Without accounting standards, businesses could easily skew their financial results to make themselves look more successful. It would also be much harder to compare how different companies are performing.
Here is where generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) come in. These two sets of guidelines—one American and one international—are what most companies follow when preparing financial statements. With these accounting standards in place, people can be sure businesses are accurately reporting their finances and, in turn, make informed decisions about where they invest their money.
What are generally accepted accounting principles (GAAP)?
Generally accepted accounting principles (GAAP) is the accounting standard set by the Financial Accounting Standards Board (FASB) for the Securities and Exchange Commission (SEC) in the United States. It’s a rule-based system that all domestic and Canadian publicly traded companies must follow when filing financial statements. The purpose of GAAP is to help investors analyze financial data and compare different companies to make informed financial decisions.
What are International Financial Reporting Standards (IFRS)?
International Financial Reporting Standards (IFRS) are the accounting standards set by the International Accounting Standards Board (IASB). It’s a set of guidelines followed by 15 of the G20 countries. China, India, and Indonesia do not follow IFRS accounting standards but have similar standards, while Japan allows companies to follow IFRS standards if they choose.
What are the differences between GAAP and IFRS?
While GAAP and IFRS both pertain to how financial documents are structured and filed, there are significant differences. The two main distinctions are:
- Enforcement. GAAP is rule-based, meaning publicly traded US companies are lawfully required to follow its directives. On the other hand, IFRS is standard-based, meaning no one is required to follow its guideline—though it’s recommended. As a result, the theoretical framework and principles of IFRS leave more room for interpretation and sometimes require lengthy disclosures on financial statements.
- Source and scope. GAAP is US-based, while IFRS is used worldwide. The IASB, which sets IFRS, is globally influential; its accounting standards are adapted to accounting rules in countries worldwide. The US, where the Securities and Exchange Commission requires American companies to use GAAP when preparing their financial statements, is the only exception.
There are other notable differences in how GAAP and IFRS handle specific elements of various financial documents, including:
1. Inventory valuation methods
Inventory valuation is figuring out how much your inventory is worth. There are three standard accounting methods for doing this: the first in, first out (FIFO) method, which assumes that the first (or oldest) items in your inventory will be the first to sell; the last in, first out (LIFO) method, which assumes that the last (or newest) items in your inventory will be the first to sell; and the weighted average method, which uses the amount earned from selling a portion of your inventory to determine the value of the remaining portion.
Here’s how GAAP and IFRS differ when it comes to inventory valuation methods:
- GAAP. GAAP allows companies to use any of the three inventory valuation methods. When using FIFO, GAAP uses “net asset value”—the total value of a company’s assets minus the total value of its liabilities—to determine inventory valuation.
- IFRS. IFRS allows the FIFO and weighted average method but does not allow the LIFO method, because LIFO can be manipulated to distort a company’s earnings to lower tax liability. When using FIFO, IFRS uses “net realizable value,” which considers how much an asset might generate when sold, minus an estimate of costs, fees, and taxes associated with the sale.
2. Cash flow statement
A cash flow statement is a financial statement that shows precisely how cash and cash equivalents enter and exit a business over a specific reporting period. GAAP and IFRS handle cash flow statements differently, particularly in how they classify interest and dividends:
- GAAP. With GAAP, interest paid and received, and received dividends are listed under the operating section, while dividends paid are listed in the financing section.
- IFRS. With IFRS, all interest and dividends can be listed under the operating or financing section.
3. Balance sheet
A balance sheet is a financial statement that summarizes a company’s assets, liabilities, and shareholder equity at a given point in time. It’s essential to know how to organize your balance sheet so that your investors and other interested parties can quickly and accurately read it. GAAP and IFRS differ in how categories are arranged on a balance sheet:
- GAAP. GAAP requires assets in order of liquidity, with the most liquid assets listed first—that is, current assets, non-current assets, current liabilities, non-current liabilities, and owners’ equity.
- IFRS. IFRS suggests putting assets in the opposite order of liquidity, with the least liquid assets listed first—that is, non-current assets, current assets, owners’ equity, non-current liabilities, and current liabilities.
4. Asset revaluation
The value of a company’s assets may fluctuate over a given period, meaning they need to be re-evaluated (i.e., reappraised). Asset revaluation is crucial because it can help you save for replacement costs of fixed assets once they’ve run through their useful lives, and gives investors a more accurate understanding of your business. Asset revaluation can also reduce your debt-to-equity ratio, which can paint a healthier financial picture of your company.
GAAP and IFRS have different approaches to asset revaluation:
- GAAP. GAAP only allows the revaluation of fair market value for marketable securities (i.e., investments and stocks).
- IFRS. IFRS allows for the revaluation of more assets, including plant, property, and equipment (PPE), inventories, intangible assets, and investments in marketable securities.
5. Inventory write-down reversals
A company’s inventory may lose value over time. An asset may, for example, lose value because of market or technological factors, which classifies it as a “loss on impairment.” GAAP and IFRS require that businesses write down their inventory as soon as its cost exceeds its net realizable value (i.e., how much the inventory is expected to generate when sold).
While a loss is often permanent, the value of an asset may increase again if the impairing factor is no longer present. GAAP doesn’t allow companies to re-evaluate the asset to its original price in these cases. In contrast, IFRS allows some assets to be evaluated up to their original price and adjusted for depreciation.
6. Development costs
In accounting, development costs are the internal costs of developing intangible assets—assets with no physical form, like patents, intellectual property, and client relationships. GAAP considers these expenses, while IFRS allows companies to capitalize and amortize them over multiple periods. Your accounting standard, therefore, determines where on your financial documents you must list intangible assets and affects your balance sheet’s final balance.
GAAP vs. IFRS FAQ
What is GAAP?
GAAP stands for generally accepted accounting principles. It is a set of rules, standards, and recommendations for financial documents set by the Financial Accounting Standards Board (FASB) for the Securities and Exchange Commission (SEC) in the United States. All publicly traded US companies are required to follow GAAP when filing financial documents.
Is IFRS more accurate than GAAP?
While it’s difficult to gauge which is more accurate, some consider IFRS to be more accurate than GAAP because IFRS is considered a more principles-based accounting standard and more accurately reflects the economics of a transaction. For example, IFRS allows inventory write-downs to be reversed in the future if certain criteria are met.
Can US companies use IFRS instead of GAAP?
No, US companies cannot use IFRS instead of GAAP. The Securities and Exchange Commission (SEC) requires that US companies use GAAP when filing financial documents.