In this lesson, you’re expected to learn about:
– international accounting standards
– generally accepted accounting principles and international financial reporting standards
– fair value and historical cost
What are Accounting Standards?
What appears in a company’s accounts is determined by accounting standards. These standards cover:
· What transactions we have to account for
· How we account for them
· How we present the information
· How much additional information we have to disclose
· The terminology we use
Accounting Standards in the UK
For example, in the UK, accounting standards start with the Companies Act 2006 which states that a company must prepare its accounts either:
– in accordance with international standards
– in accordance with the rules set out in the Companies Act itself and also with additional standards issued by the body designated for that purpose.
This combination of rules is known as GAAP, which stands for Generally Accepted Accounting Principles.
Just be aware that if you look at a private company’s accounts that the standards they are using might be different.
International accounting standards are produced by a body called the International Accounting Standards Board (IASB).
A set of their standards has been adopted by the EU so all European companies that are required to use international standards are using this one set of standards.
Ultimately, it would be ideal if all listed companies in all countries use the same standards but as things stand, this is not the case, particularly since the US currently uses its own standards.
The standards issued by the IASB are identified either as:
– IAS xx (International Accounting Standard)
– IFRS xx (International Financial Reporting Standard)
Accountants adhere to it for consistency, fairness, and accuracy in measuring and disclosing financial information. Since a company’s fiscal reports have a significant impact on the decisions made by investors, employees and financial institutions, GAAP provides a set of foundational guidelines.
Though publicly-traded companies are require to create financial reports using GAAP, they have the freedom to release additional reports prepared using non-GAAP principles.
Many businesses assert that non-GAAP earnings more accurately reflect their positions – the two approaches can lead to vastly different figures though in the short term.
GAAP requires that companies use accrual accounting which differs from cash accounting in that related revenues and expenses are reported together at the time of transaction rather than simply when cash is exchanged.
The method used for preparing financial reports matters most to investors when it comes to earnings per share.
While public companies in the US are currently required to follow GAAP standards when filing financial statements, private companies are free to choose their preferred accounting system.
The biggest difference between the two reporting standards is the number of rules behind the principles. GAAP principle re governed by more detailed rules and guidelines then IFRS. However both standards are in place to ensure that accountants remain honest.
However, international standards have moved to reporting assets and liabilities at ‘fair value’ rather than at cost.
The International Accounting Standards Board (IASB) defines fair value as “an amount at which an asset could be exchanged between knowledgeable and willing parties in an arms length transaction”.
Companies today enter into a lot of transactions where the resulting assets and liabilities change value significantly depending on what’s happening in the world economy.
The time value of money shows that there is a big difference in the value today between an amount of money that you don’t have to pay for a few years. If you can delay paying someone for several years that is valuable because you can invest the money in the meantime.
We can adjust for the time value of money by discounting future cash flows to give us their value today – the discounting is done by applying an annual percentage discount rate to the future cash flow.
Because money in the future is less valuable than money today, this always get you to a lower figure than the undiscounted figure.
Discount rates used by companies in their accounts vary, depending on what’s being valued from as low as 1% up to as much as 15-20%.
Effect on the balance sheet:
· increase future obligation
· decrease retained profit
This is known as unwinding of the discount.
Another thing that you’ll frequently come across on a listed company’s accounts is something called impairment.
When there are assets that are not restated to fair value at each balance sheet date, there is a need to consider impairment.
This means that if the recoverable amount or fair value of such an asset is actually lower at the balance sheet date than the standard accounting shows, the company is obliged to write down the value of the asset to the fair value.