By Jay Richardson
Financial statements¹ are integral to a business transaction and are referred to frequently in transaction documents. Many of those agreements also refer to generally accepted accounting principles (GAAP).² GAAP is not fully understood even by accountants. Indeed, one prominent local CPA told the author that asking what the meaning of life is might be an easier question to answer than what is GAAP. Thus, it is not surprising that the author has seen a wide variety of references to GAAP in transaction documents. Though many transaction lawyers refer to GAAP in their documents, they may not fully understand its meaning, scope, and implications. In short, there may be a GAAP “gap” in transaction documents. This article provides guidance to attorneys whose transaction documentation involves references to financial statements and financial statement standards such as GAAP.
A brief overview of GAAP
Financial reporting standards is the language that communicates key financial information. If financial statements are prepared following GAAP, then the user can compare an issuer’s financial performance (i) year-over-year and (ii) with another issuer’s financial statements. GAAP financial statements provide a level of credibility to an issuer’s financial statements. GAAP must be followed when an issuer distributes its financial statements outside of the issuer. (In this article, “user” refers to any outside entity or person that receives financial statements, such as government, a buyer, lender, or landlord; and “issuer” refers to the entity that issues the financial statements such as a seller, borrower, or tenant.)
The Financial Accounting Standards Board (FASB) – along with the Securities Exchange Commission (SEC) for public companies – determines GAAP. GAAP is not static. Standards evolve as the FASB and SEC explore new ways to improve the understandability of financial statements for users.
A key GAAP principle is “consistency,” which means that once an issuer adopts an accounting principle or method, the issuer must continue to follow it. The issuer can change an accounting method if the new method improves the understandability of the financial statements.
If a privately held entity communicates only with its owners and management, financial reporting that employs GAAP standards is not required. Indeed, most issuers do not follow every GAAP standard. However, GAAP may be required by a user as discussed below.
GAAP and CPAs
An issuer can prepare GAAP-based financial statements in Oregon without the assistance of an independent CPA. A CPA can be hired to compile GAAP-compliant financial statements or “attest” to the issuer’s financial statements. Attested financial statements will be either audited or reviewed.
Audited financial statements provide the best assurance that the issuer’s financial statements are materially accurate. An audit also considers the issuer’s internal accounting controls and may identify material weaknesses or significant deficiencies in those controls. An audit opinion letter will read something like this:
“The financial statements present fairly, in all material respects, the financial position of issuer as of December 31, 20XX, and the results of its operations and its cash flows for the year then ended in accordance with GAAP...”
Reviews provide limited assurance on the issuer’s financial statements. Reviews rely upon the CPA’s inquiry of company management, and the performance of analytical procedures applied to financial data. These procedures are significantly less in scope than the substantive testing that is performed in an audit. As such, in a review, a CPA is less likely than in an audit to identify missing or inaccurate amounts in the financial statements. If financial statements are reviewed, the CPA’s letter will say:
“Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in accordance with GAAP.”
Compiled financial statements (write-ups) provide no assurance on the issuer’s financial statements. The CPA is obligated to investigate any obvious GAAP departures. There is very little CPA attestation of compiled financial statements.
In an audit or a review, the CPA’s opinion is limited by a materiality standard. In an audit, the CPA is opining that the financial statements “fairly present” the issuer’s financial condition; but does not promise accuracy. Audited, reviewed, and compiled financial statements are not a guarantee that an issuer’s financial statements are free from fraud, errors, or omissions. Users are always encouraged to read the CPA’s “opinion letter” carefully.
Excerpted from the article originally published in the February / March 2019 edition of The Accountant. Read the full story: Bridging the GAAP: Understanding references to Generally Accepted Accounting Principles in business transaction documents (PDF)