Gain a deep understanding of accounting principles and standards, specifically GAAP and IFRS, used by companies for compiling their financial statements. Learn about their key differences, treatment of inventories and leases, and how to manage inconsistencies when building a trading comp model.
Key Insights
- GAAP, or generally accepted accounting principles, are the set of accounting principles, standards, and procedures followed by US companies and their accountants when compiling their financial statements.
- IFRS, or International Financial Reporting Standards, was established to create a common accounting language for business and accounts to be understood across companies and countries, and is currently adopted by more than 144 countries.
- While the SEC has expressed an interest in switching from GAAP to IFRS, the progress has been slow.
- GAAP is rules-based while IFRS is principles-based. The latter's theoretical framework and principles leave more room for interpretation and often require lengthy disclosures on financial statements.
- There are differences in how GAAP and IFRS treat inventories and leases. For example, GAAP rules allow for LIFO, as well as FIFO and WAC as accounting methods while IFRS rules ban the use of LIFO inventory accounting methods.
- When building a trading comp model, it is crucial to ensure all companies use the same method due to differences in GAAP and IFRS methods for operating leases. For instance, if there is 1 US GAAP company in a comp set, but 5 IFRS companies, the US GAAP company should have its numbers changed to fit IFRS.
| Approach | |
|---|---|
| GAAP | Rules-based; primarily US standard. More prescriptive. |
| IFRS | Principles-based; international standard. More judgment-heavy. |
In this video we’ll talk about GAAP and IFRS accounting principles and standards.
- GAAP—generally accepted accounting principles. It’s a common set of accepted accounting principles, standards, and procedures that the US companies and their accountants must follow when they compile their financial statements
- IFRS – International Financial Reporting Standards and was established to have a common accounting language, so business and accounts can be understood from company to company and country to country
- More than 144 countries around the world have adopted IFRS, which aims to establish a common global language for company accounting affairs.
- While the Securities and Exchange Commission (SEC) has openly expressed a desire to switch from GAAP to IFRS, development has been slow
Key differences
- GAAP is rules-based and IFRS is principles-based
- Theoretical framework and principles of the IFRS leave more room for interpretation and may often require lengthy disclosures on financial statements
- On the other hand, the consistent and intuitive principles of IFRS are more logically sound and may possibly better represent the economics of business transactions
There’s a difference on how GAAP and IFRS treat inventories and leases.
Inventory:
GAAP rules allow for LIFO, as well as FIFO and WAC as accounting methods
IFRS rules ban the use of LIFO inventory accounting methods. Allow FIFO and WAC.
Leases:
GAAP has a distinction between finance / capital leases and operating leases. With finance leases the ownership transfers at the end of the lease term. Income statement expenses operating leases in operational costs, no interest or depreciation shown on the income statement here.
Whereas IFRS treats all leases equally.
The issue may appear when you need to build a trading comp model (valuation method where you compare different but similar in size companies that are from the same industry). If the comp set is made up of some companies using US GAAP, and other companies using IFRS and the US GAAP and IFRS methods for operating leases are different. So, what to do? Best practice is to ensure all of the companies use the same method. For instance, if there is 1 US GAAP company in a comp set, but 5 IFRS companies, the US GAAP company should have its numbers changed to fit IFRS.
