Accounting standards setting

What Is Accounting Standards Setting?

Accounting standards setting refers to the process by which authoritative bodies establish the rules, principles, and procedures for how financial transactions are recorded, measured, and presented in financial statements. This crucial function falls under the broader category of financial accounting, aiming to ensure consistency, transparency, and comparability in financial reporting. The goal of accounting standards setting is to provide investors, creditors, and other stakeholders with reliable and decision-useful financial information, facilitating informed economic decisions and fostering trust in capital markets.

History and Origin

The evolution of accounting standards setting has largely been a response to economic developments and financial crises, underscoring the need for greater transparency and investor protection. In the United States, formalized accounting standards gained prominence after the 1929 stock market crash. The creation of the Securities and Exchange Commission (SEC) in 1934 granted it the authority to prescribe accounting methods for financial reports. The SEC subsequently looked to the private sector for leadership in this area.¹⁰

This led to the establishment of the Financial Accounting Standards Board (FASB) in 1973, an independent, private-sector, not-for-profit organization. The FASB was created to replace the Accounting Principles Board (APB) and was tasked with setting financial accounting and reporting standards for public companies and private companies in the U.S. that follow Generally Accepted Accounting Principles (GAAP).⁹,⁸ The SEC formally recognized the FASB as the designated accounting standard setter for public companies.⁷

Concurrently, on the international stage, the International Accounting Standards Committee (IASC) was formed in 1973 by accountancy bodies from ten countries to develop International Accounting Standards (IAS). This initiative aimed to unify diverse national accounting rules as businesses expanded globally.⁶ In 2001, the IASC was restructured and replaced by the International Accounting Standards Board (IASB), an independent body responsible for developing International Financial Reporting Standards (IFRS). The IASB's inception marked a significant push toward a single set of high-quality global accounting standards, with the European Union and over 100 countries requiring or permitting IFRS.⁵

Key Takeaways

• Accounting standards setting creates the rules for financial reporting, ensuring consistency and transparency.
• The primary bodies are the FASB for U.S. GAAP and the IASB for IFRS.
• Standards provide a common language for financial information, aiding investor decisions.
• Regulatory bodies like the Securities and Exchange Commission (SEC) oversee these private-sector standard setters.
• Effective accounting standards setting is crucial for the integrity of financial markets.

Formula and Calculation

Accounting standards setting does not involve a specific formula or calculation. Instead, it defines the principles and methods by which financial figures are derived and presented within financial statements, such as the balance sheet and income statement. For instance, a standard might dictate the methodology for calculating depreciation or the criteria for recognizing revenue, rather than providing a universal formula for the standard-setting process itself.

Interpreting the Accounting Standards Setting

Understanding accounting standards setting means recognizing the framework that underpins all financial reporting. These standards dictate how economic events are translated into monetary terms and reported. For example, standards define what constitutes an asset or a liability, how to value them, and when to recognize their impact on a company's financial performance. Interpreting these standards is vital for auditors who verify compliance and for financial analysts who use reported data to assess a company's health. The process of setting these standards is ongoing, evolving with new business models and financial instruments to maintain relevance and usefulness.

Hypothetical Example

Imagine a newly established tech startup, "InnovateCo," which develops cutting-edge software. As InnovateCo grows and seeks external funding, its management realizes the necessity of transparent financial statements to attract investors. To ensure their financial reports are credible and comparable with other tech firms, InnovateCo adopts U.S. Generally Accepted Accounting Principles (GAAP).

The accounting standards setting process, specifically the FASB's work, dictates how InnovateCo must account for its software development costs. Should these costs be expensed immediately, or can they be capitalized as an asset? GAAP provides specific guidance on the criteria for capitalization (e.g., technological feasibility). InnovateCo's accountants follow these rules, ensuring that their balance sheet accurately reflects the capitalized development costs and that their income statement correctly expenses costs that do not meet capitalization criteria. This adherence to established standards provides investors with confidence in the reported financial performance.

