IFRS vs. US GAAP

What is IFRS Vs. GAAP?

International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) are two prominent accounting standards companies use to prepare their financial statements. 

International Financial Reporting Standards (IFRS) is a comprehensive set of accounting standards that underscore how companies worldwide are required to prepare and present their accounting statements.

While companies worldwide use IFRS, companies in the USA use the Generally Accepted Accounting Principles (GAAP) as per SEC regulations. GAAP is a set of rule-based standards that detail how companies should undertake the financial reporting process. 

Broadly, IFRS and GAAP standards differ on the following grounds.

Nature of a standard-setting body

A company’s financial statements are the holy grail for investors, lenders, and all other parties curious about the company’s operations. Therefore, ensuring the quality and reliability of these statements is paramount.

Accounting standards step in to preserve the quality of a company’s financial statements. But who sets these standards? These standards are usually developed by entities known as “standard-setting bodies.” 

Examples of prominent accounting standard-setting bodies include the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB).

These bodies are usually not under the umbrella of the government but are private organizations where accountants and auditors from around the world work together to develop the standards we use today.

Standard-setting bodies may establish advisory councils or boards that include representatives from various stakeholder groups, such as preparers of financial statements, auditors, and investors. These committees provide input and insights into the standard-setting process.

They often provide educational resources, guidance documents, and interpretations to help practitioners and entities understand and apply accounting standards.

The role of a standard-setting body is limited to developing the standards. They are not responsible for enforcing the standards because they have no legal authority unless a regulatory body like the Securities and Exchange Commission (SEC) deems it so.

IFRS And GAAP On Revenue Recognition

GAAP and IFRS allow companies to prepare income statements in one of two ways.

• Prepare a comprehensive income statement, including the income statement.
• Prepare the income statement and a statement of other comprehensive income separately.

We know that any increase in the value of an asset is classified as an income and reduces the equity value in the balance sheet. But income itself is of two types - revenues and gains. While revenues arise from the business’s operations, gains result from non-operating activities.

So how and when is revenue recognized? Over time, US GAAP and IFRS have converged towards a common standard for revenue recognition. The standards advise companies to go through five steps before recognizing revenue. These steps are:

1. Presence of a contract

The law provides a comprehensive definition of a contract. For our understanding, a contract is any document enforceable in a court of law. The very first step prescribed by the standards is that all requirements for a contract must be met.

2. Presence of identifiable performance obligations

Let’s say A, the seller, agrees to transfer 1000 units of rice to B, the buyer. This is a performance obligation because B benefits from the purchase of the rice, and the purchase of the rice is not tied to any other obligation in the contract.

If A does not sell the rice unless B purchases 2000 units of wheat from him, this is not a separate performance obligation.

3. Presence of transaction price

All contracts have a transaction price. The parties determine this transaction price once the performance obligations have been established. 

Let us take an example of the following contract.

The transaction price is the total of all performance obligations, i.e., $200,000.

1. Allocation of Transaction Price: Now that the transaction price has been identified, the total price must be split between the performance obligations in the contract so that revenue can be recognized for each obligation. In this case, the price apportioned to rice and wheat is $100,000.
2. Recognizing revenue: Irrespective of when the payment is made, the seller can recognize revenue when the sale is complete and the ownership of the goods has been transferred to the customer. If payment is made before the sale is complete, it is called “unearned revenue” and is a liability for the seller.

IFRS Vs. GAAP - Inventory Expense Recognition

One of the primary differences between IFRS and GAAP is the recognition of inventory expense. Companies primarily use three methods to value inventory.

1. First In, First Out (FIFO) method

When the FIFO inventory pricing method is adopted, the oldest inventory is sold first. Previously stocked goods represent the cost of goods sold, and the cost of ending inventory is reflected in the most recently acquired stock.

On 31st January, the company will have 400 units of inventory on hand. We can see that 300 units were sold on 28th January. According to FIFO, the opening stock of 200 units is sold first, followed by 100 units from the stock purchased on 1st January.

The inventory in hand at the end of the month is only composed of the stock purchased on 1st January.

2. Last in, First Out (LIFO) method

Under the LIFO method, the most recently purchased goods are sold first. In our example, 300 units are sold from the stock of 500 units purchased on January 1st. Our closing inventory comprises the 200 units in hand at the beginning of the month.

