Accounting Standards are guidelines and rules governing how corporations prepare and present their financial statements. These Standards ensure companies use the appropriate procedures and principles in their accounting methods. Without Accounting Standards, companies could report, present, and adopt any accounting method they choose which would always showcase their financial position and operations in the best possible light.

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What are Accounting Standards?

Accounting standards are essential principles that guide how corporations present and report their financial performance and position. Without these standards, companies could manipulate their results to appear better than they actually are. This would make it difficult for investors, creditors, and other stakeholders to interpret financial statements.

Creativity is great-but not in accounting.

Charles Scott

Before the 1930s stock market crash, companies were largely free to develop their own accounting practices. Where creativity often meant “skewing” the books. However, after the crash, accounting standards were introduced to prevent companies from inaccurately reporting their financial position. Standards and accounting principles were brought in to safeguard stakeholders and to ensure companies remained ethical and honest in their reporting.

Accounting standards are important because they establish an acceptable approach to recording and reporting economic activity for a business. They ensure a transparent and consistent method for presenting relevant information to stakeholders. This helps to build confidence that financial statements accurately reflect the financial activity and overall position of the business.

The two main Account Standards are US GAAP and IFRS.

There are two key accounting standards: IFRS and U.S. GAAP. IFRS stands for International Financial Reporting Standards and is adopted internationally. U.S. GAAP stands for Generally Accepted Accounting Principles and is adopted by the United States only.

IFRS	GAAP
International Financial Reporting Standards.	Generally Accepted Accounting Practices.
Internationally Adopted by 144+ countries.	Adopted by only the United States.
Principles Based.	Rules Based.
Governed by the Accounting Standards Board in each country.	Governed by the FASB (Financial Accounting Standards Board) in the US.
More transparent, flexible, consistent and comprehensive.	Slightly Less transparent, flexible, consistent and comprehensive.

These two guidelines are what most companies adopt when reporting and presenting their financial statements. IFRS is a principle-based accounting method while the US GAAP is a rule-based method.

IFRS is used internationally and falls under the IASB (International Accounting Standards Board). Most companies listed on the world’s stock exchanges follow IFRS. Each country operates independently and will have its own accounting board. However, they will still follow the IFRS. For example, in Australia, the AASB (Australian Accounting Standards Board) governs how companies report their accounting according to IFRS.

In America, the FASB (Financial Accounting Standards Board) ensures companies adopt and report according to the GAAP method. Although internationally, IFRS is adopted more widely, the US makes up a large portion of the equities market globally, so it cannot be ignored. Investors need to understand the key differences to be able to interpret the financial statements, model them, and understand the different accounting methods used. Both methods are equally important.

The key differences between US GAAP and IFRS.

Below I have outlined some key differences between IFRS and US GAAP. They are important to understand from an analysis and valuation perspective. The differences are also important when comparing companies that fall under different Accounting Standards that the comparison is like-for-like.

The main difference is between rules and principles. IFRS uses the principle-based approach. This approach sets out guidelines that a company should adopt but has room for interpretation. US GAAP uses a rules-based approach, which sets out the accounting practices to be used with rules around them and has little interpretation or space to move.   

The aim of this is to ensure companies don’t take liberties by “engineering” a far greater financial picture than the firm has.

Revenue Recognition

This refers to how a company reports its revenue. IFRS uses a more generalised approach than GAAP. GAAP has specific rules around whether revenue has been earned or realised. The guideline revolves around revenue not being recognised and recorded unless there has been an exchange of a product or service. Every industry will have different revenue recognition rules.

IFRS is based on the principle that revenue is recognised when there has been a delivery of value. IFRS has a guideline that suggests revenue equals the cost whilst GAAP suggest revenue is considered under the completed contract method. There are 4 categories of revenue, the sale of goods, construction contracts, the provision of services and using another entity’s assets.  

Cash Flow Statement

The key difference between GAAP and IFRS on the Cash Flow Statement is how interest and dividends are reported. The IFRS guidelines allow interest and dividends to be listed under operating or financing activities, so more discretion is given. However, GAAP outlines that interest paid or received is an operating activity so must fall under this section, and dividends must fall under the financing activity.

Balance Sheet

The differences between IFRS and GAAP on the balance sheet has to do with liquidity and how line items are arranged on the balance sheet. IFRS suggests reporting assets in increasing order of liquidity i.e. the least liquid assets are listed first. GAAP lists assets in decreasing order with the most liquid assets listed first.

