GAAP vs. IFRS (part 3). Part I can be found here, part II here.
In order to better understand the significance of the difference between IFRS accounting standards and GAAP accounting standards, in the previous article I presented a basic example of LIFO vs. FIFO. In this article I list more specific ways that the two systems.
One way that IFRS differs from GAAP can be found when long term assets are being measured according to the standards. With GAAP, these assets would be valued by their book value. Under IFRS, however, the company is allowed to value their plant, property, and equipment at fair value. This can already be a major change between the two methods of valuation. Of two companies that are evaluated differently (one IFRS and the other GAAP) but are otherwise equal, the one using IFRS could show significantly higher (or lower) assets. This is true especially in the manufacturing field where a lot of machinery can be used, or in the tech field where thousands of dollars can be tied up in computers that are obsolete within a few years. Overall this could affect debt-to-equity ratios, any ratios which include assets in their calculations, and even total value of the company on the books (if you change the assets side of the accounting equation, you must also reflect that on the liabilities and owner’s equity side as well).
Let’s take a quick look in depth at how something so simple can completely change the financial statements of a company. A sample firm is provided below for a base case analysis.
This is a firm that has a lot of money tied up in their equipment necessary to run their operations (between 65 and 70%). So, assuming that this company is located in the United States and follows GAAP rules, let us take a brief look at what could happen to this company if it were to use the IFRS standards.
As you can see in the first change (Sample Company – 2) something happened where the equipment was valued higher than the original amount. This is because under IFRS companies are able to evaluate their assets (specifically property, plant, and equipment) at fair value. So if the industry was experiencing growth and multiple people were looking to create or expand their product lines, then because of supply and demand the equipment could be sold (and would therefore be valued) at a higher rate. In the second change (Sample Company – 3) the equipment has dropped. This could be caused by to a competitor getting out of the market and trying to sell off all of his assets. Or, maybe this is from a new form of automation being created within the industry, so the older equipment isn’t as useful as it once was. Either way, the fair valuation of the equipment has dropped and the total assets have also decreased.
Another point to note is that the total asset numbers have changed. Both sides of a balance sheet must equal, and then depending on the situation, value through equity has either been created or destroyed for the owners.
Aside from affecting the financial statements themselves, this can severely alter the asset ratios as well. Imagine finding out that the method of calculating the same exact asset in two different companies have suddenly caused one of the assets to change your total assets by as much as 5 or 10 percent. Under the two major forms of accounting, you could wind up getting the wrong idea about a company.
When it comes to accounting rules for cash, receivables and prepaid expenses, GAAP has another major difference versus IFRS standards. Under GAAP, a company follows the industry specific guidelines for any acquired loans and receivables. However, IFRS calls for any and all loans and receivables in this category to be measured at amortized cost. Trying to evaluate two companies with the same loans that have the same standards of accounting regardless of industry (such as IFRS) would be much easier to produce an accurate comparison than under the current rules of GAAP which may skew the figures and amounts.
Another difference between the two accounting methods occurs with the revenue recognition. While over the long term these things will usually phase out, however, this can cause a major difference in the short run. Under GAAP you must amortize and recognize revenue over the period for which it is accrued, and under IFRS you have more flexibility to recognize the revenue up front. This could be significant where a company gets a contract (or multiple contracts) that will last even a few months. Under the GAAP standards, the company would have to equally recognize the amount of revenue brought in to the amount of work that was done. If a 10 month job is secured and started in December, then one tenth of the total contract would go on the books for this year, with the remaining 90% not recognized until next year. Meanwhile, depending on the specific numbers associated with the contract, the IFRS system will allow the company to recognize more revenue upfront than GAAP would allow. This allows the company to report higher revenue earlier and therefore can significantly affect the financial statements.
Obviously the differences between GAAP and IFRS are not able to be summed up in just a few examples. However, these are just a few more ways of looking at the overall differences between the two systems and recognizing that while they may be based on the same principles, the end results can be completely different numbers even for two similar companies. At the end of the day, I must stress that you continue to look into the other differences between the two types of accounting in order to get a better idea of how they may differ in evaluations. Also, be sure to know some of the ways that they are actually the same in the reporting process so that you know what numbers actually are comparable.
