Understanding GAAP

So many contracts contain the phrase “in accordance with generally accepted accounting principles,” but do lawyers really understand what this phrase means or how it may affect a client in any given contract? Generally accepted accounting principles, often referred to simply as GAAP, constitute a body of rules, principles, and practices that is not as well defined as many people think, despite the fact that the fortunes of a company, its managers, and its investors can rise and fall depending on how GAAP is applied to determine the company's financial results. Before placing the above phrase in a contract, a lawyer should have at least a basic understanding of how that phrase may operate within the contractual terms.

U.S. GAAP is the term that describes the rules companies use to prepare financial statements ' the rules that tell companies how to account for transactions and disclose the results. When people refer to GAAP, they generally mean the body of accounting rules developed from a succession of different standard setters. Today, these rules have mostly been rolled into one primary authoritative source known as the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“Codification”). However, not all of the rules that companies follow as GAAP are found in the Codification. The Codification excludes some followed guidance and even leaves some of the principles up to industry practice. For example, the very basic definition of an asset is not in the Codification. The term “asset” is defined in a FASB Concepts Statement, but FASB Concepts Statements have been excluded from the Codification and, thus, are non-authoritative literature that, nonetheless, are considered GAAP in the absence of specific guidance in the Codification.

Why GAAP Matters to Contracts

The significant majority of GAAP clauses in contracts require that the financial statements of one or more of the contracting parties be prepared “in accordance with generally accepted accounting principles.” For example, a franchise agreement might require a franchisee to prepare its financial statements in accordance with GAAP so the parties can determine the appropriate annual franchise fee. In this context, the phrase is boilerplate language that usually is appropriate. However, there are situations in which a contracting party may want to caveat the boilerplate language, because applying GAAP often is not a straightforward task ' it requires judgment by preparers of financial statements. If contracting parties are unwilling to live with the uncertainty that these types of rules produce, then they should consider revising or caveating the boilerplate language.

Example: Caveating boilerplate language for anticipated changes in GAAP. FASB's proposed changes to the way parties must account for operating leases is a timely example of why franchisees and franchisors may wish to alter boilerplate language in their contracts. A debtor typically violates a debt covenant if its liabilities exceed a certain amount, derived from financial statements prepared in accordance with GAAP. Currently, under GAAP, lessors and lessees do not have to reflect operating leases on their balance sheets. But a proposed change to GAAP would require these entities to report operating leases as both assets and liabilities on their balance sheets: The asset for the lessee would reflect the lessee's right to use the leased property, and the corresponding liability would be the present value of the future lease payments. The resulting change could mean an increase in booked liabilities, which could cause entities to violate their debt covenants, even though the entities would not be in any different economic position after this accounting change than they were before the accounting change.

This adverse consequence could occur if FASB decided to apply these proposed rules to leases existing on the date the rules become effective. Because no one knows whether these proposed rules ultimately will become GAAP or whether they would apply to leases existing on the rules' effective date, parties entering into debt covenants now should consider protecting themselves by adding the specific language that a change to GAAP's lease accounting rules would not, in itself, cause the debt covenants to be violated.

Example: Specifying a non-GAAP standard in assigning maintenance costs. Contracts also might contain language that requires the contracting party to apply GAAP rules to a specific transaction or type of transaction. In that instance, the parties may want to specify how GAAP is to be applied, that non-GAAP accounting principles should be applied, or that certain non-accounting rules should be applied.

A common occurrence in commercial leases is for the lease to specify that certain costs will be assigned to one contracting party in accordance with GAAP. For example, a commercial lease might require a tenant to pay a percentage of all building maintenance costs during the year that such costs are expensed, in accordance with GAAP. In this example, assume a tenant is responsible for 10% of all such maintenance costs. At first glance, this provision seems fine. However, a lawyer drafting such a lease needs to look past the words to see the financial reality for the contracting parties.

If a cost is expensed in its entirety when incurred, the tenant would be responsible for 10% of the cost in that year. However, if the cost is capitalized and amortized over five years, then the tenant would be responsible for only 10% of the yearly amortized amount. Spreading the payments over five years can produce a significant savings to the tenant from a time-value-of-money perspective. Moreover, if a major maintenance expense occurs in the lease's last year, and the tenant plans not to renew the lease, the tenant would pay only 10% of one year's amortized cost. In contrast, should the landlord expense the entire maintenance cost in the last year of the tenant's lease, the tenant would be responsible for 10% of the entire cost. So the accounting question facing the drafting lawyer is, “What are the GAAP rules for capitalizing versus deducting maintenance expenses?” The practical question, then, becomes, “How will these accounting rules affect my client?”

