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GAAP

  • GAAP stands for “Generally Accepted Accounting Principles”
  • Refers to a common set of rules/standards to be used when preparing financial reports for external parties (investors and creditors)
  • When a publicly-traded company is preparing its financial statements, these financial reports must be prepared according to GAAP
  • GAAP is not the same for each country
    • Some countries (e.g., the United States) use their own local GAAP
    • Other countries use the International Financial Reporting Standards (IFRS)

Standard-setters

  • U.S. GAAP
    • In the United States, the Securities and Exchange Commission (SEC) has the authority to create accounting standards
    • However, the SEC has delegated this authority to a private, non-profit organization called the Financial Accounting Standards Board (FASB)
        • Before the FASB, there was the Committee on Accounting Procedure (CAP) from 1939-1959 and the Accounting Principles Board (APB) from 1959-1973
    • The seven board members of the FASB are appointed by another private organization, the Financial Accounting Foundation, to 5-year terms
    • The FASB periodically issues Accounting Standards Updates (ASUs) that amend the Accounting Standards Codification (ASC)
    • The ASC is organized by areas, topics, subtopics, sections and paragraph
    • The ASC includes all the rules that comprise GAAP
    • The FASB is assisted by two organizations:
      • The Financial Accounting Standards Advisory Committee (FASAC) provides advice to the FASB
      • The Emerging Issues Task Force (EITF) addresses issues of divergent accounting practice by reaching a consensus about the appropriate accounting treatment with the existing GAAP rules (they handle issues so the FASB doesn’t have to get involved; they focus on short-term projects while the FASB does long-term projects)
  • IFRS
    • IFRS are created by the International Accounting Standards Board (IASB)
      • However, the IASB has about twice the number of board members as the FASB
    • The IASB is a private organization based in London with board members from around the world
    • The structure of the IASB is similar to the FASB in several respects
      • IASB board members are selected by the IFRS Foundation
      • The IASB is supported by an advisory council and an IFRS Interpretations Committee (the Interpretations Committee has a similar role to that of the EITF)
      • However, the IASB has about twice the number of board members as that of the FASB

The FASB’s Conceptual Framework

  • The FASB created a conceptual framework to guide the develop of GAAP
    • The conceptual framework includes the accounting elements (assets, liabilities, equity, revenues, expenses, gains, losses, comprehensive income, investments by owners, distributions to owners) and qualitative characteristics of financial accounting information
    • The fundamental characteristics are relevance (predictive value, confirmatory value, materiality) and faithful representation (completeness, neutrality, freedom from error)
    • The enhancing characteristics are timeliness, verifiability, comparability, and understandability)

The SEC and Reporting Requirements for Publicly-traded U.S. Firms

  • The Securities Act of 1933 and The Securities Exchange Act of 1934 were passed by Congress to restore investors’ confidence following the stock market crash of 1929 and the onset of the Great Depression
    • The Securities Act of 1933 required firms to provide extensive financial disclosures when issuing stock to the public
    • The Securities Exchange Act of 1934 required all publicly-traded firms to periodically file audited financial reports with the newly-created SEC
      • Firms must file an annual report (the 10-K) and quarterly reports (the 10-Q). They must also file a report (the 8-K) whenever there is a material event such as a bankruptcy, change of ownership, etc.
  • The SEC can enforce securities laws, hold disciplinary proceeds, and bring legal action or sanctions against publicly-traded companies to protect investors and creditors

The Sarbanes-Oxley Act (SOX)

  • SOX is a federal law passed in response to a wave of accounting frauds in 2002
  • SOX requires the CEO and CFO of a company to certify the veracity of the financial statements and imposes strict penalties for fraud
  • SOX requires companies to issue a statement regarding the effectiveness of their internal controls; it also requires a company’s auditor to issue a statement regarding the effectiveness of the company’s internal controls
  • Audit firms must have a second partner review all audit reports
  • The lead partner and reviewing partner cannot audit the same client for more than 5 years
  • Audit are prohibited from providing a number of nonaudit services to their audit clients (this is to prevent auditors from losing their objectivity if they are receiving a lot of money in nonaudit fees from a client)
  • SOX also created the Public Company Accounting Oversight Board (PCAOB)
    • The PCAOB’s role is to regulate the audit industry
      • The PCAOB is in charge of creating auditing standards for audit firms
      • Any audit firm with a publicly-traded client must register with the PCAOB
      • The PCAOB will periodically sample audits to make sure auditors are doing a good job
      • The PCAOB has the ability to discipline audit firms and impose sanctions