GAAP vs. IFRS

Dive into the world of accounting standards as we discuss the nuances between Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

From understanding their basic principles to uncovering 13 key differences, this blog post promises to simplify GAAP vs. IFRS. In this article, we’ll cover:

What are the Generally Accepted Accounting Principles (GAAP)?

Generally Accepted Accounting Principles (GAAP) are set, monitored, and revised by the Financial Accounting Standards Board (FASB) in the United States. All U.S. publicly traded companies must follow GAAP standards when creating their financial statements, as well as governments, including state and municipal entities. However, it’s worth noting that the U.S. government is not responsible for setting GAAP standards – this is done by independent boards.

Although GAAP is not a requirement for non-public companies, many banks and lenders require GAAP-compliant financial statements before issuing a business loan.

The goal of the GAAP standards is to ensure that companies’ financial statements are complete, consistent, and comparable. This ensures that investors, auditors, and team members can easily evaluate different financial statements, identify trends over time, and make evidence-based decisions.

GAAP is comprised of 10 core principles, including:

1. Principle of regularity: Accountants following GAAP must adhere to set rules and regulations.
2. Principle of consistency: The same standards are used throughout the financial reporting process.
3. Principle of sincerity: Accountants using GAAP are dedicated to accuracy and impartiality.
4. Principle of permanence of methods: The same procedures are used to prepare all financial reports.
5. Principle of non-compensation: All parts of a company's performance, good or bad, are reported fully with no chance of debt offset.
6. Principle of prudence: Guesswork does not affect the reporting of financial information.
7. Principle of continuity: When valuing assets, it's assumed the company will keep operating.
8. Principle of periodicity: Revenue is reported in standard accounting periods like quarters or years.
9. Principle of materiality: Financial reports show the full financial situation of the company.
10. Principle of utmost good faith: It's assumed that everyone involved is acting honestly.

These ten principles distinguish a company's transactions from the personal dealings of its owners, normalize the currency units utilized in reports, and clearly state the time frames that specific reports cover. They also rely on widely accepted best practices that regulate cost, disclosure, matching, revenue acknowledgment, professional discretion, and caution.

What are the International Financial Review Standards (IFRS)?

International Financial Review Standards (IFRS) are a set of standards for public companies’ financial statements. These standards are set by the International Accounting Standards Board (IASB). Unlike GAAP, IFRS applies to 167 jurisdictions, including the European Union.

U.S. companies do not have to abide by GAAP reporting standards, which can be challenging for international companies when creating financial statements.

IFRS standards function similarly to GAAP in that they aim to ensure a company’s financial statements are complete, consistent, and comparable, regardless of industry or country. However, IFRS standards specifically detail how to maintain records and reports of inventory and income.

Much like GAAP, IFRS has a set of standards, including:

1. Fair presentation and compliance - Financial statements should accurately reflect the financial position, performance, and cash flows of an entity.
2. Substance over form - Transactions should be accounted for and presented based on their actual substance and economic reality, not just their legal form.
3. Going concern concept - Assumes the company will continue operations in the foreseeable future without the intent or need to liquidate or significantly reduce its operations.
4. Accrual basis of accounting - Transactions are recognized when they occur, not when cash is received or paid.
5. Materiality and aggregation - All relevant and material facts should be disclosed in financial statements. Aggregation involves adding together items with similar characteristics.
6. Consistency and comparability - Consistency involves applying the same accounting principles across different accounting periods. Comparability allows for the comparison of financial statements across different companies, which is crucial in the context of IFRS.

13 key differences between GAAP vs. IFRS

You've just brushed up on the basics of GAAP and IFRS, so now let's get to the heart of the matter. In this next section, we’ll outline 13 key differences between the two standards, so you can see where they diverge.

1. GAAP is rules-based but IFRS is principles-based

The biggest difference between GAAP and IFRS is that GAAP is rules-based and IFRS is principles-based. Rules are more rigid and allow less room for interpretation, whereas principles provide a flexible framework for financial statements.

2. Different inventory valuation methods are permissible

GAAP permits three different inventory valuation methods, including the weighted-average cost method; first in, first out (FIFO); and last in, first out (LIFO). The FIFO method of inventory management dictates that the assets that are acquired first are sold or used first. Conversely, LIFO requires that the assets that are acquired last are sold or used first.

While all these inventory valuation methods are permissible in GAAP, LIFO is not compatible with IFRS reporting standards.

3. Differences in inventory write-down reversals

Both GAAP and IFRS require companies to note when the cost of their inventory is higher than its realized value. However, sometimes the value of a company’s inventory can increase in value, in which case, an inventory write-down reversal can be made as part of IFRS reporting standards. These reversals can be made in the period in which they occur and are limited to the original write-down cost. However, GAAP prevents inventory write-down reversals.

4. Balance sheet formatting differences

Both GAAP and IFRS use the same balance sheet categories, including assets, liabilities, and equity. However, GAAP and IFRS require that these categories are listed in a different order on a company’s balance sheet. Under GAAP, the balance sheet order is assets, liabilities, and equity. Under IFRS, the balance sheet order is assets, equity, and liabilities.

5. Differences in how investing is reported on the balance sheet

GAAP requires that a company’s most liquid assets and liabilities are listed first on the balance sheet. In contrast, IFRS requires companies to list their least liquid assets first. In addition, GAAP lists the most current assets first, whereas IFRS lists non-current assets first.

6. Interest and dividend classification differences in the statement of cash flow

As we discussed earlier, GAAP rules are stricter than the principles of IFRS. As a result, interest received, and dividends received can be classified as operating or investing activities under IFRS. However, GAAP classifies them as operating activities only.

