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IFRS Vs GAAP Accounting Standards
Over the past twenty years there has been a growing demand to unify the business world under a conceptual framework for reporting financial statements. Currently, there are two types of frameworks used throughout the accounting world. They are General Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).
Currently, more than seven thousand companies in a hundred countries around the world use IFRS instead of GAAP. To harmonize these foreign capital markets, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) are working together to integrate GAAP with IFRS. The main objective of this conversion is to have a common global financial reporting standard that allows financial statements to become more relevant and reliable. This would allow both United States and foreign companies to make their financial statements more consistent and comparable. The overall objective of this conversion is to provide better financial information for capital providers, lenders and stockholders.
Generally Accepted Accounting Principles (GAAP) is a rules-based system used in the United States. These rules are used to prepare, present and report financial statements of companies. The Securities and Exchange Commission (SEC) requires compliance with GAAP among publicly traded companies. GAAP is made up of many rules but there are four basic ideas. These include consistency, relevance, reliability and comparability. Consistency means that all information is collected and presented the same across time periods. Relevance relates to the idea that all information presented is important to the company. The reliability aspect means that all the information given in the financial statements is reliable or true and can be verified. Comparability is perhaps the most important part of GAAP. Since all businesses use the same system of financial reporting, it will be easier to compare companies. Without the ability to compare companies, it would be difficult for investors to evaluate companies and hold each company up to industry benchmarks and competitors.
International Financial Reporting Standards (IFRS) is a principles-based system used by more than a hundred countries around the world. These principles are general guidelines that should be followed but there is flexibility. The main goal of IFRS is to reflect true and accurate information about a company. Lack of guidance under IFRS requires management to make estimates, assumptions and judgments in financial reporting.
Both GAAP and IFRS methods have the same basic ideas but differ when it comes to specific details. First, there are financial statement presentations. Both systems have common elements of a complete set of financial statements. These statements include the balance sheet, income statement, statement of cash flows, other comprehensive income for GAAP or statement of income recognized as expense for IFRS, and the accompanying notes. Both methods require that statements be prepared using the accrual basis of accounting. However there are some differences. According to GAAP rules, the balance sheet must cover the last two most recent years. All other statements must have a three-year term. IFRS requires only prior period information. While GAAP does not have general requirements for the presentation of a balance sheet or income statement, IFRS has a list of minimum items that must be included. Under GAAP the classification of expenses must be presented on the basis of function. IFRS allows companies to choose between a function base or a cost structure. If a function is selected, some cost forms must be listed in the notes.
Another category of variance is inventory. Assets are defined as assets held for sale in the ordinary course of business, used in the production process or in the production of goods or services for such sale. The methods of measuring costs, the standard cost method or the marginal method, are the same under both GAAP and IFRS. Also under both systems, inventory costs include direct costs of selling finished inventory, allocated overhead. Selling expenses and general administrative expenses are excluded from cost of inventory. Under GAAP, the last in first out (LIFO) costing method is acceptable. It is obviously not necessary to follow the same formula for all lists of the same format. In IFRS however, LIFO is prohibited. The same formula must be used on all lists. The method of measuring inventory is also different. GAAP inventory is carried at the lower of cost or market. Inventories are carried at cost less net realizable value as per IFRS standards.
Completion of the revenue process and receipt of assets since completion is considered as revenue recognition. Under both systems, revenue is not recognized until it is received and earned. Both systems have certain criteria that must be met before revenue is recognized. Under GAAP, there are four main criteria, persuasive evidence, delivery, fixed/fixed cost, and collectibility assurance. IFRS has five different criteria that must be met. These criteria are transferability of risk and reward, lack of continuous management involvement, measurement reliability, potential financial benefits, and costs to be incurred reliably. Another difference is construction contact. Under GAAP, construction contracts may be, but are not required to be consolidated or split if certain criteria are met. Under IFRS, construction contracts are consolidated or separated if certain criteria are met. GAAP and IFRS have different criteria.
Intangible assets are defined as non-monetary assets without physical substance. The definition under both systems is the same. Both systems must have potential future economic benefits and costs that can be reliably measured. Start-up costs are never capitalized. Both GAAP and IFRS require amortization of intangible assets over their estimated useful lives. If there is no predetermined limit to the period over which an intangible asset is expected to generate new cash flows, the useful life is considered indefinite and the asset is not amortized. Development cost makes a difference. According to GAAP, development costs are expensed unless otherwise addressed by separate standards. However, computer software is capitalized once technical feasibility is established. Under IFRS, development costs are capitalized when the technical and financial feasibility of a project can be demonstrated. There are no separate guidelines regarding computer software costs. There is also a difference in advertising costs. GAAP allows advertising and promotional expenses to be expensed either as incurred or when the promotion is first incurred. Advertising and promotional expenses are expensed as incurred under IFRS. Another difference is that revaluation is not allowed under GAAP while IFRS allows revaluation at fair value of intangible assets other than goodwill.
Finally, there are several limitations in converting US GAAP to IFRS. However, there is a need for conversion and the discussion of conversion has started. The conversion to the GAAP framework will completely change how companies report their financial results in the coming years. Conversion from GAAP to IFRS will create the benefits of stronger comparability and consistency between the financial statements of US and foreign corporations. The merger of the two accounting standards will create more transparent and understandable standards that will provide a major benefit to investors.
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