GAAP and IFRS: Six Degrees of Separation

A number of technical issues must be resolved before U.S. accounting rules can be converged with international standards, says one expert.

Next year American and international accounting standard setters will complete their eight-year mission to develop one set of global rules. In the end, the so-called convergence project will make U.S. generally accepted accounting principles look more like international financial reporting standards.

Although much uncertainty surrounds whether American companies will be forced to make a wholesale switch to IFRS, international standards will be “a reality” in the United States, predicted Ronald Kral, managing partner at accounting firm Candela Solutions, at a recent conference sponsored by the Institute of Management Accountants.

Companies in mid-2011 will have their hands full with at least 10 major new standards issued as joint projects of the Financial Accounting Standards Board and the International Accounting Standards Board. The areas covered include accounting for financial instruments, fair-value measurement, leases, and revenue recognition. FASB originally intended to release a dozen new exposure drafts in June, noted Kral, but the board mercifully put the brakes on, promising to have only four drafts out for comment at any one time.

The Securities and Exchange Commission will decide next year whether publicly traded companies will be required to adopt international standards. It’s likely that U.S. exceptions will be written into the version of IFRS that the SEC sanctions, said Kral. “Just about every country that has adopted IFRS tweaks it…to some degree,” he said.

But in addition to finalizing new accounting standards, FASB and the IASB must iron out a number of technical accounting issues before the convergence project can be completed, said Kral. Finding common ground on those issues should make the SEC’s decision about switching to IFRS easier, he said, as U.S. GAAP would look similar to international standards in several critical areas. Kral singled out six differences between U.S. and international rules for comment:

1. Error correction. According to IFRS rule IAS 8, it’s not always necessary to retrospectively restate financial results when a company corrects errors, especially if the adjustment is impractical or too costly. U.S. GAAP, on the other hand, requires restatements in many error-correction cases.

2. Death of LIFO. Last-in, first-out inventory accounting is prohibited under IAS 2, so any American company using the method will have to abandon it (and the tax benefits) and move to another methodology. Although LIFO is permitted under U.S. GAAP, the repeal of LIFO for tax purposes is an ongoing debate.

3. Reversal of impairments. IAS 36 permits companies to reverse impairment losses up to the amount of the original impairment when the reason for the charge decreases or no longer exists. However, U.S. GAAP bans reversal.

4. PP&E valuation. IAS 16 allows for the revaluation of property, plant, and equipment, but the entire asset class must be revalued. That means a company can choose to use the revaluation model if its fair value can be measured reliably. But it must choose to use one model or the other; both cannot be used at the same time. U.S. GAAP does not allow revaluation.

5. Component depreciation. Also under IAS 16, companies must recognize and depreciate equipment components separately if the components can be physically separated from the asset and have different useful life spans. In practical terms, that means controllers will have to rely on the operations side of the business to help assess equipment components. U.S. GAAP allows component depreciation, but it is not required.

6. Development costs. Based on IAS 38, companies are permitted to capitalize development costs as long as they meet six criteria. However, research costs are still expensed. U.S. GAAP requires that all R&D costs be charged to expense when incurred.

Kral also warned preparers and users of financial statements to get ready for an avalanche of footnotes. Since using IFRS requires more judgment than using U.S. GAAP, he said, “two to three times as many footnotes” will be needed to explain the rationales for accounting approaches. Indeed, Kral asserted that although principles-based standards are supposed to promote more comparability between financial statements, all they really do “is force investors to read more footnotes.”

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