GAAP vs. IFRS: Key Differences in Accounting Standards

Introduction

Accounting practices are used to record transactions that reflect changes in a corporation's assets and liabilities, aiding in determining the financial future of the company. The two primary practices are Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), and this paper compares the two standards with each other. As noted by scholars, "Rules for accounting for particular events sometimes differ across countries" (Wiley & Sons, 2014). The Securities and Exchange Commission (SEC) sets the standards and holds the responsibility to govern U.S. financial markets. In other words, the SEC is referred to as the governing authority for all reporting businesses in the United States and accounting standard-setting bodies.

On November 14, 2008, the SEC released a proposed road map toward IFRS convergence (Seay, 2014). Both GAAP and IFRS accounting practices are similar, yet the differences may be significant enough for the U.S. to switch over to IFRS in the near future. U.S. accountants need to become educated and familiar with IFRS accounting practices.

Fair Value Measurement

In order to paint an accurate picture of a corporation's assets, determining the current cash value of those assets is essential. In financial statements, this standard is known as fair value measurement. As one researcher notes, "Simultaneously, fair value refers to the fairness of value in a specific time period, and fair value is meaningless without the concept of time" (Sun, 2010). Many factors affect the value of business assets, such as age and depreciation. Both IFRS and GAAP include information regarding fair value measurement practices in their notes sections. Regardless of which system is used, businesses are required to report assets as either book value or fair value. Goods of the same class must receive the same evaluation; it would not be ethical to overvalue assets in the same category.

Component Depreciation and Asset Revaluation

International companies operating overseas under IFRS accounting practices are required to use component depreciation. According to accounting literature, "IFRS requires that each part of an item of property, plant, and equipment that is significant to the total cost of the asset must be depreciated separately" (Wiley & Sons, 2014). For example, when a company like Amazon purchases a warehouse building, it must account for all associated construction costs—including the foundation, structure, roof, heating and cooling system, and elevators—and these components must be segregated and depreciated separately. Under GAAP, component depreciation is not permitted.

The revaluation of plant assets can be defined as the process of adjusting recorded values from book value to fair value. Fair value may increase or decrease depending on current market conditions. Once significant changes in the market have occurred, this revaluation process is then required under IFRS. As researchers observe, "General conceptual frameworks highlight the constraints related to financial reporting costs" (Tilea & Serban, 2013). An example of an increase in market value occurs when a company purchased land decades ago and it is subsequently rezoned commercially; the new increase in value can be adjusted to reflect the current fair value.

Research and Development Costs

A critical accounting decision involves determining which expenditure classification is appropriate when recording product development costs. The key question is whether such expenditure should be classified as a development expense or as a capital development cost. IFRS only places this condition on research costs. Once technology feasibility has been established through research, it becomes optional for a company to begin reporting development costs as capital expenditures. This method allows the cost to be depreciated over the useful life that the technology provides. In contrast, under GAAP, research and development costs are expensed by reporting them directly on the income statement rather than capitalized.

Contingent Liabilities and Debt Recording

In accounting practice, contingent liability refers to future predictable costs that a company can accurately forecast as resulting from a particular event. Consider an offshore oil rig belonging to Shell that experiences an accidental explosion in the Pacific Ocean. The potential fines imposed by the Environmental Protection Agency (EPA) for environmental violations can be reasonably forecasted. Even though the company has not yet been fined, Shell is required under IFRS to note the contingent liability. Because these fines are expected to occur, this information must be disclosed to all shareholders.

Liabilities are a form of debt, and the recording of liabilities under both GAAP and IFRS is accomplished in similar manner with only minor differences. One of the biggest differences is the recording of contingent liabilities—future debt obligations. As previously mentioned, IFRS allows for the recording of contingent liability. Under GAAP accounting procedures, liabilities must be recorded in order of liquidity; under IFRS, the order is reversed. Regarding interest calculations, GAAP may use either the straight-line method or the effective interest rate method. Under IFRS, the straight-line method is not an option, requiring use of the effective interest rate method instead.