May 22, 2008

IFRS vs GAAP Accounting

There will be convergence in accounting standards for all public reporting entities in the the world. For the most part the world follows IFRS while the US and Canada follow GAAP with some difference between the two countries. Beginning 2011 all public companies must report their financials adhering to International Financial Reporting Standards (IFRS) rather than Generally Accepted Accounting Principles (GAAP). US companies will still follow GAAP, however using a harmonized version with IFRS, but foreign companies listed in the US will file under the new standards.

The impact of the convergence will not be limited to financial statements presentation and finance but will transcend to all functions of the company. Some impacted areas include,but not limited to, HR, IT, hedging and foreign exchange, Taxes, and executive compensation plans. Moreover, there are significant differences between GAAP and IFRS that will impact earnings reporting. I believe that these differences and convergence will lead to investing opportunities, if the capital markets are not fully ready to understand the differences and their impact.

The new converged standards will not be "better" or "worse" than existing ones, accounting will be accounting and still will have its drawbacks and limitations to provide a true economic picture of the business. However, the convergence will serve to enhance compliance and comparative issues between companies.

Please note that some standards are still influx and I am studying to update my knowledge, so some of these notes are preliminary.

Some notable Differences, many more exists:

  • all types of inventory will be treated using the same method. Under GAAP companies can pick and choose a different treatment for different types of inventory, which companies can use to manage earnings. LIFO is prohibited.
  • It will be tougher for banks to float SIVs and other off-balance sheet entities without reporting them on their books.
  • Treatment of deferred taxes will differ as well as its presentation all deferred tax liabilities will be non current
  • Companies will no longer able to report extraordinary items separately or after operating margins. Under IFRS extraordinary items will impact operating margins.
  • IFRS will allow for some up revision of impaired asset values
  • Under IFRS banks may not had to recognize all those credit write-downs, depending on the circumstances, as IFRS calls for impairment recognition for available for sale debt instruments only when evidence of credit default exists.
  • Consolidation of entities under IFRS is much wider and comprehensive than GAAP.

Depending on capital market readiness for this convergence, I see arbitrage opportunities between adopters and non-adopters. A scenario like the following can develop where two companies in the same industry may report similar economic results but earning may differ due to the accounting standards adopted. If markets focus on the absolute figures without any adjustments, which they do usually, the company with lower earnings will be punished. Buying the lower earnings and selling the higher one may result in some gain as markets readjust. These differences can create buying opportunities due to reaction to accounting policies rather than business economics.

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