Globalization created a common conceptual framework and set the principles of functioning for global financial environment. With the increasing financial cooperation between countries, the need in an internationally recognized set of principles has grown exponentially. Otherwise, the problems with interpretation of terms and situations in this sphere would be inevitable. For this reason, the generally accepted accounting principles (GAAP) are believed to be less appropriate and not complying with the needs of time. The International Financial Reporting Standards (IFRS) could be regarded as the substitution of the GAAP but these frameworks have their advantages and disadvantages. The differences between the GAAP and the IFRS are predetermined by the nature of these standards. While the GAAP implies the principles accepted within the country, IFRS identifies the standards of financial reporting that are recognized globally. The IFRS is sometimes referred to as the financial “lingua franca,” the means of business communication between countries to make them collaborate under the common denominator. However, the controversy concerning the best option for a business still persists. Hence, the issue whether the differences between the GAAP and IFRS allow choosing more appropriate set of standards for a country could be considered on the basis of comparison of advantages and disadvantages of these frameworks.
Overview and Backgrounds
The major difference between the two frameworks is that IFRS is a globally recognized set of principles, while the GAAP is a program that is exceptionally suited for the United States. Moreover, IFRS functions as a principle-oriented framework, while GAAP suggests rule-oriented standards (Firm of the Future). Additionally, there is one discrepancy between the two standards in the content of financial statements. Thus, the IFRS includes the statement of comprehensive income along with other five items on the list (Firm of the Future). To realize the factors or circumstances that shaped the differences between GAAP and IFRS, the history of each framework, their benefits and drawbacks, as well as the comparative analysis of the differences, should be considered and performed.
History of GAAP
The history of GAAP takes up more than 80 years. GAAP history can be traced back to 1933, when the Securities Act was introduced to help recover the trust of investors in the financial system, following the stock market’s meltdown (Fosbre, Kraft, and Fosbre 63). The year 1934 was marked with the Securities Exchange Act, which led to the creation of the U.S. Securities and Exchange Commission (SEC). Additionally, the 1934 Act also targeted the same purpose of reassuring investors in the stability of national financial system after the period of economic recession in the United States (Fosbre et al. 63). The SEC was assigned to create the accounting and reporting principles for organizations with publicly traded securities (Fosbre et al. 63). Fosbre et al. note that although the FASB obtained the responsibility from the SEC, the authority to change standards still belongs to the SEC (63). In the beginning, the standard was issued by the American Institute of Accountants (AIA), which became the American Institute of Certified Public Accountants (AICPA) in 1957 (Fosbre et al. 63). Since the accounting principles, provided by the AICPA, were not deemed satisfactory, the Accounting Principles Board (APB) was created in 1959, instead of the issuing committee of the AIA and AICPA. The APB existed throughout the time period between 1959 and 1973 (Fosbre et al. 63). The task of the APB was to improve the framework for foundational concepts of financial accounting and reporting. However, the APB was criticized for its dependence on the potentially biased attitudes of accounting professionals, who were the board members (Fosbre et al. 63). In response to this opposition from the government and other stakeholders, the FASB was formed back in 1973 (Fosbre et al. 64). The number of members of this board reduced approximately by half. The FASB members are obliged to work exclusively for the FASB, and, due to this fact, they are expected to demonstrate greater loyalty and unprejudiced attitude to the accounting standards’ creation (Fosbre et al. 64). The FASB seems to correspond with the requirements to the setter of accounting principles and has created more than 160 accounting standards until now (Fosbre et al. 64). Therefore, there were several committees that replaced each other in the process of issuing the GAAP to ensure unprejudiced attitude of the board members.
History of IFRS
As above-mentioned, the need in the IFRS has occurred due to the countries that collaborate and require common financial reporting and accounting platform. According to Pacter, “the vision of a single set of global accounting standards first set out by the leaders of key accounting organizations around the world over 40 years ago is today a reality” (9). The history of the more appropriate financial reporting system started in 1967 with the establishment of the Accountants’ International Study Group, which, in 6 years, became the International Accounting Standards Committee (IASC) (Pacter 12). The year 2001 was marked with the replacement of the IASC with the IASB. The latter emphasizes on the enhanced management of the standard-setting processes (Pacter 12). The European Union (EU), New Zealand, Australia, Hong Kong, Japan, and South Africa agreed to implement IFRS, starting from 2005 (Pacter 12). China joined the standards system in 2006, and Russia joined in 2012 (Pacter 12). Therefore, the process of the framework’s adoption was gradual and was based on the fact that the countries assessed the possibility as well as benefits of implementing IFRS for their businesses and economies, and accepted it as appropriate.
Cons and Pros of the GAAP and IFRS Standards
The advantages and disadvantages of the GAAP and IFRS frameworks could be analyzed based on examples of their major characteristics. The underlying differences in financial statements, methodology, classification of liabilities and other aspects predetermine the differences between two systems, which make IFRS a global framework for financial reporting.
