The Richard C. Adkerson Gallery on the SEC Role in Accounting Standards Setting

Finding the Right Structure

Examples of Gaps in GAAP

Some of the more prominent form-oriented accounting methods included poolings of interests, stock compensation and off-balance sheet financings.

Accounting for mergers and acquisitions: Until 2001, there were two ways to account for business combinations. The only method allowed now is the purchase method, based on values exchanged. Acquired assets and liabilities are recorded at fair values, and any purchase premium over allocated values is goodwill. But, before 2001, certain acquisitions could be accounted for as poolings of interests, whereby all assets and liabilities were recorded at book values of the acquired company. There was no goodwill, and financial statements were restated as if the companies had always been combined. More importantly, the effect on future results was favorable by avoiding the expenses related to values that would have been increased under purchase accounting. Thus, it was possible for two almost identical acquisitions to be treated entirely differently, depending on the tweaking of the transaction structure.

The pooling-of-interests method arose from mergers of entities of such comparable nature and size that identifying an acquirer was considered impracticable. However, the size criterion was quickly eroded, and pooling might be used whenever shares were exchanged. Before 1970, one of GAAP’s most curious applications was “part purchase, part pooling,” in which portions of a single acquisition were accounted for by the purchase method, and other portions as a pooling of interests. It was sometimes called the infusion of confusion into fusion.

Stock options: The accounting for stock compensation had some roots in the tax laws. If a stock purchase or option plan was a qualified plan for tax purposes, generally no compensation was recorded. Thus, no expense was recognized if options were granted at then current fair values. It was the only instance in GAAP in which options issued for assets or services were not based on value. Few denied that options had value, particularly the recipients. In 2004 the FASB was finally able to require a fair value-based method of accounting for stock options.⁽¹⁹⁾

Off-balance sheet financing: If there has been an art form for structuring GAAP information, it may be in the area of keeping debt off the balance sheet. An example is leases, whereby the financing of asset acquisitions can readily be relegated to the footnotes by following the detailed GAAP criteria. The FASB and the International Accounting Standards Board have proposed significant revisions to the lease rules that would restore many lease obligations to the balance sheet. Other off-balance sheet financings have taken many forms, including so-called special purpose entities (SPEs), which gained particular notoriety in the Enron downfall. Earlier, the SEC had participated in the EITF’s formulating the original form-based criteria for off-balance sheet treatment of SPEs.⁽²⁰⁾ After the fall of Enron, the FASB substantially revised the rules, and qualifying entities are now referred to as variable interest entities. 

There were other “gaps in GAAP,” including comprehensive guidance for revenue recognition, one of the most frequently-cited problem areas in SEC enforcement actions. Rules that existed had been developed principally for specific industry application. In the absence of general standards, in 1999 the SEC staff issued guidance in applying generally accepted accounting principles to selected revenue recognition issues.⁽²¹⁾ In 2012, the FASB and IASB have been collaborating to develop comprehensive revenue recognition guidance.

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