Communicating with Investors

Communicating with Investors

GAAP financial statements are a tool for communicating with investors. 

Such financial statements can be published in annual reports, along with an opinion from an independent auditing firm.  While the statements are still the responsibility of management, an audit opinion stating that the statements comply with Generally Accepted Accounting Principles gives them substantial credibility.  Further, such statements are required in Form 10-K by the US Securities and Exchange Commission for publicly-traded companies.

Sometimes the absolute level of GAAP earnings is not as important as the pattern of those earnings.  Investment advisors like to see a stable pattern of earnings that can be projected into the future.  Earnings that show an erratic pattern might not be considered reliable for making future projections, and could therefore lead to lower market valuations.

GAAP rules for insurance organizations require a special set of actuarial assumptions be used to calculate reserves and deferred acquisition costs.  These assumptions are supposed to represent a “best guess” for future experience plus a provision for adverse deviation.  Management is responsible for setting these assumptions, but they receive significant scrutiny from independent auditors.  One can imagine that reasonable people can come up with a fairly wide range of GAAP assumptions for the same insurance risk.

Conservative GAAP assumptions, by definition, tend to defer earnings to future reporting periods.  Deferring earnings can help create the stable pattern of earnings discussed above.  However, conservative GAAP assumptions can become a problem for companies who start growing significantly.  GAAP earnings may not grow as fast as the company is growing, and that could require some explanation.

More liberal GAAP assumptions will help earnings to grow at a pace closer to the growth rate of the company.  However, should the company stop growing, or begin to shrink, GAAP earnings will follow those patterns more closely if liberal assumptions are used.  Flat or decreasing GAAP earnings are nearly always a bad thing for market valuations.

Thus, GAAP financial statements, and the actuarial assumptions behind them, require some very careful consideration by management.  Remember, they are a tool for communicating with investors.

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