio that includes both equity and fixed-income (bond) components.

100% Equities Strategy Types

In the 100% equity strategy category, an investor will find a wide range of sub-classes to choose from, including those that focus on one (or a combination of) labels like capital appreciation, aggressive growth, growth, value, and income. Outlined below are some of the characteristics investors can expect from some of the most prominent 100% equity strategies.

Growth

Growth investing is a style used by many aggressive equity investors who are comfortable with higher-risk investments and seek to take advantage of growing companies. The Russell 3000 Growth Index is a broad market index that helps to represent the growth category.

Growth companies offer emerging technologies, new innovations, or a significant sector advantage that gives them above average expectations for revenue and earnings growth.

Value

Value stocks are often known as long term core holdings for an investor’s portfolio. These equity funds will rely on fundamental analysis to identify stocks that are undervalued in comparison to their fundamental value.

Investment metrics for value investing often include price-to-earnings, price-to-book, and free cash flow.

Income

Income investing is also a top category for core long-term holdings in a portfolio. Income funds will invest in equities with a focus on current income. Income from equity investments is primarily focused on mature companies paying steady dividend rates.

In the income category, real estate investment trusts and master limited partnerships are two publicly traded stock categories with unique incorporation structures that require them to pay high levels of income to equity investors.

Market Capitalization

Capitalization is a popular investing strategy for all equity portfolios. Generally, capitalization is broken down by large cap, mid cap, and small cap.

Large-cap companies can offer the lowest volatility as they have established businesses and steady earnings that pay dividends. Small-cap companies, on the other hand, are usually considered to have the highest risk since they are typically in the early stages of their development.

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What Are Alternative Investments? Definition and Examples

Written by admin. Posted in A, Financial Terms Dictionary

What Are Alternative Investments? Definition and Examples

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What Is an Alternative Investment?

An alternative investment is a financial asset that does not fall into one of the conventional investment categories. Conventional categories include stocks, bonds, and cash. Alternative investments can include private equity or venture capital, hedge funds, managed futures, art and antiques, commodities, and derivatives contracts. Real estate is also often classified as an alternative investment.

Key Takeaways

  • An alternative investment is a financial asset that does not fit into the conventional equity/income/cash categories.
  • Private equity or venture capital, hedge funds, real property, commodities, and tangible assets are all examples of alternative investments.
  • Most alternative investments have fewer regulations from the U.S. Securities and Exchange Commission (SEC) and tend to be somewhat illiquid.
  • While traditionally aimed at institutional or accredited investors, alternative investments have become feasible to retail investors via alternative funds.

Understanding Alternative Investments

Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, lack of regulation, and degree of risk. Many alternative investments have high minimum investments and fee structures, especially when compared to mutual funds and exchange-traded funds (ETFs). These investments also have less opportunity to publish verifiable performance data and advertise to potential investors. Although alternative assets may have high initial minimums and upfront investment fees, transaction costs are typically lower than those of conventional assets due to lower levels of turnover.

Most alternative assets are fairly illiquid, especially compared to their conventional counterparts. For example, investors are likely to find it considerably more difficult to sell an 80-year old bottle of wine compared to 1,000 shares of Apple Inc. due to a limited number of buyers. Investors may have difficulty even valuing alternative investments, since the assets, and transactions involving them, are often rare. For example, a seller of a 1933 Saint-Gaudens Double Eagle $20 gold coin may have difficulty determining its value, as there are only 13 known to exist and only one can be legally owned.

Regulation of Alternative Investments

Even when they don’t involve unique items like coins or art, alternative investments are prone to investment scams and fraud due to the lack of regulations.

Alternative investments are often subject to a less clear legal structure than conventional investments. They do fall under the purview of the Dodd-Frank Wall Street Reform and Consumer Protection Act, and their practices are subject to examination by the U.S. Securities and Exchange Commission (SEC). However, they usually don’t have to register with the SEC. As such, they are not overseen or regulated by the SEC as are mutual funds and ETFs.

So, it is essential that investors conduct extensive due diligence when considering alternative investments. In some cases, only accredited investors may invest in alternative offerings. Accredited investors are those with a net worth exceeding $1 million—not counting their primary residence—or with an annual income of at least $200,000 (or $300,000 combined with a spousal income). Financial professionals who hold a FINRA Series 7, 65, or 82 license may also qualify as an accredited investor.

Some alternative investments are only available to accredited investors—e.g., those with a net worth above $1 million, or an annual income of at least $200,000.

Strategy for Alternative Investments

Alternative investments typically have a low correlation with those in standard asset classes. This low correlation means they often move counter to the stock and bond markets. This feature makes them a suitable tool for portfolio diversification. Investments in hard assets, such as gold, oil, and real property, also provide an effective hedge against inflation, which hurts the purchasing power of paper money.

Because of this, many large institutional funds such as pension funds and private endowments often allocate a small portion of their portfolios—typically less than 10%—to alternative investments such as hedge funds.

