IFRS vs. GAAP

In this assignment, I will talk about four ways in which financial reporting can differ between US GAAP and IFRS. The first issue is the way in which inventory is carried from period to period. Another is the revaluation of Property, Plant, and Equipment, which is allowed under IFRS. US GAAP does not allow such flexibility. The next difference I found interesting was that US GAAP has specific guidelines surrounding when to expense Advertising Costs. Given how global advertising has become nowadays, I thought this would appealing to look at. The last difference I want to study is how the treatment of certain costs in interim periods can vary between US GAAP and IFRS.

All of these differences can result in significantly different financial statements and major headaches to financial analysts across the globe. Inventory, in some industries, can be the single most expensive asset that a company carries on its balance sheet. The method in which their value is calculated can have enormous impacts on stated financial position of a company.

Let’s take an example of my company McKesson. We are one of the United States largest drug distributors and we can carry a large amount of inventory at any one time. Under normal market conditions, using the FIFO method for recording inventory may be the prudent calculation and result in the highest stated revenues. However, if the price of a certain ingredient for a particular drug sky rockets because of a worldwide drought, then it would make more sense to use the LIFO method.

This is because the LIFO method would result in higher Cost of Goods Sold, and thus less Taxable Income. IFRS does not permit companies to use the LIFO method, which seems odd given that IFRS is generally considered to be less-restrictive, principles-based approach versus the rules-based approach US GAAP models. Try to imagine yourself being a financial analyst who is attempting to decide between two international companies that use different inventory valuation methods.

It could be extremely difficult to make apple to apple comparisons by simply looking at balance sheets if their main assets are valued differently. The other difference in inventory carrying value is that IFRS requires inventory to be reported at the lower of cost or NRV. US GAAP requires that you calculate the lower of cost or replacement cost. This is where expenses can fluctuate from period to period depending on whetherи the NRV or the replacement costs are higher.

McKesson, using US GAAP, may have $20,000 of inventory of a particular drug and the replacement cost is $15,000. A Japanese company, using IFRS, may have the same amount of inventory, but the NRV of its inventory in Japan is $25,000. Which company’s inventory is more valuable? The next difference I wanted to study is the valuation of Property, Plant, and Equipment (PPE). Specifically, IFRS allows for a revaluation of PPE. I found this particularly interesting because the price of real estate can vary dramatically based upon factors outside of the company’s control. Allowing revaluation of PPE can result in potentially much more accurate stated values.

For example, let’s say that a manufacturing company decides to build a plant in Rio De Janeiro in 2004. They cost their plant and building at $5M and production starts and the business starts growing rapidly. Three years later, it is announced that Rio De Janeiro will host the 2014 World Cup and the government has plans to build a soccer stadium directly across the street from your new plant.

There are rumors that the head of the stadium committee plans to make you an offer of $10M for your plant so he can expand the parking lot and add a few hotels. Under US GAAP, you would not be able to revalue your land to $10M, which is the true market value! Another difference with IFRS is the necessity to value your PPE in components. This approach forces companies to value different subsections of your plant separately. For example, staying with the manufacturing example from above, the office space part of the plant would be valued at one number, and the manufacturing space would be valued at a different rate.

The motor of a machine will have a separate valuation from the Iron Shell that encases it. This can result in a much more accurate picture of the actual value of a company’s PPE. Another issue I would like to examine is the difference in how and when advertising costs are calculated in US GAAP and IFRS. The Deloitte article “IFRS – Implications for the Retail Industry” discusses at a high level the timing differences of when these costs are expensed. US GAAP actually permits companies to wait to expense advertising costs until they are actually run.

This could lead to big differences in stated expenses. Let’s use the World Cup example from earlier. The competition to buy ad space for the World Cup is at an all time high. Companies want exposure during this event and this competition leads companies to commit funds to advertising space 2-3 years in advance. Well, under US GAAP, a company could capitalize this as an asset and wait to expense this cost until 2014, when their ad actually runs on television.

A company using IFRS may have to expense this cost immediately depending on the circumstance. If I am an investor who is not familiar with this difference, the international company may look less attractive given that they have lower stated profits because of the advertising expense they were forced to recognize. This is another reason why it is important to state details like this in the notes. US GAAP and IFRS have differing theories on the treatment of costs over interim periods. IFRS specifically does not allow companies to defer costs across periods. Each period is viewed as a “discrete reporting period” and thus all costs incurred during this period must be expensed in that period.

The same cannot be said for US GAAP, which allows an accrual or deferral treatment of costs over several different periods. Let’s go back to our manufacturing plant example one last time. Our manufacturing plant, which uses IFRS, is having a problem with product quality which can be attributable to too much sunlight entering our plant. It just so happens that the entire ceiling is made out of glass, thus allowing harmful UV rays to poor in 8-12 hours a day.

Management decides to purchase some window tint to help block out these rays that are hurting our product quality. This thin layer of tint has a useful life of 2 years, when it will need to be replaced again. Under IFRS, our plant would have to expense this in the quarter in which it is purchased. Under US GAAP, the plant is allowed to spread out the costs of this purchase over the 2 years. As you can see, this could result in significantly different income statements, especially when we start getting into more expensive purchases.

It makes more sense to allow these costs to be deferred to periods in which they are actually used or are of some benefit. There are obviously significant differences between US GAAP and IFRS on a multitude of financial reporting topics. The four that we looked at were inventory measurements, PPE valuation differences, advertising costs and when they can be expensed, and the different treatments of costs over interim periods. The world has a long way to go until we achieve universal financial reporting, but pointing out the differences is the first step.