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Week 1: U.S. GAAP - Lecture

U.S. GAAP

Introduction | What is GAAP? | U.S. GAAP? | IFRS | Differences Between U.S. GAAP and IFRS |Conceptual Framework | Levels of Accounting Information | Accountants Provide Unbiased Informationfor Decision Making | Rules of Accounting | Some Definitions | The Accounting Cycle | Test YourKnowledge | Tutorials

This week some of the information we cover will be a review of your first financial accounting course. Much of theinformation, however, especially in the accounting standards area, will be new. In addition, this week andthroughout the term, we will be covering the International Financial Reporting Standards (IFRS), sometimes calledi-GAAP.

GAAP stands for Generally Accepted Accounting Standards.

The GAAP rules found in the United States are often referred to as U.S. GAAP. The IFRS are quickly emerging asan international standard. During the course, when we refer to "GAAP" we will be discussing U.S. GAAP, unless

otherwise noted. International GAAP will be noted as iGAAP. We will be looking at both sets of standards duringthe course and how they will impact financial statement presentation.

For U.S. GAAP purposes, the standards that govern accounting are set by the Securities and ExchangeCommission (SEC) for public companies. The standards that are required by the SEC require public companies tofile a variety of forms with the SEC, the most important being the annual reporting Form 10-K. This report, as wellas other public documents, can be obtained using the EDGAR system at http://www.sec.gov/

On the SEC website, there are a variety of topics, such as investor information, regulatory actions, staffinterpretations of accounting rules, and a variety of other related topics. Important information, such as the

regulatory responsibilities of the SEC, is spelled out on this website.

The Financial Accounting Standards Board (FASB) sets the accounting rules primarily for the private sector. TheFASB's website is http://www.fasb.org You will be extensively studying the accounting rules passed by thisorganization throughout Intermediate Accounting and other financial accounting courses. The FASB Statements,as they are known, are being phased out since accounting literature will be codified by category. We will discussresearch during the term in our Threaded Discussions and readings.

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Introduction

What is GAAP?

U.S. GAAP?

IFRS

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The International Accounting Standards Board (IASB) http://www.iasb.org, has the duty, among other obligations,to develop international standards for financial reporting. In a world-wide economy, there is a great appeal forhaving a universal set of accounting standards, versus several different ones. Advocates for the convergence ofaccounting standards state that by using one set of accounting rules, there would be uniformity in reportingpractices, financial information would be less costly, and financial statements would be easier to understand.There are, however, significant differences between the two primary methods of accounting, U.S. GAAP andIFRS.

Some of the significant differences include the fact that the U.S. GAAP model is rules-based and IFRS is basedon broad principles. As a result, IFRS's rules application is more interpretative by management than U.S. GAAPis. Also, U.S. GAAP uses historical cost for asset valuation for most assets, especially in the area of long-termassets, whereas IFRS allows for fair value for most assets. In addition, when an asset is written down under U.S.GAAP, it cannot be artificially written up. Under IFRS, however, it can be in many cases. Changing from historicalcost to fair value methodology will create artificial increase, or decreases, in the profits of a company. The exactmethodology of how to change to fair value accounting is currently one of the issues that that not been overcomeby the two bodies of accounting standards.

Since fair value is very subjective as it applies to asset valuation, this is a major contrast between the two different

accounting standards. Many accountants believe that fair value could be arbitrarily applied in order to undulyenhance the financial statements. In other words, assets could be overstated at the directive of a corporation'sunethical management team under IFRS.

Nonetheless, the FASB and the IASB have been closely working on one set of standards through a processreferred to as convergence. We will discuss this process throughout the term as we examine the similarities anddifferences between U.S. GAAP and IFRS.

Differences Between U.S. GAAP and IFRS

Similarities and Differences Between U.S. GAAP and IFRS

What is the difference between U.S. GAAP and IFRS?

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One is based more on specific rules (U.S. GAAP) the other is based more on broadprinciples (IFRS).

How tall would the authoritative accounting rules stand for IFRS and U.S. GAAP, respectively?

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The accounting rules for IFRS rules are two inches high.

U.S. GAAP has rules that are nine inches high, plus additional supplementarymaterials from a variety of other sources as well.

