US GAAP versus IFRS.
US GAAP: United States Generally Accepted Accounting Principles.
IFRS: International Financial Reporting Standards.
US GAAP and IFRS are the two main accounting standards in the world, for use by publicly
listed companies.
US GAAP is developed by the FASB, the US-based Financial Accounting Standards Board headquartered
in Norwalk, Connecticut.
IFRS is developed by the IASB, the International Accounting Standards Board headquartered in
London, United Kingdom.
US GAAP is obviously the standard in use in the United States, a country with a highly
diverse and very large economy, and a very long history of an active market for buying
and selling stocks and bonds, where companies need to synchronize the way they report financial
results to investors.
How many countries use IFRS, the self-proclaimed “global standard for global markets”,
the “global solution for a global need”?
Take a guess!
Here are some maps of various parts of the world with countries that require IFRS in
red, and countries that permit IFRS in green.
According to the IFRS Foundation, 144 jurisdictions in total now require the use of IFRS Standards
for all or most publicly listed companies,
whilst a further 12 jurisdictions permit its use.
So 156 countries in total.
The European Union adopted IFRS Standards as the required financial reporting standards
for the consolidated financial statements of all European companies whose debt or equity
securities trade in a regulated market in Europe, effective in 2005.
In Japan, voluntary adoption is allowed since 2010, but no mandatory transition date has
been established.
China has continued to amend Chinese Accounting Standards so that its principles are generally
consistent with IFRS.
Indian Accounting Standards are based on and substantially converged with IFRS Standards.
So if US GAAP and IFRS are different accounting standards, should this topic only be interesting
for accountants?
Quite the opposite!
Of course, accountants, CFO’s and finance directors need to have the most in-depth knowledge
of how accounting standards work, but many others should have at least a high level understanding.
It is essential for any investor to understand how US GAAP and IFRS work.
It is very important for anybody comparing the performance of companies (business leaders,
stock market analysts, business developers, marketing leaders).
There are several high-quality documents that can help you understand similarities and differences
between US GAAP and IFRS in great detail: the 52-page SEC document from 2011, or more
recent publications like the 51-page document from accounting firm Ernst & Young, KPMG’s
515-page handbook, Deloitte’s 72-page publication, and PWC’s 237-page guide.
Or maybe get the high level idea first by watching
this Finance Storyteller video!
Let’s take an example in the oil and gas industry.
The income statements of ExxonMobil and Shell.
Both companies report their financial results in US dollars, the currency of choice for
transactions in the oil business.
That should make the comparison easy, right?
Revenue at the top: $279 billion for ExxonMobil, $388 billion for Shell.
Net income at the bottom: $21 billion for ExxonMobil, $23 billion for Shell.
Now that we found those two key numbers of revenue and net income for both companies,
we can jump straight into financial ratio analysis for this year, trend analysis over
the past three years, etcetera, right?
No, no, no, no!!!
We would be comparing apples to oranges.
ExxonMobil prepares its financial statements based on US GAAP, Shell prepares its financial
statements based on IFRS.
If the standards you apply are different, the calculation of a number like Net Income
is different.
We have no indication what Shell’s Net Income would have been under US GAAP, nor what ExxonMobil’s
Net Income would have been under IFRS.
Comparing ExxonMobil to Chevron (US GAAP to US GAAP) is apples-to-apples.
Comparing Shell to BP (IFRS to IFRS) is oranges-to-oranges.
But sadly, comparing the financial performance of Exxon Mobil to Shell is not possible without
a lot of rough estimates, wild guesses, and disclaimers.
Is there any way of finding out exactly how much the difference is between US GAAP and
IFRS for one and the same company in the same year, for example in the area of profitability?
I have searched far and wide, but have only found one recent example of a company that
provides a recent reconciliation between their US GAAP and their IFRS numbers.
ONE COMPANY!
ASML, the world's leading supplier of semiconductor manufacturing equipment and the innovator
behind ever-advancing lithography systems.
ASML’s shares are listed for trading on NASDAQ and Euronext Amsterdam.
They publish an annual report based on US GAAP as well as an annual report based on
IFRS, and a reconciliation between the two.
In both 2016 and 2017, IFRS Net Income for ASML was higher than US GAAP Net Income by
around $100 million per year, a difference of around 5%.
Specifically for ASML, there are two main differences: the way development expenditures
are treated under US GAAP (fully charged to operating expense) versus IFRS (capitalized
and then amortized), and the way income tax expense and deferred tax assets are recorded.
This is a very small sample: one company in one specific industry.
The same or different elements of the US GAAP and IFRS accounting standards may cause differences
for other companies.
Who knows….
Why is it not easy to find more examples of companies that publish their financial results
for both US GAAP and IFRS?
There surely must be more companies like ASML that have a dual listing, in other words companies
that have their shares listed in the US (NYSE or NASDAQ)
as well as somewhere else in the world?
Yes, there are plenty of those companies, around 500 to be more precise.
Under the current rules of the US Securities and Exchange Commission (SEC), foreign issuers
(corporations incorporated under the laws of any foreign (non-US) country) are allowed
to use IFRS financial statements in their registration statements and periodic reports!
This saves foreign issuers a lot of time, money and effort as they don’t have to prepare
“dual” annual reports under both US GAAP and IFRS.
But it’s not great for global comparability.
In addition, in November 2007, the SEC unanimously approved a proposal that no longer requires
foreign registrants to reconcile their financial statements with US GAAP, as long as they use
IFRS as issued by the International Accounting Standards Board.
So there are lots of examples of US GAAP to IFRS comparisons for 2006, but few to none
for more recent financial years.
And let’s face it, 2006 in today’s VUCA world is pretty much ancient history.
If you do find a recent example of a company publishing both US GAAP and IFRS numbers,
and the reconciliation between them, then please let me know in a comment below.
