What it means
Without standards, every company could decide for itself when a sale counts as revenue, how to value its inventory or whether a lease is a debt. Comparing two businesses would be impossible and manipulating results would be easy.
Standards remove that freedom by defining what must be done in each situation, or by narrowing the choice to a small set of acceptable methods and requiring the choice to be disclosed. IFRS are issued by the International Accounting Standards Board (IASB) in London and are largely principles-based: they set out the objective of each requirement and expect preparers to apply judgement to meet it.
US GAAP, issued by the Financial Accounting Standards Board (FASB), is more rules-based, with detailed guidance for specific industries and transactions. The two boards have worked for years to bring the frameworks closer together, and on major topics such as revenue recognition and leases they are now similar, but differences remain in areas such as inventory valuation (LIFO is allowed under US GAAP but not IFRS), the treatment of development costs and the revaluation of fixed assets.
Many countries also have national standards for smaller entities, such as FRS 102 in the United Kingdom or IFRS for SMEs, which simplify the full requirements. Public sector bodies follow their own standards.
A company's accounts always state which framework was used, usually in the first note, and an audit opinion confirms whether the statements comply with it. Standards change.
New standards on revenue (IFRS 15 and ASC 606) and leases (IFRS 16 and ASC 842) transformed reported figures for many companies in recent years, bringing billions of lease liabilities onto balance sheets that had previously shown them only in the notes. Reading the accounts of any period therefore means knowing which version of the rules applied.
In practice
Real-world examples.
Example
A German engineering group listed in Frankfurt prepares its consolidated accounts under IFRS as required for listed companies in the European Union.
Example
A US technology company follows US GAAP and applies ASC 606 to decide how much of a bundled hardware, software and support contract to recognise as revenue each year.
Example
A family-owned UK manufacturer uses FRS 102, a simplified national standard, because it is not listed and does not need full IFRS.
Think of it
“Accounting standards are the official rules that govern financial reporting-what everyone must follow.
Formula
Calculation
Standards set rules rather than formulas, but the effect of a standard on the numbers can be shown. IFRS 16 requires most leases to appear on the balance sheet as a right-of-use asset and a lease liability.
Worked example. A retailer signs a five-year shop lease at $100,000 a year, paid annually in arrears. Its borrowing rate is 6%.
- Present value of the five payments at 6% = $100,000 x 4.2124 = $421,240
Before IFRS 16, the balance sheet showed nothing and the income statement showed rent of $100,000 a year. After IFRS 16:
- Balance sheet at signing: right-of-use asset $421,240 and lease liability $421,240
- Year 1 income statement: depreciation of $84,248 ($421,240 / 5) plus interest of $25,274 ($421,240 x 6%) = $109,522, instead of rent of $100,000
- EBITDA rises by $100,000 because rent is no longer an operating expense, while reported debt rises by $421,240
Nothing about the shop or the cash paid has changed, yet debt ratios, EBITDA and operating profit all move. This is why analysts restate figures when a standard changes.Case study
Seen in the real world.
A private equity fund was comparing two acquisition targets: a Canadian distributor reporting under IFRS and a US distributor reporting under US GAAP. On the face of it the US business had lower inventory costs and higher margins. The fund's accountants found that the US company used LIFO (last-in, first-out) for inventory, which US GAAP permits and IFRS forbids, and that in a period of rising prices LIFO had pushed its cost of goods sold up and its reported inventory value down by about $9 million relative to FIFO.
Restating both businesses to the same basis narrowed the margin gap to under half a percentage point. The fund also found that the Canadian company's balance sheet carried $30 million of lease liabilities under IFRS 16 that the older US GAAP comparatives had shown only in a footnote. Once both sets of accounts were on a like-for-like basis, the "cheaper" target was in fact the more expensive one.
Watch out
Common mistakes.
- Comparing companies reporting under different frameworks without adjusting for known differences such as inventory methods, lease treatment and development cost capitalisation.
- Assuming a standard applies to every company. Small and private entities often use simplified national frameworks with different rules.
- Reading old accounts with new rules in mind, or the reverse. Always check which version of a standard applied to the period.
Questions
People also ask.
Who sets accounting standards?
The IASB sets IFRS; the FASB sets US GAAP; national bodies set local standards, often based on one of the two.
Are accounting standards law?
They gain legal force through securities regulation and company law in each jurisdiction. Listed companies are generally required by law to follow the designated framework.
What is the difference between principles-based and rules-based standards?
Principles-based standards state objectives and require judgement; rules-based standards give detailed prescriptions. IFRS leans to the former, US GAAP to the latter.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related