WFU Law School
Law & Valuation
3.1.1 History of Accounting

3.1.2 Accounting Reports and GAAP

An accounting system involves keeping records of business transactions as they occur and producing reports that summarize the results of the transactions. The reports, called financial statements, are typically prepared according to generally accepted accounting principles (GAAP). The most basic and most frequently encountered financial statements are:

  • the balance sheet
  • the income statement
  • the statement of cash flows

These reports are meant to provide financial information useful to persons making economic decisions about a company, including the owners, managers, investors, and creditors.

Reading financial statements

For publicly-traded companies these essential accounting statements are typically found in a company's annual report.

How do you read an annual report? The Motley Fool has some suggestions.

Accounting 'Cheat Sheet'
10 tips to keep your company out of trouble

Stanley Siegel Corporate Counsel 10-08-2002

The mere mention of financial statements these days sends shivers down the spines of many corporate attorneys. Even before this year's debacles in accounting and financial disclosure, many lawyers doubted their ability to draw meaningful conclusions from these invariably complex and often ambiguous documents.

Today, with multiple revelations of accounting failures grabbing the headlines, forming these opinions has become even harder and more important. How should an in-house lawyer review the financial statements of his employer, and those of companies with whom his business is involved?

Here are 10 rules of the road. (More>>)

What is GAAP? These are the rules of thumb that must be followed by most publicly held corporation in the United States when they report their financial operations to the public. GAAP is not codified, but instead is a set of rules and principles that describe how accountants should report business/fianancial events.

Who sets GAAP? It's kind of like the question - who creates the common law? The most authoritative accounting standards are published by the Financial Accounting Standards Board (FASB), a panel created by the main financial disclosure regulator (Securities & Exchange Commission) and the leading accounting professional group (American Institute of Certified Public Accountants). (The predecessor of FASB was the Accounting Principles Board, whose pronouncements hold weight to the extent FASB has not overruled them.)

Since 1973, the Financial Accounting Standards Board (FASB) has been the designated organization in the private sector for establishing standards of financial accounting and reporting. Those standards govern the preparation of financial reports. They are officially recognized as authoritative by the Securities and Exchange Commission (Financial Reporting Release No. 1, Section 101) and the American Institute of Certified Public Accountants (Rule 203, Rules of Professional Conduct, as amended May 1973 and May 1979). Such standards are essential to the efficient functioning of the economy because investors, creditors, auditors and others rely on credible, transparent and comparable financial information.

From FASB Statement of Mission and Structure (

Next in the hierarchy are accounting standards published by AICPA, followed by general principles found in practice and the accounting literature. Although the SEC has statutory authority to set accounting rules, the agency has mostly deferred to the accounting profession.

Public Company Accounting Ovesight Board. In response to the spate corporate scandals, the Sarbanes-Oxley Act of 2002 created a new Public Company Accounting Oversight Board to oversee the audits of public companies. The board's functions include --

  • registering public accounting firms
  • establishing rules to govern auditing, quality control, ethics, and independence
  • inspecting public accounting firms (and those associated with the firms)
  • enforcing compliance by disciplining and sanctioning auditing firms.

The Board has five financially-literate members, appointed for five-year terms and serving on a full-time basis. Exactly two of the members must be or have been certified public accountants. Board members are appointed by the SEC, after consultation with the Chair of the Federal Reserve Board and the Secretary of the Treasury. (This is where Harvey Pitt got into trouble when it first seemed he would appoint John Biggs, the retiring head of TIAA-CREF, and then appointed William Webster, without disclosing that Webster had served on the audit committee of a company engaged in questionable accounting practices.)


The Securities and Exchange Commission staff will keep working toward accepting foreign firms' financial filings made under international accounting standards and a key task in the process will be gauging annual reports to be completed by mainly European-listed companies for 2005 and 2006, the SEC's chief accountant says. He pledges to work "for full acceptance of international accounting standards to the point that we believe" public company accounting carried out under them is close to accounting done under U.S. generally accepted accounting principles. . . .

Under the Board's audit standards, auditors must evaluate whether company records accurately and fairly reflect company transactions, be reasonably sure that company transactions are authorized by senior management or the company's board, be reasonably sure transactions are recorded so financial statements can be prepared in accordance with GAAP, and describe any material weaknesses in the internal controls.

Auditors of public companies (including foreign firms that audit US-traded companies) must register with the Board. Public companies (based on their equity capitalization) must pay fees to fund the Board, as well as to fund FASB which will continue to set GAAP.

The Board is to conduct annual quality reviews (inspections) for firms that audit more than 100 public companies; all others must be conducted every 3 years. The Board can discipline or sanction registered firms and their associates for intentional conduct or repeated instances of negligent conduct.

3.1.1 History of Accounting

©2003 Professor Alan R. Palmiter

This page was last updated on: March 29, 2004