For those in the business world – particularly in the accounting field – a major issue has surfaced in recent years relating to the differences between Generally Accepted Accounting Principals (GAAP) and the International Financial Reporting Standards (IFRS). Currently, the majority of countries in the world follow International Financial Reporting Standards guidelines; however, the United States still uses Generally Accepted Accounting Principals. This topic has been a main focus because 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 in the long-run the idea is to simplify the accounting procedures around the world. The main difference between GAAP and IFRS is that GAAP is considerably rule-based, whereas IFRS is more principal-based which means IFRS has room for interpretation. The specific differences are far too many to cover in a short presentation, however, an explanation of some major differences are mentioned below.
In certain instances, GAAP and IFRS follow different approaches for the determination of specific amounts as well as how these amounts are recognized in financial statements and within the notes. One of these instances occurs in the measurement of inventory. Unlike GAAP which accepts the FIFO, LIFO, and weighted-average methods, IFRS does not accept LIFO. Also, when inventory is recorded on the balance sheet, IFRS requires that it be reported at the lower of historical cost or Net Realizable Value. GAAP, on the other hand, requires inventory to be reported at the lower of historical cost or replacement value. Another difference occurs in the measurement of property, plant, and equipment. Property, plant, and equipment are originally measured at cost. After recognition, however, GAAP and IFRS have variations in how they treat these assets. Under IFRS, PPE can be revalued if there is a higher fair value; GAAP does not allow for any revaluation after recognition.
There are also differences for sales of services, particularly the means in which revenue is recognized. For US GAAP the cost-to-cost percentage of completion method is prohibited unless the contract specifically says otherwise. The completed-performance method is the generally accepted method under GAAP. When the outcome of a service cannot be reasonably estimated then the revenue must be temporarily deferred. For service sales under IFRS the percentage of completion method is followed. When the transaction cannot be reasonably estimated under this framework, the zero-profit model is used and the revenue is recognized to the degree of recoverable expenses taken on. In certain circumstances the outcome may be very uncertain: if this is the case then the revenue must be deferred until a better estimate of the transaction can be made.
Revenue is also recognized differently for warranties. Under Generally Accepted Accounting Principals, revenue for product maintenance is usually deferred and recognized as income on a straight-line basis over the contract life. When the warranty is bought separately or in addition to the original warranty, the revenue is determined through reference to the selling price for maintenance contracts. Under International Financial Reporting Standards, the revenue from the extended warranty will be deferred. The recognition of this revenue will occur over the period that is covered by the warranty.
Construction contracts are also an area in which the recognition of revenue differs between the two accounting frameworks. The preferred method that is most commonly used under US GAAP is the percentage of completion method. However, when a reasonable estimate cannot be made, the completed-contract method is required to be used. The percentage of completion method has two different approaches: the first is the revenue approach and the second is the gross-profit approach. IFRS generally uses the revenue approach under the percentage of completion method. When the construction project cannot be estimated reasonably, the zero-profit method is used because IFRS does not allow the gross-profit method to be used.
As stated above, the details of all the variations and changes that must occur are far too many to cover in a brief presentation. All the differences that were mentioned – although they were few of many – were important in the scope of things. Accounting standards are extremely specific and complicated to understand, hence the reason there is a planned convergence in for the future. There will be much less confusion in the accounting world if some kind of unity exists between most countries. US GAAP is easily the most in depth framework of all the currently existing frameworks. With IFRS having more room for interpretation, it takes away from the rule-based complications that exist within GAAP standards. Hopefully with the convergence there will be more unity and less confusion in terms of accounting all over the world.
Genna Francesca Squadroni
We have many more Financial Planning Help Articles Now Available.