Corporate reporting and the auditors often rely on a rule matrix to interpret and apply GAAP. Rules are used as the compass for determining reporting solutions. This narrows the analytical lens significantly and economic substance gets lost.

The approach seeks to assign transactions to strata within GAAP because there is some overlap of facts or characteristics. It can result in reported values on the balance sheet and P&L that are not reflective of the underlying cash flows and risk because they are slave to a rule they bear a limited resemblance to.

It’s difficult to frame the economics of unique business transactions with a process-oriented matrix of accounting rules. Economics are driven by behaviors and are evidenced by the movement of ownership, risk and obligation. These variables are not detected well by a rule matrix.

Economic variables are best understood by assembling them into their natural design. This gives clarity to a transaction’s economic substance and specific GAAP begins to demonstrate relevance and applicability against that framework.

Economic substance refers to how money and assets are moving within transactions. What substantive course do they take and do ownership, risk, obligation & benefit move with them? Or is it non-substantive and risk/benefit remains with one or more parties, regardless of cash and asset flows?

There should be a binding exchange of goods, services, or rights and at some juncture cash (excluding non-monetary transactions). A quality analysis and modeling at this level will establish how the transactions should be reported on the financial statements. There is no substitute for a solid understanding of what’s truly happening economically, from a third party view (i.e. a view with no interest in the outcome).

All this works to the advantage of the investor. Reported information will accurately represent the business underneath the financial statement values. This protects investors, as it assures them their financial decisions related to securities are based on an accurate economic valuation, not one made for the sake of compliance to rules with limited relevance.