There are many accounting standards in the world, with each country using a version of its own generally accepted accounting principles, also known as GAAP. These allow firms to report their financial statements in accordance to the GAAP that applies to them. The complication lies within whether the firm does business in multiple countries.

How can investors then deal with multiple standards, which ones are accurate, and how can corporations be compared based upon their financials? The answer to these questions lies within the adoption of the International Financial Reporting Standards, or IFRS, which is being developed and supported by the International Accounting Standards Board (IASB).

With more and more countries adopting the IFRS as their accounting standard, over 120 as of March 2018, investors and analysts should be well advised on how this transition affects company's reporting, and what it means moving forward. To do this, this article will look at the background of IFRS, the benefits, its goals, the fundamental differences between IFRS and U.S. GAAP, and go into a few of the major changes that occur within the various financial statements when converting to IFRS from U.S. GAAP. (For more, see "Breaking Down the Balance Sheet.")

Background and Overview of IFRS

International Financial Reporting Standards (IFRS) is a set of international accounting standards that states how certain transactions and events should be reported in financial statements. It is based upon principles rather than hard-set rules, which is in contrast to U.S. GAAP. As a result of this fundamental difference, IFRS allows management to use greater discretion and flexibility when preparing a company's financials.

In recent years, there has been a trend toward a common globalized accounting standard with IFRS used in many parts of the world, including the European Union, Hong Kong, Australia, Russia and Singapore, among other nations. In January 2011, Canada officially adopted the IFRS standard, with more countries switching from their own accounting requirements to the IFRS standard. As of March 2018, the United States still operates under U.S. GAAP. (For more, see "International Reporting Standards Gain Global Recognition.")

Benefits of IFRS

It is believed that IFRS, when adopted worldwide, will benefit investors and other users of financial statements by reducing the cost of investments and increasing the quality of the information provided. Additionally, investors will be more willing to provide financing with greater transparency among different firms' financial statements. Furthermore, multinational corporations serve to benefit the most from only needing to report to a single standard and, hence, can save money. It offers the major benefit where it is used in over 120 different countries, while U.S. GAAP is used only in one country.

The IASB, in regards to IFRS, has four stated goals:

  1. To develop global accounting standards requiring transparency, comparability and high quality in financial statements
  2. To encourage global accounting standards
  3. When implementing global accounting standards, to take into account the needs of emerging markets
  4. Converge various national accounting standards with the global accounting standards

IFRS Versus GAAP

Public accounting rules in the United States are governed by its generally accepted accounting principles, or GAAP, which is considered a "rules-based" approach to bookkeeping standards. Conceptually, IFRS as used by nations around the globe is more "principle-based" than GAAP, which makes it somewhat less complicated and more consistent, offering fewer exceptions and unique applications. The only downside is the IFRS is a little less adaptable.

The methodological distinction between a rules-based approach and a principle-based approach causes most of the fundamental differences between IFRS and GAAP. This is because it changes how the IASB and FASB set guidelines and interpret accounting practices. GAAP is more specific, circumstantial and full of exemptions based on feedback from the U.S. accounting community. While this has some advantages in terms of certainty, it can lead to frustrating and confusing inconsistencies in applied accounting standards.

By focusing on principles, the total volume of IFRS legislation is remarkably smaller than GAAP. This also creates flexibility of interpretation when making principle judgments and often extensive disclosures in the financial statements to compensate for uncertainty.

IFRS and U.S. GAAP have many technical differences, and both the International Accounting Standards Board, and Financial Accounting Standards Board, or FASB (which oversees U.S. GAAP), are publicly committed to converging in those technical areas. That does not necessarily mean the disparate methodologies between IFRS and GAAP are necessarily reconciled, however.

Revenue Recognition

One of the areas where the fundamental differences between IFRS and GAAP is most evident is revenue recognition. Under GAAP, the revenue recognition literature is extensive and full of unique, conditional rules and applications, while IFRS can qualify all revenue transactions in one of four categories: sale of goods, construction contracts, rendering of services or others' use of an entity's assets. The rules and application governing these categories are specifically designed to limit circumstantial exceptions.

Compared to GAAP, IFRS allows companies to recognize revenues earlier, even if a contingency is associated with a portion of the revenue. GAAP specifically prohibits recognizing contingent revenue and requires companies to defer it until the contingency is resolved. An example of contingent revenue is an arrangement under which a fee, receivable by a football player agent, is cancellable if the football player breaches his contract with a football team. Under IFRS, the result of recognizing revenue earlier is higher revenues, higher profitability ratios (return on investment, return on assets, return on equity) and lower leverage ratio.

Impact on Financial Statements

Differences in the Balance Sheet

A few of the differences on the balance sheet between U.S. GAAP and IFRS include the way inventory, property and equipment, and goodwill are recorded.

Inventory

Two inventory method standards normally used are FIFO (first-in, first-out) and LIFO (last-in, first-out). Under GAAP, companies can choose either the LIFO or FIFO method to value their inventory, while IFRS specifically prohibits the use of LIFO and only allows FIFO.

Property and Equipment

Also known as the fixed assets of the firm, property and equipment are reported at their initial cost less the accumulated depreciation. U.S. GAAP does not allow any upward adjustments of property and equipment, whereas IFRS does. This can have a profound impact on a firm's reporting. For example, if equipment is marked down, it results in a loss on a firm's income statement. However, if the asset is then marked back up under IFRS from an increase in value, the adjustment is recorded as a gain, up to the initial cost. Any further upward adjustment will be reported directly to equity.