In order to better understand the significance of the difference between IFRS accounting standards and GAAP accounting standards, in the previous article I presented a basic example of LIFO vs. FIFO. In this article I list more specific ways that the two systems.
One way that IFRS differs from GAAP can be found when long term assets are being measured according to the standards. With GAAP, these assets would be valued by their book value. Under IFRS, however, the company is allowed to value their plant, property, and equipment at fair value. This can already be a major change between the two methods of valuation. Of two companies that are evaluated differently (one IFRS and the other GAAP) but are otherwise equal, the one using IFRS could show significantly higher (or lower) assets. This is true especially in the manufacturing field where a lot of machinery can be used, or in the tech field where thousands of dollars can be tied up in computers that are obsolete within a few years. Overall this could affect debt-to-equity ratios, any ratios which include assets in their calculations, and even total value of the company on the books (if you change the assets side of the accounting equation, you must also reflect that on the liabilities and owner’s equity side as well).
Let’s take a quick look in depth at how something so simple can completely change the financial statements of a company. A sample firm is provided below for a base case analysis.
This is a firm that has a lot of money tied up in their equipment necessary to run their operations (between 65 and 70%). So, assuming that this company is located in the United States and follows GAAP rules, let us take a brief look at what could happen to this company if it were to use the IFRS standards.
As you can see in the first change (Sample Company – 2) something happened where the equipment was valued higher than the original amount. This is because under IFRS companies are able to evaluate their assets (specifically property, plant, and equipment) at fair value. So if the industry was experiencing growth and multiple people were looking to create or expand their product lines, then because of supply and demand the equipment could be sold (and would therefore be valued) at a higher rate. In the second change (Sample Company – 3) the equipment has dropped. This could be caused by to a competitor getting out of the market and trying to sell off all of his assets. Or, maybe this is from a new form of automation being created within the industry, so the older equipment isn’t as useful as it once was. Either way, the fair valuation of the equipment has dropped and the total assets have also decreased.
Another point to note is that the total asset numbers have changed. Both sides of a balance sheet must equal, and then depending on the situation, value through equity has either been created or destroyed for the owners.
Aside from affecting the financial statements themselves, this can severely alter the asset ratios as well. Imagine finding out that the method of calculating the same exact asset in two different companies have suddenly caused one of the assets to change your total assets by as much as 5 or 10 percent. Under the two major forms of accounting, you could wind up getting the wrong idea about a company.
When it comes to accounting rules for cash, receivables and prepaid expenses, GAAP has another major difference versus IFRS standards. Under GAAP, a company follows the industry specific guidelines for any acquired loans and receivables. However, IFRS calls for any and all loans and receivables in this category to be measured at amortized cost. Trying to evaluate two companies with the same loans that have the same standards of accounting regardless of industry (such as IFRS) would be much easier to produce an accurate comparison than under the current rules of GAAP which may skew the figures and amounts.
Another difference between the two accounting methods occurs with the revenue recognition. While over the long term these things will usually phase out, however, this can cause a major difference in the short run. Under GAAP you must amortize and recognize revenue over the period for which it is accrued, and under IFRS you have more flexibility to recognize the revenue up front. This could be significant where a company gets a contract (or multiple contracts) that will last even a few months. Under the GAAP standards, the company would have to equally recognize the amount of revenue brought in to the amount of work that was done. If a 10 month job is secured and started in December, then one tenth of the total contract would go on the books for this year, with the remaining 90% not recognized until next year. Meanwhile, depending on the specific numbers associated with the contract, the IFRS system will allow the company to recognize more revenue upfront than GAAP would allow. This allows the company to report higher revenue earlier and therefore can significantly affect the financial statements.
Obviously the differences between GAAP and IFRS are not able to be summed up in just a few examples. However, these are just a few more ways of looking at the overall differences between the two systems and recognizing that while they may be based on the same principles, the end results can be completely different numbers even for two similar companies. At the end of the day, I must stress that you continue to look into the other differences between the two types of accounting in order to get a better idea of how they may differ in evaluations. Also, be sure to know some of the ways that they are actually the same in the reporting process so that you know what numbers actually are comparable.
