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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.
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