We often hear about financial reporting standards such as US GAAP and IFRS and that companies need to abide by these standards while preparing their financial reports. One may ask why we need these financial reporting standards. Each business is unique with its own business needs, financial requirements, and style of operations. Then what’s the purpose of these financial reporting standards? The uniqueness of businesses is the exact reason why we need these reporting standards.
The International Accounting Standards Board (IASB), the international accounting standard-setting body, expresses the following:
The objective of financial statements is to provide information about the financial position, performance, and changes in financial position of an entity; this information should be useful to a wide range of users for the purpose of making economic decisions.
The financial statements prepared by a company are used by a variety of people such as investors, creditors, employees, and customers, among other people. For these financial statements to become useful for such wide variety of consumers, the reports must be consistent and comparable. This is what these financial reporting standards help us achieve – consistency and comparability. Businesses are complex, and the financial transactions can get even more complex. Unless there is a set of guiding principles that help us in bringing order to how we record our transactions, the financial statements will remain meaningless, and will lead to a plethora of accounting scandals.
Let’s take a simple example to understand this. Assume that two companies buy similar machinery at the same time. These machines will serve the companies for several years. The financial reporting standards require that at the time of purchase the cost of the machinery should be recorded as an asset and then this cost should be apportioned as depreciation over the estimated life of the machinery. Because it’s a part of the standards each company will be required to record the machinery in this way. If there were no financial reporting standards, each company will record the transaction in their own way. One company may choose to record it as an asset while the other may record it as an expense. Things can just get more difficult with the complexity of transaction, for example, the concept of cash vs. accrual accounting. If the reporting standards did not provide guidelines for recognition of revenue and expenses, different business would have reported their revenues and profits that would be totally incomparable.
These financial reporting standards, while bringing consistency and comparability to the financial statements, also allow some level of flexibility to account for the different economic realities of different businesses. In our example of machinery, the standards allow the companies to have some flexibility over choosing the useful life of the asset depending on how they use it.
We will focus on two key accounting standard-setting bodies, namely, International Accounting Standards Board (IASB), and Financial Accounting Standards Board (FASB), that have developed similar financial reporting standards called International Financial Reporting Standards (IFRS), and the Generally Accepted Accounting Standards (U.S. GAAP).
It is imperative for us to understand these financial reporting standards and the differences between them to be able to able to evaluate the reported financial information with more clarity and be able to better analyze the financials of companies.