The lawyer would find, much to his or her dismay, that the GAAP rules are gray in this instance. The Codification is silent on whether to expense or capitalize maintenance costs, which leaves the decision to capitalize or expense any given maintenance cost to industry practice. It is understandable that a tenant, particularly a large tenant that might be responsible for much more than 10% of annual maintenance expenses, would want more clarity. Fortunately, the federal tax rules, including the Internal Revenue Code, case law, and various regulatory rulings, are much more developed on this issue than the GAAP rules, and they provide much more clarity on when to expense and when to capitalize costs. A tenant, therefore, could insist that a lease contain language stating that, for purposes of determining the tenant's annual maintenance obligation, the maintenance costs will be expensed or capitalized in accordance with federal tax rules and their interpretations.

What Effect International Accounting Standards Might Have on U.S. Contracts

When one refers to GAAP in the United States, he or she typically means GAAP as codified in the FASB Codification. Some contracts will specifically reference “U.S. GAAP,” but many others simply will reference “GAAP.” It is quite possible, though, that as early as 2015, the Securities and Exchange Commission will require U.S. publicly traded companies to begin using GAAP as promulgated by the International Accounting Standards Board. This international GAAP is known as International Financial Reporting Standards (“IFRS”).

If this occurs, IFRS will replace the FASB Codification as GAAP for U.S. publicly traded companies. If the SEC makes such a move, it is possible that the FASB will state that IFRS also will constitute GAAP for all non-publicly traded entities, but it is not certain if or when the FASB would do so. So the United States could have a bifurcated system, at least for a few years, in which GAAP for publicly traded companies consist of IFRS, but GAAP for all other companies consist of the FASB Codification (along with current non-authoritative sources such as FASB Concepts Statements).

When drafting a contract, the parties may want to consider whether to specify that the GAAP to be applied is that recognized by the SEC as appropriate for publicly traded companies or that recognized by the FASB as appropriate for all other types of entities. For long-term contracts, the parties also might want to understand what effect a move to IFRS will have on any contractual provisions pegged to GAAP.

Conclusion

Lawyers need not be accounting experts to properly draft contracts that require adherence to GAAP. They, however, should realize that sometimes placing a clause in a contract that requires a financial item to be determined in accordance with GAAP might produce adverse consequences for their clients. Therefore, before placing such clauses in contracts, lawyers should have at least a basic understanding of how those clauses will operate and whether there are any potential changes to GAAP on the horizon that may alter the manner in which the contracts are applied.

Joan Rood is counsel in the Washington, DC, office of Buchanan Ingersoll & Rooney, PC, and focuses her practice on tax and accounting matters. Laura Kinney is an associate in the same office and focuses her practice on tax, accounting, and employee benefits. Both authors provide editorial services for the Bureau of National Affair's Accounting Policy and Practice Series.

So many contracts contain the phrase “in accordance with generally accepted accounting principles,” but do lawyers really understand what this phrase means or how it may affect a client in any given contract? Generally accepted accounting principles, often referred to simply as GAAP, constitute a body of rules, principles, and practices that is not as well defined as many people think, despite the fact that the fortunes of a company, its managers, and its investors can rise and fall depending on how GAAP is applied to determine the company's financial results. Before placing the above phrase in a contract, a lawyer should have at least a basic understanding of how that phrase may operate within the contractual terms.

U.S. GAAP is the term that describes the rules companies use to prepare financial statements ' the rules that tell companies how to account for transactions and disclose the results. When people refer to GAAP, they generally mean the body of accounting rules developed from a succession of different standard setters. Today, these rules have mostly been rolled into one primary authoritative source known as the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“Codification”). However, not all of the rules that companies follow as GAAP are found in the Codification. The Codification excludes some followed guidance and even leaves some of the principles up to industry practice. For example, the very basic definition of an asset is not in the Codification. The term “asset” is defined in a FASB Concepts Statement, but FASB Concepts Statements have been excluded from the Codification and, thus, are non-authoritative literature that, nonetheless, are considered GAAP in the absence of specific guidance in the Codification.

Why GAAP Matters to Contracts

The significant majority of GAAP clauses in contracts require that the financial statements of one or more of the contracting parties be prepared “in accordance with generally accepted accounting principles.” For example, a franchise agreement might require a franchisee to prepare its financial statements in accordance with GAAP so the parties can determine the appropriate annual franchise fee. In this context, the phrase is boilerplate language that usually is appropriate. However, there are situations in which a contracting party may want to caveat the boilerplate language, because applying GAAP often is not a straightforward task ' it requires judgment by preparers of financial statements. If contracting parties are unwilling to live with the uncertainty that these types of rules produce, then they should consider revising or caveating the boilerplate language.

Example: Caveating boilerplate language for anticipated changes in GAAP. FASB's proposed changes to the way parties must account for operating leases is a timely example of why franchisees and franchisors may wish to alter boilerplate language in their contracts. A debtor typically violates a debt covenant if its liabilities exceed a certain amount, derived from financial statements prepared in accordance with GAAP. Currently, under GAAP, lessors and lessees do not have to reflect operating leases on their balance sheets. But a proposed change to GAAP would require these entities to report operating leases as both assets and liabilities on their balance sheets: The asset for the lessee would reflect the lessee's right to use the leased property, and the corresponding liability would be the present value of the future lease payments. The resulting change could mean an increase in booked liabilities, which could cause entities to violate their debt covenants, even though the entities would not be in any different economic position after this accounting change than they were before the accounting change.

