IFRS vs US GAAP – Simplifying the Difference
Before we differentiate between the IFRS and US GAAP, it’s important to understand their meaning and the context in which these two terms are used. Wait a minute! Are they not set of accounting standard? No, not exactly. US GAAP and IFRS are technically classified as generally accepted accounting principles which in financial and accounting world is commonly known as GAAP.
In this article, we look at the following topics –
- What is GAAP?
- Why different GAAP’s
- Impact of differnt GAAPs
- Problems of different GAAPs?
- Fraud and Financial Reporting
- US GAAP vs IFRS
What is GAAP?
GAAPs are the broad framework or the structure which is used to prepare financial statements of the companies. Like JAVA, C++ or HTML are used by the software engineers to write computer programme, in the same manner accountants all over the world use a language – GAAP, to prepare financial statements. But there is one huge difference between Computer language and GAAP. Unlike a programmer who uses the same language irrespective of whether he is sitting in Silicon Valley or Shanghai, an accountant will use different reporting language in different jurisdiction because every country has different GAAP. For example, Account in India will use IGAAP (Generally accepted accounting principles in India), the one sitting in United States will use US GAAP (Generally accepted accounting principles in India) and the one sitting in UK will use UK GAAP (Generally accepted accounting principles in UK) in preparation of financial statement or books of account.
Why Different GAAP?
So why accountants in different jurisdiction uses different reporting language or GAAP?
Well, different GAAP’s are used because every country is governed by different set of Laws. Though various laws – Income-tax Act, Companies Act sound similar but they vary in great detail amongst each other. Criminal Law applicable in UK and US may sound similar but its sections, provisions, clauses and sub-clauses vary in great detail between them. Difference arises because of the diversity in language, ethnicity, culture and above all customs and practices. Hence, to accommodate all these there arises the need to have different set of laws in different countries. This is also applicable for the business and financial acts as the business environment and practices also vary greatly between nations. Hence very country follows its own reporting language or GAAPs like – IGAAP (Applicable in India), US GAAP (Applicable in USA), UK GAAP (Applicable in UK) and etc.
Impact of Differences in GAAP
Now let’s look at the impact it causes to the users of the Financial Statement?
Imagine yourself to be a private equity fund manager having millions in coffers to invest. What would you like to do first before investing? Well, there could be many answers to that question but most of you would definitely agree with me that you would like to have a look at the financial health (Balance Sheet and Statement of Profit and Loss) of those companies.
So after searching through many good companies you finally came across newly established Pine-Apple Inc. Pine- Apple Inc sells smartphones and in order to capture the existing market in emerging countries (India) it sells its products at a discount. Let’s assume Pine-Apple sells smartphones at cash discount of 20%. For simplicity, let’s also assume it has sold 50,000 phones annually in both India and US, whose market price is $ 125 per phone.
So how much you expect the recorded revenue in books of accounts of Pine-apple Inc in its holding company in US and subsidiary company in India?
Well, one would think that $ 5,000,000* is the revenue earned by the company in both US and India.
(Discounted price equals to $125 less 20% which comes out to $100.
50,000*100= $ 5,000,000*)
You are right in pointing out that company earned 5 million dollars in US and India. But revenue recorded in the books of account will be different in US and in India.
In US Company of Pine-Apple Inc. revenue will be recorded at 5 million $. But in Indian Subsidiary of Pine-apple Inc. revenue will be recorded at 6.25 million dollars (50,000 * 125). Well, that’s a huge difference of 1.25 million dollars. Yes, it’s a huge difference. But it’s not because accountants in USA are smarter than their counterparts in India. It’s because of the different GAAP being followed by two countries.
As per the US GAAP revenue is measured at fair value of the economic benefits (Which in simple terms means net of discount and rebates). Whereas in I-GAAP revenue is measured at gross value of economic benefits. (Inclusive of cash discount)
Let’s look how financial statement in two different countries will look like
|Revenue from Operation||5,000,000|
|Revenue from Operation||6,250,000|
Please note, though the net profit in both cases are equal but the top-line (Figure analyzed by analyst) is different by huge 1.25 million dollars. If one were given the option to invest in one of the two companies, he would definitely would like to invest in Indian Subsidiary despite the fundamentals in both the companies remaining same.
Also, it’s important to understand that though there are huge differences between different GAAP. But there are also various points of convergence. There are many accounting principles and standards which are similar in different GAAP.
Problems of different GAAPs?
Yes there is one – IFRS. International financial reporting standard or commonly known as IFRS was set up in 2001. IFRS foundation is an independent, privately organized and not for profit organization. Its board has members of 30 different nationalities. It’s most important job is to prepare a common GAAP by formulating and pronouncing IFRS Accounting Standard. Accounting Standards are a set of rules and requirements followed by companies when they prepare their financial statements (A practical example of it has already depicted above where we have shown a revenue measurement principle of Pine-Apple INC).
Standards set by the IFRS are used in many countries. And many countries have replaced their Local GAAP Standards with IFRS Standards. In those countries public as well as non-public accountable companies apply them for preparation and presentation of financial statements. As of now more than 100 countries and jurisdiction require the use of IFRS Standard for all or most publicly accountable companies. The use of IFRS standards brings about some major benefits and helps in overcoming the shortcomings of local GAAP. All the benefits can be grouped under the two main sub headings and these are discussed below -:
- Transparency –Transparency can be simply be defined as showing or projecting things as they are. Now how this does comes into picture with the use of IFRS? Well Folks, Using IFRS Standards (IFRS GAAP) as the global language in preparing the financial statement or books of accounts will make the financial statements comparable, which in turn will enable the investors and other stakeholders in making sound economic and transparent decisions.
