Financial reporting in the US is on the verge of a monumental shift from the rules driven by Generally Accepted Accounting Principles (GAAP) towards the more principles-based International Financial Reporting System. (IFRS) As you would expect from a switch between systems that are fundamentally different, this will mean many changes in the way companies report their business activities. These changes include the reporting of inventories, leases, income taxes and consolidation of subsidiary companies.
One of the big differences between GAAP and IFRS is how companies keep track of their inventory. Under GAAP, companies can use the last in, first out (LIFO) method to track inventory. A big reason companies use LIFO is a way to keep company taxes low. This occurs when the cost of goods sold increases, making a company’s net income lower than it actually is. As a result of the seemingly lower income, they have to pay less taxes. Businesses can also change their financial status by increasing their inventory costs right at the end of the period, causing the last and most expensive batch of inventory to be sold. Under IFRS, companies must use the first-in-first-out (LIFO) inventory method. The effect of using FIFO will be the opposite of LIFO in that companies will pay more taxes than assuming that the cost of their goods sold is constantly increasing, because their net income will appear to be higher. Another important difference between GAAP and IFRS if inventory is written off under GAAP, once inventory has been noted, any reversal is prohibited. The IFRS allows the reversal through the income statement in the period in which the reversal occurs, the amortizations that have been recognized in previous years.
Leases under GAAP are much stricter in the way they are reported than under IFRS. Under GAAP, there is specific guidance for determining whether a lease is considered an operating or capital lease. The four specific criteria include: whether ownership is transferred to the lessee, whether there is an advantageous purchase option, the term of the lease in relation to the economic useful life (75%) and the present value of the minimum lease payments in relation to the fair value of the leased asset. (90%) IFRS focuses on the general substance of the transaction and on the substantiality all risks or benefits of ownership are transferred to the lessee. IFRS measures all the criteria that GAAP uses, but does not establish a specific threshold on the amount. This is a classic example of how GAAP follows a strict set of rules, while IFRS is more principled.
There are several differences between IFRS and GAAP related to income tax accounting and reporting. The tax rate used to measure deferred taxes under GAAP is the tax rate enacted in place when the temporary difference is expected to reverse, while under IFRS, the substantially enacted tax rate is used. Under GAAP, the classification of the deferred tax asset or liability is short-term or long-term, depending on the underlying relationship of the time difference. Under IFRS, deferred tax assets and liabilities are always recorded as long-term. Under GAAP, a detailed reconciliation of expected to actual tax expense is not required and a disclosure of the nature of the reconciling items is only required, when IFRS requires full reconciliation, including the nature and amounts.
The IFRS rules for reporting to the subsidiary company are different under GAAP. Under IFRS, subsidiaries must adopt all accounting policies of the consolidating parent. With GAAP, it must be determined whether or not a specific entity is considered a related party that must be consolidated. Consolidation decisions are based on determining who is entitled to incur the income and losses of a related entity. The IFRS focuses on the notion of ‘control’, where GAAP is based on Control is defined as the ability to govern an entity’s operating assets to obtain benefits.
GAAP and IFRS are fundamentally very different. GAAP is governed as demonstrated in the reporting of inventories, leases, income taxes, and consolidation of subsidiaries; while IFRS focuses excessively on principles. Due to these philosophical differences, there will be numerous changes that companies will need to make to comply with the new regulations. Despite the work required to make the changes, the benefits appear to outweigh the costs.