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Finance glossary

GAAP vs IFRS: comparing and contrasting the two

Bristol James
6 Min

Generally Accepted Accounting Principles, known as GAAP, are a set of accounting standards set by the Financial Accounting Standards Board (FASB). These standards apply to US companies that are listed on the Securities and Exchange Commission. However, most US companies abide by GAAP accounting when issuing financial statements for external parties, like lenders and investors.

The goal of US GAAP is to standardize the financial reporting process, giving investors the ability to easily compare information between companies. For example, if one company reports revenue using the cash method, while another uses accrual, there is minimal comparability. This can lead to uniformed investment decisions.

What are International Financial Reporting Standards (IFRS)?

International Financial Reporting Standards, known as IFRS, are a set of accounting standards issued by the International Accounting Standards Board (IASB). These guidelines establish routine accounting standards for companies in the international landscape. Like US GAAP, IFRS looks to streamline financial reporting for transparency, consistency, and comparability.

IFRS isn’t used by all countries worldwide. In fact, the US specifically has its own set of accounting standards. US companies that have an interest both domestically and internationally may need to issue two sets of financial statements to comply with all requirements.

The Differences Between GAAP and IFRS

Although GAAP and IFRS have similar goals, methods of reporting have some key differences. Let’s explore these differences in more detail.

Enforcement

GAAP is a rule-based framework, meaning that US companies are legally required to follow reporting regulations. On the contrary, IFRS is standard-based, which means that the guidelines are recommended, not required. Since IFRS doesn’t have formal requirements that companies must abide by, the framework is open to more interpretation.

Companies that choose to bend the interpretation of IFRS standards will often have lengthy disclosures describing their rationale, thought process, and calculations applicable to the financial statements.

Source and Scope

GAAP is only applicable to companies operating in the US, while IFRS applies broadly to most international countries. Although different countries can require certain aspects of IFRS or expand on the requirements, the framework is generally accepted as the overall standard for financial reporting.

Inventory Valuation

Inventory valuation is the process of determining the value of your inventory. There are three main methods for assigning inventory value: FIFO, LIFO, and average cost. FIFO means first-in-first-out and assumes that the oldest item in your inventory will be the first to sell. LIFO, which stands for last-in-first-out assumes that the newest item in your inventory will be the first to sell. Average cost uses the amount earned from the sale to determine the value left in inventory.

GAAP gives companies the option to choose between the above three methods, while IFRS only allows FIFO or weighted average. LIFO is specifically disallowed under IFRS because companies can manipulate their earnings by moving the newer inventory purchases to earnings. Over time, the cost of purchasing inventory will increase, resulting in more inventory costs moved to cost of goods sold under LIFO.

Balance Sheet

The balance sheet is one of the main financial statements a company will issue. This document tracks the items the company owns, like cash and accounts receivable, and the items the company owes, like notes payable. Additionally, the balance sheet will track equity, which includes everything the company has earned or lost since its inception, owner distributions, and owner contributions.

Under GAAP, balance sheet items are listed in order of liquidity, with the most liquid assets being first. This means that the balance sheet would retain the following order: current assets, non-current assets, current liabilities, non-current liabilities, and finally, equity.

On the contrary, IFRS believes in listing the least liquid assets first. This creates the following balance sheet order: non-current assets, current assets, equity, non-current liabilities, and finally, current liabilities.

Although the overall category amounts, like current assets, might be the same under both methods, the order in which they are listed on the balance sheet differs.

Cash Flow Statement

The cash flow statement also has some notable differences between GAAP and IFRS, particularly when it comes to interest and dividends. The cash flow statement shows the movement of cash for a certain time period, which is usually one year. Both GAAP and IFRS break the cash flow statement down into three main sections: cash flow from operations, cash flow from investing activities, and cash flow from financing activities.

Under GAAP accounting, interest paid, interest received, and dividends received are reported as other income on the statement of income. As a result, these items are included under the operating cash flow section. The operating section does not include a separate line item for interest and dividends, as they are worked into the overall net income or loss. However, dividends paid to shareholders are listed under the financing section since it’s an equity transaction that is not reported on the income statement.

Under IFRS, companies can choose where to report interest and dividends. Some companies report these transactions under the operating section, while others report the income under the financing section. Companies have more leniency under IFRS, which can make it difficult for investors and other third parties to compare cash flow statements between companies.

Asset Revaluation

Like inventory, GAAP and IFRS differ in how assets are re-evaluated. Revaluation is the process of re-assigning a value to a company’s assets. For example, a piece of machinery might be re-evaluated after five years because the value is no longer the same as the initial purchase price. Revaluation keeps a company’s assets in line with current prices and gives investors more transparency.

Under GAAP accounting standards, only marketable securities, like stocks, can be re-evaluated. This means that fixed assets will stay on the books at actual cost until they are sold and removed. This doesn’t mean that the other categories of assets are inaccurate. Bad debt is a way to truing up accounts receivable, while inventory is constantly adjusted based on the company’s chosen method.

On the flip side, IFRS accounting principles allow companies to re-evaluate a wider range of assets, including fixed assets, inventory, intangible assets, and marketable securities. This option can create more backend work for companies to maintain accurate balances. However, one of the main advantages of revaluation opportunities is clarity in your financial position.

Development Costs

Development costs are expenses associated with generating a product or service, like research, patents, intellectual property, and client relationships. Under GAAP, companies are able to immediately expense these costs, while IFRS requires companies to capitalize the expenses and amortize the amount over a certain time frame.

Costs aren’t always expensed under GAAP. For example, if your company purchases a five-year trademark, you might be required to capitalize the amount and take amortization over five years. The amount of the development cost and the useful life will factor into which items are immediately expensed and which costs are capitalized.

Summary

  • Generally Accepted Accounting Principles are a set of standards applicable to companies reporting in the United States.
  • International Financial Reporting Standards are a set of standards adopted by dozens of countries.
  • Both GAAP and IFRS look to streamline financial reporting for investors, lenders, and other third parties relying on the financial statements in the decision-making process.
  • GAAP and IFRS treat enforcement, the scope of work, inventory valuation, the balance sheet, the statement of cash flows, asset revaluation, and development costs differently.
  • Consulting with an accounting professional is the best way to determine which set of standards you must comply with.

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