US GAAP vs IFRS Essay
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For the business world, especially those in the accounting field, a major issue has risen in recent years relating to the differences between the United States Generally Accepted Accounting Principles (US GAAP) and the International Financial Reporting Standards (IFRS). Currently, the majority of countries in the world (more than 100 countries) follow IFRS guidelines; however, the United States still uses GAAP. This topic has become a main topic of discussion as there is a plan for convergence between the two frameworks in the near future.
The United States accounting system will undergo drastic changes when this occurs, but the end result is intended to simplify the accounting procedures around the world.
“Through these projects, some covering major components of the financial statements, the boards intend to improve financial reporting information for investors while also aligning the US and international accounting standards. These projects are a significant move toward achieving a common accounting framework, a necessary step in the globalization of business and investment” (“US GAAP vs. IFRS: The basics”, 2010). The main difference between US GAAP and IFRS is that US GAAP is considerably rule-based, where IFRS is more principal-based which means IFRS has room for interpretation. There are too many specific differences to cover in a short presentation, however, an explanation of a select few major differences are discussed herein. A discussion of some of the advantages and disadvantages for the worldwide convergence of accounting standards are included, as well.
Keywords: US GAAP, IFRS, Convergence Project, FASB, IASC
US GAAP VS IFRS
In our current global economy, financial reporting requires operators to understand the accounting practices used by the company, the language of the country in which the company exists, the currency utilized by the company to prepare its financial statements and how to attract investors and creditors to invest in or lend money to their company.
It is not surprising that many people who follow the development of worldwide accounting standards today might be confused and frustrated. Convergence is a high priority on the agendas of both the US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). Merriam-Webster defines convergence as “moving toward union or uniformity” (Gove, Webster’s third new international dictionary of the English language, unabridged, 1993). However, there is much discussion of the many differences that exist between US GAAP and International Financial Reporting Standards (IFRS). This suggests to many people, that the two accounting frameworks continue to speak languages that are worlds apart. This apparent contradiction has prompted some to ask just how different are the two sets of standards? Where do the differences exist, why do they exist, and when, if ever, will they be eliminated?
In the guide, “US GAAP v. IFRS: The basics” a look is taken to attempt to answer these questions and provide an overview, by accounting area, of where the standards diverge. While the US and international standards do contain differences, the general principles, conceptual framework and accounting results between them are often the same or similar, even though the areas of difference seem to have overshadowed these similarities. Any discussion of this topic should not lose sight of the fact that the two sets of standards are generally more alike than different for most commonly encountered transactions, with IFRS being largely, but not entirely, grounded in the same basic principles as US GAAP.
No report or publication that compares these two broad sets of accounting standards can include all the differences that could arise in accounting for the various business transactions that could potentially occur. The existence of any differences depends on a variety of specific factors including: the nature of the entity/business, the detailed transactions it enters into, its’ interpretation of the more general IFRS principles, its industry practices, and its accounting policy elections (“US GAAP vs. IFRS: The basics”, 2010). Let us focus on a select few of the most commonly found differences in present practice. In addition, we will discuss the disadvantages and advantages of the pending convergence of these two accounting frameworks.
Since 1973, the Financial Accounting Standards Board (FASB) has been designated as the establishment of financial accounting that regulates the preparation of financial reports by non-governmental entities. These standards are identified as authoritative by the Securities and Exchange Commission (SEC) who has the authority to institute financial accounting and reporting standards for publicly held companies under the Securities Exchange Act of 1934 (“Facts About FASB”). The United States Generally Accepted Accounting Principles (US GAAP) is considered a more rules based system of accounting,
The International Accounting Standards Committee, formed in 1973, was the first international standards-setting body. It was reorganized in 2001 and became an independent international standard setter, now known as the International Accounting Standards Board (IASB). Since then, the use of international standards has progressed. “As of 2013, the European Union and more than 100 other countries either require or permit the use of international financial reporting standards (IFRSs) issued by the IASB or a local variant of them” (“International Convergence of Accounting Standards- A Brief History”). The IFRS is more principal-based which means there is room for interpretation. It can be said or argued that by being more principles based, the IFRS represents and captures the economics of a transaction better than U.S. GAAP.
