June/July 2010 / Features
The Impact of Changing Accounting Rules on Existing Contracts
Generally Accepted Accounting Principles (“GAAP”) are frequently revised and the revisions may affect several aspects of a company’s financial statements. It is essential that this fact be taken into account when entering into contracts containing provisions that are tied to numbers derived from financial statements.
To address this issue, in a contract GAAP generally is defined in one of two ways: as it may be amended from time to time (floating GAAP), or as it is at the time of the contract (fixed GAAP). With floating GAAP, as accounting principles change so too do the meanings of contractual provisions tied to GAAP. With fixed GAAP, the company must keep two sets of books, one for its financial statements and another to make calculations relating to the contract.
Contracts potentially affected by GAAP changes include credit agreements, indentures governing bonds, merger and acquisition agreements, and employment agreements with related compensation arrangements. Revenue recognition polices, expense recognition policies, the timing of expenses, inventory valuation, the booking of reserves, whether or not an instrument or obligation is accounted for as debt, and a company’s hedging and derivatives policies all could be affected by changes in the GAAP.
The possible impact of proposed as well as current GAAP changes should be clearly laid out in public disclosures.