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2.3 The Need for Accounting Standards

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Describe the purpose of accounting standards such as U.S. Generally Accepted Accounting Principles (U.S. GAAP) and International Financial Reporting Standards (IFRS) and the benefits that these rules provide.
  2. Explain the importance of accounting standards to the development of a capitalistic economy.
  3. Understand the role played by the Financial Accounting Standards Board (FASB) in the ongoing evolution of accounting standards in the United States.
  4. Discuss the advantages and the possibility that financial reporting will switch from U.S. GAAP to IFRS.

The Existence of Formal Accounting Standards

Question: Rules and principles exist within financial accounting that must be followed. They provide the structural guidance that is essential for achieving effective communication. For example, assume that a reporting organization encounters an uncertainty (such as a lawsuit) and is now preparing financial information to portray the reality of that event. When faced with such complexity, how does the financial accountant know which method of reporting is appropriate? How does a decision maker who analyzes that reported information know what guidelines were used in its preparation?

 

Answer: The existence of financial accounting standards is essential to ensure that all communicated information is understood properly. Both the accountants within the reporting organization and the decision makers analyzing the resulting financial statements must understand those rules. The question that has haunted the accounting profession in recent times is, who should have the authority to create those standards?

For decades, a wide variety of formal accounting principles were developed in the United States as well as throughout the rest of the world. Japanese accounting rules evolved differently from those in Australia while Australian standards were not consistent with those in the United States. In earlier times, such country-by-country rules caused few problems because most businesses operated solely within their country’s boundaries. During the past ten years or so, as a truly global economy became a reality, two primary systems of accounting rules emerged. U.S. Generally Accepted Accounting Principles (U.S. GAAP)A recognized set of accounting rules used and followed in the United States; it is created and updated by the Financial Accounting Standards Board (FASB). are applied to most financial information presented within the United States. International Financial Reporting Standards (IFRS) are now used almost exclusively in the rest of the world. In accounting at the present time, two languages exist rather than one.

Having two bodies of rules causes problems for decision makers. For example, on its Web site, BP presents a 2010 set of financial statements prepared according to IFRS. One of its biggest competitors, Exxon Mobil, posted its own 2010 financial statements, but those amounts and explanations were created by following U.S. GAAP. Clarity and understanding are not enhanced when different communication standards are applied by such similar businesses.

Not surprisingly, many corporate officials and decision makers would prefer to see one universal set of accounting standards. If that were to happen, a corporation in Michigan and a corporation in Germany would produce comparable financial information that could be utilized for all reporting purposes around the world.

Over the past few years, extensive progress has been made in bringing these two sets of standards into alignment. However, a number of significant differences continue to exist. Many interested parties want to see IFRS adopted exclusively in the United States. According to this group, it is unlikely that the rest of the world will choose to follow U.S. GAAP so harmony can only be achieved by a general acceptance of IFRS. Others believe that U.S. GAAP is a superior system and should not be abandoned.

The debate has been intense and promises to continue to be so until some type of official resolution occurs.

Typical Opinions on Moving to the Use of IFRS

  • Ford (Motor Co.) supports the move to International Financial Reporting Standards, saying the company would save money by simplifying and standardizing its accounting across all 138 countries where Ford operates.”
  • “Companies like Hallador Energy Co., a small Denver coal-mining company that doesn’t do business outside the United States (opposes) moving to the international standards. ‘We didn’t join the metric system when everybody else did,’ says W. Anderson Bishop, Hallador’s chief financial officer. U. S. accounting rules are ‘the gold standard, and why would we want to lower our standards just to make the rest of the world happy?”
  • “Larger companies, big accounting firms, and top rule makers favor the switch. They contend that global unity would save companies money by consolidating bookkeeping and make it easier to raise capital around the world.”
  • “James Barlow, chief financial officer of drug company Allergan Inc. and an opponent of IFRS, estimates the change could cost companies as much as 1 percent of revenues.”Michael Rapoport, “Accounting Move Pits Big vs. Small,” The Wall Street Journal, July 6, 2011, C1.

