What it means
Imagine every company inventing its own way to count revenue and costs. Investors could not compare any two firms, and managers could choose whatever method made the results look best.
Accounting standards prevent that by setting a common rulebook for recognising, measuring and disclosing items. Different countries use different standards.
IFRS is issued by the International Accounting Standards Board and is used in many countries around the world, while US GAAP is set by the Financial Accounting Standards Board and applies to companies in the United States. Some countries have their own local standards for smaller private companies.
Standards cover topics such as how to recognise revenue, how to value inventory, how to treat leases and when to record a liability. They also dictate what must be disclosed in the notes.
These rules change over time, so finance teams track new standards and prepare for their effect on reported numbers. For non-finance professionals, the practical point is that two companies reporting under different standards may not be perfectly comparable.
Development costs, for example, can be treated differently, which changes reported profit and assets. Analysts adjust for these differences when they compare businesses across borders.
Auditors test financial statements against the relevant standards and give an opinion on whether the statements follow them. A clean opinion does not guarantee the business is healthy, but it does tell you the numbers were prepared using accepted rules.
Lenders, investors and regulators rely heavily on that assurance. Standards also shape business decisions well beyond the finance department.
A change in the rules on leases, for example, can move large commitments onto the balance sheet, which affects debt ratios and sometimes loan agreements. Managers who understand this can negotiate contracts and covenants with the reporting effect in mind.
In practice
Real-world examples
Example 1
A European manufacturer lists shares on a stock exchange and prepares its group accounts under IFRS. Its overseas subsidiaries keep local books but convert them to IFRS for consolidation. Investors can then compare the group with rivals using the same rules, which lowers the cost of raising money because the numbers are easier to trust.
Example 2
A US-based software company must follow US GAAP when it files its annual report. Its finance team studies a new revenue standard well before it takes effect, to learn how it will change the timing of subscription revenue, and it briefs the sales team so that contract terms are written with the new rules in mind.
Example 3
A small family-owned retailer prepares simple accounts under a local standard for smaller entities. The rules are lighter than full IFRS, with fewer disclosures. The owners still use the statements to support a bank loan application, and the bank accepts them because the rules are well understood locally.
Think of it
Accounting standards are the official rules that govern financial reporting-what everyone must follow.
Case study
Seen in the real world
Meridian Wireworks is a fictional manufacturer that, in this illustrative story, was acquired by a larger group reporting under a different set of standards. Meridian's old statements treated certain product development spending as an expense, while the acquirer's standards allowed some of it to be recorded as an asset.
When the finance team converted the numbers, Meridian's profit rose by about $350,000 and its assets by the same amount, even though not a dollar of cash had changed. The managers needed to explain to the board that the business had not suddenly improved.
By reconciling the two sets of numbers line by line, the team showed that the difference was purely a matter of rules. The board then judged performance using cash flow and operating results, which were unaffected by the standards, and asked for a short note explaining the difference in every future report.
Watch out
Common mistakes
- Assuming all companies follow the same accounting standards. Different countries and company sizes use different rulebooks.
- Treating compliance with standards as proof that a business is financially strong. Standards govern how numbers are prepared, not whether the business is profitable.
- Ignoring new standards until they become mandatory. Changes can alter reported profit, ratios and loan covenants, so early planning is wise.
Questions
People also ask
What is the difference between IFRS and US GAAP?
IFRS is principles-based and used in many countries, while US GAAP contains more detailed rules and is used in the United States. They differ on topics such as inventory methods and development costs.
Who sets accounting standards?
Independent standard-setting bodies do, such as the International Accounting Standards Board and the Financial Accounting Standards Board. Governments and regulators then decide which standards apply locally, and stock exchanges often add their own listing requirements on top.
Do private companies have to follow them?
Often yes, although many jurisdictions allow simplified standards for smaller private companies. Lenders and tax authorities may also require specific standards, so it is worth checking requirements before the books are set up.
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