Generally accepted accounting principles (GAAP) are accounting rules used in the preparation, presentation and reporting financial statements in various business entities including private and public companies, not-for-profit organizations as well as government institutions (. GAAP comprises of local accounting frameworks, an accounting laws as well as rules and accounting standards (Jefferey & Dale, 2006).
In the U.S, the federal government is not directly involved in the process of setting accounting rules and standards. Instead, the responsibility of establishing GAAP for private and public companies has been assigned to the Financial Accounting Standards Board (FASB). Security and Exchange Commission (SEC) is responsible for monitoring all publicly-traded companies and ensuring that they follow the set accounting standards in their financial reporting. GAAP requirements for local and state governments are regulated by the Governmental Accounting Standards Board (GASB) while financial reporting in the federal government institutions is controlled by the Federal Accounting Standards Advisory Board (FASAB).
Evolution of GAAP in the U.S.
In the early 20th century, a private organization of professional accountants known as the American Institute of Accountants (AIA) was primarily involved in the development of accounting principles in U.S. At this time, AIA collaborated with several interested groups such as the NY Stock Exchange, Federal Trade Commission and Federal Reserve Board to achieve this primary goal of ensuring accountability and transparency in the public and private companies’ financial reporting (Morris & Campbell, 2006). When the U.S stock market crashed in 1929, the U.S Congress saw the need to create the Securities and Exchange Commission (SEC) to monitor financial reporting in all private and public companies.
After its establishment, SEC was given the mandate to promulgate generally accepted accounting principles for private and public entities which fell under its jurisdiction. To handle this issue better, SEC transferred the responsibility of making GAAP entirely to the accounting profession through the original AIA organization. The AIA organization thrived through leaps and bounds and later in the 20th century, it was renamed into American Institute of Certified Public Accountants (AICPA). Apart from making GAAP, AICPA expanded its scope to cover other activities such as setting the professional standards of performance for certified public accountants (CPAs) and for auditing professionals (Morris & Campbell, 2006).
In the early 1970s, the federal government as well as many financial-statement users expressed concern that, AICPA was playing two conflicting roles as a GAAP maker and as a performance setter for professional auditing standards. As a result, the Financial Accounting Standards Board (FASB) was established in 1973 and it took over the role of setting GAAP requirements which it still plays to date.
Despite all these changes, SEC has retained its legislative mandate to regulate GAAP for publicly-traded companies although both SEC and AICPA still recognize FASB as the authoritative support and first hand maker of GAAP for all public and private companies in U.S (AICPA codification, 2004).
Historical Development of Theory
The debate of the Big GAAP versus Little GAAP has existed in U.S for over 30 years now (Morris & Campbell, 2006). Many accountants have expressed their dissatisfaction with the “one-size-fits-all” accounting standards set by GAAP requirements. For this reason, calls to separate the GAAP requirements for private and public companies have been mounting since as early as 1974 with concerns ranging from excessive public disclosure to the complexity of rules and requirements of GAAP.
Many public certified accountants have in the past expressed concern over the inadequacy of GAAP requirements applied in the smaller companies arguing that the some of these requirements are irrelevant for small private companies. For instance, small-firm practitioners in the early 1974 argued that requiring a small company to name a long list of non-compliance with GAAP was quite confusing for the company’s clients since most of the statements appeared as meaningless and too complex for them (Jeffrey & Dale, 2006).
In 1974, former CPA Journal editor Block stated that making accounting standards mandatory to both public and private companies without exceptions as in the case of GAAP was very wrong. He added that these accounting standards should be made optional for the private companies since in his view, public and private companies are two separate entities which need to be sharply distinguished from one another.
On the contrary, some practitioners in the early 20th century expressed contrasting opinions to those calling for separate GAAP arguing that there is no need for separate GAAP requirements for public and private companies. Naus a co-author of the 1974 Journal of Accountancy argued that separating the rules may weaken the ability of the accounting profession to achieve full and fair presentation and disclosure of financial reports (Jeffrey & Dale, 2006).
Due to the growing concern in regard to the applicability of GAAP requirements in private companies, various AICPA accounting divisions carried out a study in the late 1970s on the application of GAAP requirements in closely-held private businesses. The findings of this study as reported in the 1978 Journal of Accountancy discovered two different sets of principles of GAAP . This included those principles used in the measurement process and those used to regulate public disclosure practices.
