How cash flow standards differ between US GAAP and IFRS

. Introduction

Accounting is the language of business. It helps key stakeholder groups to better access the financial position of a company they are looking to engage with. This is critical as it relates to vendors, suppliers, customers, investors, governments, communities. For one, all of these stakeholders must trust that the organization will keep its promises and commitments. They must also protect their own downside risk as it relates to their ability and wherewithal to do business with the organization. Accounting standards help to answer a variety of questions including the investment worthiness of a company, the ability to determine if the company is worthy of a government contract, or to determine if a company is over leveraged. All of these circumstances are used to help mitigate risk, make better investment decisions. To do so however, the user of this financial information must have an understanding of generally accepted accounting principles and their impact on the financial statements presented by organizations

Unfortunately, creators of financial statements data understand the importance placed on them by third part users. As a result, they often use assumptions that are much more optimistic in order to indicate a much more favorable operating environment than the one that is prevailing. Likewise, in a particularly bad quarter management man optimistically take impairment charges to make the next few quarters look much more favorable. In addition, management can change assumptions related to pension returns, loan loss provisions, allowances for doubtful account, and many other line items in an effort to make consensus estimates or other financial data forecasts. This ultimately undermines the data being presented and causes confusion for unsophisticated financial statement users. As a result, it is critical to understand the differences between GAAP and IFRS standards in order to help lower the likelihood of making poor investment and financial decisions.

The standards discussed is this assignment will be that of the cash flow statement and how different classifications can only impact financial ratios but also discounted cash flow models. These standards is therefore important as it directly impacts the inputs used in valuations models by investors throughout the world (Ashbaugh, 2002).

2. Summary of the GAAP and IFRS standard

With intangible assets, under US GAAP intangibles are recorded at their cost. IFRS allows a business to utilize the fair value treatment. This created more variability with IFRS reporting as intangible assets can increase of decrease overtime depending on their value. This could potentially have a negative impact on earning particularly if the decline due to fair value accounting is steep.

Other IFRS standards provide companies with much more flexibility but also much more variability in operating results. For example, under U.S. GAAP property is often included in the broad category of “Property, Plant, and Equipment.” Under IFRS property can be located in very different line items. For example, rental properties that are held specifically for income are often separated from the typically “Property, Plant and Equipment” line items (Badertscher, 2012).

Liabilities are often subject to the differences in philosophy as it relates to U.S. GAAP and IFRS. Contingent liabilities are no different in this regard. Here, contingent liabilities are amounts that are subject to future events or circumstances. This could include a future insurance claim or a large future purchase that is required if certain conditions are not met. US GAAP and IFRS standards differ in the standards used to determine if a future settlement or payment is “likely.” Table 1 below provides many of the differences

As it relates to current liabilities, the largest difference between the two stands in operating and finance leases and how they are accounting for in the financial statements. These differences have very large differences in the financial ratios being used. Under certain methods higher amount of current liabilities and current assets will occur under US GAAP as operating leases are now required to be reported on the balance sheet. Finally, IFRS standards provide much more flexibility in how items are reported on the statement of cash flows which also can skew cash flow related ratios and data.

All of the items presented above related to the cash flow statement in some manner. Operating leases pay interest, property plant and equipment are depreciated, intangible assets are amortized, and so forth. As a result, one of the most important elements relating to the difference between US GAAP and IFRS is the cash flow statement (Bartov, 2014).

3. Discussion of the similarities and differences among each standard

To begin there are many similarities between GAAP and IFRS. In fact, both GAAP and IFRS are looking to converge their accounting standards to mitigate the influences of different accounting standards on investor decision making. The first similarity is related to the manner in which revenue is recognized. With both standards aligning a five-step process is used for various revenue recognition methods. This process can apply to long term contracts with customers other revenue recognition techniques. The similarities are designed to help accounting standards better match the underlying economics of the business being evaluated.

Once key difference between IFRS and US GAAP is the statement of cash flow and how certain line items are accounted within it. US GAAP is much more rigid and requires interest income, interest expense, and dividend income to be properly accounted for in the operating section of the cash flow statement. Dividend that are paid are then reporting in the financing section under US GAAP. As noted earlier, IFRS is much more flexible and allows firms the flexibility to report these items as operating cash flows (OCF) or as investing or financing. This flexibility heavily impacts the manner in which invests value businesses. For one, operating cash flow (OCF) is a critical input to free cash flow models. By being selective in the manner in which they classify items, OCF can be obscured and mislead investors (Barth, 1999).

4. Relate each standard to the relevant topic you learned in class

The cash flow standards are relevant to the efficient functioning of the markets as discussed in class. In order for markets to be efficient, confidence is needed in the both the system and financial data being presented. If trust is lost or there is a lack of confidence in the information being provided, then stock valuations may diverge from economic reality. As a result, investors must know and understand the various cash flow standards and how they can impact perspective returns and valuations.