LM02 Financial Reporting Standards

Part 1

1.  Introduction

Financial reporting standards provide principles for preparing financial reports. They also determine the types and amount of information that must be provided to users of financial statements. There are several financial reporting standards but the most prominent ones are the U.S. generally accepted accounting principles (US GAAP) and International Financial Reporting Standards (IFRS). This reading focuses on the context within which these standards are created.

2.  The Objective of Financial Reporting

The following paragraph is an excerpt from the Conceptual Framework for Financial Reporting 2010 formulated by IASB:

“The objective of financial reporting is to provide financial information that is useful to users in making decisions about providing resources to the reporting entity, where those decisions relate to equity and debt instruments, or loans or other forms of credit, and in influencing management’s actions that affect the use of the entity’s economic resources.” The providers of resources include investors, lenders, and other creditors.

For the users of financial statements, financial reporting standards facilitate comparison across companies (cross sectional analysis) and over time for a single company (time-series analysis). The accounting standards must be flexible enough to recognize that differences exist in the underlying economics between businesses. The financial transactions that companies aim to disclose are often complex and often require accruals and estimates, both of which necessitate judgment. Accordingly, the accounting standards must also be flexible enough to achieve some consistency in these judgments.

Let us consider some simple examples. Suppose two companies buy similar equipment for long-term use. One company expenses (shows the entire amount as an expense on the income statement) and the other company capitalizes the cost of the equipment (creates an asset on the balance sheet). For an analyst, this represents a challenge when comparing the two companies. The different accounting treatment will lead to two very different income statements and balance sheets for the two companies. Financial reporting standards address such a challenge by creating accounting standards which ensure that both companies record similar transactions in a similar manner. For example, the standards might require that both companies create an asset on the balance sheet.

However, suppose one company will make extensive use of the equipment while the other will not use it so extensively. How do financial reporting standards allow for such a difference? The answer is that financial reporting standards retain some flexibility in giving companies the discretion to decide on the estimated useful life of an asset. The cost of the machine is then apportioned over this useful life as an expense – this expense is known as depreciation. Financial standards allow companies to record different amounts of depreciation every period based on the usage of the machines. For example, the company that uses the asset extensively will show a higher depreciation expense each year for a shorter number of years. Whereas, the company that uses the asset less extensively will show a lower depreciation expense each year but for a longer number of years.

3. Accounting Standards Board

Standard-setting bodies

Standard-setting bodies are private sector organizations that help develop financial reporting standards. The two important standard-setting bodies are:

• Financial Accounting Standards Board (FASB) – For the U.S. The standards developed by FASB are called U.S. GAAP (Generally Accepted Accounting Principles).
• International Accounting Standards Board (IASB) – For the rest of the world. The standards developed by IASB are called IFRS (International Financial Reporting Standards).

Standard-setting bodies simply set the standards but they do not have the authority to enforce the standards.

4. Regulatory Authorities

Regulatory authorities are government entities that have legal authority to enforce the financial reporting standards. The two important regulatory authorities are:

• Securities and Exchange Commission (SEC) – For the U.S.
• Financial Services Authority (FSA) – For the UK

Regulatory authorities are also responsible for the regulation of capital markets under their jurisdiction.

The International Organization of Securities Commissions (IOSCO)

Technically not being a regulatory authority, IOSCO still regulates a significant portion of the world’s financial markets. (Think of it as an umbrella organization of regulatory authorities). This organization has established objectives and principles to guide securities and capital market regulation.

Core objectives

• Protect investors.
• Ensure fairness, efficiency, and transparency in markets.
• Reduce systemic risk.

Principles

• There should be full, accurate, and timely disclosure of financial results and risks.
• Financial statements should be of a high and internationally acceptable quality.

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