The two opposing perspectives pro and against the establishment of separate GAAP requirements triggered a flickering interest in the 1970s. This led to a comprehensive study supported by FASB which provided empirical data on the possibility of having two separate accounting principles one for the public companies and the other for the private companies financial reporting. The findings of the study which was completed in 1983 indicated that, while most accountants acknowledged the benefits of separating the accounting principles, bankers on the other hand felt that a common GAAP was better as it ensured that all companies provided comprehensive and reliable information in their financial reports.
Still in the same year, FASB published a special report which showed that most lenders and creditors shared similar views on that the financial reporting needs for private and public companies are more or less the same (FASB, homepage). This report temporarily settled the issue until 1995 when AICPA Practice Executive Committee renewed the debate of “big GAAP vs small GAAP” arguing that the accounting standards overload was one of the major concerns of accounting professionals practicing in small firms. The issue of a separate GAAP for small companies was again rejected at this time on the basis that, a new basic financial reporting system would only alleviate the overload problem.
In 1996, AICPA released a report on standards overload for private companies which made several recommendations requiring the Financial Accounting Foundation (FAF) to take concerted moves in recruiting and selecting trustees and FASB board members who have a clear understanding of the financial reporting needs of small private companies (Swift, 2003).
At the turn of the 21st century, AICPA decided to take more serious studies in the issue of a separate GAAP for private companies and this move led to the “Big GAAP versus Little GAAP” comprehensive study carried out by AICPA Private Company Financial Reporting Task Force. The main objective of this study which began its research in early 2004 was to determine whether financial statements for private companies prepared in accordance with the current GAAP are able to meet the needs of financial reporting as well as establishing whether the cost of providing such financial statements is justified in regard to the benefits they confer to the respective private companies (AICPA task force report, 2005).
There are many views put across regarding the issue of the current GAAP as applied to both public and private companies. The AICPA task force report of 2005 clearly outlines the inadequacies of having a single GAAP to govern financial reporting in both public and private companies. The main problem with the current GAAP is that it is primarily geared by the public companies and hence it does not meet the financial needs of the private companies. Moreover, both public and private companies have unique financial reporting environments which govern their needs in reporting. Such needs can only be addressed by having separate sets of GAAP which is applicable to individual parties.
Since 1995, the issue of big GAAP versus little GAAP in the U.S had become quite suppressed until the turn of 21st century which has seen it become very popular again. The reason for this renewed interest is primarily as a result of the increased strictness in the regulatory environment for financial reporting, excessive public disclosure of financial reports as required by the current GAAP as well as the international convergence of accounting standards issued by FASB and IASB boards.
In the U.S, there are two major initiatives related to the big GAAP-little GAAP which are of particular interest. This includes the AICPA Private Company Financial Reporting Task Force and FASB Small Business Advisory Committee. This two initiatives have come up with various suggestions regarding whether or not, a new set of GAAP accounting standards are necessary to govern financial reporting in the private companies (Morris & Campbell, 2006).
To address the inadequacy problem of the current GAAP, the AICPA private company financial reporting task force in its 2005 report suggested that, it would be better if the underlying accounting standards for the public versus private companies were made different in certain situations. This is because according to the task force, some GAAP requirements which are highly relevant to the large public companies are of little or no relevance to the private companies.
However, the task force established that allowing GAAP exceptions for the private companies would not fulfill their financial reporting needs, since such a move is bound to erode the entire value of GAAP for the companies hence deteriorating the problem of financial reporting (AICPA discussion paper, 2004). For this reason, AICPA has suggested that a set of new standards for the private companies should be established to meet their financial reporting needs. Such a framework would include; changing the structure of both FAF and FASB to reflect the needs of private companies as well as establishing a new GAAP set of accounting standards boards either under or outside the FAF.
Many studies have been carried out to determine the feasibility of establishing a new set of GAAP standards for the private companies. A study carried out through the support of AICPA on the members of Ohio Society in 2003 has indicated that most people still have mixed feelings on the benefits and limitations of different standards for the private and public companies. However, most CPA sole practitioners feel that there should be some differentiation between those GAAP requirements governing financial reporting in public companies and those governing private companies.
