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5. The Development of GAAP

Generally accepted accounting principles, or GAAP, encompass the rules, practices, and procedures that define the proper execution of accounting. It is important to note that this definition is quite broad, taking in more than just the specific rules issued by standard setters. It encompasses the longstanding methodologies and assumptions that have become engrained within the profession through years of thought and development. Collectively, GAAP form the foundation of accounting by providing comprehensive guidance and a framework for addressing most accounting issues.

5.1. The Audit Function

To provide a measure of integrity, financial reports of public companies are required to be audited by independent CPAs. Auditors will spend considerable time in evaluating the systems and data that lead to the reported financial statements. At the end of the day, however, the auditor will usually only issue an opinion letter on the fairness of the reports. This letter is rather brief and to the point and includes a paragraph similar to the following:

In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of [at] December 31, 20X3 and 20X2, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 20X3, in conformity with U.S. generally accepted accounting principles.

Note that the auditor is expressing an opinion about the conformity of the financial statements with generally accepted accounting principles. Thus, conformity with GAAP is the key to obtaining the desired audit opinion. Being alert to the detection of potential fraud is important, but it is not the primary mission of a financial statement audit. If you are quite astute, you will also note the reference to U.S. GAAP. This chapter will conclude with a discussion of global accounting issues.

5.2. The Development of GAAP

In one sense, GAAP traces its roots to the renaissance era when creative mathematicians conceived the double-entry system and the related self-balancing statements of account. However, modern efforts to bring structure and conformity are most clearly understood by considering a time line of events that were catalysts for institutionalization of GAAP development.

5.3. The 1929 Stock Crash and Great Depression

A dark moment in economic history was the collapse of the stock markets in 1929, and the ensuing shock waves that brought about business failures, unemployment, bankruptcies, and a prolonged period of economic difficulty. What you may not know is that it was preceded by several years of grand economic expansion. The introduction of assembly lines, electricity, phones, automation and other innovations created enhanced productivity and wealth. These opportunities for profit attracted large amounts of investment capital in pursuit of the hottest new concept. And, the stock markets reflected this excitement by climbing upward in what seemed to be an unstoppable phoenix. Toward the end of the expansion streak, the burgeoning supply of capital in pursuit of business opportunities surpassed the legitimate opportunities for its effective deployment, and businesses began to struggle to make the profits expected by investors. As you might suspect, some business began to stretch the limits of fair accounting in an effort to keep up a good front. Finally, though, economic truth prevailed, and investors were quickly unnerved. Capital took flight, and it was a long time before investors were willing to tread back into the capital markets.

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