While each framework requires presentation of an income statement as a primary statement, there are some major differences in the way items are handled. The three main differences are the actual format of the income statement, the handling of exceptional items and also how extraordinary items are handled (Dharma Putra, “IFRS Vs GAAP: Balance Sheet and Income Statement”, 2008).
_FORMAT OF THE INCOME STATEMENT_
Under IFRS, there is no prescribed format for the income statement. The company should select a method of presenting its expenses by either function or nature; this can either be, on the face of the income statement, or in the notes. Additional disclosure of expenses by nature is required if functional presentation is used. IFRS requires a minimum presentation of the following items on the face of the income statement: revenue, finance costs, share of post-tax results of associates and joint ventures accounted for using the equity method, tax expense, post-tax gain or loss attributable to the results and to re-measurement of discontinued operations and profit or loss for the period (Dharma Putra, “IFRS Vs GAAP: Balance Sheet and Income Statement”, 2008).
Under US GAAP; presentation is in one of two formats. Either, a single-step format where all expenses are classified by function and are deducted from total income to give income before tax; or a multiple-step format where cost of sales is deducted from sales to show gross profit, and other income and expense are then presented to give income before tax. SEC regulations require registrants to categorize expenses by their function. Amounts attributable to the minority interest are presented as a component of net income or loss (“US GAAP vs. IFRS: The basics”, 2010).
_EXCEPTIONAL OR SIGNIFICANT ITEMS_
Under IFRS; the separate disclosure is required of items of income and expense that are of such size, nature or incidence that their separate disclosure is necessary to explain the performance of the company for the period. Disclosure may be on the face of the income statement or in the notes. IFRS; does not use nor does it define the term exceptional items. Under US GAAP; the term exceptional items is not used, but significant items are disclosed separately on the face of the income statement when arriving at income from operations, as well as being described in the notes (“US GAAP vs. IFRS: The basics”, 2010).
Under IFRS, they are prohibited. Under US GAAP, these are defined as being both infrequent and unusual. Extraordinary items are rare. Disclosure of the tax impact is either on the face of the income statement or in the notes to the financial statements (“US GAAP vs. IFRS: The basics”, 2010).
UNDER IFRS, THE EARNING-PER-SHARE CALCULATION DOES NOT AVERAGE THE INDIVIDUAL INTERIM PERIOD CALCULATIONS, WHEREAS UNDER U.S. GAAP THE COMPUTATION AVERAGES THE INDIVIDUAL INTERIM PERIOD INCREMENTAL SHARES (FORGEAS, “IS IFRS THAT DIFFERENT FROM U.S. GAAP? “, 2008).
Under IFRS, LIFO (last in first out), a historical method of recording the value of inventory, a firm records the last units purchased as the first units sold or to be used. Under U.S. GAAP, companies have the choice between LIFO and FIFO (first in first out), a common method for recording the value of inventory.
Intangible assets are things like research and development and advertising costs. Acquired intangible assets under U.S. GAAP are recognized at fair value, while under IFRS, it is only recognized if the asset will have a future economic benefit and has measured reliability. (“US GAAP vs. IFRS: The basics”, 2010). The treatment of acquired intangible assets helps illustrate why IFRS is considered to be more principles based.
Convergence is a high priority on the agendas of both the US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). The FASB and the IASB have been working on a joint venture known as the convergence project. This project was announced in 2002; its purpose is to improve and converge US GAAP and IFRS. “As of 2013, Japan and China were also working to converge their standards with IFRS’s. The Securities and Exchange Commission (SEC) consistently has supported convergence of global accounting standards. However, the Commission has not yet decided whether to incorporate International Financial Reporting Standards (IFRS) into the U.S. financial reporting system. The convergence project has yet to be completed; in the meantime, more and more countries are running towards the IFRS since it is more reliable and relevant” (“International Convergence of Accounting Standards- A Brief History”).