Financial statements are essentially the same under GAAP and IFRS. The standards have very similar financial statements and include balance sheet, income statement, changes in equity, cash flow statement, and footnotes (Firm of the Future). This is, actually, the whole list of documents that are included in the IFRS, while the U.S. GAAP includes the statement of comprehensive income (Firm of the Future). Therefore, the GAAP offers a more detailed evaluation of income.
LIFO and FIFO
The two inventory methods, utilized by companies worldwide, are Last In, First Out (LIFO) and First In, First Out (FIFO) inventories. The choice of the accounting standards predetermines the choice of inventory, since IFRS does not implement the LIFO method to estimate the inventory, as opposed to GAAP (Firm of the Future). The prohibition to use the LIFO estimation is based upon the failure of the method to adequately reflect on the exact flow of inventory in majority of situations, leading to the reporting of unexpectedly low levels of income for the company (Firm of the Future). Consequently, the LIFO method is not considered a reliable tool of inventory estimation, and, for this reason, GAAP loses certain points of credibility.
Methods and Limitations
The methodology that evaluates the accounting process represents the main discrepancy between GAAP and IFRS frameworks. On the one hand, GAAP concentrates its basics on research and it is regarded as a rule-based system of standards (Firm of the Future). On the other hand, IFRS considers the general patterns and bases its performance on principles (Firm of the Future). Hence, GAAP does not provide any opportunity to interpret or question the standards, or the rules that predetermine the outcome of the situation. On the contrary, IFRS is less rule-oriented, and allows for the interpretation of the issues with taxes (Firm of the Future). Therefore, IFRS is a more specific set of standards that allows interpretations.
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Another limitation to the effective functioning of the inventory methodology under GAAP is variation in inventory reversals. GAAP stipulates that the increase in market value of the items on the inventory list would not cause the reversal of the write-down. On the contrary, IFRS implies the adherence to principles, rather than rules, and allows for reversals of the write-down (Firm of the Future). Thus, it can be stated that GAAP fails to highlight any positive alterations in the market. Alternatively stated, GAAP suggests overcautious attitude to inventory reversal.
Balance Sheet and Income Statement
The IFRS demands the balance sheet to have separated current and noncurrent assets and liabilities. On the contrary, the GAAP only recommends this separation (Firm of the Future). Income statements differ in the inclusion of extraordinary items under GAAP and IFRS. The IFRS implies that the items are not placed separately in the income statement (Firm of the Future). However, the GAAP framework segregates these items and demonstrates under the net income section within the income statement (Firm of the Future). Hence, GAAP leaves some space for certain inconsistency by separating unusual items from the ordinary ones.
Classification of Debts
Liabilities under GAAP are categorized differently in terms of the time period, when they have to be settled. Thus, GAAP indicates that the liabilities can be differentiated as debts to be paid within a year and beyond 12 months. The latter debts are considered as noncurrent liabilities on the balance sheet (Firm of the Future). Conversely, IFRS does not have any particular differentiation between liabilities, since all debts are regarded as noncurrent.
IFRS allows for capitalization of development costs under compliance with certain criteria. With this benefit, businesses working under IFRS can leverage depreciation on fixed assets (Firm of the Future). On the contrary, GAAP implies the obligatory expenditure of the development costs within the one-year period after occurrence. Therefore, businesses cannot treat their development costs more freely, and are restricted with the rule-based system.
The reporting on intangible assets is a significant advantage of IFRS over GAAP. The item of intangible assets is rather complex for assessment. For instance, research and development is one of the intangible company assets. Under IFRS, the research and development inventory item takes into consideration the potential economic benefits of the asset (Firm of the Future). Conversely, the GAAP perceives intangible assets, only as the assets of the fair market value (Firm of the Future). Thus, another advantage that involves understanding of the financial reporting system can be seen as a principle-based framework.
The GAAP and IFRS use different models to assess tangible assets. The companies’ property, equipment and furniture are fixed assets, which are valued through the cost model and revaluation model under GAAP and IFRS, respectively (Firm of the Future). The cost model utilizes the historical cost of a tangible asset for the exception of accumulated depreciation. The revaluation model takes into consideration the fair value of the asset at the exact moment, except for the accumulated depreciation and write-downs (Firm of the Future). Therefore, IFRS can be regarded as a more reliable system to value the assets.
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In general, the need to introduce and implement IFRS seems to be inevitable for the countries that have not accepted these principles. Thus, the example of the United States demonstrates that, even when GAAP meets all the needs within the country, the international business community may require this change (PWC 5). Moreover, the growth and expansion of the United States companies caused the involvement of non-U.S. stakeholders, who, eventually, raised questions about the implementation of the IFRS (PWC 4). The admitted presence of non-U.S. stakeholders, and the important role that the United States plays in the development and implementation of IFRS, the country does not make any significant steps to transfer its domestic businesses to this standardization framework (KPMG). As a result, some researchers believe that both GAAP and IFRS will continue to have wide application in the financial markets in the nearest future (KPMG). However, as the issue arose in 2016, the SEC was expected to consider the proposal to allow local UnitedStates businesses to provide their financial reporting information, based on IFRS standards, in addition to the GAAP based inventory. This supplement can be accomplished only on a voluntary basis, and it reflects the need of the business all over the world to comply with international rules and guidelines. For this reason, it can be assumed that the United States will consider the need to implement IFRS on a more consistent basis.
