From a Certain Point of View, US GAAP and IFRS are the Same
Author: Brian Hock
Source: HOCK Training
Published: 22 November 2012
Brian Hock, President, CMA
A common question in accounting is, “What is the difference between US GAAP and IFRS?” This is a question that becomes more relevant for a company switching from US GAAP to IFRS, or in the United States whenever the discussion of “adopting” IFRS becomes louder. The answer, as most people know, is neither simple nor short; there are entire books and training courses devoted to this topic. You can read and read and still may not be able to identify and understand all of the potential differences.
However, I would like to propose a different answer to this question. The answer I propose is, “From a certain point of view, there is no difference between US GAAP and IFRS.” This is also the answer for any question that asks about the differences between any two accounting methods or applications – US GAAP vs. cash basis, IFRS vs. Venezuelan GAAP, Variable vs. Absorption Costing or FIFO vs. LIFO.
The explanation to this answer lies in the first phrase, “From a certain point of view…” There are actually two perspectives that we need to consider: the first is time, and the second is total income. Adding these, the answer becomes, “Over the life of the company, there will be no difference in the total income of the company if it is reported under US GAAP than if it reported under IFRS.”
Having said this, we need to understand what accounting standards are (whether US GAAP, IFRS or any other). Standards are essentially a dictionary. Every company has approximately the same types of transactions and reports their financial results on a balance sheet, income statement and statement of cash flows. However, without a definition for what is meant by the individual lines in the financial statements, the numbers have no meaning. It is the accounting standards that define these terms. For example, under US GAAP, the definition of a fixed asset states that fixed assets should be measured at their historical cost and adjusted for accumulated depreciation. However, under IFRS we find that fixed assets may be measured at fair market value.
So, while the two numbers both represent fixed assets, they are defined slightly differently. Without the dictionary (the accounting standards) it would be difficult to know what a company meant when they state that they “have $3 million of fixed assets”. Only when we know how it is that they have defined fixed assets is this number useful.
At this point, someone may ask, “If the definitions are different, how can they be the same?” It has to do with the treatment of cash paid and received under the different accounting methods:
Every dollar that a company spends will eventually go to the income statement as a reduction of income. Every dollar that a company receives will eventually go to the income statement as an increase in income. Under the different accounting methods, the money is recognized on the income statement at different times, but every dollar spent and every dollar received will at some point go to the income statement.
I will show this by looking at variable and absorption costing. (Note: Variable costing is not allowed under US GAAP or IFRS, but it is an accounting treatment that is used internally.) The main difference between variable and absorption costing is the treatment of factory rent (a fixed payment). Under variable costing, the rent is expensed each month as it is paid. For example, if rent were $1 million a month the entry would be:
Dr Rent expense......................................................... 1,000,000
Cr Cash............................................................................. 1,000,000
This entry would be repeated every month.
Under absorption costing, the monthly rent payment is allocated to the units that are produced during the month. This means that when the unit is produced, some of the rent payment goes to the balance sheet as inventory. When the units are sold, that part of the rent payment is moved to the income statement as cost of goods sold.
If, at the end of the month, the company sold fewer units than it produced, they will report a higher income for the month under absorption costing because part of the $1 million of rent is “temporarily” still on the balance sheet in inventory. So, not all of the $1 million has yet been expensed under absorption costing. However, under variable costing, all of the $1 million of rent is on the income statement. So, in the short-term these two accounting treatments do give a different income (and different ending inventory, too).
However, over the long term, it is impossible that a company’s inventory increases every month. In a future month when inventory levels decrease, the company will have a higher monthly income under variable costing because only $1 million of rent will be on the income statement, while under absorption costing all of that month’s rent will be in cost of goods sold, and some of the rent from a previous month will also be expensed.
So, under both methods, all of the money paid for rent will go to the income statement. Under variable costing, it goes in the month it is incurred. Under absorption costing it goes when the units produced are sold.
This is when people ask, “what if the company does not sell all of its inventory?” Even in this case, under absorption costing, all of the rent will go to the income statement because the unsold inventory will eventually have to be written off as obsolete. When this is done, the money spent for rent will go to the income statement.
We could provide many further examples of this process, but I will do only one more with fixed assets, since there is such a different treatment under US GAAP and IFRS. Let us assume that a company buys a fixed asset for $50,000 and sells it five years later for $75,000. In each of the five years that it holds the asset, the fair value of the asset increases by $5,000. The company depreciates using the straight-line method. We will look at the income statement for each year under both US GAAP and IFRS.
Under US GAAP, the company will have the following items on the income statement each year:
Year 1: $(5,000) Depreciation Expense [Book value now $45,000]
Year 2: $(5,000) Depreciation Expense [Book value now $40,000]
Year 3: $(5,000) Depreciation Expense [Book value now $35,000]
Year 4: $(5,000) Depreciation Expense [Book value now $30,000]
Year 5: $(5,000) Depreciation Expense [Book value now $25,000]
Year 5: $50,000 Gain from the sales [$75,000 - $25,000 BV]
Total effect: $25,000 of income. This makes sense since the company paid $50,000 for it and sold it for $75,000.
Under IFRS, the company will have the following items on the income statement each year:
Year 1: $5,000 Gain on revaluation of fixed assets [Book value now $55,000]
Year 2: $5,000 Gain on revaluation of fixed assets [Book value now $60,000]
Year 3: $5,000 Gain on revaluation of fixed assets [Book value now $65,000]
Year 4: $5,000 Gain on revaluation of fixed assets [Book value now $70,000]
Year 5: $5,000 Gain on revaluation of fixed assets [Book value now $75,000]
There is no gain on the sale because the book value of the asset is $75,000 and it is sold for $75,000.
Total Effect: $25,000 of income. Again, this makes sense because the company paid $50,000 for it and sold it for $75,000.
In the end, no matter what we do with those numbers, the company has a net change of plus $25,000 in cash and income. As with the difference between variable and absorption costing, the difference between US GAAP and IFRS for fixed assets is simply the timing of when the gain is recognized. Under IFRS it is done each year, while under US GAAP it is done only when the asset is sold.
We could repeat this example many more times, but it is not necessary. All we need to keep in mind is that cash received WILL be on the income statement at some point in the future and cash paid WILL also be on the income statement at some point in time. This means that even though many people think that there is a significant difference between US GAAP and IFRS, there really is no difference between them – from a certain point of view.
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