Key Takeaways
- Accounting Standards are set of rules and principles that help ensure that the information provided in the financial statements is relevant, reliable, comparable, and consistent.
- Most domestic companies in the United States follow the U.S. GAAP, which are accounting standards that were established by the Financial Accounting Standards Board (FASB). However, more than 155 jurisdictions outside the United States have adopted the International Financial Reporting Standards (IFRS) which was issued by the International Accounting Standards Board (IASB).
- One of the main differences between the U.S. GAAP and the IFRS is that the latter is principles-based while the former is rules-based when it comes to the recognition and recording of the business transactions of a company.
Introduction to Accounting Standards
An Accounting Standard is the framework of accounting principles, standards and procedures that guides accountants in financial reporting and the preparation of financial statements.
Accounting standards consist of the conventions, rules and procedures that are followed by accountants in recording business activities and preparing financial statements. These standards are widely accepted by accounting practitioners either by agreement or derivations from a set of basic accounting concepts.
If you’re an investor, you would want to have an accurate picture of the financial condition and performance of the company you’re going to invest in before you risk your hard-earned money on them. Accounting standards like the Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS) should provide you and other investors confidence on a company’s financial statements.
Accounting standards are developed based on the following factors:
- Pronouncements and standards set by policy boards and professional bodies;
- Regulations from government entities;
- Opinions of accounting and auditing practitioners;
- Custom or accepted ways of presenting accounting information based on experience and agreements by accountants; and
- Business and industry practices.
Why Are Accounting Standards Important?
Accounting standards sets out how business transactions are recognized, measure and reported in the financial statements. These standards serve the following purposes:
1. Relevance, Reliability, Accuracy, and Transparency
Accounting standards assure the financial statement users that the information contained in the financial statements are relevant, reliable, accurate, and transparent since they are prepared based on principles and methods that are acceptable to most accountants and regulators. This allows investors and other stakeholders to make informed judgment and investment decisions.
However, it is important to note that accounting standards are by no means comprehensive or completely guarantee that the financial statements of a company are free from errors or misleading information intentionally made by deceitful accountants. Investors are still encouraged to scrutinize financial statements that are prepared according to GAAP or IFRS.
2. Consistency
Accounting standards ensure that the financial statements are prepared in a consistent manner based on the same rules and principles making it easier for financial analysis across different periods of the company’s operations. Being consistent means that any calculations or methods used are the same as those used in prior accounting periods.
However, while accounting standards call for consistency in the recording of economic transactions and preparation of financial statements, a company’s accountant might sometimes find it necessary to make some changes to better reflect the company’s financial condition and performance. These changes can either be classified as a change in accounting estimate or a change in accounting principle, both of which will be discussed in a more advanced accounting topic.
Changes are allowed as long as it is acceptable under a country’s GAAP or the IFRS and provided that the changes and their impact will be disclosed by the company. The reason for the disclosure is that the change could impact past, current and future financial statements, depending on whether it is a change in accounting estimate or a change in accounting principle.
3. Comparability
Accounting standards allow stakeholders to compare the financial statements of one company to other companies in the same industry in a meaningful way since the financial statements across different companies were prepared using the same set of rules and principles. Being able to compare financial statements of different companies allows investors to evaluate the financial condition and performance of companies easier and to make better investment decisions.
Any incident where one company appears more profitable on paper than others just because they adhere to a different set of accounting standards is avoided. Accounting standards discourage businesses to manipulate the information on their financial statements to their own advantage.
Can companies use non-GAAP methods?
The Securities and Exchange Commission (SEC), or its equivalent in other countries, requires that all companies whose stock is publicly traded and companies that release financial statements to the public to adhere to accounting standards such as GAAP or IFRS (for those outside U.S.). Non-publicly traded companies and smaller companies are also encouraged or required to follow or adopt these standards when preparing their financial statements.
A company might sometimes diverge from GAAP or established accounting standards if these standards don’t present an accurate picture of the company’s financial situation. While using non-GAAP methods and practices are not illegal, it is required to be disclosed in the financial statement’s footnotes and also reported to the SEC. These methods are not in any way allowed to create a false picture of the company.
Using non-GAAP methods and practices may encourage companies to falsify and distort earnings to show more favorable numbers on their financial statements. Investors should be very cautious and must examine the company’s financial statements very carefully for any signs of manipulation.
International Financial Reporting Standards (IFRS) and the U.S. GAAP
GAAP or accounting standards vary from one country to another which may be the result of different business practices, pronouncements by policy boards or regulations by government bodies. In the United States, the Financial Accounting Standards Board (FASB) establishes and develops the U.S. GAAP. Most companies in the U.S. follow the U.S. GAAP even if some of them are not required to adhere to it.
In a highly-globalized world where international trade, investments and shareholdings are prevalent, having uniform and internationally-recognized accounting standards makes sense especially for companies with operations in several countries. In addition, some countries with emerging markets that don’t have an established single set of accounting standards can make investors skeptical about the reliability of the financial statements of companies in those countries.
As a response to the demand for a common set of accounting standards that will be observed and adopted worldwide, the London-based International Accounting Standards Council (IASC) published the International Accounting Standards (IAS) on June 1973. The aim of these international standards is to help investors compare businesses globally using a single set of accounting standards and to increase trust on companies from other countries.
The IASC was then replaced by the International Accounting Standards Board (IASB) on April 2001. The IASB adopted the old IAS and issued the new International Financial Reporting Standards (IFRS). The IAS and IFRS, which are now being used in more than 150 countries or jurisdictions, are the alternative to the U.S. GAAP.
What is the difference between the IFRS and the U.S. GAAP?
The difference between the IFRS and U.S. GAAP lie on the methodology used and the basis of the standards. U.S. GAAP are rules-based which means that transactions should follow specific rules. The IFRS are principles-based which gives room for different interpretations and use of judgment. It is also being revised regularly based on changes in the international financial environment.
Some key differences between the IFRS and the U.S. GAAP include the treatment of inventories, recognition of intangible assets, flexibility for interpretation, recognition of revenue, fair value revaluations of assets, and classification of liabilities.
Currently, a move by the SEC for the United States to fully adopt the IFRS is underway and may result with the abandonment of the GAAP. The FASB and IASB have been routinely meeting and working on the convergence of IFRS and GAAP since 2010.
However, as of 2016, the GAAP still continues to be used by domestic issuers of financial statements in the United States and any progress of transitioning to IFRS has been slow. As a result, a U.S. company that plans to operate on other countries might have to issue two sets of financial statements – one prepared under U.S. GAAP while the other prepared under IFRS.
Review Questions
- How do accounting standards such as the U.S. GAAP and the IFRS help improve the information presented in the financial statements?
- Why is there a need for an internationally-recognized set of accounting standards?
- Can companies use accounting methods that are not based on GAAP or any established accounting standards?
- Can companies change to an accounting principle or estimate that is different from what they are currently using?
- Why do investors need to be cautious and to scrutinize a company’s financial statements before investing in them?