Goodwill

An intangible asset, goodwill is treated similarly to property and equipment: It is reported on the balance sheet at the initial cost less accumulated amortization. Any downward revaluation will cause a loss on the income statement and if it is marked up, which is not allowed under U.S. GAAP, and then a gain is recorded up to the initial cost amount. Any adjustment beyond that will be reported directly to equity.

Costs

GAAP requires all costs associated with developing products to be recognized as expenses immediately. IFRS allows capitalization of development costs under certain conditions. For example, a drug company's lab expense in developing a drug can be capitalized on the balance sheet under IFRS. Capitalizing development costs under IFRS results in lower expenses compared to GAAP, leading to higher revenues, higher profitability ratios, lower leverage ratio and lower asset turnover ratio.

Differences in the Income Statement

One of the areas where the fundamental differences between IFRS and GAAP is most evident is revenue recognition. Under GAAP, the revenue recognition literature is extensive and full of unique, conditional rules and applications, while IFRS can qualify all revenue transactions in one of four categories: sale of goods, construction contracts, rendering of services or others' use of an entity's assets. The rules and application governing these categories are specifically designed to limit circumstantial exceptions.

Compared to GAAP, IFRS allows companies to recognize revenues earlier, even if a contingency is associated with a portion of the revenue. GAAP specifically prohibits recognizing contingent revenue and requires companies to defer it until the contingency is resolved. An example of contingent revenues is an arrangement under which a fee, receivable by a football player agent, is cancellable if the football player breaches his contract with a football team. Under IFRS, the result of recognizing revenue earlier is higher revenues, higher profitability ratios (return on investment, return on assets, return on equity) and lower leverage ratio.

The main philosophies are similar, but U.S. GAAP provides more industry specific guidance than IFRS. A few of the differences lie within how cost of goods sold (COGS) is determined, the operating expenses of the firm, and construction contracts.

Construction Contracts

Depending on the accounting method adopted, the revenues and profit for construction projects can be affected. Under U.S. GAAP, if the outcome of a project cannot be estimated, the completed contract method is required. However, under IFRS, if the outcome of a project cannot be estimated, revenues are recognized only to the extent of contract costs, and profit is only recognized at project completion.

Cost of Goods Sold

Since LIFO is not allowed under IFRS, LIFO firms have to convert their inventory into FIFO terms in the footnotes of the financials. This difference is known as the LIFO reserve, and is calculated between the COGS under LIFO and FIFO. The benefit in doing this is an increase in the comparability of LIFO and FIFO firms. However, since everything is moving towards IFRS, FIFO will be the standard moving forward if the U.S. passes the legislation.

This has an effect on the financials of a firm. In particular, during periods of high inflation, a firm that uses LIFO will report higher COGS and lower inventory as compared to a firm that uses FIFO. Higher cost of goods sold results in lower profitability and lower profits results in lower income taxes. Lower profits will also result in lower equity for the firm, which affects retained earnings in a negative way.

In contrast, in a low inflationary period, the effects mentioned are reversed. Companies that use FIFO under IFRS have lower profitability ratios, higher leverage ratio and higher inventory turnover ratio compared to companies that follow GAAP and use LIFO.

Operating Expenses

IFRS does not differentiate between expenses and losses, but U.S. GAAP does. With IFRS, any losses that are due to a firm's main business are included in its operating expenses.

Leases

GAAP provides specific number-based criteria for companies to determine whether a particular lease is classified as operating or capital. Operating leases are off-balance sheet liabilities and are not recorded on the company's financial statements, while capital leases are capitalized and affect both asset and liability sides of the company's balance sheet.

GAAP requires a lease with a term equal to at least 75% of the economic useful life of an asset to be classified as capital. Also, GAAP requires capitalizing leases if the present value of minimum lease payments equals at least 90% of the leased asset's fair value. IFRS, on the other hand, does not have such specific thresholds.

A difference in lease classifications can result in higher leverage ratio, lower return on assets and higher operating profit margin, if the lease is classified as operating under IFRS as opposed to capital lease under GAAP.

Impact of IFRS on Financial Ratios

There's an impact on more than one financial ratio when converting U.S. GAAP to IFRS. Some of them include the current and quick ratios (due to the difference in inventory methods), the interest coverage ratio (as EBIT can be affected by the difference in COGS) and return on assets (net income is affected by the COGS as well), among others. It is up to the analyst or investor to keep these in mind when making an investment decision.

The Bottom Line

Using the International Financial Reporting Standards, or IFRS, most helps American companies that have operations or physical locations overseas. The vast majority of the world uses IFRS, as opposed to the United States system of generally accepted accounting principles or GAAP, and compliance with foreign accounting practices is easier and more cost effective if IFRS is already in place. Other benefits include a general reduction in accounting compliance costs, as the IFRS is much smaller than GAAP, and easier comparisons between companies in different countries. A business using IFRS practices can more easily compare its financial health to foreign competitors'.

Foreign investors may be distrustful of companies that do not use the IFRS system. After all, they are used to reading reports from companies in a specific format and are likely to be confused by or reticent around a GAAP-based set of financial statements. This could be a small benefit to many U.S. companies and a major benefit to some. Of course, the opposite is also true; American investors might not be as trustful of a company that uses IFRS accounting statements.

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