7. Asset revaluation differences

Asset revaluation, the reassessment of a company's asset values, plays a crucial role in funding replacement costs of assets at the end of their lifespan and providing investors with an accurate picture of the business. While GAAP permits revaluation only for marketable securities like investments and stocks, IFRS extends this to a wider range of assets including plant, property, equipment, inventories, intangible assets, and investments in marketable securities.

8. Capitalizing and amortizing development costs, leading to nonstandard EBITA

GAAP and IFRS have distinct approaches to capitalizing and amortizing development costs. Under GAAP, all development costs are typically expensed as incurred. On the other hand, IFRS allows for the capitalization of development costs given certain criteria are met. This includes internal costs and interest costs related to the acquisition or construction of qualifying assets. Consequently, this difference in treatment can lead to nonstandard Earnings Before Interest and Taxes (EBIT) between the two standards.

9. Impairment losses

GAAP and IFRS differ significantly in their treatment of impairment losses. Under GAAP, a two-step process is used to identify and measure impairment losses. First, an impairment exists if the carrying amount of an asset exceeds its undiscounted future cash flows. Then, the impairment loss is measured as the difference between the asset's carrying amount and fair value.

In contrast, IFRS uses a one-step approach where an impairment loss is recognized if an asset's carrying value exceeds its recoverable amount, which is the higher of an asset's fair value less costs to sell and its value in use. Importantly, while GAAP prohibits the reversal of impairment losses, IFRS permits reversals under certain conditions.

10. Investment property

Under GAAP, investment property is accounted for at historical cost less depreciation. However, IFRS offers a more flexible approach, allowing for investment property - which includes property held for rental income or capital appreciation - to be measured either at cost or revalued to fair value with changes recognized in profit or loss.

11. Lease accounting

Both GAAP and IFRS require lessees to report most of their leases on the balance sheet as assets and liabilities, but their classifications differ. Under GAAP, leases are classified as either capital or operating leases, based on certain criteria.

However, IFRS simplifies this approach by considering all leases as 'finance leases', eliminating the need for classification. Another key difference lies in the treatment of intangible assets. While IFRS includes leases for some kinds of intangible assets, GAAP categorically excludes leases of all intangible assets.

12. Revenue recognition

Under GAAP, revenue is recognized when it is realized or realizable, and earned. However, IFRS is more general, allowing recognition when the risks and rewards of ownership have been transferred, the buyer has control of the goods, and the amount of revenue can be measured reliably.

13. Classification of liabilities 

Under GAAP, a liability can be classified as current if it is expected to be settled within one year or the operating cycle, whichever is longer. However, IFRS has a more nuanced approach. It allows a liability to be classified as non-current, even if it is due within 12 months if the company has an unconditional right to defer settlement for at least 12 months after the reporting period. This means that under IFRS, some short-term obligations could be classified as non-current, which would not be possible under GAAP.

What about the IASB vs. FASB? 

In 2002, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) met to align their financial reporting standards. This included finding common ground on revenue recognition, business combinations, fair value measurement, and stock compensation and earnings per share. However, the IASB and FASB were unable to agree on standards for leases and credit losses, classification and measurement of financial instruments, the distinction between liabilities and equity, derecognition of financial assets, and the accounting for postemployment benefits. The group was disbanded in 2014 after establishing new standards for revenue recognition, and they continue to work independently of one another. 

Common questions about GAAP vs. IFRS

Here are some frequently asked questions about the similarities and differences between GAAP vs. IFRS.

What's the difference between GAAP and IFRS?

GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) are two different sets of accounting standards used worldwide. While GAAP is mainly used in the United States, IFRS is used in over 110 countries and focuses on general principles, offering more flexibility than the more rules-based and detailed approach of GAAP.

Which is better: IFRS or GAAP?

Whether IFRS or GAAP is better largely depends on the context. IFRS, with its principles-based approach, can offer more flexibility and adaptability to various business contexts, while GAAP, with its rules-based system, provides more detailed guidance and can reduce ambiguity in financial reporting.

Why is the IFRS not used in the US?

The U.S. uses its own set of accounting standards known as GAAP (Generally Accepted Accounting Principles) primarily due to historical and regulatory reasons. The switch to IFRS (International Financial Reporting Standards) is considered complex and costly, and there are concerns that IFRS's principles-based approach may not provide the level of detail and specificity often required in the U.S. financial reporting framework.

How are R&D-related expenditures treated under GAAP vs. IFRS?

Under GAAP, Research and Development (R&D) expenditures are generally expensed as they occur with few exceptions such as capitalized software costs. In contrast, IFRS treats research costs similarly but allows for development costs to be capitalized if certain criteria are met, thereby recognizing some R&D costs as assets on the balance sheet.

What's the difference between GAAP vs. IFRS in how they treat inventory?

Under GAAP, inventory is valued at the lower of cost or market value and allows for the use of the last-in, first-out (LIFO) method, while IFRS requires inventory to be valued at the lower of cost or net realizable value and does not permit the use of LIFO. 

What is it called when a company using GAAP acquired a company using IFRS, or vice versa?

When a company using GAAP acquires a company that uses IFRS, or vice versa, this situation is referred to as a cross-border acquisition or merger.

This process typically involves the complex task of reconciling the two different accounting standards, often called "conversion" or "convergence" from one standard to the other.

Conclusion: GAAP vs. IFRS, explained

And there you have it - a comprehensive look at GAAP vs. IFRS, packed with insights and key differences to help you navigate these complex standards.

Whether you're just dipping your toes into the world of accounting standards or you're a seasoned pro, we hope this deep dive has provided valuable insights and answered your burning questions. Remember, understanding these principles is more than just a numbers game - it's about making sense of the financial world around us.

Want to learn more about how Prophix supports GAAP and IFRS reporting standards? Watch our 3-minute video.