3. Weighted average cost method

The weighted average cost method is slightly trickier.

At the time of purchasing 500 units, the company had 200 units of inventory valued at $10 per unit. It purchases 500 units at $13 per unit. Therefore, the weighted average cost of inventory in hand comes to $12.14 per unit.

The sale of 300 units is made at this cost. Therefore, at the end of the month, the company has 400 units of inventory in hand, valued at $12.14 per unit.

There are other methods, such as the Highest In, First Out (HIFO), that are rarely used. 

The primary distinction between IFRS and US GAAP is that the IFRS standard outrightly forbids businesses from adopting LIFO. 

How does the LIFO rule under IFRS affect the financial statements?

We now know that IFRS expressly forbids the use of the LIFO method. Let us compare how different economic scenarios affect the financial statement figures under the FIFO and LIFO methods. The weighted average cost method usually spreads the cost across units.

We will see how inflation and deflation affect the cost of goods sold and ending inventory under each inventory valuation method.

1. Inflation

In an inflationary scenario, prices are constantly rising. Since the FIFO method sells the earliest goods purchased first, it will evidently have the lowest cost of goods sold in an inflationary environment because the goods sold belong to a period when prices were lower. 

So, under IFRS, in an inflationary scenario, COGS will be lower, and Ending inventory will be higher. But under GAAP, since LIFO is allowed, companies can adopt LIFO to understate their profit margins and show a greater margin in the following year to meet analyst’s expectations.

2. Deflation

In a deflationary scenario, prices are constantly on the decline. When this happens, companies that follow GAAP and adopt LIFO would see a higher gross profit as the cost of goods sold would be lower.

However, since IFRS prohibits the use of LIFO, a deflationary scenario would mean that the company faces higher costs and lower margins.

We will now look at the effect of inflation on balance sheet items under both inventory valuation methods.

IFRS Vs. GAAP - Impairment of a non-current asset

Before we talk about impairment, we must understand a few key terms.

1. Carrying value

The carrying value of an asset is its recorded value on the balance sheet, calculated as the initial cost of the asset minus accumulated depreciation.

2. Fair value

An asset’s fair value is nothing but its market value. This is the price the asset would fetch if you sell it in the open market.

3. Value in use

Every asset would generate cash flows. An asset’s value in use is the value of its future cash flows discounted from its present value.

Now that we’ve understood these terms, let us talk about impairment. Simply put, impairment loss occurs when the carrying value of an asset exceeds its fair value.

While the loss treatment is the same, IFRS and GAAP differ greatly in the impairment loss calculation.

To understand the process of impairment loss calculation, let us take the following example.

1. IFRS: Under IFRS, we first measure the fair value of the asset (minus any selling costs) and the value in use (the discounted value of future cash flows). The higher of these two is then measured against the carrying value.

Impairment loss = Carrying value - Value in use

Impairment loss = $3,000,000 - $1,800,000 = $1,200,000

2. GAAP

Unlike IFRS, GAAP has two steps to measure impairment loss.

Step 1 - An impairment exists since the carrying value is greater than the undiscounted value of future cash flows.

Step 2 - The loss is the difference between the asset’s carrying value and fair value.

Let us say that the asset’s fair value is $5 million after a year. IFRS would allow the impairment loss of $1.2 million to be reversed such that the carrying value is now $3 million. Any reversal beyond the original loss is not permitted. GAAP strictly prohibits impairment reversals.

Summary

Both the IFRS and GAAP standards are vast, and covering them would be a massive exercise. We started our discussion by pointing out the differences between the two standards: the entities responsible for developing the standards and the nature of those standards.

We saw various accounting areas where IFRS and GAAP standards contradict each other. We also saw areas where the standards converged.

Firstly, we discussed the concept of revenue recognition from the perspective of IFRS and GAAP. Both accounting standards have developed a converged standard wherein revenue recognition is based on performance obligations arising from a contract.

We then went on to discuss inventory valuation under both IFRS and GAAP. Inventory valuation is a significant area of difference between the two standards, especially considering the presence of metrics such as FIFO and LIFO.

Since IFRS does not permit the use of LIFO, we saw how different inventory methods would affect various parts of a company’s financial statements.

We wrapped up the article on IFRS and GAAP by discussing the recognition and treatment of impairment losses and reversals under both accounting standards.

Researched and authored by Sathyanarayana Sairam | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

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