In the world of finance and accounting, adhering to a common set of rules and standards is crucial for maintaining transparency, consistency, and comparability of financial information. In the United States, these rules are known as Generally Accepted Accounting Principles (GAAP). This article will provide an in-depth understanding of GAAP, its key principles, and its importance in financial reporting.
GAAP refers to a comprehensive set of accounting rules, standards, and procedures that guide the preparation and presentation of financial statements. These principles are established and issued by the Financial Accounting Standards Board (FASB), a private, non-profit organization recognized as the authoritative accounting standard-setting body in the United States. Public companies in the U.S. are required to follow GAAP when preparing their financial statements.
The Purpose and Benefits of GAAP
The primary objective of GAAP is to enhance the clarity, consistency, and comparability of financial information communicated to stakeholders. By adhering to GAAP, companies ensure that their financial statements are complete, accurate, and reliable. This, in turn, facilitates effective analysis and decision-making by investors, creditors, and other users of financial information.
GAAP also provides several benefits, including:
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Improved transparency: GAAP ensures that financial information is presented in a standardized and easily understandable format, enabling stakeholders to assess a company's financial position and performance with greater confidence.
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Enhanced comparability: GAAP enables the comparison of financial information across different companies, industries, and time periods. This comparability is vital for benchmarking, evaluating trends, and making informed investment or lending decisions.
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Regulatory compliance: Publicly traded companies are legally required to follow GAAP to maintain their listing on stock exchanges. Additionally, lenders and creditors often require GAAP-compliant financial statements as part of their debt agreements, reinforcing the importance of GAAP in the business world.
Key Principles of GAAP
GAAP is guided by ten key principles that form the foundation of its rules-based framework. These principles ensure consistency, reliability, and accuracy in financial reporting. Let's explore each principle:
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Principle of Regularity: Accountants must adhere to GAAP rules and regulations as a standard practice.
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Principle of Consistency: Accountants commit to applying the same accounting standards consistently throughout the reporting process, facilitating comparability between periods. Any changes or updates to accounting standards must be fully disclosed and explained in the footnotes of financial statements.
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Principle of Sincerity: Accountants strive to provide an accurate and unbiased depiction of a company's financial situation, avoiding any intentional manipulation or misrepresentation.
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Principle of Permanence of Methods: Financial reporting procedures should be consistent over time, allowing for meaningful comparison of a company's financial information.
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Principle of Non-Compensation: Financial statements should transparently report both positive and negative events without offsetting one against the other. This principle discourages the expectation of debt compensation.
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Principle of Prudence: Accountants emphasize the use of factual and conservative financial data representation, avoiding speculation or overly optimistic assumptions.
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Principle of Continuity: When valuing assets, it is assumed that the company will continue to operate unless there is substantial evidence to the contrary.
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Principle of Periodicity: Entries should be recorded and distributed across the appropriate accounting periods. For example, revenue should be recognized in the period it is earned.
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Principle of Materiality: Accountants must disclose all relevant financial data and accounting information in financial reports, ensuring the information provided is meaningful and useful to stakeholders.
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Principle of Utmost Good Faith: Derived from the Latin phrase "uberrimae fidei," this principle implies that all parties involved in financial transactions should act honestly and with utmost good faith.
Compliance with GAAP
Compliance with GAAP is crucial for public companies, as they must meet the reporting requirements established by the U.S. Securities and Exchange Commission (SEC) to maintain their listing on stock exchanges. The SEC mandates the regular filing of GAAP-compliant financial statements. External audits conducted by certified public accounting (CPA) firms provide assurance on the compliance of financial statements with GAAP.
While non-publicly traded companies are not legally required to follow GAAP, many choose to do so voluntarily. Lenders and creditors often consider GAAP-compliant financial statements as a measure of a company's financial health and stability when extending credit or evaluating loan agreements.
Summary
Freddie Mac is a government-sponsored company which purchases mortgages from banks and securitizes them for sales to investment banks or individuals. Freddie Mac is not a government organization, but was established by a congressional mandate in the 1970’s.
It’s proper name is the Federal Home Loan Mortgage Corporation (FHLMC). The company’s purpose is to make mortgage debts into marketable securities by purchasing the mortgage risk and cash flow from banks and dividing into tranches which are sold to or through investment banking institutions. The securitized mortgages are known as Collateralized Mortgage Obligations, or CMO’s.
By increasing the size of the secondary market for mortgages, it infuses the lending bank system with more liquidity to fund additional home purchases. The risk of the mortgage loan is effectively shifted from the lending bank to the investment bank with Freddie Mac as the conduit.
The incentive of the lending banks to make good loans to qualified individuals is lessened significantly through this arrangement, however, and the additional bad loans that this process brought into the economy, and the significant overweighting that many institutions had in this asset class, were a main cause of what came to be known as the Subprime Meltdown and the Great Recession that occurred between 2007 and 2009.
Freddie Mac and its sister organization, Fannie Mae, along with the eleven Federal Home Loan Banks were taken over in a conservatorship arrangement by the FHFA (Federal Housing Finance Agency) in 2008, effectively infusing bailout money from taxes into the enterprises to assist with the housing correction and restructuring of the businesses.
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