This week we discuss the difference between GAAP and IFRS. Watch now!
VIDEO SUMMARY
Introduction
I have hesitated to put out a video on GAAP versus IFRS because this is something that is constantly changing. I am shooting this video on Aug 5, 2018, and this information will probably be different next year. But I wanted to share my perspective on what is going on right now, because this is one of the most controversial topics in accounting.
Definitions
First you need to understand what these things are. GAAP and IFRS are accounting standards. GAAP stands for Generally Accepted Accounting Principles which is the accounting framework used in the United States. IFRS stands for International Financial Reporting Standards which is the accounting framework used in the rest of the world.
What is an accounting standard? They are basically a set of guidelines you need to follow for accounting in your business. It is not laws, but it is really self-regulation where accountants have gotten together and agreed on the methods to use. When we talk about GAAP and IFRS, we are describing two different accounting standards.
Example
The example I like to use is Monopoly. Most of us have played the board game Monopoly, and there is a set of rules. But sometimes people have different interpretations. The biggest example of this is landing on the space called “Free Parking.” Every time I have played Monopoly, everyone has a different interpretation of what happens when you land on that space. Some people say nothing happens. Some people say you get a whole bunch of money. I personally like the rule where you get a bunch of money, but I do not actually know what the rule is. If anyone knows, please leave a comment below. This is just like GAAP and IFRS. There is an overall set of standards, but in certain circumstances, there are different approaches under GAAP and IFRS.
Differences
In general, GAAP and IFRS are very similar already. The fundamentals of accounting are the same anywhere in the world. You still have the same financial statements and basic processes. However, there are still some significant differences.
The biggest difference between GAAP and IFRS is that GAAP is rules based, whereas IFRS is principles based. GAAP actually writes out all these different rules that US companies are required to follow, which does not leave much room for interpretation. IFRS focuses on the principles. This means that GAAP is much longer and more detailed than IFRS. The reason that GAAP is so detailed, is there have been some pretty big accounting scandals in the US. Every time a business has a major accounting scandal, more rules get added to the list, to make sure there are no misunderstandings in the future.
One of the biggest differences that has not yet been resolved is LIFO. LIFO means Last-In First-Out which is a method of valuing your inventory. US companies are allowed to use LIFO. International companies are not. A lot of US companies use LIFO, because most of the time it reduces your reported profit, which reduces your taxes. We are talking about a lot of money. No one knows for sure what the estimated tax savings is, but it is estimated at over $100 Billion in the US over 10 years. To give you an idea of how complicated this is, for treatment of LIFO to change, the US would have to change that part of the IRS tax code, which would require the US legislature to pass a law increasing corporate taxes by $100 Billion. This presents a real challenge. LIFO is just one example, but there are many more differences between GAAP and IFRS.
To see the top ten differences, check out this article.
Benefits
The benefits of having one global accounting standard are obvious. We have so many global companies now, that it is difficult to have multiple locations using different accounting standards. Imagine if you wanted to merge an American company and an International company that were using two different accounting standards. You can figure out the differences, but it just makes things more difficult.
Criticism
There are also criticism of convergence between the two standards. The US started moving to IFRS in 2006, so we have been working on this for over a decade. It has taken much longer than everyone expected. It has been controversial because not everyone agrees this is the best thing to do. I will probably get a lot of people mad by saying this, but you have to understand that the US is giving up a lot. The person who controls the rules of business has a lot of power. Currently, GAAP is determined by Financial Accounting Standards Board (FASB) and controlled by the Securities and Exchange Commission (SEC). The SEC is the part of the US Government that regulates financial markets in the US. In the convergence of GAAP to IFRS, the SEC is giving up control to an international organization.
Who is this international organization? IFRS is run by an entity called the IFRS Foundation. The IFRS Foundation is a non-profit organization that was founded in Delaware in the US, and receives a large amount of donations from US companies. You can download the annual report from the IFRS Foundation website and see the long list of companies that donate. Just to clarify, we are negotiating to move from the SEC to an international organization funded by corporations that want to change from detailed rules-based accounting standards to a much shorter principles based accounting standard that allows for a lot of interpretation.
My Thoughts
I am not concerned that there is funny business going on. I think there are good intentions here. Personally, I feel more comfortable if the SEC stayed more involved to watch our back. My real concern is the impact on growth for the US. If the US gives up control of our own accounting standards, in order to change anything, we would have to ask permission to an international organization. That makes us less flexible as a nation.
For example, imagine the US has a new growing industry, like the Commercial Space Industry. We are going to need to write new accounting standards for things like manufacturing items in space. The US needs the flexibility to write new accounting standards. I do not want to have to go to an international organization so they can evaluate the impact on every country around the world. I do not have time for that. We have business to do. Giving up control impacts our own country’s flexibility and interests.
Summary
I hope that gave you a good overview of the difference between GAAP and IFRS. I know we talked about a lot. In general, a lot of people agree there are benefits to standardization of accounting around the world. GAAP and IFRS are already pretty similar already. But there are still some sticking points, and convergence will be an ongoing conversation for many more years.