Inventory Valuation

The way inventory is valued and recorded is a major difference between IFRS and GAAP. There are three accounting standards to determine inventory valuation. FIFO (First In, First Out) suggests that the oldest (first in) inventory will sell first. LILO (Last in, Last Out) assumes that the newest (last in) inventory will be the first to sell. The last method is the weighted average method which takes the value earned from selling a portion of the inventory to calculate the remaining inventory. IFRS and GAAP adopt both FIFO and weighted average calculation methods.

IFRS prohibits the use of the LIFO (Last in First Out) method when calculating inventory. The reason is that LIFO may not accurately show the flow of inventory items in a business and can result in lower levels of income. GAAP allows a company to use any of the three methods.

GAAP when using the FIFO method uses the Net Asset Value (Total Assets – Total Liabilities) to work out the inventory value. IFRS when using the FIFO method uses Net Realisable Value, which looks at how much value an asset may generate when sold then deducting any costs associated with the sale.

Inventory Write down

GAAP and IFRS accept inventory write-downs as inventory may lose value over time. Both accounting standards suggest that a business write down its inventory the moment costs outweigh the Net Realisable Value. The one difference is that sometimes the market value of inventory does increase again and IFRS allows the reversal of write-downs whilst GAAP does not.

Fixed Asset Valuations

Over time the valuation of Fixed Assets such as PP&E (Property, Plant & Equipment) can change. To value assets there is the cost model or the revaluation model. GAAP records the value of fixed assets at historical cost (what they paid for the asset) and then depreciated. The value can never increase or be reevaluated and only adopts the cost model. IFRS on the other hand values assets at cost but is allowed to revalue fixed assets at the current market value, either increase or decrease. This requires a different depreciation process.

Intangible Assets

The costs associated with developing intangible assets vary between both GAAP and IFRS. IFRS expenses costs of research and development as they are incurred. Costs when developing intangibles can be capitalised when certain criteria are met, and them amortised over a time period. GAAP, however, requires the expenses of research and development activity and does not allow capitalisation in most cases.

Leasing Activity

Leases can vary significantly across companies that use fixed assets as a part of their core business. Leases become more important for a business with long-term large leasing costs as opposed to a capital-light business that doesn’t require a lot of space. IFRS includes leases on Intangible Assets based on certain criteria while GAAP does not recognise this. IFRS also allows the lessee to ignore leases for assets that are valued lowly. GAAP does not allow for this.

Accrual Accounting Vs Cash Basis Accounting.

Public companies typically use the Accrual Accounting method. In a nutshell, Accrual Accounting records sales and expenses based on when they occur, rather than when cash is exchanged. This is different from Cash Accounting, which only recognizes revenue when cash changes hands. Most small businesses use cash accrual accounting because they receive cash at the time of sale.

Accrual accounting records transactions when they happen, regardless of when the actual cash is exchanged. This means that it recognizes revenue when it’s earned, not necessarily when it’s received in cash. This is why we have accounts receivables and accounts payable. If public companies only paid for expenses or received cash at the exact time of each transaction, there would be no need for a cash flow statement to connect to the income statement.

How do Accounting Standards impact Valuation work?

When conducting modeling and valuation work on companies, it is important to understand the key differences between GAAP and IFRS. The way we model a company will vary significantly depending on the type of business and the accounting standard adopted.

We need to adjust certain models for companies operating in different regions. This could involve assessing the value on the balance sheet, as an asset might have been recorded at historical prices but is actually more valuable. Additionally, we may need to consider the way a company records its leasing arrangements or asset write-downs.

This becomes particularly important when comparing two companies, for example, one in the US operating under GAAP and another in Europe operating under IFRS. Understanding the major differences and how the accounting process may impact the financial statements is crucial. Investors may need to make adjustments to forecasting models, Discounted Cash Flow models, or when trying to rebuild the three financial statements.

Being aware of these differences can help prepare you when valuing a business, allowing you to identify areas that will impact the final outcome.

In Summary…

This is by no means an exhaustive look at breaking down GAAP or IFRS accounting standards. It is more of an indication that there are differences, and they will impact how you interpret financial statements. To go into an in-depth analysis of each method would be out of place here. Investors need to understand accounting standards and how to read financial statements, but not to the level of becoming a practising accountant.

I find the differences important when comparing companies that adopt different accounting standards. Investors may need to add back, remove, ignore, or adjust certain valuations based on the financial statements due to the difference in reporting methods. While most of the world uses IFRS, investors still need a very good idea of how GAAP works. The stock exchange in the US makes up a huge part of the global equities market. There are thousands of viable companies listed there (outside of the tech giants).

So, investors that are not in the US, will no doubt be looking at companies listed there. For a lot of investors, the US is their primary hunting ground. Understanding these two accounting standards can help you improve your analysis work and see value where others can’t. By understanding the reporting requirements, you will be able to understand the business model in greater detail.