Pros. There are many advantages of differentiating GAAP requirements. For one, separate GAAP requirements would help to maintain the CPE requirements. This is particularly true for sole practitioners who more often than not attend to small clients whose standards are quite simple as opposed to those applied by the larger clients. In this case, separate accounting standards would assist sole practitioners to do continuing education and keep up with the current standards of accounting especially if they only attend to the small clients (ASB, 2004).
The cost issue is another important factor which needs to be considered especially for the small firms which perform work for SEC registrants. It has been noted that there is a substantial cost difference between small clients and large companies/SEC registrants. A little GAAP would ensure that all the costs incurred by the private companies on adhering to the GAAP standards are minimal since it would avoid some complex processes which are only relevant to the big companies.
Moreover, differentiating the GAAP requirements would greatly simplify and ease financial reporting in small companies by getting rid of complex standards which are only applicable to the large companies. This is very important in that, it gives the company’s shareholders and clients all the necessary financial information especially in cases where an outside financial source is involved.
Cons. Despite the huge benefits of splitting GAAP requirements, this move has been met with strong opposition from bankers, creditors, some CPA professionals and other financial statement users. Some CPAs argue that splitting the GAAP requirements at this time when the accounting profession is believed to be quite poor would be ineffective and confusing both for the CPAs and the public at large. They further add that establishing a different set of standards for big companies versus small companies would compromise the current efforts by the IASB to set common financial reporting standards for all entities.
Other opponents also argue that having different standards for the private and public companies is likely to promote negative financial reporting which will in turn erode the public user confidence through simplified reporting. In this case, they argue that by establishing a separate GAAP for private companies, some essential requirements are likely to be omitted and this will make the financial reporting of this companies shallow and inadequate.
According to Wallace & Wortmann (2003), common requirements provide a common ground for those private companies which wish to compare themselves with the larger public companies in terms of performance of competition. In this case, common GAAP requirements enable such companies to learn from their larger competitors and it also equips them with the relevant information which would be very helpful in case they decide to become public corporations in future. Therefore, if separate standards are created, small private companies are likely to face a major difficulty in evolving into publicly-traded companies because according to most opponents, the business environment in the modern society continues to evolve and currently, more financial reporting which is favored by the current GAAP requirements is considered to be trendy by investors and the larger public.
Other opposing views are based on the assumption that, differentiation of small GAAP from large GAAP is likely to cause confusion especially for the practitioners who attend to both small and large companies as well as SEC registrants. The current GAAP requirements are already complex and creating a different set of standards is likely to increase the complexity for the practitioner. In this case, opponents believe that the available AICPA standards, GAAP requirements and the standards set by SEC for public companies adequately address the issue of big GAAP versus little GAAP.
Despite the strong opposition towards the formulation of separate GAAP requirements, many people in the accounting profession agree that the differences which exist between the financial reporting standards for the private and public companies need to be explored and addressed accordingly. CPAs feel that though the contribution of the private sector to the U.S economy is highly significant, the attention given to this sector by the standards-setters is almost non-existent as compared to the attention given to the public sector which contributes much less to the nation’s economic growth and development.
In addition, AICPA feels that a time has come to change the U.S financial reporting system in order to focus more on its quality and not quantity (AICPA discussion paper, 2004). In this case, flexibility of the accounting standards is highly critical in order to effectively address the issue of financial reporting in both private and public companies while at the same time, adequately providing the necessary consistency required to compare the performance of companies operating in the same industry.
To address the issue of big GAAP vs small GAAP, AICPA proposes that standard-setters should aim at providing proper implementation guidelines to CPAs based on a coherent conceptual framework which will allow the accountants to exercise their professional judgment on matters concerning financial reporting.
The underlying foundation of the current GAAP is a conceptual framework which is based and built on the existing IASB and FASB frameworks (IASB preliminary views, 2004). The objective of this conceptual framework is to develop a common foundation for the developing future accounting standards for both public and private companies. This is very important for developing universal accounting standards which are internally consistent, centrally based and internationally converged.
This conceptual framework is being conducted as a joint project by FASB and IASB boards in eight major phases (FASB homepage). Under the conceptual framework, both public and private companies will share similar fundamental underpinnings. Though the framework does not get rid of the current differences in the private and public companies’ accounting standards, it provides the much needed flexibility on how GAAP can be applied to different circumstances.
