The industry practices constraint, also referred to as the industry practices concept, states that companies in certain industries can use different accounting practices.
In other words, some industries require specialized accounting and/or reporting which is unlike the generally accepted standards. The industry practices concept allows this to happen and for companies to use different accounting principles if it is infrequent and justifiable.
Companies operating in the United States must comply with the local accounting rules and regulations dominant there in the form of US GAAP. The US GAAP is a set of rules and accounting practices that were jointly developed by the Financial Accounting Standards Board (FASB) and the Government Accounting Standards Board (GASB). They are applicable to both governmental and non-profit organizations as well.
Any publicly traded company in the United States releasing its financial statements are required by the US law to follow the accounting rules and practices as set in the GAAP standard. An alternative to US GAAP is the IFRS, which were developed by the International Accounting Standards Board (IASB) and is more prevalent in countries operating outside the United States. IFRS can be found being used in the European Union, South America and even Asia.
History of Standards
The history of corporations has generally been scarred with wrongful, deceitful, and downright fraudulent financial reporting. One of the reasons for the infamous 1929 stock market crash was the less than forthright reporting by the listed companies resulting in the Great Depression.
During this period, the federal government realized that there was a need for a common and consistent accounting standard for financial reporting to protect the interests of the investors. They started working with the different financial accounting groups in the United States to establish standard and practices for accurate and consistent financial reporting.
GAAP was established by the passing of legislation like Securities Act 1933 and Securities Exchange Act of 1934. Since then, GAAP has undergone a process of gradual reform and evolution to become what it is today. It is widely accepted as the best practices across different industries in the country.
Importance of Standards
GAAP was introduced to safeguard the interests of investors from the fraudulent and deceitful reporting behaviors that organizations used to practice a century ago. The emphasis of GAAP is on reliable, consistent, fair, and honest reporting so that the investors can take informed decisions. GAAP also promulgates full disclosure reporting which implies inclusion material information in the footnotes of the financial reports, so that investors are not caught off guard by such events.
Deviation from the Standards
The industry practice constraint states that slight departure from the normal accounting standards might be acceptable and/or even required in certain industries, due to the nature of those industries. The accounting practice will differ from traditional theory in these industries. These industries will require specialized accounting or reporting practices that are not common to the normal practice. The industry practices concept allows these companies to practice specialized accounting so long as they are infrequent and/or justifiable.
Even in situations which call for specialized accounting due to the nature of a particular industry, the company cannot outright disregard all the accounting rules in the GAAP or IFRS. There will be at most one or two conflicts arising in which the company can bend the rules and that too only if they are able to justify it.
This makes complete sense since every industry is different and is faced with its own challenges with regard to financial accounting. Some industries might not be able to follow the accounting standards rule by rule due to the significant financial costs they might bear while doing so.
This ties back to the cost benefit principle that we studied in an earlier article which states that company should weight the costs of providing the financial information to the users with its benefits. If the costs of doing so are more, then the company should consider not providing the information if it is immaterial.
Therefore, sometimes following the accounting standards rule by rule is very difficult for some industries in terms of either the cost or the time required to do so. In this case, the industry practice constraint helps in allowing these industries to adopt slightly modified and altered rules and practices.
There are several unusual practices associated with different industries due to the nature of those industries. Departure from traditional accounting practices might be warranted in each of the following cases.
The agriculture industry is an example of one such industry. The historical cost concept states that companies must report their assets at their production cost or original cost. This is a difficult and a costly proposition for companies operating in the agriculture industry because the original cost cannot be determined easily for crops.
Therefore, it is easier for farmers to report their crops at the market value on the balance sheet. This departure in accounting rule for the agriculture industry is necessary since as per the cost benefit principle, the cost of providing this information to the users of financial statements is more than the benefits to do so.
Another industry that conforms to its own industry practices is the utility industry. Utilities companies are usually highly capitalized and have huge investments in infrastructure. Therefore, most utility companies will typically present their non-current assets before their current assets on the balance sheets. This is done to emphasize to the financial statement users the long-term assets of the company.
There are some points to note related to the industry practices constraints that are important:
- A slight departure from the normal accounting standards is acceptable based on the nature of the industry.
- Following the accounting standard rule by rule can place an enormous financial burden on some industries.
- The cost-benefit principle is at play here. If the costs of providing a certain piece of information to the users of financial statements is more than the benefit, an easier and simpler approach can be used.
- In the agriculture industry, the price of crops is recorded on market value rather than the cost of production or historical cost.