What it means
Each standard deals with a defined topic: revenue, leases, inventory, financial instruments, employee benefits and so on. It sets out the scope, the measurement basis, the point of recognition and the disclosures required, usually with worked illustrations.
Taken together the standards form the framework a set of accounts is prepared under, which is named on the first page of those accounts. Standards matter because comparability has real money attached to it.
Investors price risk partly on reported figures, banks write covenants against them, and acquirers build offers on them, so inconsistent treatment of the same transaction distorts real decisions. A standard narrows the range of acceptable answers without pretending there is only one.
They are written through a public due process rather than handed down. A standard setter publishes a discussion paper, then an exposure draft, collects comment letters, holds public meetings and issues a final standard with an effective date and transition rules.
That process typically takes years, which is why a new standard rarely surprises a well run finance team. Applying a standard is where judgement returns.
The rule may require revenue to be recognised as control passes to the customer, but deciding when control passes on a complex contract is a matter of analysis and documentation. Finance teams record that analysis in an accounting policy paper so the same question gets the same answer next year and the auditor can follow the reasoning.
Two variants are worth knowing. Full standards apply to listed and larger entities, while reduced disclosure frameworks for smaller private companies cut the volume of notes without changing most measurement rules.
There are also industry specific standards, for insurance contracts or extractive activities, that override the general rules where they apply. For a non-finance manager the useful habit is to ask which standard drives a number that feels odd.
Lease accounting, for example, puts rented property on the balance sheet as both an asset and a liability, which surprises people who think of rent as a simple monthly cost. Knowing the standard behind the presentation turns an argument into a short explanation.
In practice
Real-world examples.
Example
A software company adopts the revenue standard and splits a $240,000 three year contract into a licence element and a support element. The licence revenue of $120,000 is recognised on delivery and the support revenue of $120,000 is spread at $40,000 a year. Reported revenue in year one falls, even though the cash collected is unchanged.
Example
A restaurant group applies the lease standard and brings 42 leases onto the balance sheet, adding $18,000,000 of assets and liabilities. A bank covenant measured on net debt is breached on the new presentation. The group renegotiates the covenant definition to use the previous basis for the remaining term.
Example
A manufacturer in a smaller company regime uses a reduced disclosure framework and files accounts with far fewer notes than a listed competitor, while measuring fixed assets and inventory on the same principles. A prospective investor asks for the missing disclosures separately. The finance team provides them as a supplementary pack rather than changing the filed accounts.
Formula
Calculation
Standards are rules rather than equations, but almost every standard contains a measurement rule that can be calculated. The inventory standard is a clear example:
Inventory Carrying Value = Lower of Cost and Net Realisable Value
Net Realisable Value = Estimated Selling Price - Estimated Costs to Complete and Sell
A clothing wholesaler holds end of season stock that cost $500,000 to buy. It expects to sell that stock through a clearance channel for $560,000 and to spend $90,000 on repackaging, carriage and commission to do so. Net realisable value is $560,000 - $90,000 = $470,000.
Because $470,000 is lower than the $500,000 cost, the standard requires the stock to be carried at $470,000 and a write down of $500,000 - $470,000 = $30,000 to be charged to profit in the current period. If the clearance price later recovered to $620,000, net realisable value would become $530,000 and the write down could be reversed, but only up to the original cost of $500,000 and never above it.Case study
Seen in the real world.
This illustrative, fictional example follows Pine Harbour Logistics, an invented freight business, through the adoption of a new lease standard. Pine Harbour rented 60 vehicles and three depots and had always treated the payments as an operating cost of about $4,200,000 a year. Under the new standard most of those contracts met the definition of a lease and had to be recognised as a right of use asset with a matching liability.
The numbers moved sharply. Roughly $15,000,000 appeared on both sides of the balance sheet, the operating cost line fell as rent was replaced by depreciation and interest, and reported operating profit rose while profit before tax barely changed. Gearing, measured as debt to equity, went from comfortable to uncomfortable overnight.
Pine Harbour's finance director ran the transition a year early, briefed the bank with a bridge from the old presentation to the new one, and agreed a covenant that measured leverage on a frozen basis. In this illustrative story the accounting change created no new economic risk at all, and handling it well was purely a matter of explaining it before anyone else noticed.
Watch out
Common mistakes.
- Assuming a standard removes all judgement. Most standards set a principle and leave the application to documented analysis of the specific facts.
- Treating an accounting change as an economic change. A new presentation can move every ratio without altering a single cash flow.
- Adopting a new standard in the month it becomes effective. Covenants, systems, budgets and investor communications all need lead time.
Questions
People also ask.
Who writes accounting standards?
Independent standard setters following a public due process, with national regulators deciding which standards apply to which entities in their jurisdiction.
Do accounting standards and tax rules say the same thing?
No, tax law sets its own definitions of income and allowable cost, which is why deferred tax exists to bridge the two.
Can a company choose which standards to apply?
Only within the options its jurisdiction allows, such as full international standards or a reduced framework for smaller entities, and the chosen framework must be stated in the accounts.
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