Value of Accounting Standards

¶ … Value of Accounting Standards

Accounting rules are designed to serve the capital markets and make these markets work efficiently. Accounting rules are essential to the efficient functioning of the economy because decisions about the allocation of resources rely heavily on credible, concise, transparent and understandable financial information. Without standard measures of the worth of a company, lenders and investors would have no way in which to evaluate the worth of the business, so these rules are essential to the capital markets. With the rise of multinational businesses, it is essential that these rules be uniform throughout the world. Generally accepted accounting principles (GAAP) are the accounting rules used to prepare financial statements for publicly traded companies and many private companies in the United States. In the United States, as well as other countries practicing English common law system, the government does not set accounting standards, in the belief that the private sector has better knowledge and resources. GAAP is not written in law, although the SEC requires that it be followed in financial reporting by publicly traded companies. "Regulators are now mulling over the obligations that investment bank underwriters owe to investors when placing securities - and whether reliance on audited (by independent auditor or other expert) financial statements is sufficient without further inquiry to discharge such obligations."

GAAP has four basic assumptions. The economic entity assumption assumes that the business is a separate entity because the revenues and expenses should be kept away from personal expenses. This applies even for partnerships and sole proprietorships. The going concern assumption assumes that the business will be in operation for a long time. This validates the methods of asset capitalization, depreciation, and amortization. The monetary unit assumption assumes a stable currency is going to be the unit of record. The FASB accepts nominal value of the U.S. Dollar as the monetary unit of record, unadjusted for inflation. The periodicity assumption assumes that the business operations can be recorded and separated into different periods. This is required for comparison between present and past performance.

There are four basic principles underlying GAAP. The historical cost principle requires companies to account and report based on acquisition costs rather than fair market value for most assets and liabilities. The revenue recognition principle requires the business to record when revenue is realized or realizable and earned, not when cash is received. This is called accrual basis accounting. The third principle is the matching principle. Expenses have to be matched with revenues as long as it is reasonable doing so. The full disclosure principle requires that the amount and kinds of information disclosed should be decided based on trade-off analysis as larger amount of information costs more to prepare and use. Information disclosed should be enough to make judgments while keeping costs reasonable.

There are four basic constraints underlying GAAP. The cost-benefit relationship states that the benefit of providing the financial information should also be weighted against the cost of providing it. Materiality states that significance of an item should be considered when it is reported. Industry practices states that accounting procedure should follow industry practices. Conservatism states that when choosing between two unfamiliar solutions, the conservative method should prevail.

The Financial Accounting Standards Board (FASB) is the organization whose primary purpose is to develop Generally Accepted Accounting Principles in the United States, along with the Securities and Exchange Commission (SEC), the American Institute of Certified Public Accountants (AICPA), the Financial Accounting Standards Board (FASB) and the Governmental Accounting Standards Board (GASB). It was created in 1973, replacing the Accounting Principles Board and the Committee on Accounting Procedure of the AICPA. The FASB is not a governmental body and it has no official legal standing. The Securities and Exchange Commission (SEC) has statutory authority to establish financial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934. Throughout its history, however, the Commission's policy has been to rely on the private sector for this function to the extent that the private sector demonstrates its ability to fulfill the responsibility in the public interest.

The FASB is part of a structure that is independent of all other business and professional organizations. Before the present structure was created, financial accounting and reporting standards were established first by the Committee on Accounting Procedure of the American Institute of Certified Public Accountants (1936-1959) and then by the Accounting Principles Board, also a part of the AICPA (1959-73). Pronouncements of those predecessor bodies remain in force unless amended or superseded by the FASB.

The mission of the FASB is to establish and improve standards of financial accounting and reporting for the guidance and education of the public, including issuers, auditors and users of financial information. The public uses financial information about the operations and financial position of individual entities in making various kinds of decisions. The Board believes that this broad public interest is best served by developing neutral standards that result in accounting for similar transactions and circumstances in a like manner and different transactions and circumstances should be accounted for in a different manner. To accomplish its mission, the FASB acts to improve the usefulness of financial reporting by focusing on the primary characteristics of relevance and reliability, and on the qualities of comparability and consistency. Standards must be kept current to reflect changes in methods of doing business and changes in the economic environment. It must consider promptly any significant areas of deficiency in financial reporting that might be improved through the standard-setting process, and promote the international convergence of accounting standards concurrent with improving the quality of financial reporting. "The Strategic Plan of the FASB indicates that our efforts in international activities should be guided by the belief that the ultimate goal of internationalization of accounting standards should be a body of superior accounting standards."

It is also charged with increasing the common understanding of the nature and purposes of information contained in financial reports.

The FASB develops broad accounting concepts as well as standards for financial reporting. It also provides guidance on implementation of standards. Concepts are useful in guiding the Board in establishing standards and in providing a frame of reference, or conceptual framework, for resolving accounting issues. The framework will help to establish reasonable bounds for judgment in preparing financial information and to increase understanding of, and confidence in, financial information on the part of users of financial reports. It also will help the public to understand the nature and limitations of information supplied by financial reporting.

The Board's work on both concepts and standards is based on research aimed at gaining new insights and ideas.

The Board follows certain precepts in the conduct of its activities. They are to be objective in its decision-making and to insure, insofar as possible, the neutrality of information resulting from its standards. To be neutral, information must report economic activity as faithfully as possible without altering the image it communicates for the purpose of influencing behavior in any particular direction. The FASB is committed to following an open, orderly process for standard setting that precludes placing any particular interest above the interests of the many who rely on financial information. It must weigh carefully the views of its constituents in developing concepts and standards. However, the ultimate determinant of concepts and standards must be the Board's judgment, based on research, public input and careful deliberation about the usefulness of the resulting information.