At the time of this writing, U.S. GAAP continues to be the required system for most of the financial reporting found in the United States although a mandated switch to IFRS (in some form) during the next few years is quite possible. Because of the current situation and the uncertainty as to how legal requirements will eventually change, this textbook is primarily a presentation of U.S. GAAP. For the most part, U.S. GAAP and IFRS are based on the same accounting principles. However, varying interpretations of those principles have resulted in differences between U.S. GAAP and IFRS standards. In areas where IFRS disagrees with U.S. GAAP in significant ways, both methods of reporting will be described in this textbook.

The Development of Accounting Standards

Question: Whether in the form of U.S. GAAP or IFRS, financial accounting standards must be created in some logical fashion. Who is in charge of the production of formal accounting standards? How often do these official standards come into existence?

 

Answer: The Financial Accounting Standards Board (FASB) has held the authority to develop U.S. GAAP since 1973. An abundance of information can be found about this board and its activities by going to http://www.fasb.org/ and clicking on “About FASB.”

IFRS are produced by the London-based International Accounting Standards Board (IASB). This group took over responsibility for international standards from a predecessor group in 2001. Information about the resulting official pronouncements and the standard setting process is available at http://www.iasb.org/ by clicking on “About us.”

Although some basic elements of accounting standards have been in use almost throughout history, many reporting rules are relatively new—often developed within the last few decades. Whether U.S. GAAP or IFRS, accounting standards evolve quite quickly as the nature of business changes and new reporting issues, problems, and resolutions arise. The growth of advanced technology speeds this process even more quickly. Fairly important changes in the formal structure of accounting rules occur virtually every year.

In the United States, the existence of U.S. GAAP means that a business in Seattle, Washington, and a business in Atlanta, Georgia, must account for financial information in much the same manner. As will be discussed later in this textbook, a few allowed alternatives do exist in connection with specific reporting challenges.

Because standardization exists in most areas of the reporting process, any decision maker with an adequate knowledge of financial accounting—whether located in Phoenix, Arizona, or in Portland, Maine—should be able to understand the fairly presented financial information conveyed by a wide variety of organizations. They all speak the same language. Put simply, the existence of accounting standards enables organizations and other interested parties to communicate successfully.

Test Yourself

Question:

An investor is studying a set of financial statements prepared for a company. He is considering buying some of its ownership shares. While studying the financial statements, he notices that they have been prepared in accordance with U.S. GAAP. Which of the following statements is true?

  1. The rules and principles that make up U.S. GAAP have been the same now for over forty years.
  2. The rules and principles that make up U.S. GAAP are consistent throughout the United States.
  3. The rules and principles that make up U.S. GAAP are used consistently throughout the world.
  4. The rules and principles that make up U.S. GAAP are the same as those used for income tax purposes.

Answer:

The correct answer is choice b: The rules and principles that make up U.S. GAAP are consistent throughout the United States.

Explanation:

U.S. GAAP provides a standardization of rules so that information can be better understood. These rules evolve rapidly; thus, much of U.S. GAAP is less than ten to fifteen years old. A different set of rules known as IFRS is used in much of the rest of the world and might eventually be applied in the United States. Income tax laws help governments raise revenues, a completely different purpose than U.S. GAAP. U.S. GAAP is designed to help organizations produce fairly presented financial statements.

The Importance of Accounting Standards

Question: Several years ago, a front page article in the Wall Street Journal contained a controversial assessment of U.S. GAAP: “When the intellectual achievements of the 20th century are tallied, GAAP should be on everyone’s Top 10 list. The idea of GAAP—so simple yet so radical—is that there should be a standard way of accounting for profit and loss in public businesses, allowing investors to see how a public company manages its money. This transparency is what allows investors to compare businesses as different as McDonald’s, IBM and Tupperware, and it makes U.S. markets the envy of the world.”Clay Shirky, “How Priceline Became a Real Business,” Wall Street Journal, August 13, 2001, A-12.

Could formal accounting standards be so very important? Can the development of U.S. GAAP possibly be one of the ten most important intellectual achievements of the entire twentieth century? A list of other accomplishments during this period includes air travel, creation of computers, birth of the Internet, landing on the moon, and the development of penicillin. With that level of competition, U.S. GAAP does not seem an obvious choice to be in the top ten. How can it be so important?

