Accounting Standard: Definition, Benefits and Types

In this article we will discuss about Accounting Standard:- 1. Definition of Accounting Standard 2. Benefits of Accounting Standards 3. Types.

Definition of Accounting Standard:

The term ‘Accounting Standard’ may be defined as written statements issued from time to time by institutions of the accounting profession or institutions in which it has sufficient involvement and which are established expressly for this purpose.

Such accounting institutions/bodies are currently found in many countries of the world, e.g., Accounting Standards Board (India), Financial Accounting Standards Board (USA), Accounting Standards Board (UK), Accounting Standards Committee (Canada), etc.

At the international level, International Accounting Standards Board (IASB) has been created “to formulate and publish, in the public interest, basic standards to be observed in the presentation of audited accounts and financial statements and to promote their worldwide acceptance and observance.”

Littleton defines ‘standard’ as follows:

“A standard is an agreed upon criteria of what is proper practice in a given situation; a basis for comparison and judgment; a point of departure when variation is justifiable by the circumstances and reported as such. Standards are not designed to confine practice within rigid limits but rather to serve as guideposts to truth, honesty and fair dealing. They are not accidental but intentional in origin; they are expected to be expressive of the deliberately chosen policies of the highest types of businessmen and the most experienced accountants; they direct a high but attainable level of performance, without precluding justifiable departures and variations in the procedures employed.”

Bromwich observes:

“Accounting standards (are) uniform rules for financial reporting applicable either to all or to a certain class of entity promulgated by what is perceived of as predominantly an element of the accounting community specially created for this purpose. Standard setters can be seen as seeking to prescribe a preferred accounting treatment from the available set of methods for treating one or more accounting problems. Other policy statements by the profession will be referred to as recommendations.”

Accounting standards deal mainly with financial measurements and disclosures used in producing a set of fairly presented financial statements. In this respect, accounting standards can be thought of as a system of measurement and disclosure. They also draw the boundaries within which acceptable conduct lies and in that and many other respects, they are similar in nature to laws.

Accounting standards can thus be seen as a technical response to calls for better financial accounting and reporting; or as a reflection of a society’s changing expectations of corporate behaviour and a vehicle in social and political monitoring and control of the enterprise.

Accounting standards, however, do not aim to put accounting in a straight jacket. Rather, they attempt to limit the theoretically possible flexibility and to give practitioners realistic working guidelines.

If the individual circumstances of a particular business firm are such that an existing standard is not suitable, then alternative practices, regarded as more suitable, can be adopted. It is, therefore, possible to achieve both uniformity and flexibility in accounting practice.

These two apparent opposites, i.e., uniformity and flexibility are not incompatible. It is also important to recognise that if standards are not acceptable, if they are not enforceable, and if they are not enforced, then they are not standards in any meaningful sense of the word. The process of enforcement is essential because if standards are not made compulsory they lose their utility and cease to be standards.

In case., standards do not enjoy mandatory supports, members of the accounting profession are expected when acting as auditors or professional accountants, to observe accounting standards or to seek observance of standards by business enterprises.

Benefits of Accounting Standards:

Accounting standards have evolved out of the concern and criticism which the flexibility in accounting practice has created. At present, accounting standards are regarded a major component in the framework of accounting and reporting practices. Standards exist to help the accounting practitioners to apply those accounting practices regarded as the most suitable for the circumstances covered.

Further, they help individual companies and their managements to justify whatever practices they adopt when producing their financial statements. The benefits of establishing accounting standards manifest themselves in different ways, either because they are real effects of those standards because people perceive certain effects, or because they expect certain effects to follow and modify their behaviour accordingly.

The benefits of accounting standards may be listed as follows:

(1) To Improve the Credibility and Reliability of Financial Statements:

Financial statements of business enterprises are used by a diverse group of users for making sound economic decisions such as shareholders (existing and potential), suppliers (existing and potential), trade creditors, customers employees, taxation authorities, and other interested parties.

It is necessary, therefore, that the financial statements, the users use and upon which they rely, present a fair picture of the position and progress of the enterprise. It is the function of accounting (and auditing) standards to create this general sense of confidence by providing a structural framework within which credible financial statements can be produced.

Where various alternative methods of measuring an economic activity exists, it is important that the best available one be used uniformly within a firm, by different firms, and to the extent practicable, by different industries.

This guideline is required in order to meet a basic need of managers, investors and creditors to compare results and financial conditions of different segments of firms, different periods of a firm, different firms, and different industries.

The value of the information provided by each enterprise to its investors is greatly enhanced if it can be compared easily; with information from other enterprises. In the absence of standards, there would be no incentives to encourage an enterprise to conform to any particular model for the sake of comparability.

Regulation, like rule of the road for drivers, is necessary to secure what everyone wants. Thus, the main aim of accounting standards is to protect users of financial statements by providing them with information in which they can have confidence.

(2) Benefits to Accountants and Auditors:

Accountants and auditors with the passage of time and a changing climate of opinion, have to work in an environment where they face the threat of stern sanctions and bad name to their professions. These result partly from changed penalties and remedies available under the company law and partly from the greater willingness of aggrieved parties and to take their causes before the courts.

