In the United States, GAAP (generally accepted accounting principles) is required by the SEC. There are thousands of rules that govern GAAP. In many other countries GAAP is not allow, and companies must report using International Financial Reporting Standards (IFRS). In almost every European country IFRS is required to be used. Additionally, IFRS is mandatory in over 100 countries worldwide.
Why is it important to know the difference between the two? There are many reasons to have an understanding of IFRS. 1. While it is not imminent, there is a good chance the US will switch to IFRS standards in the future. 2. There are ~8,000 publicly traded companies in the US, outside the US there are tens of thousands, and if you want to invest in these companies you must understand the difference between the two. 3. Even if you do not invest abroad many ADRs use IFRS.
While GAAP and IFRS are very similar there are a number of differences between the two accounting standards. Below is a brief explanation of the topic. In future articles, I intend to show how a company could show different numbers on their financial statements depending on which method is used (in a theoretical case where either one could be used)
IFRS is a set of standards that (compared to GAAP) are based more upon principle and idea, rather than staying specific to the letter of the law. While the founding idea behind GAAP was a concrete one (rather, a much larger set of rules and procedures), it has long since become too complex for many and is actually starting to be phased out for international accounting standards. This is also due to the fact that we live in an increasingly interdependent world, and it does not make sense for a global investor to evaluate two identical companies on completely different measures, just because they are headquartered in separate countries. Guy Spier touches on this point in an interview I conducted, which I will be posting shortly.
The problem that we run into before the full transition is complete, is that if any given company were to report their statements using both GAAP and IFRS, they would come out with two different sets of figures and possibly even two different forecasts based upon those figures.
For one example, GAAP allows the use of LIFO (last in – first out) in inventory evaluation while IFRS does not (it must be noted that GAAP also allows FIFO). That means that a company under GAAP could continue to report their inventory cost under the LIFO methods, which will essentially save them by reducing taxes. If a company using LIFO sells of some but not all of their inventory for a given period of time, then as time goes on they will have inventory valued at rates below the current market rates (assuming an inflationary environment). This is due to them selling off the inventory (from an accounting point of view anyway) which has just been created, and any remaining inventory stays on the books. As time goes on, the cost of goods sold for new items should increase, but the cost of goods for the inventory still on the books will remain low.
The main reason that a company uses LIFO is because the company will be able to sell off their goods for a lower cash flow when inventory costs are rising. They are still actually bringing in the same amount of sales, but by writing off a higher “cost of goods sold” for their units sold, they are able to manipulate the books without actually doing anything to affect their inventory; only the way it appears on the financial statements.
However, a company under IFRS would not be able to use the LIFO method, so they are actually seen as better off in terms of gross margins but they also never get to “manipulate” to reduce the tax burden. By using FIFO (first in – first out) a company is not able to create that artificial “tax shield” which would otherwise allow them to maximize the cost of goods sold on the accounting statements. However, it would also mean that they would never have the risk that a company using LIFO possesses in regards to having to liquidate their assets.
If a company using LIFO has to sell off more of their inventory than they can add, they have to “eat away” at that LIFO layer and report the cost of goods sold as a much lower number as compared to the current market value. This would result in much high profit than it otherwise would, and could even end up hurting the company in higher taxes than they otherwise would have owed. The company using FIFO, however, would never actually have to be exposed to that large inflation of accounting profit because they never actually create an artificial LIFO layer to mark down the cost of goods.
There are multiple ways that GAAP differs from IFRS, and while this is just one of the ways, you can already see how just by evaluating one specific method a company is actually able to change their financial outlook. The point is that if the same company was to report their financial statements in both GAAP and IFRS standards, the information would show up differently and could cause investors to grade the company differently than it otherwise would. This is definitely a tricky subject that needs to be paid more attention to when evaluating financial statements.
http://www.valuewalk.com/
Why is it important to know the difference between the two? There are many reasons to have an understanding of IFRS. 1. While it is not imminent, there is a good chance the US will switch to IFRS standards in the future. 2. There are ~8,000 publicly traded companies in the US, outside the US there are tens of thousands, and if you want to invest in these companies you must understand the difference between the two. 3. Even if you do not invest abroad many ADRs use IFRS.
While GAAP and IFRS are very similar there are a number of differences between the two accounting standards. Below is a brief explanation of the topic. In future articles, I intend to show how a company could show different numbers on their financial statements depending on which method is used (in a theoretical case where either one could be used)
IFRS is a set of standards that (compared to GAAP) are based more upon principle and idea, rather than staying specific to the letter of the law. While the founding idea behind GAAP was a concrete one (rather, a much larger set of rules and procedures), it has long since become too complex for many and is actually starting to be phased out for international accounting standards. This is also due to the fact that we live in an increasingly interdependent world, and it does not make sense for a global investor to evaluate two identical companies on completely different measures, just because they are headquartered in separate countries. Guy Spier touches on this point in an interview I conducted, which I will be posting shortly.
The problem that we run into before the full transition is complete, is that if any given company were to report their statements using both GAAP and IFRS, they would come out with two different sets of figures and possibly even two different forecasts based upon those figures.
For one example, GAAP allows the use of LIFO (last in – first out) in inventory evaluation while IFRS does not (it must be noted that GAAP also allows FIFO). That means that a company under GAAP could continue to report their inventory cost under the LIFO methods, which will essentially save them by reducing taxes. If a company using LIFO sells of some but not all of their inventory for a given period of time, then as time goes on they will have inventory valued at rates below the current market rates (assuming an inflationary environment). This is due to them selling off the inventory (from an accounting point of view anyway) which has just been created, and any remaining inventory stays on the books. As time goes on, the cost of goods sold for new items should increase, but the cost of goods for the inventory still on the books will remain low.
The main reason that a company uses LIFO is because the company will be able to sell off their goods for a lower cash flow when inventory costs are rising. They are still actually bringing in the same amount of sales, but by writing off a higher “cost of goods sold” for their units sold, they are able to manipulate the books without actually doing anything to affect their inventory; only the way it appears on the financial statements.
However, a company under IFRS would not be able to use the LIFO method, so they are actually seen as better off in terms of gross margins but they also never get to “manipulate” to reduce the tax burden. By using FIFO (first in – first out) a company is not able to create that artificial “tax shield” which would otherwise allow them to maximize the cost of goods sold on the accounting statements. However, it would also mean that they would never have the risk that a company using LIFO possesses in regards to having to liquidate their assets.
If a company using LIFO has to sell off more of their inventory than they can add, they have to “eat away” at that LIFO layer and report the cost of goods sold as a much lower number as compared to the current market value. This would result in much high profit than it otherwise would, and could even end up hurting the company in higher taxes than they otherwise would have owed. The company using FIFO, however, would never actually have to be exposed to that large inflation of accounting profit because they never actually create an artificial LIFO layer to mark down the cost of goods.
There are multiple ways that GAAP differs from IFRS, and while this is just one of the ways, you can already see how just by evaluating one specific method a company is actually able to change their financial outlook. The point is that if the same company was to report their financial statements in both GAAP and IFRS standards, the information would show up differently and could cause investors to grade the company differently than it otherwise would. This is definitely a tricky subject that needs to be paid more attention to when evaluating financial statements.
http://www.valuewalk.com/