ADVANTAGES OF CONVERGENCE
Conversion to IFRS offers many benefits to companies. “The most obvious and beneficial aspect of adopting IFRS is consistency. Public companies in over 100 countries are using IFRS and Canada is on track to adopt the new system” (Fellman, “The benefits and drawbacks of conversion from GAAP to IFRS”, 2009). It seems only logical that the United States should do the same. “Additionally, if a company has foreign operations, adapting IFRS would give them more internal consistency. They would be able to make their financial reports uniform which can reduce costs because all reporting will be done the same way. This will allow them to streamline their operations, reporting standards, auditing, training, development and company standards. Whether domestic or global, this streamlining, once put in place in all of a companies’ offices, will result in precise and consistent company records and reporting.
If IFRS adaptation is ruled to be optional before a set date, a company can gain a large advantage if they were to adopt the reporting standards early, because they would be giving themselves a head start on using and becoming familiar with the system. According to Stanley Todd, “By adopting IFRS, a business can present its financial statements on the same basis as its foreign competitors, making comparisons easier. Furthermore, companies with subsidiaries in countries that require or permit IFRS will be able to use one accounting language company-wide. Companies also may need to convert to IFRS if they are a subsidiary of a foreign company that must use IFRS, or if they have a foreign investor that must use IFRS. Companies may also benefit by using IFRS if they wish to raise capital abroad” (Todd, “The Convergence of International and U.S. Financial Reporting Standards”, 2008).
DISADVANTAGES OF CONVERGENCE
It goes without saying that along with benefits come drawbacks. Changing to IFRS from US GAAP is not simply a change in accounting procedure. The U.S. will have to pay a lot of money in the process of converting. Some of these costs include work force training, personnel preparation, and entire system changes. Once a company makes the decision to change to IFRS, it must to be a total transformation. “Additionally, because IFRS is different to US GAAP, it would be beneficial for companies to hire financial advisors and staff that are knowledgeable in IFRS as they will be able to help guide the company through its conversion” (Fellman, “The benefits and drawbacks of conversion from GAAP to IFRS”, 2009). Hiring this new staff will increase costs and also makes layoffs and staff cutbacks very possible. Companies will most likely also have to upgrade their technology and computer programs for the change from US GAAP.
All reports, financial documents, contracts and agreements will have to be revised since they were originally drawn up under US GAAP standards. Finally, companies will incur additional costs for the auditors and advisors needed for the initial conversion” (Fellman, “The benefits and drawbacks of conversion from GAAP to IFRS”, 2009). This expense would most likely be a one-time expense. This stark change would impact the delivery/operations side of the business with respect to how contracts are written with both customers and vendors/suppliers (Forgeas, “Is IFRS That Different From U.S. GAAP?”, 2008) .The upside to all of these expenses is that they could turn out to be helpful by reducing net income and therefore cutting down on taxes paid by the companies.
The U.S. generally accepted accounting principal (US GAAP) and international financial reporting standard (IFRS) are standards governing how economic events are reported. In the United States, the Securities and Exchange Commission (SEC) relies on the FASB, the accounting standard-setting body of the U.S., to develop accounting standards that public companies must follow when publishing financial statements. On the other hand, many countries outside of the United States have adopted the International Financial Reporting Standard (IFRS) which is issued by the International Accounting Standard Board (IASB).
In recent years, the FASB and IASB have worked closely to try to minimize the differences in their standards and principals and plan to merge the two systems in the future. This paper is intended to give some background of both frameworks, compare and contrast some of the differences between US GAAP and IFRS, as well as, the advantages and disadvantages of the upcoming convergence.
Although the arguments from both sides of the issue are compelling, plans are already in place for convergence of the standards by 2015. “Since the change from US GAAP to IFRS is inevitable, companies need to focus on developing an action plan, as well as, a clearly defined plan for their future as IFRS users. There needs to be a strategy for conversion that will allow it to go as smoothly as possible so they can keep interruptions to their daily performance at a minimum” (Fellman, “The benefits and drawbacks of conversion from GAAP to IFRS”, 2009).