Defense contractors are required by DFARS (DoD FAR Supplement) 252.242-7006, Accounting System Administration, to establish and maintain an acceptable accounting system. The clause defines "acceptable" by listing eighteen criteria. (By the way, these eighteen criteria closely mirror the requirements of the SF Form 1408, Preaward Survey of Prospective Contractor Accounting System which most contractors are aware of). The eighteenth criteria states that the accounting system must provide for accounting practices in accordance with standards promulgated by the Cost Accounting Standards Board, if applicable, otherwise, Generally Accepted Accounting Principles (GAAP). The SF 1408 phrases the requirement a bit differently but with the same intent. It asks the question; Is the accounting system in accord with Generally Accepted Accounting Principles applicable in the circumstances?
So what is GAAP? That's a complex question but in general, GAAP is a collection of commonly-followed accounting rules and standards for financial reporting. The rules and standards are mandated for the creation of uniform financial reports. GAAP ensures consistency, fairness, honesty and accuracy in measuring and disclosing financial information. One of the fundamental tenants of GAAP is that financial statements are maintained on an accrual, rather than a cash basis. So for example, revenue is recognized when a sale is made even though payment has not been received.
How does one know if their accounting system is GAAP compliant? If you have had your financial statements "audited" or "reviewed" by an independent public accountant (i.e. a CPA), there is a strong likelihood that your financial statements are GAAP compliant. A "review" report will state something like the following:
Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in accordance with the accounting principles generally accepted in the United States of America.An "audit" will make a more affirmative statement concerning GAAP. An "audit" opinion might state the following:
In our opinion, the financial statements present fairly, in all material respects, the financial position of X Company as of [at] December 31, 20XX, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.Now if you have neither a review report or an audit report, you're at the mercy of a contract auditor or a contract specialist, or a contracting officer in making an informed (or uninformed) decision as to whether your accounting system is GAAP compliant. And good luck with that. While contract auditors have the requisite education and skills to assess whether a system is GAAP compliant, it is our experience that they do not perform the necessary tests to conclude one way or another. And if it is a contract specialist or a contracting officer making the determination, there is absolutely no way such a determination is based on anything more than their desire to check the "yes" box. But perhaps that's a good thing. If a GAAP compliant accounting system were truly required as a condition of contract award, the entire Government procurement system would grind to a halt.