GAAP vs. IFRS: Key Differences and Convergence Prospects

Overview of GAAP and IFRS

Standards governing financial accounting and reporting differ from one nation to another. American financial reporting practices have been established by the Financial Accounting Standards Board (FASB) and organized as part of the Generally Accepted Accounting Principles (GAAP) framework ("About the FASB," 2020). GAAP implies a common collection of recognized accounting standards, procedures, and principles that organizations and their accountants must follow when compiling financial statements. International Financial Reporting Standards (IFRS) denotes a collection of international accounting standards issued by the International Accounting Standards Board (IASB), stating how financial statements should report specific kinds of events and transactions. They stipulate precisely how accountants' records should be maintained and reported ("About the International Accounting Standards Board," 2021).

The IFRS was formulated to establish a shared accounting language so that accounts and business activities can be better understood from one organization to the next and from one nation to another ("Why global accounting standards?" 2021). Over 144 nations have adopted these standards worldwide to institute a common international language targeted at corporate accounting affairs ("Use of IFRS Standards…," 2018). Despite the SEC's (Securities and Exchange Commission) clear desire to shift from the GAAP framework to IFRS, not much progress has been seen ("Spotlight on Work Plan…," 2019). This paper examines the differences between IFRS and GAAP, the possibility of a future common set of accounting guidelines, and the limitations to achieving that possibility.

Key Differences Between GAAP and IFRS

GAAP is more of a rules-based framework that offers more thorough and exact guidance, whereas IFRS standards are more principles-based and characterized by less prescriptive application guidance.

GAAP has specific requirements for analyzing individual elements of multi-component arrangements to ensure appropriate recognition of corresponding revenues. For instance, the analysis must identify contracts with complex implementation work such that license revenues are not instantly recognized but must be deferred. The additional analysis encompasses the ascertainment of vendor-specific objective evidence (VSOE) of the fair value of both delivered and undelivered elements included in the contract. The absence of VSOE for any contract element may require additional revenue deferral, as may the presence of extended payment terms.

IFRS resembles GAAP in this area, though it does not prescribe when revenue must be recognized based on the overall arrangement instead of applying distinct revenue recognition conditions to separate deliverables.

Under American GAAP, goodwill is not amortized; instead, it is tested annually for impairment — and sometimes more frequently when circumstances or events suggest the potential impairment of an asset. Impairment testing takes place in two steps. Step I entails comparing the reporting unit's fair value with its carrying value (which includes goodwill). If the carrying value exceeds the fair value, Step II must be undertaken, which requires the measurement and recording of the impairment as the excess of recorded goodwill over its implied fair value (PWC, 2020), computed by allocating the reporting unit's fair value to its liabilities and assets.

IFRS resembles American GAAP in this regard, except that the annual goodwill impairment test is conducted in a single step rather than two. Furthermore, under IFRS, impairment testing is carried out at the level of the Cash Generating Unit, which differs in certain organizations from the Reporting Unit level required under GAAP.

US GAAP treats impairment losses as permanent and irreversible. Under IFRS, by contrast, earlier impairment losses associated with tangible and intangible assets — except for goodwill — are reversible.

US GAAP first allocates a surplus of the purchase price over the fair market value of tangible liabilities and assets to identified intangibles with determinable useful lives. All remaining excess is allocated to goodwill.

While IFRS resembles American GAAP in that it also treats goodwill as the purchase price surplus over net assets, IFRS potentially identifies a larger number of intangible assets, thereby reducing the amount of recognized goodwill (Smith, 2012). Under US GAAP, intangible assets that fail to meet separable or contractual-legal criteria are not recognized as assets. Various other intricate differences regarding purchase price accounting exist between US GAAP and IFRS, though these are typically associated with specific situations and facts.

US GAAP measures the value of consideration within a reasonable timeframe before and after the date on which acquisition terms were announced and accepted. IFRS, by contrast, measures consideration value at the acquisition date — that is, when the acquirer begins to control the acquiree.

Under US GAAP, lessees classify leases as financing or capital leases if they fulfill at least one of the following conditions (PWC, 2020):

If none of these conditions is fulfilled, the lessee accounts for the lease as an operating lease. US GAAP also provides additional prescriptive guidance on applying these conditions to particular situations and facts, grounded mostly in the form of the contract.

Under IFRS, lessees classify leases as financing leases if the arrangement substantially transfers all rewards and risks incident to ownership. Leases are classified as operating leases if they do not substantially transfer such rewards and risks to the lessee (Liu et al., 2014). Within IFRS, the classification depends on the substance of the transaction rather than the contract's legal form. As a result, IFRS is less prescriptive than US GAAP and may produce different outcomes in areas such as sale-leaseback transactions and lease accounting more broadly.

Under American GAAP, deferred income tax assets are reduced by valuation allowances if, based on the weight of existing evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. Valuation allowances must be sufficient to reduce deferred tax assets to the amount that is more likely than not to be realized (Smith, 2012). Deferred income tax liabilities and assets are measured based on tax rates enacted as of the balance sheet date.

Under IFRS, carried-forward deferred income tax assets are recognized to the extent that it is probable that future taxable income will be available against which unused tax losses can be utilized. Deferred income tax liabilities and assets are computed based on enacted or substantively enacted tax rates as of the balance sheet date.

One of the most notable differences between these two accounting frameworks is the approach to inventory cost accounting (Gavin, 2019). IFRS disallows the Last In, First Out (LIFO) inventory calculation method. GAAP, on the other hand, permits the use of both LIFO and First In, First Out (FIFO) techniques for estimating inventory costs.

The reason LIFO is excluded from IFRS is that it does not accurately reflect inventory flows and may report lower income levels than actually exist (Gavin, 2019; Smith, 2012). The flexibility to employ either LIFO or FIFO under GAAP enables firms to select the technique most appropriate for their inventory valuation needs.

Concerning revenue recognition, IFRS is a more general standard compared with GAAP. GAAP begins with determining whether revenue is earned or realized and contains definite rules concerning revenue recognition across several different sectors. The guiding principle is that revenues are not recognizable until the exchange of services and goods is complete (Liu et al., 2014). Once a transaction is recognized and recorded, accountants must also apply sector-specific rules.

IFRS, by contrast, is grounded in the principle that revenues are recognized after value has been delivered. All revenue transactions are clustered into four groups: sales of goods, rendering of services, use of another entity's assets, and construction contracts. Organizations that adopt IFRS utilize the following two revenue recognition techniques (Liu et al., 2014):