The accounting industry is full of guidelines, regulations, and oversight committees that dictate how transactions should be recorded and reported. Entities such as the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) have been set up to keep a watchful eye on financial proceedings, and specific rules have been laid out that dictate how accountants should do their jobs. While all of these rules and restrictions may seem overly strict or arbitrary, especially to those outside the accounting world, they’re actually quite necessary when you stop to consider the repercussions of (criminally) incorrect accounting practices, the most egregious of those being the Enron/Arthur Andersen scandal of the early 21st century.
Because accounting plays a huge role behind the scenes of practically any and every operation, be it a multi-national corporation, a local hardware store, a charity, whatever, entire textbooks could be written about the various rules of how they should operate. Today, we’re just focusing on two of the major sets of accounting guidelines and how they differ: the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP). If the worlds of accounting and finance are totally new to you, check out this intro course on financial accounting, and this article on the basics of finance to learn more about these complex industries.
What Are IFRS and GAAP?
These two frameworks of guidelines dictate the rules and standards of how financial accounting should operate. GAAP is considered to be more “rules based”, meaning there are hard and fast boundaries that dictate whether or not a practice is acceptable, whereas IFRS is more “principles based”, meaning it lacks explicit sets of guidelines, but rather has overarching principles and standards that say how things should be done, which can result in differing interpretations of the same interaction. This course on IFRS explains the key principles and theories behind this set of accounting standards.
The accounting practices laid out by GAAP represent the framework for how most accounting is, and has been, done in the United States since around the 1930s. While they haven’t been too much of an issue in and of themselves, the biggest issue is the fact that the rest of the world doesn’t adhere to these standards. IFRS, however, is practiced in 110 foreign countries and counting, and can even be considered the more dominant of the two, in that changes in GAAP are influenced by the concepts of IFRS. The problem that arises is when American businesses, adhering to GAAP, interact with businesses overseas that rely on IFRS, and discrepancies arise in their respective accounting practices. There is currently an effort being made to make a universal set of accounting standards that businesses around the world can follow,hopefully by the year 2015.
Examples of the Differences Between the Two
Besides the underlying differences between the two accounting standards, there are concrete examples of how GAAP and IFRS differ, and the following is just a handful of these differences. Illustrations of some of these differences can be found in the various financial statements that are ubiquitous in the accounting world, and this course on how to analyze financial statements will tell you more about them.
- Intangibles: Assets such as trademarks, Internet domain names, licensing agreements, and other non-physical valuables with a useful life greater than a year are recognized at fair value under GAAP. However, under IFRS, intangible assets are recognized only if they are reliable, and will have future economic value for the company.
- Inventory Costs: There are three methods for accounting for inventory costs: last in, first out (LIFO), first in, first out (FIFO), and weighted average cost. In the IFRS system, LIFO is never used (FIFO and weighted average are acceptable), but in GAAP, all three methods are used, depending on the type of inventory being analyzed. As it stands, if LIFO is being used by an American company, overseas companies dealing with them must adjust for this difference.
- Inventory Reversal Write-Down: Inventory is written down when its cost becomes higher than its net realizable value, but when economic circumstances change, causing an increase in the value, the amount of the write-down is reversed in future periods. This is allowed under IFRS, but is prohibited under GAAP.
- Definition of Asset: GAAP defines an asset as a future economic benefit, whereas IFRS defines it as a resource from which future economic benefits will flow to the firm.
- Development Costs: Outflows of money for labor, materials, overhead, and taxes used to fund the creation of a project all fall under the heading of development costs, and under IFRS, these costs can be capitalized, or expensed over a period of time with depreciation or amortization, as long as certain criteria are met. Under GAAP, these costs are considered expenses.
- Earnings per Share: The calculation for earnings per share under IFRS does not take into account the interim period calculations (any reporting period shorter than a full fiscal year), but GAAP does, averaging them out.
- Revenue Recognition: GAAP is very specific about not only what can be considered revenue, but also how it should be measured, and how timing affects its recognition. With IFRS, the method of measurement and timing the revenue recognition is not specific, and there is no industry-specific guidance.
We tried to make these potentially complex and confusing accounting terms and concepts palatable for the casual accounting fan so that these differences between the Generally Accepted Accounting Principles and the International Financial Reporting Standards could be easily understood by the laymen out there. However, if you were able to grasp these differences, the information you just picked up may end up being obsolete in the coming months and years as GAAP slowly evolves into IFRS, or another universally-accepted framework of accounting standards. If you plan to run a startup at some point in the future, and want to save money on the accounting, then check out this course on finance and accounting for startups.