So if we can’t start the comparison between US GAAP and IFRS from a sufficiently large
sample of actual differences for real-life companies, let’s take a look at the possible
differences that could occur.
US GAAP and IFRS each provide a way to map economic events onto financial reports: providing
principles, rules and guidance to book accounting journal entries, and put together financial statements.
For most common transactions, there are more similarities than differences between US GAAP
and IFRS.
However, it is important to realize that significant differences in treatment can and do occur.
Some differences are cosmetic.
If we compare the balance sheets of two companies that we discussed earlier, ExxonMobil and
Shell, we find that ExxonMobil (US GAAP) lists assets from most liquid to least liquid, and
Shell (IFRS) lists assets from least liquid to most liquid.
A cosmetic difference: you just have to look in a different place for the information you need.
What is more worrisome is substantive differences: differences in the way revenues and expenses
are recorded in the income statement, differences in how assets, liabilities and equity are
valued on the balance sheet, and differences in how cash flow items are classified on the
cash flow statement.
Let’s zoom out to the big picture on US GAAP versus IFRS.
US GAAP is mostly rules-based, while IFRS is mostly principles-based.
What does rules-based versus principles-based mean?
Here’s a metaphor that viewers with children, or those that grew up with a brother or sister,
might relate to: the two ways to run a family.
Some parents use a rules-based system: they tell their kids which behaviors are allowed
and what is prohibited: you can’t kick or punch your brother or sister, but you may
give him or her a hug.
Other parents may use a principle-based system: “in this family, we are nice and friendly
to each other”.
Is rules-based better than principles-based, or is principles-based better than rules-based?
I don’t think one is better than the other, each has advantages and disadvantages.
With rules, you try to provide clarity and be specific.
The more specific the guidance, the more consistent the application, right?
Or not quite?
Unfortunately, in the case of families, by making a list of rules you might also encourage
children to try things behind your back as a parent, kids might test the “limits”
of the rules, and your list of rules is probably never ever going to be complete to describe
each and every possible interaction between siblings.
An equivalent of this in US GAAP accounting standards is the use of “bright lines”:
when the FASB specifies a percentage as a minimum or maximum for applying a certain
rule, companies might adapt their behavior to just meet the minimum requirements (complying
with the “letter” of the standard, but not necessarily with the “spirit” of the
accounting standard).
With principles, you leave a lot of room for interpretation; different people might each
have their own subjective interpretation of the principle.
Opponents of principle-based structures would say that a lack of detailed rules might lead
to more abuse, and in a business context to different interpretation for similar transactions.
Neither system will be perfect, and it is not easy to find an optimal mix between rules
and principles that works best.
A rules-based standard like US GAAP is definitely more sizable than a principles-based standard
like IFRS.
Estimates of the size of US GAAP versus IFRS vary from 7200 pages of US GAAP (when printed)
versus 1300 for IFRS, to 25,000 pages of US GAAP to 2000 pages for IFRS.
Whether it’s a 6-to-1 ratio or 12-to-1 ratio, rules-based is more extensive.
This remains one of the criticisms of US GAAP by practitioners: a standards overload with
too much detail and a high level of complexity.
It’s important to understand that both US GAAP and IFRS are changing over time.
New industries emerge, new types of transactions occur, and the thinking about how certain
economic transactions need to be treated accounting-wise changes.
Some years, big impact changes in the standards occur.
In other years, the number of changes might be large, but the impact fairly low.
And sometimes things are fairly quiet in the area of standard setting.
So even if you compare numbers for one and the same company over a large number of years,
you might be comparing “various types of apples”.
An interesting question is whether US GAAP and IFRS will converge (grow more close),
or diverge (grow further apart).
The FASB and IASB have been working together over the years to try to develop common standards
in various areas.
A success story in convergence between US GAAP and IFRS is the new standard for recognizing
revenue from contracts with customers,
ASC606 in US GAAP, and IFRS15 in IFRS, effective 2018.
With the exception of a few fairly minor areas, the new model eliminates many of the existing
differences in accounting for revenue between the two frameworks.
As revenue is (for most companies) the biggest line item in the profit and loss statement,
it is great for comparability if recognition of revenue is synchronized between the two
accounting standards.
A project with mixed results is the new standard for leasing, ASC842 in US GAAP, and IFRS16
in IFRS, effective 2019.
While both new standards basically require lessees to recognize right-of-use assets and
lease liabilities on their balance sheets, there are significant differences between
the standards.
The new standards narrowed the differences, but did not eliminate them.
What are some examples of areas where US GAAP and IFRS could yield very different outcomes?
Measurement, recognition and valuation of financial instruments is one such complex area.
Valuation of inventory is another, with the question whether to LIFO or not to LIFO as
a central theme.
LIFO is acceptable under US GAAP, but prohibited under IFRS.
Inventory value on the balance sheet tends to be lower under LIFO (Last In First Out)
than under FIFO (First In First Out), therefore Cost of Goods Sold tends to be higher under
LIFO than under FIFO, and profit tends to be lower under LIFO than under FIFO.
This might sound like a trivial matter, but it makes a major financial difference.
For all companies in the US that still use LIFO, to change to FIFO could generate a one-time
(taxable) profit of tens of billions of dollars.
So will listed US public companies ever be required or allowed to transition from US
GAAP to IFRS?
It was certainly hinted at and discussed in the past.
The SEC and Financial Accounting Standards Board (FASB) have been hesitant to relinquish
control over accounting rules.
There may be more convergence projects in the future, maximizing similarities and minimizing
differences, which effectively bring US GAAP and IFRS closer.
But a full transition?
I think that the US adopting IFRS is as likely as the US converting to the metric system.
Possible, maybe even advisable, but very unlikely.
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