What should GAAP look like?

Based on extant literature, we articulate a positive theory of GAAP under the assumption that GAAP’s objective is to facilitate the efficient allocation of capital within an economy. The theory predicts that GAAP’s principal focus, as shaped by the demand for and supply of financial information, is on the use of the income statement and balance sheet for performance measurement and control (stewardship). This is consistent with efficient contracting considerations guiding financial reporting. Financial reports produced under the positive theory of GAAP would also generate information useful for equity valuation, but equity valuation is not predicted to be the primary objective underlying GAAP. Thus, artificially imposing equity valuation as the primary objective for financial reporting standards will result in a GAAP that is unlikely to adequately serve stakeholders ’ needs. The theory allows us to compare and contrast extant GAAP, as observed in a regulated setting, with GAAP that might arise endogenously as a result of market forces. Building on previous research, we argue that verifiability and conservatism, while detracting from accounting’s role in equity valuation, are critical features of GAAP under efficient contracting. We recognize the advantage of using fair values i