Research Paper on "US GAAP vs. IFRS"

Research Paper 6 pages (2231 words) Sources: 6

[EXCERPT] . . . .

U.S. GAAP vs. IFRS

Accounting procedures across the world confirm to two international standards i.e. U.S. GAAP -- Generally Accepted Accounting Principles and the IFRS -- International Financial Reporting Standards. Major countries like the UK, France, Germany, Japan and Australia use either one of the two standards. Most application of these international standards reveals the institutional framework of the individual countries, confirming the crucial role of national regulators and standard setters in helping companies to attain more comparable international reporting. With the rising proliferation of global business activities, the comparability of financial information between companies from different nations has become a crucial matter. The use of international accounting standards helps in bringing about comparability and transparency in financial reporting. Besides, the drive for companies to use international standards and the degree to which they are able to do so will reflect the institutional framework in each country.

Over time, the institutional framework in each nation has evolved and changed reacting to the demands for higher comparability in reporting standards. Initiatives aimed at harmonization have initiated at the national, regional and international levels. They have been impacted by the development of IASC and a set of standards which have been either adopted or used in establishing national standards across the globe. Restructuring of the IASC in 2001 and receiving the support of the Securities and Exchange Commission -- SEC involves national standards setters officially in the IASC processes. The European Commission -- EC suggested its member nations to adopt IAS for consolidated accounts from 2005 onwards. Although pressure for companies for adoption of common standards, certain matters associated to their needs and enforcement are yet to be settled. However the ultimate call for accounting standard setting and regulation once again gained momentum following the downfall of U.S. Company Enron.

Differences between GAAP and IFRS:

Currently two principal accounting frameworks are existent. They are GAAP framed by the Financial Accounting Standards Board -- FASB and International Financial Reporting Standards -- IFRS framed by the International Accounting Standards -- IASB. While GAAP has been followed by the U.S. For pretty long time, the rest of the world has been following the IFRS. While some form of IFRS is in practice in more than hundred countries with thirty of them following them on a mandatory basis, and over 12,000 companies currently adhere to IFRS representing a third of the global market capital. At the conceptual level, IFRS may be seen as a principle-based standard while GAAP is more comprehensive, detailed and a rule-based standard.

Some of the fundamental differences are:

(i) Treatment of Inventory: As regards treatment of income and assets, GAAP is identified with the concept of LIFO -- Last in First Out accounting for inventory. Under LIFO, the last raw material purchased goes into the making of the product first. In the phase of rising material costs, under the LIFO system, the cost of goods is maximized which in turn reduces income as well as income taxes, and minimizes the value of raw materials inventory appearing on the balance sheet. IFRS on the contrary uses FIFO -- First in First Out accounting for inventory. Comparing two companies in the same line of business with one using GAAP and the other using IFRS, the company practicing GAAP will be underreporting its income and assets, while the company following IFRS will be overstating the same. As regards payment of income taxes, the GAAP adhering company will pay a lower amount on a comparable amount of business. Even so, the income statements and balance sheets of the two companies following different system of reporting standards will not be comparable.

(ii) Recognition of Revenue: GAAP and IFRS follow different paths of revenue recognition. A GAAP compliant company's earnings can appear to be understated. For instance in case of purchase of a medical device that comes with its associated hardware and software and a year of free warranty service, the GAAP seller may not be able to recognize any income on the sale of the product till the expiry of its warranty. As opposed to that, IFRS follows a more feasible and realistic process by examining whether (a) considerable risks and rewards of ownership have been transferred in favor of the buyer and (b) any monetary benefit of the transaction has come to the customer (c) the seller maintains any management or control on the articles sold and (d) the price and costs of the exchange are able to be calibrated in a more reliable manner.

(iii) Leases: In GAAP, a rules-based test based on ownership transfer is existent, lease term corresponding to the real economic life of the asset, current value of the minimum lease payments relative to the real value of the asset and so on. IFRS follows a more substantive approach by allowing a more flexibility in treating a lease as operating, with lease payments treated as expense which has a reducing effect on income.

R&D costs: Under the GAAP system, Research and Development costs associated to a company's progressive operations are usually charged as incurred, whereas under IFRS though treating research costs as expense, development costs are treated to be of capital nature. While comparing similar companies under GAAP and IFRS, R&D costs will be charged more in GAAP to expense. Thus lower earnings will be reported compared to IFRS reporting company.

Equity compensation: GAAP and IFRS follow different treatment in equity compensation such as option grants, share grants. The rules are complex, but on a generalized basis IFRS lends more flexibility in accounting for equity-based compensation.

Investment Property: GAAP treats property held for investment to be carried in the books of accounts on historical cost offered by IFRS as well. But IFRS also has the option of reporting the asset at its fair value. With the change of fair value in course of time, the IFRS reporting company charges profits and losses to its income statement. While certain fluctuations in the IFRS reporting company's Income Statement will be observed, which will not be such in case of a GAAP complaint company.

Plant & Machinery: Plant & Machinery in use by a company, once purchased and valued will undergo depreciation over the estimated useful lives of the various items under GAAP while IFRS will recognize differential useful lives for different components of a complete asset. For instance, the moving parts of machinery will have shorter life than the fixed part of a same machine. Under certain situations, IFRS might allow a revaluation of a depreciable asset during the course of its life which GAAP does not permit.

Impairment: Machinery is said to have undergone impairment when its value is lower compared to what it is stated in the balance sheet. Impairment may happen either because of a change in the market for the asset, or the asset is no more used in the company's current business and put up for sale. Whereas GAAP as well as IFRS expect periodic checking of impairment, valuation under IFRS can fluctuate. GAAP does not permit lowering of impairment once it has bee recognized. Hence, in situations wherein asset values recover, the amount ascribed to the asset in the balance sheet will remain more realistic with market values under the IFRS system compared to GAAP. In order words, asset impairment can rise and net value of an asset can decrease under GAAP, but net value under IFRS can either rise or fall with the changing fortunes of the market.

Convergence Issues:

The process towards convergence is assuming pace with the FASB announcing in the U.S. The convergence of U.S. GAAP and IFRS to be of primary objective as IFRS offers a single set of high quality standards for the global marketplace. As IFRS has already become the norm in Europe and Asia, IFRS will permit international comparisons of financial statements. Accounting professionals are of the opinion that IFRS lends a more practical picture of profits and losses compared to the national standards presently have to offer. Even though converting to IFRS sometimes remain costly and takes time, but a lot of companies are realizing that conversion enhances capital access, lowers cost of raising capital, augments shareholder relations and above all improves transparency and comparability.

The Security and Exchange Commission -- SEC is thoroughly re-evaluating the implementation of IFRS, especially in Europe and emphasizing for convergence between IFRS and U.S. GAAP. It is also stressing for the development of a high quality internationally accepted accounting standards to replace the standards thought to be challenged by the SEC. In this manner the odds of an unintentional outcome of abolishing the compromise for non-domestic filers using IFRS might be the stumbling block for convergence efforts. As regards short-term convergence efforts, reconciliation has repeatedly been the centre of attraction. Considering that from a U.S. outlook, lifting the reconciliation for IFRS filers would affect foreign companies listing within the U.S. And making financial statements based on IFRS, it appears worthwhile that removal is a trivial price to be paid in order to keep… READ MORE

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