Accounting standards: Meaning, Criticisms & Real-World Uses

What Are Accounting Standards?

Accounting standards are codified rules and guidelines that dictate how financial transactions are recorded, summarized, and presented in financial statements. These standards fall under the broad umbrella of financial accounting, providing a framework to ensure consistency, transparency, and comparability in financial reporting. They are crucial for businesses, investors, and regulators by establishing a common language for financial information, making it easier to understand and analyze a company's financial position and financial performance. Without clear accounting standards, entities could manipulate their financial figures, leading to confusion and a lack of trust in reported data.

History and Origin

The need for formalized accounting standards became acutely apparent following major financial downturns, such as the U.S. stock market crash of 1929 and the subsequent Great Depression. These events highlighted the perils of inconsistent and opaque financial reporting. In the United States, early efforts to standardize practices involved cooperation between the federal government, notably through the Securities Act of 1933 and the Securities Exchange Act of 1934, and the private accounting profession. This collaboration laid the groundwork for the development of Generally Accepted Accounting Principles (GAAP). Over time, the responsibility for setting U.S. GAAP primarily shifted to private sector bodies, with the Financial Accounting Standards Board (FASB) being established in 1973 as the authoritative standard-setter for public companies in the U.S.,¹⁶,¹⁵. More information on the FASB's history can be found on its official website.

Concurrently, a global movement towards harmonization of accounting standards gained momentum, driven by the expansion of multinational corporations and cross-border investments. This led to the formation of the International Accounting Standards Committee (IASC) in 1973, which eventually evolved into the International Accounting Standards Board (IASB) in 2001.¹⁴,,¹³ The IASB is responsible for developing International Financial Reporting Standards (IFRS), which are now mandated or permitted in over 140 jurisdictions worldwide, serving as a global language for financial reporting.¹² The history of IFRS, including the transition from IASC to IASB, is detailed on the IFRS Foundation's website.¹¹

Key Takeaways

Accounting standards provide a structured framework for preparing and presenting financial information.
They enhance the transparency and comparability of financial statements across different entities and time periods.
Major sets of accounting standards include U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
Compliance with accounting standards is often legally required for publicly traded companies and helps build trust among stakeholders.
Standard-setting bodies continually update accounting standards to reflect changes in business practices and the economic environment.

Formula and Calculation

Accounting standards themselves do not typically involve specific mathematical formulas or calculations in the way a financial ratio might. Instead, they provide the rules and principles that govern how financial elements are recognized, measured, and disclosed. For example, an accounting standard on revenue recognition will specify when revenue should be recorded and how it should be measured, rather than providing a direct formula.

For instance, a standard might dictate the calculation of depreciation expense for a tangible asset valuation. The formula for straight-line depreciation is:

\text{Annual Depreciation Expense} = \frac{\text{Cost of Asset} - \text{Salvage Value}}{\text{Useful Life}}

Here, the "Cost of Asset," "Salvage Value," and "Useful Life" are inputs whose definition and acceptable estimation methods would be guided by relevant accounting standards.

Interpreting Accounting Standards

Interpreting accounting standards involves understanding the principles and specific rules that guide financial reporting. For users of financial statements, interpreting standards means recognizing how different accounting treatments might affect reported figures and what those figures truly represent. For preparers, it involves applying these guidelines consistently to ensure that the financial statements accurately reflect the economic reality of the entity.

For example, two companies might have different reported liabilities or equity based on their application of specific accounting standards, such as those related to leases or financial instruments. Understanding the underlying accounting standards allows stakeholders to adjust their analysis and make meaningful comparisons. This deep understanding is critical for accurate auditing and informed decision-making.

Hypothetical Example

Consider two hypothetical companies, Alpha Corp. and Beta Inc., operating in different countries. Both companies acquire new machinery for $1,000,000.

Alpha Corp. operates in a country that uses GAAP, which may allow for different depreciation methods. Alpha chooses the straight-line method with a 10-year useful life and zero salvage value. Their annual depreciation expense would be $100,000.
Beta Inc. operates in a country that uses IFRS, which also permits various depreciation methods. Beta uses a declining balance method, recognizing higher depreciation in earlier years.