The non-accredited retail investor also has access to alternative investments. Alternative mutual funds and exchange-traded funds—also called alt funds or liquid alts—are now available. These alt funds provide ample opportunity to invest in alternative asset categories, previously difficult and costly for the average individual to access. Because they are publicly traded, alt funds are SEC-registered and regulated, specifically by the Investment Company Act of 1940.

Example of Alternative Investments

Just being regulated does not mean that alt funds are safe investments. The SEC notes, “Many alternative mutual funds have limited performance histories.”

Also, although its diversified portfolio naturally mitigates the threat of loss, an alt fund is still subject to the inherent risks of its underlying assets. Indeed, the track record of ETFs that specialize in alternative assets has been mixed.

For example, as of January 2022, the SPDR Dow Jones Global Real Estate ETF had an annualized five-year return of 6.17%. In contrast, the SPDR S&P Oil & Gas Exploration & Production ETF posted a return of –6.40% for the same period.

What Are the Key Characteristics of Alternative Investments?

Alternative investments tend to have high fees and minimum investments, compared to retail-oriented mutual funds and ETFs. They also tend to have lower transaction costs, and it can be harder to get verifiable financial data for these assets. Alternative investments also tend to be less liquid than conventional securities, meaning that it may be difficult even to value some of the more unique vehicles because they are so thinly traded.

How Can Alternative Investments Be Useful to Investors?

Some investors seek out alternative investments because they have a low correlation with the stock and bond markets, meaning that they maintain their values in a market downturn. Also, hard assets such as gold, oil, and real property are effective hedges against inflation. For these reasons, many large institutions such as pension funds and family offices seek to diversify some of their holdings in alternative investment vehicles.

What Are the Regulatory Standards for Alternative Investments?

Regulations for alternative investments are less clear than they are for more traditional securities. Although alternative investment vehicles are regulated by the SEC, their securities do not have to be registered. As a result, most of these investment vehicles are only available to institutions or wealthy accredited investors.

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China A-Shares: Definition, History, Vs. B-Shares

Written by admin. Posted in A, Financial Terms Dictionary

China A-Shares: Definition, History, Vs. B-Shares

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What Are China A-Shares?

China A-shares are the stock shares of mainland China-based companies that trade on the two Chinese stock exchanges, the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE). Historically, China A-shares were only available for purchase by mainland citizens due to China’s restrictions on foreign investment.

However, since 2003, select foreign institutions have been able to purchase these shares through the Qualified Foreign Institutional Investor (QFII) system. Established in 2002, the QFII program allows specified licensed international investors to buy and sell on mainland China’s stock exchanges.

A-shares are also known as domestic shares because they use the Chinese renminbi (RMB) for valuation.

Key Takeaways

  • China A-shares are the stock shares of mainland China-based companies that trade on the two Chinese stock exchanges, the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE).
  • Historically, China A-shares were only available for purchase by mainland citizens due to China’s restrictions on foreign investment.
  • China A-shares are different from B-shares; A-shares are only quoted in RMB, while B-shares are quoted in foreign currencies, such as the U.S. dollar, and are more widely available to foreign investors.

China A-Shares vs. B-Shares

China A-shares are different from B-shares. A-shares are only quoted in RMB, while B-shares are quoted in foreign currencies, such as the U.S. dollar, and are more widely available to foreign investors. Foreign investors may have difficulty accessing A-shares because of Chinese government regulations, and Chinese investors may have difficulty accessing B shares most notably for currency-exchange reasons. Some companies opt to have their stock listed on both the A-shares and B-shares market.

Due to the limited access of Chinese investors to B-shares, the stock of the same company often trades at much higher valuations on the A-shares market than on the B-shares market. Although foreign investors may now invest in A-shares, there is a monthly 20% limit on repatriation of funds to foreign countries.

The Shanghai Stock Exchange (SSE) publishes the key performance index for A-shares, known as the SSE 180 Index. In composing the index, the exchange selects 180 stocks listed on the SSE. The selection is diversified between sector, size, and liquidity to ensure adequate representation. Thus, the index’s performance benchmark reflects the overall situation and operation of the Shanghai securities market.

History of China A-Shares

Since its inception in 1990, including a major reform in 2002, the index has seen great fluctuations. However, it has grown along with the Chinese economy. The years 2015 to 2016 were a particularly difficult period, with a 52-week performance of -21.55% as of July 20, 2016.

As China grows from an emerging market to an advanced economy, there is substantial demand for Chinese equity. Stock exchange regulators continue efforts to make A-shares more broadly available to foreign investors and have them recognized by the global investing community.

In June 2017, the MSCI Emerging Markets Index announced a two-phase plan in which it would gradually add 222 China A large-cap stocks. In May 2018, the index began to partially include China large-cap A shares, which make up 5% of the index. Full inclusion would make up 40% of the index.

It is important for countries such as China to open their markets to global investors to stay competitive and thrive economically. China A-shares provide an alternative investment for those interested in trading in Chinese securities.

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