Since 2002 when the Sarbanes-Oxley Act was passed, there has been many GAAP reforms emerging from SEC, the U.S Congress and other private and public regulatory bodies in U.S. This reforms have been mainly aimed at all aspects of oversight ranging from financial reporting to the role of SEC, GASB as well as the performance of the New York stock exchange (SOX Act 2002). AICPA has taken serious steps towards reforming the accounting profession and by working with other regulatory bodies, AICPA hopes to restore the investor confidence in the local financial markets.
Three major possible approaches to creating a little GAAP for the private companies include:
- Adopting a top-down approach based on the current GAAP which will provide exemptions for the private companies.
- Adopting international financial reporting standards for SMEs with some modifications.
- Developing totally new and independent accounting standards based on the conceptual framework.
According to the 2005 AICPA task force report, there are various fundamental changes which should be implemented in the current GAAP requirements to ensure that financial reporting needs of small private companies are met. The task force has recommended a thorough revision be done on the current GAAP to fit the needs of the private companies. According to the task force, a new GAAP should incorporate concepts which are relevant to the financial reporting of small companies with appropriate funding and dedicated staff to put into consideration the needs of the private companies.
The task force has further recommended that, all the representatives of private companies should come together to determine who should be responsible for establishing a little GAAP, come up with a strategy on how fundamental changes can be implemented in the current GAAP standards and finally, develop and monitor the whole process of little GAAP implementation. However, the task force recognizes that such substantive changes can only be effected over time and thus it has thus recommended that the FASB and FAF work together to facilitate timely change.
The issue of Big GAAP versus Little GAAP has been around since the early 1970s and in the recent years, this debate has attracted a lot of attention among accountant professionals, bankers, auditors among others. One of the major factors which has led to this non-ending debate is the diversity of the needs of those people who use financial statements released by either the private and public companies. According to the AICPA task force 2005 report, much of the pressure for a different set of GAAP requirements for the private companies comes from the accounting practitioners and not the users. All in all, the above discussion shows that there is a dire need for an alternative set of GAAP requirements in order to meet the financial reporting needs of the private companies.
As clearly put by the FASB chairman Robert Hertz in 2005, private companies play a key role in the growth and development of a nation’s economy (Jeffrey & Dale, 2006). It is thus critical that the needs pertaining to the financial reporting in the private sector be addressed through a conceptually sound, relevant, cost effective and reliable framework of information. However, this does not necessarily mean that there should be two sets of GAAP separate requirements which have no common components but rather, most CPAs feel that a differentiation is necessary to show which standards apply to the small or to the large companies. This would go a long way in addressing the financial reporting needs of the private companies more effectively.
With increasing pressure calling for a split in the current GAAP, the dream of a small GAAP which started in the early 1970s is likely to be realized whereby, separate standards will be created to meet the individual financial reporting needs of the private and public companies in U.S.
- Accounting Standards Board. (2004). Amendment to Financial Reporting Standard for Smaller Entities.
- American Institute of Certified Public Accountants. (2004). Codification of Auditing Standards.
- American Institute of Certified Public Accountants. (2004). Private Company Financial Reporting Discussion Paper. Retrieved on 2 November, 2008, from <<http://www.aicpa.org/download/news/2004/Discussion_Paper_5-10-04.pdf>>
- American Institute of Certified Public Accountants. (2005). Private Company Financial Reporting Task Force Report. Retrieved on 2 November, 2008, from http://www.aicpa.org/members/div/acctstd/pvtco_fincl_reprt/download/Report_Draft_Final.pdf
- Financial Accounting Standards Board. (2004). Small Business Advisory Committee: Agenda. Retrieved on 2 November, 2008, from <<http://www.fasb.org/small_business_advisory_committee/sbac_mtg_handouts.shtml>>
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- Sarbanes Oxley Act of 2002. Retrieved on 2 November, 2008, from <<http://corporate.findlaw.com/industry/corporate/docs/publ107.204.html>>
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- Wallace, E. & Wortmann, R. (2003). Two GAAPs or Not Two GAAPs? Pennsylvania CPA Journal, Fall 2003.