What Is an Applicable Financial Reporting Framework?

An applicable financial reporting framework is the foundation of rules and standards that guide the preparation of a company’s financial statements. It acts as a common language for communicating financial information, ensuring that reports are consistent and comparable across different companies. This standardized approach allows investors, lenders, and other stakeholders to make informed decisions based on reliable financial data.

General Purpose Financial Reporting Frameworks

General purpose frameworks are designed to meet the common information needs of a wide range of external users, such as investors and creditors. In the United States, the primary framework is U.S. Generally Accepted Accounting Principles (GAAP). Maintained by the Financial Accounting Standards Board (FASB), GAAP is a comprehensive and rules-based system that public companies in the U.S. are required to follow. It provides detailed guidance on a variety of accounting topics, from how to recognize revenue to how to classify items on the balance sheet.

The goal of GAAP is to ensure that financial statements are complete, consistent, and comparable, which helps users evaluate a company’s performance over time and against its competitors. While non-public companies are not required to use GAAP, many do so because lenders or investors may require financial statements prepared in accordance with these standards. The detailed nature of GAAP provides a high degree of structure, which can be beneficial for complex organizations.

Outside of the United States, most of the world uses International Financial Reporting Standards (IFRS). Developed and maintained by the International Accounting Standards Board (IASB), IFRS is required for publicly listed companies in over 140 jurisdictions, including those in the European Union. The objective of IFRS is to create a single, high-quality global accounting standard that enhances transparency and comparability of financial information across international borders.

A distinction between IFRS and GAAP lies in their approach; IFRS is more principles-based, while GAAP is more rules-based. This means IFRS provides broader principles for accountants to follow, allowing for more judgment in applying them to specific transactions. In contrast, GAAP provides more detailed and specific rules for a wider range of situations, which can lead to different accounting treatments for similar transactions under the two frameworks.

Special Purpose Financial Reporting Frameworks

Beyond general purpose frameworks, special purpose frameworks are designed to meet the specific needs of a particular group of users. These are simpler and less costly to apply than GAAP or IFRS, making them a popular choice for smaller, non-public entities. Common special purpose frameworks include:

• Cash basis of accounting: Under this method, revenue is recognized when cash is received, and expenses are recorded when cash is paid.
• Tax basis of accounting: This framework uses the same rules and principles that a company follows when preparing its income tax return, which is efficient for businesses that already prepare one.
• Contractual basis of accounting: This is used when a company needs to prepare financial statements that comply with the terms of a specific agreement, such as a loan covenant.
• Regulatory basis of accounting: This is used when a government agency imposes specific accounting requirements on the entities it oversees, which is common in industries like insurance and banking.

Selecting the Appropriate Framework

The choice of a financial reporting framework depends on several factors, primarily the users of the financial statements. If a company seeks investment from external parties, a general purpose framework like GAAP or IFRS is necessary. If statements are for internal management or a specific creditor, a special purpose framework may be more appropriate.

Regulatory and contractual requirements can also dictate the framework. The U.S. Securities and Exchange Commission (SEC) mandates that publicly traded companies use GAAP. Loan agreements may also specify that financial statements be prepared in accordance with a particular framework.

The entity’s size and complexity are also considerations. A large corporation with complex transactions will likely need the structure of GAAP or IFRS. A small business with simple operations may find a cash or tax basis framework sufficient, as the cost and complexity of adopting GAAP or IFRS can be significant.

Presentation and Disclosure in Financial Statements

The selected financial reporting framework must be clearly communicated in the notes to the financial statements. This is done in a section titled “Summary of Significant Accounting Policies,” which allows users to understand the basis on which the financial information has been prepared.

An independent auditor’s role is to provide an opinion on whether the financial statements are presented fairly in accordance with the chosen framework. The auditor’s report will explicitly mention the framework used, such as “in accordance with U.S. Generally Accepted Accounting Principles,” providing assurance to users.

The auditor’s responsibility is to audit the financial statements against the framework selected by management, not to choose the framework. The auditor evaluates if the company’s accounting policies are appropriate and consistently applied. If the financial statements do not conform to the chosen framework, the auditor will modify their audit opinion, signaling potential issues to users.