GAAP vs. IFRS: Cash Flow Statement Standards Compared

Introduction

Accounting is the language of business. It helps key stakeholder groups better assess the financial position of a company they are looking to engage with. This is critical as it relates to vendors, suppliers, customers, investors, governments, and communities. 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 to do business with the organization. Accounting standards help answer a variety of questions, including the investment worthiness of a company, whether a company is eligible for a government contract, or whether a company is over-leveraged. All of these considerations are used to mitigate risk and support better investment decisions. To do so, however, the user of 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 statement data understand the importance placed on them by third-party users. As a result, they often use assumptions that are more optimistic than warranted in order to portray a more favorable operating environment than the one that is actually prevailing. Likewise, in a particularly bad quarter, management may optimistically take impairment charges to make the next few quarters appear more favorable. Management can also change assumptions related to pension returns, loan loss provisions, allowances for doubtful accounts, and many other line items in an effort to meet 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 reduce the likelihood of making poor investment and financial decisions.

The standards discussed in this paper focus on the cash flow statement and how different classifications can impact not only financial ratios but also discounted cash flow models. These standards are therefore important because they directly affect the inputs used in valuation models by investors throughout the world (Ashbaugh, 2002).

Summary of GAAP and IFRS Standards

With respect to intangible assets, under US GAAP intangibles are recorded at their historical cost. IFRS allows a business to utilize fair value treatment instead. This creates greater variability with IFRS reporting, as intangible assets can increase or decrease over time depending on their assessed value. This could potentially have a negative impact on earnings, particularly if a decline due to fair value accounting is steep.

Other IFRS standards provide companies with considerably more flexibility, but also more variability in operating results. For example, under US GAAP, property is often included in the broad category of "Property, Plant, and Equipment." Under IFRS, property can appear in very different line items. For instance, rental properties held specifically for income are often separated from the typical "Property, Plant, and Equipment" classification (Badertscher, 2012).

Liabilities are also subject to the philosophical differences between US GAAP and IFRS. Contingent liabilities are no different in this regard. Contingent liabilities represent amounts that depend on future events or circumstances — such as a future insurance claim or a large purchase required if certain conditions are not met. US GAAP and IFRS differ in the thresholds used to determine whether a future settlement or payment is considered "likely," which can result in meaningfully different balance sheet presentations.

As it relates to current liabilities, the largest difference between the two frameworks involves operating and finance leases and how they are accounted for in the financial statements. These differences produce significant variation in financial ratios. Under certain methods, higher amounts of both current liabilities and current assets appear under US GAAP, as operating leases are now required to be reported on the balance sheet. Finally, IFRS standards provide considerably more flexibility in how items are reported on the statement of cash flows, which can also skew cash flow-related ratios and data.

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

Similarities and Differences Between the Standards

There are many similarities between GAAP and IFRS. In fact, both standard-setting bodies are actively working to converge their accounting standards in order to reduce the influence of differing frameworks on investor decision-making. One notable area of alignment is revenue recognition. Both standards now employ a five-step process for various revenue recognition methods, which can apply to long-term contracts with customers as well as other recognition techniques. These shared principles are designed to help accounting standards better reflect the underlying economics of the businesses being evaluated.

One key difference between IFRS and US GAAP is the statement of cash flows and how certain line items are classified within it. US GAAP is considerably more rigid, requiring that interest income, interest expense, and dividend income be reported in the operating section of the cash flow statement. Dividends paid are then reported in the financing section under US GAAP. As noted earlier, IFRS is more flexible and allows firms to report these items as either operating cash flows (OCF) or as investing or financing activities. This flexibility heavily impacts the manner in which investors value businesses. Operating cash flow is a critical input to free cash flow models. By being selective in how they classify such items, companies can obscure OCF and potentially mislead investors (Barth, 1999).

Conclusion

Cash flow is one of the most important elements within a business. Being unprofitable but generating high levels of cash flow can be very helpful toward the long-term success of an organization. As a result, understanding the various standards and how they impact reported cash flow is critical for informed decision-making. This paper discussed standards related to liabilities, assets, leases, property, plant and equipment, and revenue recognition — each of which ultimately affects the broader measure of cash flow. It is therefore important for investors to develop a clear understanding of the differences between US GAAP and IFRS in order to make sound financial and investment decisions (Barton, 2010).

References

Ashbaugh, H. S., & Olsson, P. (2002). An exploratory study of the valuation properties of cross-listed firms' IAS and US-GAAP earnings and book values. The Accounting Review, 77(1), 107–126.

Badertscher, B. A., Collins, D. W., & Lys, T. Z. (2012). Discretionary accounting choices and the predictive ability of accruals with respect to future cash flows. Journal of Accounting and Economics, 53(1), 330–352.

Barth, M. E., Beaver, W. H., Hand, J. R., & Landsman, W. R. (1999). Accruals, cash flows, and equity values. Review of Accounting Studies, 4(3–4), 205–229.

Barton, J., Hansen, T. B., & Pownall, G. (2010). Which performance measures do investors around the world value the most — and why? The Accounting Review, 85(3), 753–789.

Bartov, E., & Mohanram, P. S. (2014). Does income statement placement matter to investors? The case of gains/losses from early debt extinguishment. The Accounting Review, 89(6), 2021–2055.