The FASB promulgates standards only when the expected benefits exceed the perceived costs. While reliable, quantitative cost-benefit calculations are seldom possible, the Board attempts to make certain that a proposed standard will meet a significant need and that the costs it imposes, compared with possible alternatives, are justified in relation to the overall benefits. It brings about needed changes in ways that try to minimize disruption to the continuity of reporting practice. Reasonable effective dates and transition provisions are established when new standards are introduced. The Board considers it desirable that change be evolutionary to the extent that it can be accommodated by the need for relevance, reliability, comparability and consistency. It will review the effects of past decisions and interpret, amend or replace standards in a timely fashion when such action is indicated.

The capital market is the market for long-term loans and equity capital. Companies and the government raise funds for long-term investments via the capital market. The capital market includes the stock market, the bond market, and the primary market. Securities trading on organized capital markets are monitored by the government, and new issues are approved by authorities of financial supervision and monitored by participating banks. Thus, organized capital markets are able to guarantee sound investment opportunities. The capital market can be contrasted with other financial markets such as the money market, which deals in short-term liquid assets, and futures markets which deal in commodities contracts.

Financial statements portray the effects of transactions and other events by grouping them into broad classes (or elements) according to their economic characteristics. The balance sheet is the primary financial statement that helps determine an enterprise's financial position, and provides crucial information for potential lenders. Information about financial structure, relative amounts of capital provided by investors and lenders, is useful in predicting future borrowing needs and how future profits and cash flows will be distributed among those interested in the enterprise. "Global consistency is needed for financial, as well as non-financial, information disseminated to investors in our markets. Moreover, there is a growing consensus around the world that financial reporting in any marketplace should be of high quality in order to serve the needs of investors."

Financial structure information also helps predict how successful the enterprise is likely to be in future financing transactions. Information about liquidity and solvency is useful for predicting an enterprise's ability to meet financial commitments. Liquidity relates to short-term availability of cash after taking into consideration short-term financial commitments. Solvency relates to long-term availability of cash to meet commitments as they become due.

The primary financial statement that provides information about an enterprise's profitability is the income statement, also known as the profit and loss statement. Information about enterprise profitability is useful to assess likely changes in the enterprise's control of economic resources and the ability of the enterprise to generate cash flows from existing resources. Information about the variability of profits is also useful for predicting future cash flows. In addition, profitability information helps determine how effectively an enterprise might employ additional resources.

A lender wants to obtain some confidence an enterprise can generate sufficient cash to meet scheduled debt payments; cash flow information helps determine this. The cash flow statement reports cash flows from investing, financing, or operating activities. Lenders are interested in the sources from which cash is generated, the timing and certainty of its generation, and how the cash is used. For example, an enterprise's long-term prospects depend on its ability to generate sufficient cash from profitable operations to provide returns to investors and other financing sources. If current cash requirements are instead generated by investing activities such as securities, or from financing activities such as long-term borrowing or the sale of stock, this information will be valuable to lenders.

The cash flow statement is not as universally required as the other statements. The EU, for example, does not require it. The cash flow statement is becoming increasing important, however, in judging management's performance and assessing an enterprise's ability to repay a loan. "Comparability assumes there is a common measuring yardstick by which to distinguish similarities and differences that informed users can rely upon in making decisions about providing resources, that companies can rely upon to conclude whether they have properly prepared financial statements, and that securities regulators can rely upon to adequately detect potential misinformation in a timely manner."

Accounting standards also specify supplementary information that accompanies financial statements. These items, called footnotes, should contain additional relevant information about items in the balance sheet and income statement. This information could relate to the risks and uncertainties affecting the enterprise, resources and obligations of the enterprise not recognized in the balance sheet, or breakdowns of figures by geographic area, customer type, or other category. Footnotes also contain detailed information about the accounting standards a firm employs, thereby lending transparency to the statements.

No one statement tells the whole story. The income statement, for example, provides an incomplete picture of performance without reference to the balance sheet or the cash flow statement. As a result, lenders and investors need information from each of the statements to make their decisions.

As more nations develop democratic, market-based economies, adopting standards based on GAAP is becoming increasingly important to the soundness of their financial systems. This policy of international harmonization is seen as a step towards achieving the long-term objective of a global set of accounting standards, which are applicable for domestic and international purposes. Such a set of standards should be generally accepted because of their quality and comprehensiveness, and complete and in sufficient detail to facilitate operational implementation, consistency, comparability and transparency. They must also be rigorously interpreted and applied. "Given the globalization of capital flows through capital markets, and the diversification and increasing sophistication of economic transactions, there is an urgent need to develop internationally-accepted corporate accounting standards that ensure the comparability of corporate financial statements."

The adoption of internationally recognized accounting standards could ease privatization efforts because of the confidence they provide individual shareholders. International harmonization has the potential to provide reductions in the cost of capital through the resolution of uncertainty relating to the interpretation and implementation of national standards, and administrative benefits arising from the ease of filing in multiple jurisdictions and the resultant simplicity in the development of common accounting systems in place of adjusting, reconciling and explaining different bases applied in different countries. It would also enhance comparability and transparency of financial reporting requirements and credibility of the reported information and facilitate cross-border investment and fund raising and the removal of an impediment to a more efficient allocation of resources. This would lower investment risk because it reduces an element of risk associated with understanding foreign financial reporting for investors and lenders. Without such standards, the ability of privately held enterprises to attract international capital from bankers and investors is seriously impaired.