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Seeing as this is my first post on this board, allow me a brief introduction. I am a CPA, but practicing in income tax rather than financial statements. I try to keep aware of the issues my financial statement preparing colleagues face, but I'm not an expert in them. However, I do think my personal distance from the day to day issues gives me the freedom to think in broader terms.

GAAP is intended to provide a consistent way of comparing apples to apples across all different businesses.

That is the way GAAP started out. But it has morphed over the years into a grotesque monster. And the upcoming IFRS aren't much better.

At its core, accounting is an attempt to present the financial performance and position of a business so that management and investors can make intelligent and informed decisions about the business. Income is reported when earned, expenses reported when incurred, assets and liabilities of the business fully disclosed.

The problem is that management always has more information about the business than investors. And management is the one that prepares financial information for the investors to use. So it becomes easy for management to mislead investors about the finances of a business.

Many of our current accounting pronouncements are nothing more than a reaction to a problem (usually a fraud by management) that has arisen at some company. If you follow all of the big frauds over the years, you'll usually find some new accounting rule following the fraud that is an attempt to keep that fraud from happening again.

I call that "legislating morality". And you simply can't write laws and rules that cause people to behave morally. Morality and fairness don't arise from laws, they arise from within the individual. Laws and rules simply allow society to define behaviors that will be punished in some way.

So applying this to financial statements, we get back to the issue of management vs. investors. Investors are entirely reliant on management for their financial information. GAAP and IFRS cannot create fair financial reporting, they can only identify unfair reporting when that particular unfairness has happened before. Dishonest management will create dishonest reports. Honest management will create honest reports.

What does this say about GAAP vs. Adjusted Earnings? It says we need to look at management first. Financial reports that follow GAAP don't necessarily give a good picture of a business, they simply follow the rules laid down by GAAP. Adjusted earnings (or adjusted anything) can be a good thing when honest management is attempting to give investors a more complete picture of the business than can be conveyed in GAAP financial statements. But adjusted earnings can be used by dishonest management to cover up problems.

So I'd say the first step in evaluating a business is not to look at their finances, but to look at their management. Honest management will give honest financial statements. Dishonest management will give investors dishonest financial statements - even if those statements follow GAAP. When you find dishonest management, move along. You will never be able to fully trust information coming from that company.

GAAP vs. Adjusted earnings? Bring on the adjusted earnings. But before I put any faith in either, it is up to me as an investor to do my due diligence work on management.

--Peter
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