19 Accounting and financial reporting standards
‘There are no accounting issues, no trading issues, no reserve issues, no previously unknown problem issues.’
Kenneth Lay, former chairman, Enron LLC
In a nutshell
Accounting standards, also known as financial reporting standards, are rules and guidelines that set out how transactions should be recorded and presented in financial statements. ‘Standards’ set out the expected or preferred way of accounting and presentation.
To interpret or compare company performance requires an understanding of the accounting treatments used when preparing financial statements. An accounting policy note is included within financial statements to summarise the accounting standards applied in their preparation.
Comparing company performance without first understanding the accounting policies applied by companies may result in incorrect conclusions being drawn about relative performance. For example, a company revaluing its fixed assets would report a lower gearing (debt) ratio to one recording fixed assets at historic cost, even where those companies were identical in all other respects.
There is currently no single set of standards in use around the world, which makes international company comparisons difficult. Attempts continue to be made to converge standards globally, yet this objective remains elusive.
Need to know 
The requirement for companies to apply accounting standards is best understood within the context of director responsibilities. In the UK, directors have an overall responsibility to ensure the ‘truth and fairness’ of financial statements (see Chapter 20 External financial audit). While this term has never been defined in law, it is almost certainly the case that a failure by directors to comply with accounting standards, without adequate explanation, would raise concerns about whether accounts prepared by directors were true and fair. Where directors do not comply with accounting standards, they must as a minimum explain their reasons for not doing so. Failure to comply could result in auditors issuing a modified (qualified) audit report (see Chapter 20 External financial audit).
Why is this important? 
Investors and financiers want to make informed assessments about a company’s financial health. Financial information (about assets, profits, dividends, cash flows, etc.) helps investors and lenders to make decisions of whether to invest/lend, how much to invest/lend, etc. Accounting standards set the financial ‘ground rules’ for how transactions are recorded.
Standards help to ensure companies provide comparable information in a manner that fairly represents their performance and financial strength. Standards in effect limit the freedom and flexibility of companies to apply ‘clever’ accounting techniques that might otherwise enable them to hide transactions or be creative with how they are recorded and presented.
Companies may be involved in complex (some might say, clever) transactions for which standards do not yet exist meaning that regulators are unlikely to eliminate entirely the risk of clever accounting (or fraud). In the case of Enron (a now defunct US energy company), for example, loopholes in the US accounting standards framework in the early 2000s enabled the company to hide the extent of the company’s debt and borrowings through a complex web of transactions set up by the company. The failure to disclose the extent of the company’s debt resulted in one of the biggest corporate failures of that time.
When is this important? 
UK and international standards have developed over several decades as regulators seek to improve the quality of financial reporting.
In the UK, non-listed companies (companies that are not listed on a Stock Exchange) can adopt local (i.e. national) UK financial reporting standards (known as ‘FRS’) or alternatively adopt international accounting/financial reporting standards (known as ‘IAS’ and ‘IFRS’). Listed companies, because of their size and reach, must apply IFRS when preparing group accounts (see Chapter 16 Group accounting). The adoption of IFRS makes it easier to compare performance with companies internationally as an increasing number of countries around the world have mandated the use of IFRS.
Interestingly only a minority of non-listed companies in the UK have chosen to switch to IFRS, despite the advantage of comparability that a single set of global standards can bring about. It is thought that the financial and non-financial costs of switching from local rules on accountants, auditors as well as users, may be prohibitive.
Nevertheless, since 2009, all new or revised FRS (UK financial reporting standards) have been issued with an explicit objective of closer alignment (‘convergence’) with IFRS. This means that differences between local and international accounting regimes continue to narrow over time.
‘Standards’ versus choice
Perhaps surprisingly, many standards still permit a degree of choice over how to account for transactions even though this may appear to contradict the very notion of creating a ‘standard’ in the first place. The justification is that companies should retain the option of choosing between alternative accounting treatments where these are equally meaningful to users of accounts, provided there is appropriate disclosure of the impact of the accounting treatment adopted.
For example, IAS 16 gives the choice of accounting for land and buildings at (original) cost or at market valuation. Looking at the balance sheets of two companies that own identical fixed assets but adopt different accounting treatments will show their assets being held at different values, i.e. one company adopting historic cost and the second using market values. The motivation to choose one policy over another is often commercial, for example because one of the companies is financed largely by debt. Including land and buildings at market value increases the equity reported in the balance sheet and therefore shows a higher level of security against the debts.
Where choice is permitted, standards require sufficient disclosure to enable direct comparisons to still be made. In the above case, the financial effects of adopting market values would need to be disclosed by the company adopting a revaluation policy (see Chapter 17 Revaluation).
Companies are required to state whether or not they have complied with all applicable accounting standards. Where a company does not comply with one or more standards, the reasons for departure need to be explained. Where the auditors do not concur with the directors’ reasons for departure and disclosures, this can lead to a modification (qualification) within the audit report (see Chapter 20 External financial audit).
