In the field of financial accounting, uniform accounting standards are crucial so that investors and banks can look at two different companies and understand each one’s financial position rapidly. As a financial accounting advisory services firm in the UAE, Affility Consulting often works with companies to assist them in analyzing financial reports.
In the UAE, publicly listed companies must prepare their financial reports according to the International Financial Reporting Standards (IFRS). But in the USA, publicly listed companies are obliged to follow the Generally Accepted Accounting Principles (GAAP).
In this article, we will look at both of these accounting standards, why they are different, and why it might be necessary to call in a financial accounting advisory services firm to assist in analyzing the financial reports of multinational companies.
Why are there two different accounting standards?
The GAAP was born in the aftermath of the 1929 stock market crash, along with the American Securities and Exchange Commission (SEC), whose purpose is to protect investors from fraud. It was believed that dubious financial reporting was partially responsible for causing the crash, and the GAAP aimed to remedy that.
The GAAP has evolved gradually since those early days but some people feel that it is not currently the most up-to-date accounting standard, considering that the way we do business has changed.
For example, under GAAP, it is not possible to capitalize investments made under the “environmental, social and governance” (ESG) heading, even though such investments might bode extremely well for the company’s future profitability. Also, intellectual capital must be expensed rather than capitalized under GAAP, often showing enormous losses on the reports when, in fact, the action is an investment that could pay out many times over in the long term.
The USA has its own GAAP, Canada once had its own one as well, and Australia also had its own version. (Canada and Australia have since adopted the IFRS.) This disparity between financial accounting standards prompted the creation of the International Accounting Standards Committee (IASC) in 1973. In the interests of fostering international trade and increasing transparency, the IASC issued what was then called the International Accounting Standards (IAS).
These international standards were then replaced by the International Financial Reporting Standards, or the IFRS, which is what exists today. And the IASC became the International Accounting Standards Board (IASB).
The IFRS is used in at least 120 countries.
The main difference between GAAP and IFRS
The primary difference between GAAP and IFRS is that GAAP is rules-based and IFRS is principles-based.
The IFRS gives financial accountants more flexibility when preparing financial reports, allowing them to use their good judgment in determining things such as whether purchases must be capitalized or expensed.
GAAP has not evolved as rapidly as modern business has, whereas IFRS regularly undergoes changes to bring the standards up to par with contemporary factors.
For example, the lease reporting standard—IFRS 16—was recently changed and will have a major impact on balance sheets and accounting ratios. The reason for this change was to increase transparency. Under the previous standard, it was technically possible to “hide” certain operating leases. This update prevents that from happening.
Because of the IFRS’s principles-based approach, financial reports often require clearly stated disclosures to explain how certain figures were arrived at. This can make reports prepared under IFRS wordier than those prepared under GAAP.
Is the regulator satisfied with GAAP?
In October 2002, the Financial Accounting Standards Board (FASB)—the USA’s accounting standards board—and the IASB signed the Norwalk Agreement, affirming that they were dedicated to bringing GAAP into convergence with IFRS.
But as late as January 5, 2017, the Chair of the SEC at the time, Mary Jo White, admitted in a public statement that:
Such a statement does not indicate regulator dissatisfaction with GAAP, but rather a commitment to bringing different accounting principles into conformity with each other for the good of international cooperation.
She also said that many American investors already had to study financial reports of foreign companies that used IFRS, when looking to invest in those foreign companies. These non-domestic companies are allowed to file with the SEC using their IFRS-based reports.
In a speech given on March 26, 2015, SEC Commissioner Kara M. Stein said quite clearly that there was no clear winner between IFRS and GAAP. “Neither regime worked ideally in the financial crisis [of 2008], and neither may serve investors well in today’s post-financial crisis, technologically disrupted, and data-driven world,” she said.
Investors need to know both standards until a new standard is agreed to
In a world dominated by global trade, investors need to know both accounting principles to be able to study financial reports from either GAAP or IFRS companies. The market cap of the 500+ foreign companies that file IFRS reports with the SEC totals a stunning $7 trillion. Regardless of whether the GAAP and IFRS regimes will someday be combined, investors already have to know the intricacies of both. There simply is no other way to do business.
It is quite common that professional investors will hire a financial accounting advisory firm to assist them in analyzing all the minute details of financial accounting reports prepared under the two different regimes. Even if the two standards were converged, the regularly changing nature of IFRS means that expert assistance is often needed to understand these reports anyway.
To understand how Affility Consulting helps with financial accounting analysis under either regime, please feel free to contact us at any time.