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In addition, the issues of mergers and acquisitions contribute to the issue of the same financial reporting system throughout the countries. The increasing number of businesses cross the national borders to access their potential customers, so the integration of the IFRS, as a universally recognized system, can become a real benefit for the business in the country (PWC 4). The awareness of advantages of the IFRS, compared to GAAP, is likely to increase the number of businesses that are utilizing the IFRS. Consequently, the adoption of IFRS, in the long term, is an unambiguous benefit for companies, and, especially, for multinational businesses, dealing on a global scale (PWC 4). The IFRS system provides the most appropriate guidelines in order to comply with the modern globalization trends.
GAAP and IFRS: Comparison
The foundations of the GAAP and IFRS are similar, though the interpretations of the frameworks may slightly differ. IFRS could potentially benefit international corporations with the saving of expenses on labor and time, since the adoption of IFRS implies one set of standards for all countries. Otherwise, the companies would have to prepare various financial statements for various countries that they deal with (Fosbre et al. 69). Moreover, the same set of financial statements would allow investors to effectively assess successes and failures of the business in different countries.
Although the GAAP framework has its benefits and provides more detailed guidelines for financial accounting, both the GAAP and IFRS are expected to guarantee honest and responsible business performance (Accounting.com). Researchers believe that IFRS could become the effective substitution for GAAP, and ensure the corresponding international framework (Firm of the Future). The major benefits of transforming to IFRS implies the reduction of capital cost, improved stakeholder confidence, increased transparency levels, enhanced access to capital, and better access to capital (Fosbre et al. 69). IFRS provides a considerable focus on investors (Jordan). Besides investors, there are other stakeholders involved; these stakeholders essentially benefit from the immediate recognition of losses (Jordan). Comparability, standardization of financial reporting and accounting, as well as enhanced consistency and transparency, are the attributes of the IFRS, according to many researchers (Jordan). Fosbre et al. emphasize that the change from GAAP to IFRS will require companies and labor force to readjust to the new standards (69). This will involve new expenditures, born by the companies and governments, to teach or re-train the potential and existing labor resources jointly (Fosbre et al. 69). Nevertheless, Fosbre et al. believe IFRS framework to be easier for understanding and learning, if compared to GAAP principles (69). Moreover, the researchers indicate that the long-term benefits are likely to outweigh the additional expenditures and time in the short run (Fosbre et al. 69). The concern of the global community, related to the potential prevalence of the United States in the global financial market after joining IFRS, is unlikely to be fulfilled. The SEC recognizes the issue and monitors any manifestations of it, in order to preclude the implications for monopolization of financial power (Fosbre et al. 69). With the IASCF that later became the IFRSF, the governments of the countries should communicate and interact in order to ensure the most adequate transmission from GAAP to IFRS (Fosbre et al. 69). With the IFRSF, performing as the controlling body, the problem of the United States dominance is unlikely to be realized (Fosbre et al. 69). Therefore, to accomplish the prevention of shift towards the only nation, as a result of the IFRS adoption, the IFRSF should continue controlling the process of conceptual framework transformation in the countries.
Although, IFRS has numerous benefits, there are also certain drawbacks, if compared to GAAP. Thus, the cost of implementing IFRS by multinational companies comprises the greatest disadvantage (Jordan). However, as it has been already mentioned, this cost is considered short-term, while the benefits of this implementation should be evaluated in the long run. The issue of regulation of IFRS is a subject to consideration, since the IASC is unlikely to be able to monitor and control the implementation of IFRS throughout the world (Jordan). Moreover, as a result of the mass transition to IFRS standards, the IASC is likely to become a dominant power in the financial arena, which implies the monopolization of power (Jordan). This contradicts the principles of honesty and reliability that a financial reporting system ensures, so the control over the performance of the IASC should be established. Overall, based on all the advantages and disadvantages, and taking into account the globalization tendencies, IFRS could be considered as a better option in terms of financial reporting.
The differences between the standards of GAAP and IFRS demonstrate that the IFRS tends to be more business- and international relations-friendly system. One of the major advantages of the IFRS is that it is based on the principles, rather than on rules, and allows for consideration and interpretation of situations, such as tax-based issues. Another essential benefit of the IFRS is that it provides international coverage of financial reporting systems, which is particularly advantageous for multinational businesses. The IFRS provides the framework for common foundation of financial reporting throughout the countries. Hence, businesses with branches or companies in different countries save time and reduce expenditures on the identification of discrepancies in national standards and their compliance to evaluate business outcomes worldwide. Consequently, although both frameworks for financial accounting and reporting have advantages and disadvantages, IFRS provides a complex principle-based system that allows interpretation of financial circumstances and ensures the alignment of the financial issues throughout different countries. For this reason, modern tendencies for globalization create the environment for IFRS, as the more appropriate financial reporting framework.