- Accountability – Accountability is fixing the responsibility for actions or decisions. Board of directors uses the financial statement as a tool to measure the progress and growth of their company as it contains some of useful facts and figures which are used in judging the financial health of company. For example, Revenue tells us about the market share captured by a product sold by the company, Net profit tells us about the economic viability of running the business, Net worth depicts the long term solvency period of the company. I can go on about each figure in Statement of Profit and loss and Balance sheet but I think you must have got the point of what I am trying to tell you. But in can you haven’t just remember this – Financial statement tells us the same thing about a company what your ECG report tells you about your heart.
Both transparency and accountability goes hand in hand. There cannot be any accountability without any transparency or Vice-versa. Let’s take a hypothetical scenario to understand it. Suppose your friend is not in his best of his health and feels a little ache in his hearth. He goes for a checkup in a Clinic where there are 10 different ECG machine and his Cardiologist conducts the ECG test in each of those machines. Guess what would be his reaction if all the ten machines shows ten different heart beat rates of his heart. Well I am sure he will feel little ache in his head too by now because he won’t know whether there is some problem in his heart or whether there are some technical glitches in some machines. Or in others words he would have no idea whether the reports are transparent and whether the accountability should be fixed on his eating habits or the ECG machines.
In order to over-come the above problem one common GAAP has been developed which is known as IFRS. IFRS are common global language used for preparation of books of account. It will help in overcoming the above mentioned anomaly and will make the financial statements comparable all around the world and fix the accountability. It will help the management in comparing the Revenue, Operating Cost, Net profit of their company with other companies in the same industry. IFRS eliminates the Window dressing of financial statement by accountant and ensures ethical financial reporting by Companies.
Fraud and Financial Reporting
Most of the corporate frauds in the 20th and 21st century were because of the cooking up of books of accounts or on account of window dressing by the companies to please their investors. Almost all of the publicly traded companies of the Wall Street are in a mad race to increase their Top line (Revenue) and bottom line (Net Profit) to attract new investors in there company . Company needs finances from the investor to invest in new ventures, and investors don’t write up cheques until they see revenues grow by exorbitant percentage year on year. This need of increasing revenues create enormous pressure on the management and some who buckle under this pressure resort to most commonly used technique to increase revenue – Loopholes in GAAP’s. More the number of GAAP’s the more the number of means available to take advantage of (We have already seen above how revenues of Pine Apple Inc varies because of just one difference in measurement principle of revenue in spite of economic reality of transaction remaining same. And there are more than thousands different principles and rules in each GAAP). Let’s look at some of the famous financial reporting frauds of Wall Street.
Waste Management Scandal (1998) – Company reported $1.7 billion in fake earnings by falsely increasing the depreciation time length of property, plant and equipment.
Enron Scandal (2001) – Company reported fake revenue by adopting mark to market accounting and created Special purpose entities to keep debts out of balance sheet. Shares of company dropped from $90.75 to less than $1.
Tyco Scandal (2002) – Siphoned money out of the books of accounts disguised as executive bonuses or befits.
List of companies resorting to above unethical practices are in thousands.
US GAAP vs IFRS
US GAAPS are developed by American Institute of Certified Public Accountants (AICPA) subject to Securities and Exchange Commission rules and regulations. They are used by the accountants in the USA to prepare the financial statements of companies registered in the USA. US has not yet adopted the common global IFRS, because of political and not technical or accounting reasons, and stills follows its own local GAAP known as US GAAP.
The basic concepts like assumptions, principles and constraints are similar to IFRS. But as it is said, “devil lies in the details”. US GAAP is more detailed based or “rule based” where in rules are procedures are made for different industries on case basis whereas the IFRS are “principles based” where in guidelines are much more general in scope and nature. Now let us look at some of the major differences in US GAAP and IFRS.
|Inventory||Under IFRS inventory cannot be valued on LIFO (Last in First Out) basis. However inventory can be valued on FIFO basis i.e. first in first out basis or various other methods like Weighted average cost method and etc.
Inventory is measured at lower of lower of cost or NRV ( Net realizable value)
|It consists of variety of costing methodizes on which Inventory can be valued. LIFO method is not prohibited in US GAAP.
Inventory is measured at lower of cost or market value.
|Depreciation||IFRS follows the component approach for calculation of depreciation. ( Assets belonging to same components are grouped together in single block )||US GAAP does not mandate the component approach for calculation of depreciation.|
|Revenue – General principles.||IFRS rules for revenue recognition are general in nature. They are universal and equally apply to every company irrespective of the industry to which is belongs.
Discounting of revenue of has to be mandatorily done when cash or receivables are deferred
|US GAAP rules for revenue recognition are industry specific, such as manufacturing, real estate, Oil and Gas and etc. It contains separate set of rules and guidelines for different industry.
Discounting of revenue is done only in limited situations.
|Intangibles||Internally incurred development cost can be capitalized.||Internally incurred development cost are not allowed to be capitalized.|
Differences highlighted above are just the tip of the ice-berg and there are far more differences between IFRS and US GAAP. These are far too technical depends upon the facts and circumstances of transaction. Differences in each principle may require an entire separate write –up. But it is important to understand the broad principle on which they differ. US GAAP as highlighted above is a rule based accounting principles whereas the IFRS is principle bases or universal in nature. It’s also important to point out that US is stated that it would adopt convergence based principle in adopting the broad principles of IFRS in near future. These differences have huge impact on some of the business and economic decision like mergers and acquisitions, capital raising, foreign direct investments and etc.