Accounting: International & American Basics
This article aims to act as a beginner's guide to international accounting and basic accounting terms. It also covers some of the differences between accounting standards in the United Sates and the rest of the world.
Accounting helps people make decisions about businesses and take actions based on those decisions. Accounting is the identification, measurement and communication of financial information that helps users of the information make informed judgements.
There are two kinds of accounting:
- Financial accounting, which is for the use of people outside the organization
- Managerial accounting, which is used internally in an organization
Standard Setting Bodies
Accounting rules are devised by standard setting bodies. The most widely used standard setting bodies are:
- Financial Accounting Standards Board (FASB) in the United States
- International Accounting Standard Board (IASB) internationally
IFRS vs GAAP
International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) are two different accounting regulations (also known as standards) that define how to measure and report companies' economic activities - IFRS is used globally and GAAP is used in the United States.
Regulations are important since they provide financial information in a standard and comparable manner that makes decision making efficient, transparent, and (hopefully) reliable. Regulations define things like what information companies should disclose and the formats they should use for their financial statements.
Starting January 2005, The European Commission required all public European firms to prepare their financial statements in accordance with IFRS. The US is currently using GAAP but there are increasingly more and more convergences between the two.
Prior to March 2008, any public companies that used IFRS in the US had to reconcile their financial statements to follow GAAP. That is no longer so. In recent developments, IFRS is actually expected to be mandatory in the US.
The two different financial reporting systems affect companies who deal both in the US and Europe, particularly those that partake in cross-border mergers and acquisitions. Hence it seems that a convergence is necessary.
What is the Difference Between GAAP and IFRS?
Companies that use either US GAAP or IFRS end up presenting different sets of financial results. This can be daunting for firms' accounting departments having to report two different sets of results and it can even be scandalous! For instance, when Portuguese private bank Banco Comercial Portugues (BCP), started trading on the NY Stock Exchange and had to redo their financial results to meet GAAP requirements, the resulting numbers looked very unfavorable to the bank and they decided to de-list. BCP's president, Jorge Jardim Goncalves said in an interview, "In some circumstances we had to present reports and numbers which, no matter how many explanations were offered, were disturbing”.
Let's take at examples of some of the differences between the GAAP and IFRS.
Cash Flow Statements
Direct or indirect method can be used
Can only use the direct method
Includes "extraordinary items" classiffication that needs to be reported beneath net income
No "extraordinary items" classification
Reporters can choose between LIFO and FIFO
Using LIFO (Last In, First Out) is prohibited); Need to use FIFO
Were you aware that there are differences between the accounting standards the US uses and the accounting standards that the rest of the world uses?
Components of Financial Reports
Financial reports include:
- Financial statements - these include balance sheets, income statements, cash flow statements, and statements of shareholders' equity.
A balance sheet is essentially a summary of where a business stands in terms of its current financial position. It lists assets on one side and liabilities and equity on the other side. The two are supposed to balance out. Actually, it's the essential accounting equation: Assets = Liabilities + Shareholders' Equity
An income statement (aka profit and loss account) is a summary of the financial performance of a business over a particular period of time. It tells stakeholders whether a particular business made a profit or loss over a particular period of time. The fundamental equation for calculating profit is: Profit = Revenue - Loss