 

Answer: The United States has a capitalistic economy, which means that businesses are (for the most part) owned by private citizens and groups rather than by the government. To operate and grow, these companies must convince investors and creditors to contribute huge amounts of their own money voluntarily. Not surprisingly, such financing is only forthcoming if the possible risks and rewards can be assessed and then evaluated with sufficient reliability. Before handing over thousands or even millions of dollars, decision makers must believe that they are using reliable data to make reasonable estimations of future stock prices, cash dividends, and cash flows. Otherwise, buying stocks and granting credit is no more than gambling. As this quote asserts, U.S. GAAP enables these outside parties to obtain the financial information they need to reduce their perceived risk to acceptable levels. Thus, money can be raised, and businesses can grow and prosper.

Without U.S. GAAP, investors and creditors would encounter significant difficulties in evaluating the financial health and future prospects of an organization.The wide-scale financial meltdown in the world economy that began to be evident in 2008 put a serious strain on the traditional capitalist model. The United States and other governments had to spend billions of dollars to bail out (and, in some cases, take over) major enterprises. Whether U.S. GAAP could have done a better job to help avoid this calamity will probably not be fully known for years. Because of that uncertainty, they would be more likely to hold on to their money or invest only in other, safer options. Consequently, if accounting standards did not exist, the development and expansion of thousands of the businesses that have become a central part of today’s society might be limited or impossible simply because of the lack of available resources. An expanding economy requires capital investment. That funding is more likely to be available when financial information can be understood because it is stated in a common language: U.S. GAAP.

By any method of measurement, the explosive development of the U.S. economy during the twentieth century (especially following World War II) has been spectacular, close to unbelievable. This growth has been fueled by massive amounts of money flowing from inside and outside the United States into the country’s businesses. Much of the vitality of the U.S. economy results from the willingness of people to risk their money by buying capital stock or making loans or extending credit to such companies as McDonald’s, IBM, and Tupperware. Without those resources, most businesses would be small or nonexistent, and the United States would surely be a radically different country.

The Evolution of Accounting Standards

 

Question: Accounting standards are important to businesses and decision makers alike. FASB is in charge of the creation of U.S. GAAP. As stated, all accounting standards tend to evolve over time. Official rules are modified, deleted, or added every year. How do new accounting standards come into existence?

 

Answer: As indicated earlier, since 1973, FASB has served as the primary authoritative body in charge of producing U.S. GAAP for nongovernmental entities such as businesses and private not-for-profit organizations. FASB is an independent group supported by the U.S. government, various accounting organizations, and many private businesses.

Typically, accounting problems arise over time within the various areas of financial reporting. New types of financial events can be created, for example, that are not covered by U.S. GAAP or, perhaps, weaknesses in earlier rules start to become evident. If such concerns grow to be serious, FASB steps in to study the issues and alternatives. After a period of study, the board might pass new rules or make amendments to previous ones. FASB is methodical in its deliberations, and the entire process can take years. Changes to U.S. GAAP are never made without proper consideration.

Several other official bodies also play important roles in the creation of U.S. GAAP. They are normally discussed in detail in upper-level accounting textbooks. However, the major authority for the ongoing evolution of U.S. GAAP lies with FASB and its seven-member board. It has released scores of official statements during its first four decades of existence. The impact that those rulings have had on U.S. GAAP and the financial reporting process in this country is almost impossible to overemphasize.

As just one example, FASB recently made a number of changes in the required reporting of receivables because of the chance that some (perhaps many) of these balances would not be collected. Possibly as a result of the current economic difficulties around the world, the members of FASB felt that more information was needed from organizations to inform decision makers about the risk involved with the collection of these receivables. This type of evolution takes place frequently in the language known as financial accounting. Whether U.S. GAAP or IFRS, financial accounting rules must be updated as needed to meet current informational needs.

In 2009, FASB combined all authoritative accounting literature into a single source for U.S. GAAP, which is known as the Accounting Standards Codification. By bringing together hundreds of authoritative documents, FASB has made U.S. GAAP both more understandable and easier to access. A multitude of pronouncements has been woven together in a logical fashion so that all rules on each topic are now gathered in one location.