This adverse consequence could occur if FASB decided to apply these proposed rules to leases existing on the date the rules become effective. Because no one knows whether these proposed rules ultimately will become GAAP or whether they would apply to leases existing on the rules' effective date, parties entering into debt covenants now should consider protecting themselves by adding the specific language that a change to GAAP's lease accounting rules would not, in itself, cause the debt covenants to be violated.

Example: Specifying a non-GAAP standard in assigning maintenance costs. Contracts also might contain language that requires the contracting party to apply GAAP rules to a specific transaction or type of transaction. In that instance, the parties may want to specify how GAAP is to be applied, that non-GAAP accounting principles should be applied, or that certain non-accounting rules should be applied.

A common occurrence in commercial leases is for the lease to specify that certain costs will be assigned to one contracting party in accordance with GAAP. For example, a commercial lease might require a tenant to pay a percentage of all building maintenance costs during the year that such costs are expensed, in accordance with GAAP. In this example, assume a tenant is responsible for 10% of all such maintenance costs. At first glance, this provision seems fine. However, a lawyer drafting such a lease needs to look past the words to see the financial reality for the contracting parties.

If a cost is expensed in its entirety when incurred, the tenant would be responsible for 10% of the cost in that year. However, if the cost is capitalized and amortized over five years, then the tenant would be responsible for only 10% of the yearly amortized amount. Spreading the payments over five years can produce a significant savings to the tenant from a time-value-of-money perspective. Moreover, if a major maintenance expense occurs in the lease's last year, and the tenant plans not to renew the lease, the tenant would pay only 10% of one year's amortized cost. In contrast, should the landlord expense the entire maintenance cost in the last year of the tenant's lease, the tenant would be responsible for 10% of the entire cost. So the accounting question facing the drafting lawyer is, “What are the GAAP rules for capitalizing versus deducting maintenance expenses?” The practical question, then, becomes, “How will these accounting rules affect my client?”

The lawyer would find, much to his or her dismay, that the GAAP rules are gray in this instance. The Codification is silent on whether to expense or capitalize maintenance costs, which leaves the decision to capitalize or expense any given maintenance cost to industry practice. It is understandable that a tenant, particularly a large tenant that might be responsible for much more than 10% of annual maintenance expenses, would want more clarity. Fortunately, the federal tax rules, including the Internal Revenue Code, case law, and various regulatory rulings, are much more developed on this issue than the GAAP rules, and they provide much more clarity on when to expense and when to capitalize costs. A tenant, therefore, could insist that a lease contain language stating that, for purposes of determining the tenant's annual maintenance obligation, the maintenance costs will be expensed or capitalized in accordance with federal tax rules and their interpretations.

What Effect International Accounting Standards Might Have on U.S. Contracts

When one refers to GAAP in the United States, he or she typically means GAAP as codified in the FASB Codification. Some contracts will specifically reference “U.S. GAAP,” but many others simply will reference “GAAP.” It is quite possible, though, that as early as 2015, the Securities and Exchange Commission will require U.S. publicly traded companies to begin using GAAP as promulgated by the International Accounting Standards Board. This international GAAP is known as International Financial Reporting Standards (“IFRS”).

If this occurs, IFRS will replace the FASB Codification as GAAP for U.S. publicly traded companies. If the SEC makes such a move, it is possible that the FASB will state that IFRS also will constitute GAAP for all non-publicly traded entities, but it is not certain if or when the FASB would do so. So the United States could have a bifurcated system, at least for a few years, in which GAAP for publicly traded companies consist of IFRS, but GAAP for all other companies consist of the FASB Codification (along with current non-authoritative sources such as FASB Concepts Statements).

When drafting a contract, the parties may want to consider whether to specify that the GAAP to be applied is that recognized by the SEC as appropriate for publicly traded companies or that recognized by the FASB as appropriate for all other types of entities. For long-term contracts, the parties also might want to understand what effect a move to IFRS will have on any contractual provisions pegged to GAAP.

Conclusion

Lawyers need not be accounting experts to properly draft contracts that require adherence to GAAP. They, however, should realize that sometimes placing a clause in a contract that requires a financial item to be determined in accordance with GAAP might produce adverse consequences for their clients. Therefore, before placing such clauses in contracts, lawyers should have at least a basic understanding of how those clauses will operate and whether there are any potential changes to GAAP on the horizon that may alter the manner in which the contracts are applied.

Joan Rood is counsel in the Washington, DC, office of Buchanan Ingersoll & Rooney, PC, and focuses her practice on tax and accounting matters. Laura Kinney is an associate in the same office and focuses her practice on tax, accounting, and employee benefits. Both authors provide editorial services for the Bureau of National Affair's Accounting Policy and Practice Series.