It is alleged that value of financial statement information is compromised by the latitude that GAAP gives to management.
Companies can use different accounting methods to summarize & report the outcome of otherwise similar transaction. Inventory valuation & depreciation are examples in which GAAP allows many accounting method alternatives. At one extreme, the FASB & the SEC could limit accounting flexibility by establishing a single set of accounting methods & procedures that all companies would apply. At the other extreme, FASB & the SEC could simply require companies to provide relevant & reliable financial info to outsiders without placing any restrictions on the accounting methods used.
1. Why should managers be allowed some sort of flexibility in their financial accounting & reporting choices?
2. Of the 2 approaches to accounting standard setting mentioned, which better describes the current financial reporting environment in the U.S?
3. Describe the advantages and disadvantages of these 2 approaches to accounting standard setting & tell how these pros and cons vary across different group of financial statement users.
To put the question raised in proper perspective it is worthwhile clarifying some basic accounting concepts. Accounts are used for two distinctly different purposes. One is to provide information to the managers to enable them to manage their organizations well. The other is to provide information about company's position and performance to other stakeholders such as investors and creditors. According to the purpose for which the accounting information is used, the nature of accounts prepared is quite different.
Managers try to use the most informative and accurate information for internal managers. However top management of a company may be tempted to give limited and sometimes misleading information to other stakeholders to to present a better than real picture about the organization. The GAAP guidelines are designed to control the extent of misleading picture of an organization is presented to the public by its top management. However it would be quite wasteful to have a completely duplicate the entire accounting system within an organization for the external accounting statements. Therefor the external accounts hare also extracted from the same basic accounting statements, which need to differ from company to company to satisfy the need of their internal management.
The GAAP guidelines have to provide some flexibility to the managers in the method of preparation and presentation of external accounts to allow them to prepare them without creating an entire parallel accounting system for it.
For the reasons stated in paragraph above it is not feasible to have a GAAP guideline that does not offer any flexibility to managers. On the other hand letting each company prepare its external account in the way they want without any restriction will defeat the basic purpose of GAAP. Thus none of the two alternative suggested in the question are feasible. The best that can be done is to improve the GAAP guidelines to make them more effective without being too restrictive. However it should be remembered that However good these guidelines, they can only reduce the extent of misleading accounts. The GAAP guidelines cannot completely eliminate such malpractices, just as laws against crime have helped to reduce crime but have not eliminated crime.