Practical Applications

Accounting standards setting has broad practical applications across the financial world:

• Corporate Financial Reporting: Companies rely on accounting standards to prepare their financial statements, including the balance sheet, income statement, and cash flow statement. This ensures uniformity and reliability in public disclosures.
• Investment Analysis: Investors and analysts use standardized financial reports to compare companies within the same industry or across different geographies, enabling more informed investment decisions.
• Regulatory Compliance: Governments and regulatory bodies, such as the Securities and Exchange Commission (SEC) in the U.S., mandate adherence to specific accounting standards to protect investors and maintain orderly markets. The SEC actively oversees private-sector standard setters to ensure their processes are open and impartial, serving the public interest.⁴
• Auditing: Auditors verify that companies' financial statements comply with the relevant accounting standards, adding credibility to the reported information.
• Loan Underwriting: Lenders often require businesses to provide financial statements prepared according to established accounting standards, such as Generally Accepted Accounting Principles (GAAP), to assess creditworthiness.

Limitations and Criticisms

While accounting standards setting is essential for financial transparency, it faces several limitations and criticisms:

• Complexity: Financial accounting standards can be exceedingly complex, especially with the increasing sophistication of business transactions and financial instruments. This complexity can make financial reports difficult for non-experts to understand and costly for companies to implement.³ Some research suggests that complexity in standards can lead to narrative obfuscation, making disclosures harder to read.²
• Rules-Based vs. Principles-Based: The debate between rules-based (e.g., U.S. GAAP) and principles-based (e.g., IFRS) approaches is ongoing. Critics of rules-based standards argue they can lead to a "check-the-box" mentality, allowing companies to technically comply with rules while potentially obscuring the economic substance of transactions. Conversely, principles-based standards can be criticized for being too vague, leading to diverse interpretations and potentially less comparability.
• Timeliness: The standard-setting process can be slow and bureaucratic, struggling to keep pace with rapidly evolving business practices and financial innovations. This can leave gaps in guidance for emerging issues.
• Political Influence: Despite being independent, standard setters like the FASB and IASB can face pressure from various stakeholders, including corporations, industry groups, and political entities. This influence can sometimes impact the development and adoption of new standards. For instance, the Sarbanes-Oxley Act of 2002 addressed certain criticisms related to accounting practices and corporate governance.
• Fair Value Debates: The application of fair value accounting, often mandated by standards, has been a contentious area, particularly during economic downturns, due to concerns about volatility and the subjectivity of valuations for illiquid assets.

Accounting Standards Setting vs. Financial Reporting

While closely related, accounting standards setting and financial reporting are distinct concepts.

In essence, accounting standards setting provides the blueprint, while financial reporting is the construction of the building itself, adhering to that blueprint. Without robust accounting standards setting, financial reporting would lack consistency, making it difficult for users to compare and understand company performance.

FAQs

What is the main purpose of accounting standards?

The main purpose of accounting standards is to ensure that financial information presented by companies is consistent, transparent, and comparable. This allows investors and other stakeholders to make informed economic decisions based on reliable data.

Who sets accounting standards in the United States?

In the United States, the Financial Accounting Standards Board (FASB) is the primary private-sector organization responsible for setting accounting standards, known as Generally Accepted Accounting Principles (GAAP). The Securities and Exchange Commission (SEC) oversees the FASB and mandates the use of GAAP for publicly traded companies.

What are the two main sets of global accounting standards?

The two main sets of global accounting standards are U.S. Generally Accepted Accounting Principles (GAAP), used primarily in the United States, and International Financial Reporting Standards (IFRS), which are used in over 100 countries worldwide.

Why are accounting standards important for investors?

Accounting standards are crucial for investors because they provide a standardized framework for companies to prepare their financial statements. This standardization allows investors to compare the financial performance and position of different companies, facilitating better analysis and decision-making for their portfolios.

Does the SEC set accounting standards directly?

The Securities and Exchange Commission (SEC) has the legal authority to set accounting standards for public companies in the U.S. However, it has historically delegated this responsibility to private-sector bodies like the FASB, while maintaining active oversight to ensure the standards serve the public interest and protect investors.¹