If an investor were to compare Alpha Corp.'s income statement and balance sheet directly with Beta Inc.'s without understanding the differing accounting standards and depreciation policies, they might misinterpret their relative profitability or asset values. The accounting standards govern how these figures are derived and presented, requiring disclosures that enable users to reconcile these differences.

Practical Applications

Accounting standards are fundamental to almost every aspect of finance and business.

Financial Reporting: Companies use accounting standards to prepare their mandatory financial statements, including the income statement, balance sheet, and cash flow statement, ensuring compliance with legal and regulatory requirements.
Investment Analysis: Investors and analysts rely on standardized financial statements to evaluate a company's financial health, performance, and prospects, facilitating informed investment decisions and cross-border capital allocation.¹⁰,⁹
Lending Decisions: Banks and other lenders use financial statements prepared under accounting standards to assess a borrower's creditworthiness and ability to repay debt.
Regulatory Oversight: Regulators, such as the Securities and Exchange Commission (SEC) in the U.S., enforce adherence to accounting standards to protect investors and maintain orderly markets.
Mergers and Acquisitions: During due diligence for mergers and acquisitions, accounting standards provide a common basis for evaluating the financial position of target companies, even if they operate in different jurisdictions.

The adoption of common accounting standards globally simplifies financial reporting for multinational corporations, reducing the burden of preparing multiple sets of financial statements to comply with diverse national rules.⁸

Limitations and Criticisms

Despite their critical importance, accounting standards face several limitations and criticisms:

Complexity and Volume: Modern accounting standards, particularly those like GAAP and IFRS, are incredibly complex and voluminous. This complexity can make them difficult to interpret and apply, even for experienced professionals, potentially leading to errors or inconsistencies.⁷,⁶
Principles-Based vs. Rules-Based: There is ongoing debate regarding principles-based (like IFRS) versus rules-based (like U.S. GAAP) approaches. While principles-based standards offer flexibility, they may lead to varied interpretations. Rules-based standards aim for uniformity but can be overly prescriptive and fail to address unique situations.
Subjectivity and Estimates: Even with strict standards, accounting requires significant judgment and estimates (e.g., useful life of assets, fair value measurements), introducing an element of subjectivity that can affect reported figures.⁵
Comparability Challenges: Despite efforts towards global convergence, significant differences still exist between various sets of accounting standards (e.g., GAAP and IFRS), hindering true cross-border comparability for investors and analysts.⁴,³,²
Cost of Compliance: Adhering to complex and frequently updated accounting standards can be costly for businesses, particularly smaller entities, requiring extensive resources for implementation, training, and auditing.

These challenges are actively discussed by standard-setters and stakeholders, highlighting the continuous evolution required to keep accounting standards relevant and effective. An article by the CFA Institute provides further insights into the complex and changing nature of financial reporting standards.¹

Accounting Standards vs. Financial Reporting

While closely related, "accounting standards" and "financial reporting" refer to distinct concepts. Accounting standards are the rules, principles, and guidelines that dictate how financial information should be prepared. They specify the recognition, measurement, presentation, and disclosure requirements for financial transactions and events. Think of them as the grammar and vocabulary of the language of business.

Financial reporting, on the other hand, is the process of communicating financial information about an entity to external users. It encompasses the preparation and dissemination of financial statements and other related disclosures. Therefore, financial reporting is the act of presenting financial information, and accounting standards are the framework that governs how that act is performed to ensure consistency and reliability. Financial reporting applies accounting standards to convey an organization's financial narrative.

FAQs

Q: What is the primary goal of accounting standards?
A: The primary goal of accounting standards is to ensure that financial information is presented in a consistent, transparent, and comparable manner. This helps investors, creditors, and other stakeholders make informed decisions by providing a reliable picture of a company's financial health and financial performance.

Q: Who creates accounting standards?
A: Accounting standards are primarily created by independent private-sector bodies. In the United States, the Financial Accounting Standards Board (FASB) sets Generally Accepted Accounting Principles (GAAP). Globally, the International Accounting Standards Board (IASB) develops International Financial Reporting Standards (IFRS).

Q: Why are there different accounting standards around the world?
A: Historically, different countries developed their own accounting rules based on their legal systems, economic priorities, and business cultures. While significant efforts have been made towards convergence between major standards like GAAP and IFRS to enhance global comparability, some differences persist due to varying regulatory environments and national priorities.