Generally Accepted Accounting Principles (GAAP)
GAAP provide reporting companies, investors, lenders, and others with a framework that covers both general principles and specific practices. In many areas of legal practice—from mergers and acquisitions to litigation—knowing the basics of financial reporting allows the user to ask intelligent questions and understand where crucial pitfalls may lie.
GAAP is the standard framework of guidelines for financial reporting in the United States, compared to international financial reporting standards (IFRS). U. S. GAAP includes the standards, conventions, and rules accountants follow in recording and summarizing transactions, and in the preparation of financial statements. One key aspect of GAAP is an emphasis on "general,” which does allow for some discretion in how rigidly a particular principle is followed. Some observers have called GAAP a “six lane highway” where all lanes are legal, but not the same. In essence GAAP accommodates some variation in applied accounting methods as long as the methods generally adhere to this set of principles.
In theory, adherence to GAAP allows investors and other users to make informed decisions about the financial condition of a company. Thirdparties who must rely on financial statements have a right to be confident that the data are free from bias and inconsistency, whether deliberate or not. This requires:
1) Credible information
2) Full and Fair Disclosure
3) Consistency and Comparability between Entities
It also requires regularly re-visiting the underlying principles, their use or misuse in the world of financial reporting, and whether the principles require more structure. For the last thirty six years the Financial Accounting Standards Board (FASB) has been the designated quasi-public organization for establishing standards of financial accounting. The Securities and Exchange Commission (SEC) officially recognizes FASB rules as authoritative, although the SEC has statutory authority to establish financial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934.
Besides the FASB and the SEC, the other major contributors to GAAP standards and practice include the American Institute of CPAs (AICPA) – a private entity that often address specialized industries or specialized transactions- and the International Accounting Standards Board –another private entity, which provides guidance and promotes the use of international financial reporting standards. This public-private partnership has been tested by financial crisis, both the current failures (think Bear Stearns) and past scandals (remember Enron). Irrespective of these issues, the long standing reliance on the private sector is unlikely to change in the foreseeable future. [Congress recently told the FASB to revise the fair value standards or they, Congress, would do it for them.]
What’s also clear from recent and historical events is that adhering to GAAP principles does not always ensure that we have credible information, full and fair disclosure, or consistency and comparability in reporting between entities. This may be true for many reasons ranging from the judgment of management and/or auditors to outright fraud.
For instance, when is revenue recognized by a company, and how appropriate or accurate is the matching of expenses to those revenues? There’s some degree of subjectivity to this “matching principle” and it is just one of many areas where we rely on management’s judgment in compiling the financial statements. Usually there’s an honest effort, and internal controls, that lead to fair, though perhaps somewhat subjective, reporting. Of course the auditors, the “GAAP police” evaluate whether the financial statements prepared by management are in accordance with GAAP. In the more extreme example, management may be highly deceptive and supply unreliable information or omit certain material data. One way to try and overcome these types of errors or omissions is in the auditing process. That’s where Generally Accepted Auditing Standards (GAAS) fit in.
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