Nice to know 
Since the turn of the 21st century, 140+ countries, including the UK, have signed up to using international accounting standards, commonly referred to as IFRS or IAS. There are currently around 40 international standards. IFRS are developed and issued by the IASB (International Accounting Standards Board). IAS were issued by a predecessor body and a number of these standards continue to be relevant.
IFRS adoption by many countries around the world has enhanced comparability and understandability of company performance. However, and exceptionally, US companies have not aligned with IFRS and many use local standards known as US GAAP (Generally Accepted Accounting Practice). Interpreting financial performance and making comparisons between US and international companies therefore remains a challenge. For example, Exxon Mobil (a US company) applies US GAAP whereas Shell plc (an Anglo-Dutch company) uses IFRS. Despite both operating in the oil industry, a comparison between these companies requires extensive adjustments to enable meaningful performance comparisons, which in turn may hinder investment.
The objective to converge to a single set of worldwide standards is driven by the view that having a single set of accounting requirements will increase the comparability of company performance and therefore help contribute to the flow of international investment.
Since 2002, the IASB and FASB (Financial Accounting Standards Board) in the US have been working together towards ‘convergence’ of IFRS and US GAAP standards, although this process has notably stalled somewhat since 2012.
Optional detail 
IFRS versus US GAAP
IFRS and US GAAP differ in their underlying conceptual frameworks: IFRS is principles-based whereas US GAAP is rules-based.
In a principles-based framework, different treatments of similar transactions may be permitted where they are considered appropriate. A principles-based approach requires disclosures to enable a reader to understand the impact of applying an alternative to the standard treatment proposed.
A rules-based approach is based on following a comprehensive rulebook. As a result, additional rules must continually be added to respond to new or emerging accounting issues, or to permit exceptions to accounting rules.
Changes in accounting standards
New or revised accounting standards can impact key financial ratios or affect performance reward targets set for key personnel. For example, the introduction of IFRS 16 lease accounting (issued January 2016, applicable from 2019) has had a significant (adverse) impact on the gearing ratios (see Chapter 26 Long-term solvency performance measures) and ROCE reported by companies (see Chapter 23 Profitability performance measures).
Reflect and embed your understanding 
- 1What are the benefits of a US-style ‘rules’-based regime of accounting standards compared to a ‘principles’-based approach adopted in the UK?
- 2Consider an industry in which you have worked or studied. Review the financial statements of the organisation to those of its nearest competitors.
- aCompare the accounting policies applied by the companies. Have the companies adopted identical or different accounting policies?
- bWhat reasons are given for the choice of policy adopted?
- cCan you nevertheless compare these businesses? (Look for additional disclosures that seek to reconcile between different accounting policies.)
- 3Review the financial statements of international companies that operate in the same sector (such as in oil and gas, below) to appreciate why performance comparisons are made more difficult where companies follow US and IFRS accounting regimes.
- aBP plc and Shell plc (both companies adopt IFRS)
- bShell plc and Exxon Inc. (Exxon Inc. adopts US GAAP)
- 4New accounting standards are required in response to new or emerging business transactions or events. For example, no specific guidance exists on the accounting treatment for cryptocurrencies (for example, Bitcoin) and this may result in inconsistent treatment within the accounts of companies that engage in such transactions. Can you identify other examples of new or emerging transactions that may also require accounting guidance?
For the authors’ reflections on these questions, please go to financebook.co.uk
Where to spot in company accounts 
Look in the accounting policies note, typically shown after the primary statements (profit and loss, balance sheet and cash flow statement). This note will state the accounting standards regime adopted.
The notes to the accounts may provide specific additional details of the accounting treatments adopted.
Extract from Greggs plc 2020 financial statements Appendix p. 450
(a) Statement of compliance
Both the Parent Company accounts and the Group accounts have been prepared and approved by the Directors in accordance with international accounting standards in conformity with the requirements of the Companies Act 2006 and, as regards the Group accounts, International Financial Reporting Standards adopted pursuant to Regulation (EC) No 1606/2002 as it applies in the European Union (‘IFRSs as adopted by the EU’). On publishing the Parent Company accounts here together with the Group accounts, the Company is taking advantage of the exemption in s408 of the Companies Act 2006 not to present its individual income statement and related notes that form a part of these approved accounts.
Consolidate and apply
To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 406.
- →The accounting standards adopted, e.g. US GAAP, IFRS or UK GAAP, other local country GAAP. Reported profit will be directly influenced by the standards regime adopted.
- →Differences in accounting policies adopted by companies operating in the same industry, e.g. cost versus revaluation accounting for fixed assets. The accounts should contain sufficient disclosures to make performance comparisons between companies adopting different policies.
- →Changes in accounting policy and their impact on performance reward targets set for managers, e.g. if costs of ‘borrowing’ to buy a fixed asset are capitalised instead of being expensed, this treatment would increase profitability and ROCE ratios (see Chapter 23 Profitability performance measures).