3.11: Financial Accounting Standards
Learning Outcomes
- Summarize the background and sources of financial accounting standards
The Importance of Accounting Standards
Dutch tulip bulbs were the Bitcoin of the early seventeenth century. Traders were making unheard of profits buying and selling in the backrooms of taverns and inns. Prices doubled and tripled within months. In 1637 the market collapsed, mostly because even the wealthiest speculators could no longer afford a single bulb. Purchases came to a screeching halt, and so did sales, and the trade business collapsed almost overnight, leaving investors broke.
By the turn of the twentieth century, corporations had become a primary moving force in the American economy, and the general public was investing with reckless abandon in everything from railroads to automobiles to agriculture. The frenzy caused the market to rise to astronomical levels, and it looked at the time as if it would never slow down. It was the age of economic exuberance. A few savvy investors spent the time and energy needed to research each investment, but most investors simply rode the rising tide, buying and selling stock on the New York Stock Exchange, which has started as a small merchant trading club in 1792.
Generally Accepted Accounting Principles
The bubble popped in August of 1929. Stock certificates became worthless as companies went bankrupt and disappeared. In the aftermath, the government moved to rebuild confidence in the financial markets by imposing stricter guidelines for financial reporting. The accounting profession was faced with a choice–self-regulate or accept government regulation. The end result was a little of both. Congress created the Securities and Exchange Commission (SEC) to regulate the financial markets, and the SEC charged the American Institute of Certified Public Accountants (AICPA) with the task of developing financial accounting standards in the private sector. The standards-setting committees of the AICPA struggled with both internal strife and the growing complexity of the task of creating a unified structure, so the association created a separate, independent body in 1971 called the Financial Accounting Standards Board (FASB) that still operates today, discussing, creating, and implementing Generally Accepted Accounting Standards (GAAP). These are the standards that financial accounts and the general public rely upon to ensure that financial statements are universally understandable and usable.
International Financial Reporting Standards
The United States is one of the few countries that follows its own accounting principles. More than 116 other nations have adopted International Financial Reporting Standards (IFRS) that are created by an International Accounting Standards Board (IASB). IFRS are based on broad principles as opposed to the more specific guidance of GAAP. For instance, GAAP requires companies to record and report assets at historical cost. IFRS allows a company to report assets at market value.
The SEC requires publicly traded companies to follow GAAP, and although there have been discussions in the industry about adopting IFRS, currently there is little movement in that direction.
The Internal Revenue Code
In addition to GAAP, companies must comply with an entirely different set of rules to report income to the Internal Revenue Service annually for tax purposes. The original Internal Revenue Code (IRC) of 1939 was a compilation of various tax statutes enacted during the early part of the twentieth century. Since then, the IRC has undergone two major re-codifications, one in 1954 and another in 1986. The 1986 act was extensive enough to warrant re-naming the code as the Internal Revenue Code of 1986.
In addition to Federal income tax, companies are often subject to a variety of state and local taxes, each with slightly different rules and regulations.
Practice Questions