The risks to auditors of these developments are considerable, whether in terms of uncovered financial exposure to liability or adverse effects on professional reputation resulting from un-favourable publicity. Particularly dangerous are cases of undetected fraud, and of audited accounts, which are held to be misleading due to insufficient disclosure or use of inappropriate accounting principles.

Given the increasing risks, the accounting profession realised that it needed to know what accounting standards are to prevail. Though individual accountant and chartered accountancy firm are concerned with their own reputations, the other accountants’ and firms’ misconduct would prove costly since all accountants belong to a class in the eyes of public.

While members of a chartered accountancy firm can discipline their fellow partners, it is difficult to monitor the performance of other chartered accountants. For this purpose, the establishment of standard to which all chartered or certified accountants subscribe is useful. Thus, accounting standards are beneficial not only to the business enterprises but also to the accountants and auditors as well.

(3) Determining Managerial Accountability:

Accounting standards facilitate in determining specific corporate accountability and regulation of the company and thus help in measuring the effectiveness of management’s stewardship.

They help in assessing managerial skill in maintaining and improving the profitability of the company, they depict the progress of the company, its solvency and liquidity and generally they are important factors increasing the effectiveness of management’s performance of its duties and of its leadership.

Standards aim to ensure consistency and comparability in place of (imposed) uniformity in financial reporting to permit better comparisons in profitability, financial position, future prospects and other performance indicators associated with different business firms. Management’s basic purpose should be to make a choice of the best method (standard) available.

The guidelines of relevance and appropriateness to intended use may be so crucial in a given setting that a departure from uniformity of practice (with full disclosure) may be justified. On the other hand, uniformity should never be the justification for inappropriate information.

An accounting standard should significantly reduce the amount of manipulation of the reported accounting numbers that is likely to occur in the absence of the standard. If the standard is subject to manipulation, its effect is more likely to be dysfunctional, since the managers can hide their actual performance under the cloak of reporting according to externally determined accounting standards.

(4) Reform in Accounting Theory and Practice:

Financial accounting has lacked, especially in the past, a coherent logical conceptual framework and structure for accounting measurements, financial reporting objectives and substantiated evidence on accounting practice and usefulness of accounting data. This encouraged the emerging intelligentia of accounting to develop accounting theories, to improve existing practices or to rectify their defects.

In 1960s, there was an outbreak in the accounting literature concerned with the issues and arguments about basic concepts in accounting; accounting standard, rules and law; wider effects of accounting policy choices. The search for the golden boomerang of accounting has yielded achievements and resulted into a greater awareness of alternative possibilities for defining and measuring financial performance.

According to Advisory Group on Accounting and Auditing (January 2001) setup by Reserve Bank of India:

“Standards help to promote sound financial systems domestically, and financial stability internationally. They play an important role in strengthening financial regulation and supervision, enhancing transparency, facilitating institutional development and reducing vulnerabilities. Standards also facilitate informed decision-making in lending and investment and improve market integrity and, thereby, minimise the risks of financial distress and contagion. Standards are not ends in themselves but a means for promoting sound financial fundamentals and sustained economic growth. The adoption of standards in itself, however, is not sufficient to ensure financial stability. The implementation of standards must fit into a country’s overall strategy for economic and financial sector development taking into account the stage of development, level of institutional capacity and other domestic factors.”

The RBI Advisory Group further observes:

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

i. 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 question 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/amortized 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.

ii. 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 clear 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.

Types of Accounting Standards:

Accounting Standards may be classified by their subject-matter and by how they are enforced.

According to subject-matter, standards may be as follows:

(1) Disclosure Standards:

Such standards are the minimum uniform rules for external reporting. They require only an explicit disclosure of accounting methods used and assumptions made in preparing financial statements. Such a standard is likely to be controversial or creates conflicts of interest, particularly since it does not constrain the choice of accounting policies or items to be disclosed.

(2) Presentation Standards:

They specify the form and type of accounting information to be presented. They may specify that certain financial statements be presented (e.g., a funds-flow statement) or that items be presented in particular order in financial statements. Such standards place only a little more constraint upon the choice of accounting policies than disclosure standards and aim to reduce the costs to users of utilising financial statements.

(3) Content Standards:

These standards specify the accounting information which is to be published.

There are three aspects to such standards:

(a) Disclosure:

Disclosure Content standards which specify only the categories of information to be disclosed.

(b) Specific:

Specific Construct standards which specify how specific items should be reported in accounts, e.g., a standard which specifies that finance leases be capitalized and disclosed in balance sheet.

(c) Conceptually:

Conceptually Based standards which specify the accounting treatment of items based upon a coherent and complete framework of accounting. Another classification of accounting standards may be based upon their method of preparation and enforcement.

Such standards are:

(1) Evolutionary and Voluntary Compliance Standards:

Such standards have evolved as best practices and represent the conventional approach to accounting. As such, their general acceptability implies voluntary compliance by individual companies.

(2) Privately Set Standards:

Private accountancy bodies may formulate standards and devise means for their enforcement. Other bodies such as trade associations or stock exchanges may set accounting standards for companies as a condition of membership or listing. Enforcement powers are thus more readily available.

(3) Governmental Standards:

These standards may be laws relating to company accounting practices and disclosure, as in the case of the Indian Companies Acts, or tax rules defining taxable profit. Alternatively, Government departments or agencies may regulate accounting practices for certain industries. It is significant to note that the above two classifications are complementary and not competitive.