Companies prepare financial statements to report their activities to various shareholders. Usually, these financial statements include four reports accompanying notes to the financial statements. These reports summarize the financial transactions that the company has incurred from its activities. However, they must use a similar structure or format as other companies. This process falls under the requirements of accounting standards.
An accounting standard is a common set of principles, procedures and rules. They define the basis of financial accounting policies and practices. Usually, these rules come from the jurisdiction where a company operates. On top of that, other factors may also play a role in dictating the accounting standards companies must use. The primary objective of following accounting standards is to promote consistency and comparability.
However, not all companies prepare comparable and consistent financial statements. Usually, accounting standards provide companies with the accounting treatment for financial transactions. On top of that, companies in different areas must abide by specific accounting standards. In most cases, companies follow the IFRS. However, companies in the US must report their financial statements under GAAP.
There are many differences between GAAP and IFRS. However, it is crucial to understand them individually first.
What are Generally Accepted Accounting Principles (GAAP)?
Generally Accepted Accounting Principles, or GAAP, refer to the accounting standards prevalent in the US. GAAP includes a set of accounting standards that most companies, organizations and local governments follow. Usually, these standards come from the Financial Accounting Standards Board (FASB). However, they may also fall under the Governmental Accounting Standards Board (GASB). The latter covers accounting standards for governmental bodies and nonprofits.
GAAP is mandatory for all public companies operating in the US. Apart from that, most nonprofits and government bodies must adhere to these standards. On top of that, companies outside the US may also prepare their financial statements under GAAP. However, these companies must also adhere to their local standards. In most cases, the alternative option is IFRS.
GAAP includes a combination of authoritative standards and the commonly accepted ways to record and report accounting information. It aims to improve the clarity, consistency and comparability of communication of that information. Similarly, it governs the world of accounting according to general rules and guidelines. It attempts to standardize and regulate the definitions, assumptions and methods across all industries.
GAAP requires companies to measure and report financial performance consistently. It promotes comparability between the financial statements from different companies. Usually, these companies only operate within the US. For comparisons with outside companies, the same may not apply. Most of those companies use the IFRS to prepare financial statements. Therefore, GAAP standards do not apply.
Overall, GAAP includes a set of standards maintained and developed by the FASB and GASB. It also consists of various accounting principles. It covers the recognition, measurements, presentation and disclosure of financial information. Usually, these principles also match with those set by the IFRS. The primary feature of the GAAP standards is that it only applies to companies in the US.
What are International Financial Reporting Standards (IFRS)?
International Financial Reporting Standards, also known as IFRS, are a set of accounting rules. These rules dictate the preparation process for the financial statements for companies. However, IFRS does not apply to companies in the US. Instead, IFRS is prevalent in over 140 countries. Some countries also use it as a base to prepare their own set of accounting rules and standards.
The IFRS come from the International Accounting Standards Board (IASB), which operates under the IFRS Foundation. Previously, they came from the International Accounting Standards Committee (IASC). Since 2001, the IASB has replaced the IASC as the body that maintains and develops new IFRS standards. The accounting standards from the IASC came as the International Accounting Standards (IAS).
IFRS define how companies must maintain their records and report various items. Primarily, it covers two aspects of the financial statements, financial performance and position. On top of that, it also instructs companies in reporting cash flows and other areas. However, it does not include financial statements only. IFRS also guide companies on how to record transactions consistently with others.
The primary objective of the IFRS is to bring consistency to the accounting process. Like GAAP, it promotes information consistency to allow investors to compare information across companies. However, IFRS applies to a broader range of companies than GAAP. The primary reason behind it includes the wide adoption of IFRS worldwide. GAAP lags in this aspect due to its limited scope in the US.
Overall, IFRS includes a set of accounting rules, practices and procedures that dictate the accounting process. It applies to many companies worldwide with a broader adoption than GAAP. However, IFRS is irrelevant in the US. Nonetheless, those companies may report their accounts under these standards to attract international attention. However, their primary accounting standards will remain GAAP.
What are the differences between GAAP and IFRS? Top 7 differences you should know.
Apart from their origins and scope, GAAP and IFRS also have other differences. These differences make it difficult for investors to compare companies that use those standards. Once they know the variances between them, comparisons can become more straightforward. The top seven differences between GAAP and IFRS include the following.
Rules-based Vs principles-based
GAAP uses a rules-based approach to accounting. Under this approach, companies must follow strict rules that dictate the accounting treatment for financial transactions. However, IFRS uses a principles-based approach. IFRS defines the principles that companies must follow when treating a financial transaction. However, it does not provide specific rules on how they must do so.
One of the fundamental areas where the accounting treatment differs in GAAP and IFRS is inventory. Under the GAAP standards, companies can use the FIFO or LIFO method for inventory valuation. However, IFRS does not allow companies to evaluate it using the LIFO method. The IFRS believes this method presents a distorted picture of a company’s stock.
Another area where GAAP and IFRS differ is revenues. GAAP, being rules-based, provides strict rules on how companies must recognize income. Usually, it requires them to record revenues under the completed contract method. Under the IFRS, the rules are less strict and general. Companies can use a five-step process to recognize revenues.
Property, plant and equipment
Companies using IFRS can evaluate their property, plant and equipment under two methods. These include the cost value and revaluation methods. However, GAAP does not allow companies to use the revaluation method for those items. This rule only applies to tangible assets classified as fixed assets for a company.
Apart from tangible assets, GAAP and IFRS also differ on intangibles. GAAP recognizes intangible assets at the current fair market value. However, it does not allow for any additional or future considerations. On the other hand, IFRS enables companies to recognize intangible assets with a future economic benefit attached. Similarly, IFRS requires a reliable measure for the value of intangibles.
GAAP requires companies to segregate extraordinary items in the income statement. Instead of treating them as a part of that statement, it entails showing them below net income. However, the same rules do not apply to companies using IFRS. These companies can report extraordinary items as a part of the income statement. This process does not require any segregation.
Research and development costs
Research and development costs include expenses incurred before producing an item. Under GAAP, companies cannot capitalize these assets. Therefore, they must record it as an expense in the income statement. However, IFRS allows companies to capitalize those costs if they meet specific conditions. In that case, these costs become a part of the balance sheet.
Below is a summary of the top seven differences between GAAP and IFRS.
|Inventory||Allows LIFO and FIFO||Does not allow LIFO|
|Revenues||Recognized under completed contracts method||5-step process to recognize revenues|
|Property, plant and equipment||Only cost model applicable||Allows cost and revaluation model|
|Intangible assets||Recognized at current fair market value||Recognized if they have future economic benefits|
|Extraordinary items||Reported below net income in the income statement||Reported as normal in the income statement|
|Research and development costs||Expensed out in the income statement||Capitalized in the balance sheet, if meet specific criteria|