Module: 4
Financial Standards and Codes: Report of Advisory Group on International Accounting and Auditing

International Accounting Standards and Harmonisation

Generally Accepted Accounting Principles (GAAP) and Accounting Standards

General purpose financial statements prepared by the business enterprises communicate the results of the business operations during the financial year and the state of financial affairs as at the end of the financial year. These financial statements are used by the investors, lenders and others in taking their economic and business decisions connected with the dealings with such enterprises. The phrase "Generally Accepted Accounting Principles" (GAAP) is a technical accounting term that encompasses the conventions, rules and procedures necessary to define accepted accounting practices at a particular point in time. It includes not only broad guidelines of general application, but also detailed practices and procedures. Those conventions, rules, and procedures provide a standard by which to measure presentations in the financial statements. GAAP are the ground rules for financial reporting. These principles provide the general framework in determining what information is presented in the financial statements and how the information is to be presented. The phrase "GAAP" encompasses the basic objectives of financial reporting as well as numerous broad concepts and many detailed rules.

A need for accounting standards arises mainly due to the following factors:-

• First, the financial statements are prepared by drawing an artificial line of cut-off at the year end, even though business continues as an ongoing concern and many transactions come to a logical end. In many transactions, one leg of a transaction may be completed, while the other leg of the same transaction may yet remain to take place. For instance, a questions arises as to whether to value unsold goods at the end of the accounting period at cost or realised value and which cost formula to use, which alternative method to use for evaluating depreciated/ amortised value of fixed assets, how to ascertain a number of assets/liabilities, claims and counter-claims and the correct treatment of uncertainties involved in evaluating a particular transaction. Therefore, the need arises for evolving appropriate accounting policies to deal with these questions.

• Secondly, given the fact that a number of accounting policies may emerge for dealing with the same situation, the need arises for accounting standards to narrow down the choice of accounting policies so that the financial statements are prepared in a common language which is clearly understood and which makes the financial statements prepared by different entities reasonably comparable with one another.

Accounting Standards can be described as a vehicle whereby the wisdom and experience of the profession emerges as a consensus in a complex and changing economic and business situation in preference to the views of individual compilers of financial statements. Accounting as a "language of business" communicates the financial results and health of an enterprise to various interested parties by means of periodical financial statements. Like any other language, accounting should have its grammar (set of rules) and that is Accounting Standards.

Why do national Accounting Standards in different countries differ? Gertrude Stein once said that a rose, is a rose, is a rose. But for financial statements prepared in different countries, it cannot be said so. Financial statements prepared in one country are often not acceptable in other countries. The reason is that the accounting standards are derived from the process that involves legal, economic, social and cultural considerations. Business practices, legal and fiscal framework, economic and social conditions differ in different countries and these differences impact on national accounting standards. Sometimes, even the basic philosophy and principles adopted in preparing the financial statements differ. For instance,-

1. In some countries while determining accounting treatments, form (legal form) of the transaction is given more importance, while in some countries "substance" of transaction is given more importance.

2. In some countries historical cost is considered more relevant, while in some other countries present fair value is considered more relevant for valuating various assets. Thus, in some countries revaluations of assets are permitted, while in other countries revaluations are not permitted.

3. In some countries creditors' protection is given priority, while in other countries investors'/shareholders' interest is considered more relevant.

4. In some countries corporate, tax and fiscal laws have greater influence on selection of accounting treatment than in others.

5. Rules regarding treatment of exchange differences, treatment of borrowing costs, depreciation of fixed assets, amortization of intangible assets and valuation of investments differ in different countries.

6. As discussed earlier, businesses nowadays are involved in transactions which extend over significant time periods, and which have inherent uncertainties associated with them. As a result, at any accounting date there are often significant transactions which have not been completed, and where the final outcome is uncertain. This means that compilers of financial statements must make estimates about future events in order to apportion costs and revenues to the appropriate financial periods. Thus estimates have to be made about future costs and revenues on long term contracts, on future pension costs, assets lives and on many other matters. These are inherently difficult problems. There are not necessarily only one set of "right" answers and it is therefore not surprising that standard setters in different countries deal with these matters in different ways.

Globalisation of trade and commerce has removed the barriers between the different countries. Political boundaries are becoming irrelevant for the flow of business transactions and movement of capital and funds. Information Technology, Developments in Communication facilities and E-Commerce have accelerated the process of globalisation of trade and commerce. These developments have created an urgent need for harmonization of accounting and auditing standards and practices.

The compilers of financial statements are required to issue financial statements in conformity with standards established in their country of origin. At the same time, auditors in reporting on the fairness of presentation of financial statements do so within a national framework of auditing standards.

Whilst most involved in the financial reporting process would say that like motherhood, international harmonization of accounting standards is a "good thing" and if achieved it would help in the development of international capital markets, there are many road blocks on the way to its achievement. National standards setters are naturally and indeed by their constitution concerned with and limited to the accounting standards subject to laws of their country. The standard setters have to serve the needs of their nation, and their standards therefore develop out of the economic, legal and cultural history and environment, which differ widely in different countries. There are many possible answers and the task is to find the one that best meets all the competing needs. Many standard setters have more than their hands full dealing with domestic issues.

For obvious reasons, no individual country has focussed attention on meeting the needs of providers of finance in other countries - their focus has mainly been on meeting national needs. It is against this background of issuers and auditors operating within national frameworks that the international financial and business community needs to look at the requirements of an increasingly large group - the cross border users of financial statements.

Recently, the Asian crisis has raised questions about the quality of accounting and auditing in the affected countries. The absence of transparency, harmonized standards and reliable financial information is a particular issue in respect of developing countries but is also an issue in many of the developed countries. The current position, where there is divergence in accounting standards between countries, impairs the quality and efficiency of capital markets and hampers international trade and commerce and puts obstacles in the path of a globalised economy.

In the recent past, International Forum on Accounting Development (IFAD) has been established for raising Reporting and Auditing practices worldwide. Such change requires a major role to be played by many different parties including reporting entities, accounting profession, regulators, Government and investors. Each of these parties must be an active and a willing participant in the analysis of the problems and the implementation of the solutions. It is not merely the question of accounting and reporting standards, but inherent in the vision is a generally accepted framework for corporate governance, for the accounting and auditing profession, for regulation and for education (to create awareness on the part of all the players including investors).

The ultimate objective is that all general-purpose financial statements are prepared using a single worldwide framework using common measurement criteria and fair and comprehensive disclosure. This cannot be achieved overnight and will require significant long-term efforts. The process should include the following steps.

1. National accounting standards should be at par with International Accounting Standards (IAS) as the benchmark or minimum standards.

2. All agencies should cooperate for a strong monitoring and oversight process on the implementation of national accounting standards.

3. During the transition period, the financial statements need to be supported by the use of an explanatory paragraph in these statements narrating the differences between national and international standards of accounting.