Although a CPA's primary role as an auditor is to make sure that a company's financial statements are presented fairly and accurately, he must also ensure that the generally accepted accounting principles (GAAP) are followed.
GAAP guidelines help a company determine the amount of financial information it must disclose and help it measure its assets, liabilities, revenues, expenses, and equity. That information makes up the financial statements, including the balance sheet, the income statement, and the statement of cash flows.
The GAAP guidelines, which fill bookshelves in an accountant's office, are highly technical explanations of how a company must report the financial information on each line item of these financial statements, such as how to calculate the value of each asset, liability, or equity on the balance sheet, or how to report revenue and expenses on the income statement.
Accounting standards: Four important qualities
The primary accounting standard-setting body in the U.S. is the Financial Accounting Standards Board, or FASB. It's responsible for developing GAAP, as well as updating the already developed GAAP to reflect changes in the ways companies operate. These changes occur as new ways of doing business become common in the business world.
The FASB specifies four characteristics of useful accounting information that companies need to strive for in their financial reports. These four characteristics form the basis for designing the technical GAAP requirements:
Relevance: Relevant information includes information needed to forecast a company's future earnings or confirm or correct prior expectations. The information must also be timely, which means it must be available to business decision makers before it becomes obsolete. For example, if companies had to report their earnings every five years, the information wouldn't be relevant to most company outsiders, who make decisions about the company more frequently than that.
Reliability: For accounting information to be considered reliable, it must be verifiable, factual, and accurate. The information must also be neutral. In other words, a company can't cherry-pick the information it wants outsiders to see and hide any bad news that it doesn't want to report.
Comparability: Not all companies must collect and present the information in exactly the same way. Some variation is allowed in accounting methods, but a company must disclose what accounting methods it uses. For example, numerous methods are available for tracking inventory, so companies must state which method they use. This requirement makes comparing results from company to company easier.
Consistency: The company must use the same accounting principles and methods from year to year so that financial report readers can compare results with the results of previous years. If a company changes the accounting principles or methods its financial reports are based on, it must tell the financial report readers about the change and provide information regarding how that change impacts previously reported financial results.
Changing principles: More work for the FASB
GAAP principles aren't set in stone. As business needs and the way companies do business change, so must the principles. The auditing industry is the most sensitive to emerging trends in day-to-day reporting practices, so it tends to be the profession that most frequently alerts the FASB to the need for new principles or changes in old ones.
In addition to changes noticed in the field, new legislation or regulatory decisions can be the sources of needed changes in the GAAP.
After hearing from all sources about emerging issues, the FASB decides what technical issues it will add to its agenda to change the GAAP. The board looks at a number of factors when deciding whether an issue is worth changing:
Pervasiveness of issue: The board determines how troublesome the issue is to users, preparers, auditors, and others. It also considers whether the practice being questioned impacts many different kinds of companies and whether the issue is likely to be transitory or to persist for a long time. Only issues that are likely to persist over time are considered for further action.
Alternative solutions: The board considers which of the one or more alternative solutions will improve financial reporting in terms of the key characteristics of relevance, reliability, consistency, and comparability.
Technical feasibility: The board determines whether it can develop a technically sound solution or whether the project under consideration must wait for another issue to be decided as part of a different project also underway. If another issue must be decided first, the board holds off working on the issue.
Practical consequences: The board weighs whether the improved accounting solution is likely to be generally accepted and to what extent addressing a particular issue may cause others, such as the SEC or Congress, to act.
Convergence possibilities: The board determines whether its action on the issue will lead to the elimination of significant differences in standards or practices between the U.S. and other countries, with resulting improvement in the quality of U.S. standards.
Cooperative opportunities: The board considers whether there's international support by one or more other standard setters for undertaking the project jointly or through other cooperative means with the FASB.
Resources: The board must determine whether adequate resources and expertise are available within the FASB or whether the FASB can leverage the work of other standard setters.
If the FASB decides it wants to work on an issue, it begins a long process that can take years before the issue is added to the GAAP. This process includes board meetings that are open to the public, exposure drafts circulated for public comment, and additional board meetings and comment periods, if necessary.