10 Biggest Differences between IFRS and GAAP – How to Tell Them Apart
A rather dry topic, accounting standards are nevertheless extremely attractive for entrepreneurs, investors, and tax authorities. And there are two standards used in the US. Each for a different reason: GAAP and IFRS. Since accounting is the language of business (and bookkeeping is the basis of solid accounting), it’s important to understand the differences of these accounting standards. Here are 10 key differentiators, and when and where to use them.
GAAP is the US standard approach to preparing annual financial statements. IFRS is an International Accounting Standards Board (IASB) approach to accounting that provides international standards. GAAP ensures that companies operating in the US report consistent financial statements to the US Securities and Exchange Commission (SEC). This helps reduce and protect from the possibility of malpractice in financial accountability, particularly for large companies, since they typically have a significant and large impact on the local and international marketplace. GAAP allows investors to correctly evaluate the financial position and business practices of the companies they engage with, so they can make decisions informed by sound financial records when investing. With IFRS, on the other hand, the standards developed by the IASB ensure that international financial reporting remains consistent.
Some places where IFRS is an influential accounting standard include Africa, Asia, and South America. It is also the major accounting standard implemented in the European Union. To help you grasp their similarities and contrasts, let’s take a look at the 10 biggest differences between IFRS and GAAP.
1. Based on Rules versus Principles
The general difference between the two standards is their basis on rules versus principles. IFRS is mostly based on a set of principles, while GAAP is a rules-based approach to accounting. And this is a major difference. Under IFRS, companies must use interpretation and judgment in their application of the principles underlying accounting. Under GAAP, companies must follow the rules and guidelines specific to their industries.
Compared to GAAP, IFRS does not dictate the standards but rather provides recommendations on how companies operating internationally can order their financial records. This ensures that, despite differences in fiscal policies and national jurisdictions, the accounting process remains similar worldwide.
2. Organizing the Balance Sheet
Next, balance sheets are formatted differently in IFRS and GAAP. According to GAAP, non-current assets (i.e. liquidity is available beyond a year) appear first on balance sheets. In IFRS, current assets (i.e. liquidity within a year) are the first entry. Also, the categories on balance sheets are ordered differently in the two standards. In IFRS, the assets appear beginning with the least to most liquid ones, while in the GAAP approach, the order is the reverse. So, a balance sheet appears differently in the US – which can be pretty confusing if one doesn’t know.
3. Liabilities Classification
IFRS has no distinct classification of liabilities, meaning that companies are allowed to group short-term (i.e. due within a year) and long-term liabilities (due beyond a year) onto the balance sheet. The GAAP standards group liabilities into non-current and current liabilities.
4. Cash Flow Statements
Further, the classification of dividends and interest is the most conspicuous difference between GAAP and IFRS accounting standards. GAAP is less flexible in that regard since it prescribes that companies classify interest received and paid as “operating activities”. The flexibility of IFRS allows companies to choose the most appropriate interest classification policy that suits their business operations.
5. Revenue Recognition
GAAP is a lot more specific in revenue recognition compared to IFRS. IFRS allows companies to recognize revenue after delivery. It recognizes revenue in four categories, including using other organizations’ assets, services provision, contracts in construction activities, and sales. GAAP, on the other hand, has specific rules regarding revenue recognition, which includes determining whether an entity has earned or realized revenue. Goods and service exchange must have occurred before accountants can recognize revenue under GAAP. And there are industry-specific rules in GAAP governing a company’s accounting approach to recognizing revenues, for example for SaaS companies. With SaaS companies, revenue is recognized according to the timeline of delivery of the service, not at the time of payment (if the service is prepaid). This can be really confusing for those used to IFRS standards.
6. Reevaluation of Assets
Now, when it comes to Asset Management, GAAP and IFRS also offer some differences. Technological and market factors can sometimes cause your assets’ values to drop (versus their original value). GAAP and IFRS handle this reduction differently in financial accounting and reporting. IFRS allows that companies can raise the value of particular assets back up after a reduction in value due to the factors mentioned above (even after the calculation of their depreciation). GAAP doesn’t allow this.
7. Inventory Management
Companies are allowed, under GAAP, to record their inventories in the First in First out (FIFO) and Last in First out (LIFO) methods, while IFRS companies can only use the LIFO approach. GAAP is a lot more flexible in accounting for inventory costs compared to IFRS. The GAAP standard allows companies to choose between the two methods based on their business operations. However, IFRS’ avoidance of FIFO has good reason. FIFO could show lower income levels than is really the case because of an inaccurate portrayal of inventory costs.
8. Accounting for Fixed Assets
IFRS values fixed assets differently compared to GAAP. Under IFRS, companies can value fixed assets based on their initial cost. That means it can change based on the market value of the assets. Under GAAP, while accounting for depreciation, companies can value their fixed assets based on their historic costs. Also under GAAP, companies may depreciate the value of asset components differently if they choose. For IFRS, this is mandatory when accounting for the depreciation of the components of their fixed assets.
9. Accounting for Leases
In addition, IFRS allows companies to distinguish between low-valued assets leases, which is a provision referred to as the “de minimus exception”. GAAP does not include this type of exception. Furthermore, GAAP does not recognize leases for intangible assets. IFRS allows companies to recognize leases of particular types of intangible assets.
10. Intangible Assets
Under the GAAP standard, except for internally developed software, companies should account for development costs as they incur them. Under IFRS, companies can capitalize internal costs, including development costs, as long as they meet specific criteria. GAAP decrees that companies can only capitalize software developed for internal use during the development stage. It can capitalize software developed for external use as soon as it demonstrates that it has technological feasibility. Similar treatment for software development costs are lacking in IFRS.
Summing it up
Ultimately, though the differences may seem significant, each system of standards has its usefulness and validity. Understanding the differences between GAAP and IFRS accounting standards is important for companies operating internationally. Stakeholders and investors associated with international companies should understand the differences to make informed decisions. It is good for accountants and bookkeepers to be familiar with these differences so they can explain better to stakeholders and investors how components of balance sheets and certain classifications can affect their decisions.
If you need to learn more about these standards, we can assist to see how they apply to your concrete situation. Write us at email@example.com. Also check out this Bookkeeping Checklist to see that you have your ducks lined up in a row.