Key Takeaway

No language can enable communication without some standardization of terminology and rules. At present, U.S. GAAP plays this role in the United States. The availability of these authoritative guidelines has served a central role in the growth of the U.S. economy since the end of the Great Depression and World War II. These uniform accounting rules allow investors and creditors to assess the possible risks and rewards they face. U.S. GAAP is constantly evolving as accountants seek better methods of providing financial information in an ever-changing business world. The main authority for the development of U.S. GAAP lies with the Financial Accounting Standards Board (FASB). FASB looks constantly for reporting issues that need to be studied so that needed changes can be made in official accounting rules. IFRS plays this same role in much of the rest of the world. The future of IFRS rules in the United States is yet to be determined, but acceptance of a single set of accounting standards in some form has many supporters.

Talking with an Independent Auditor about International Financial Reporting Standards

Robert A. Vallejo is a partner in the assurance (audit) practice of the public accounting firm PricewaterhouseCoopers (PwC). Rob began his career with PwC in 1992 and has spent five years working in Europe (two in Paris and three in Amsterdam). Because of his time in Europe, he has extensive practical experience dealing with International Financial Reporting Standards (IFRS) and actively helps his U.S. clients understand the significant differences between U.S. accounting standards and IFRS. He currently works in the firm’s Richmond, Virginia, office. Rob is the founder of the Philadelphia Chapter of ALPFA (the Association of Latino Professionals in Finance and Accounting) and is a member of the American Institute of Certified Public Accountants (AICPA) and the Virginia Society of CPAs.

Question: Over the past fifty years or so, the accounting profession in the United States has developed a very comprehensive set of official guidelines referred to collectively as U.S. GAAP. Recently, a strong push has developed to move away from those principles and adopt the pronouncements of the International Accounting Standards Board. If U.S. GAAP has worked successfully for so many years, why should we now think about abandoning it in favor of IFRS, a system that is not necessarily well understood in the United States?

Rob Vallejo: Economic events continue to illustrate how interrelated the world’s economies really are. Therefore, it makes common sense that all companies around the world should report their financial information in accordance with the same set of accounting standards. For investors and creditors, it is hard to compare two companies that use different reporting standards unless the individual has a truly in-depth understanding of the differences. Unfortunately, both sets of standards are complex, which makes it very difficult to have a solid grasp of both. The United States is one of the few remaining jurisdictions that has not adopted IFRS, limiting the understanding and usefulness of our standards beyond our borders. Another argument in favor of the adoption of IFRS is the complexity of U.S. GAAP. It is a very rules-based set of standards that has evolved over many decades to address the ever-changing world of business, creating a maze of standards that is difficult to navigate. IFRS is more principles-based, allowing the preparers of financial information more judgment in applying general rules to a wide variety of situations. Lastly, U.S. standard setters have become more involved in the evolution of IFRS. FASB has been working with the IASB in many instances to converge U.S. GAAP and IFRS even if formal adoption of IFRS never occurs in the United States.

Question: Rob, at key spots throughout this textbook, you have agreed to explain the impact that a possible change to IFRS will have on financial reporting in the United States. Obviously, the future is always difficult to anticipate with precision. However, what is your best guess as to when IFRS will start to be used in the financial statements issued by U.S. companies? At a basic level, as is appropriate in an introductory financial accounting course, how much real difference will be created by a change from U.S. GAAP to IFRS?

RV: The move to IFRS is being driven by the Securities and Exchange Commission (SEC), which has legal responsibility for much of the financial reporting in the United States. In 2008, the SEC published a road map that called for the largest U.S. publicly traded companies to publish their annual results for the year ending December 31, 2014, in accordance with IFRS. In February 2010, the SEC decided that IFRS would not be required of U.S. public companies prior to 2015 and, even then, only after additional study. A final decision is now expected from the SEC relatively soon, but the momentum leading to an inevitable switch to IFRS has subsided. Many believe that a much slower convergence approach, ensuring that all newly issued standards are the same under U.S. GAAP and IFRS, seems to be gaining traction. In general, any move to IFRS will not have a substantial impact on the financial information being reported by most U.S. companies. However, because of the many subtle differences between IFRS and U.S. GAAP, preparers of financial information have a lot of work to do to transition the reporting properly. As is the case many times, the devil is in the details.

Note: The role played in the U.S. economy by public accounting firms will be described in a later chapter. Some of these organizations have grown to an enormous size. According to its Web site as of July 14, 2011 (http://www.pwc.com/), PricewaterhouseCoopers employs approximately 161,000 individuals working in over 150 countries. During 2010, the firm earned in excess of $26 billion in revenues from customers as a result of the services that it rendered for them.