Which set of rules allows companies more discretion on what information is placed on thefinancial statements?

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Under IFRS, companies have more discretion in what information is placed on theirfinancial statements than under U.S. GAAP, since IFRS is based on broad principlesthat allow for management to disclose information more tailored to their needs. U.S.GAAP tends to be more specific as to the required disclosure needed in a specific

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situation.

What are the required financial statements?

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The basic required financial statements for both are the same; the income statement,balance sheet, and statement of cash flows.

However, the financial statements look quite different when contrasting U.S. GAAPand IFRS.

What does the income statement look like?

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The income statement under U.S. GAAP is either a single-step or multiple-stepformat. Under IFRS, expenses are classified by nature or function. For example, bynature, wages would be classified. By function, descriptions such as manufacturingwould be reported. A great deal of leeway is available under IFRS for financial

statement issuers. The income statement under both U.S. GAAP and IFRS classifiescomprehensive income as part of equity.

What does the balance sheet look like?

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On the balance sheet under U.S. GAAP, we usually list current assets first, and thengo down the asset side in the order of liquidity. Also, we use historical cost forpurchases and the recording of long-term assets. Under IFRS, specific items arerequired to be reported on the balance sheet; regarding U.S. GAAP, this is not arequirement. For IFRS, non-current assets are typically listed first, and often at fairvalue. The term net assets, which are total assets-total liabilities, may be placed on

the financials as well.

What about the term "reserve"?

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The term "reserve" is common under IFRS. The use of reserve is discouraged usingU.S. GAAP. Also, many long-term assets can be revaluated to fair value under IFRS,with the increase or decrease going through stockholder equity. For U.S. GAAPpurposes, property, plant, and equipment accounts are recorded at historical cost,and when required, written down for impairment. No subsequent write-up to cost isavailable under U.S. GAAP, but IFRS allows the write-up of impaired assets. This is amajor issue with U.S. GAAP users, where historical cost is one of the bedrock

concepts of accounting theory.How is the statement of cash flow accounted for under both methods?

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The statement of cash flows is required under both methods. The operating,investing, and financing sections are required under both, although the presentationmay differ under U.S. GAAP and IFRS. For instance, the disclosure rules for thestatement of cash flows are much more detailed under U.S. GAAP than IFRS.

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How are cash and receivables accounted for?

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Under U.S. GAAP, cash is pretty much the same as under IFRS.

Receivables are reported fairly similarly under U.S. GAAP compared to IFRS.However, there are no standards under IFRS for pledging, the assignment of, orfactoring receivables. This gives the financial statement issuer a great deal of leewayin how this information is presented.

How about fair value accounting?

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Fair value is accounted for in about the same manner under both systems. However,there are some complex differences between the two for several different types offinancial statement instruments.

Similarities and Differences Between U.S. GAAP and IFRS (part 2)

What are the differences in the area of inventory accounting?

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For inventory purposes, the average method and FIFO method are both allowed forU.S. GAAP. Both methods are required under IFRS. However, LIFO, which is usedextensively in the U.S., is not allowed under IFRS. This is a significant differencebetween the two methods. The lower of cost or market rules differ between U.S.

GAAP and IFRS. Inventory can be written down under U.S. GAAP to market value,but not revalued upward. Under IFRS, inventory can be written down, but also writtenup (but only to cost).

How does Property, Plant, and Equipment Accounting differ under U.S. GAAP and IFRS?

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For purposes of property, plant, and equipment, interest expense is capitalized underboth methods. Non-monetary asset exchanges are accounted for in a similar fashionas well. The same methods of depreciation are allowed for both. Impairment rules aredifferent. Property, plant, and equipment can be written up under the "Revaluation" tofair value method under IFRS. The U.S. uses historical cost which does not allow

write-ups.

Research and Development Differences

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Research and development costs under U.S. GAAP are expensed. However, underIFRS, during the research phase, the R & D is expensed. When an asset becomestechnologically feasible, the costs are capitalized under IFRS; under U.S. GAAP,such costs are generally expensed as R & D.

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Internally generated intangibles under U.S. GAAP are expensed; under IFRS, insome cases, the items can be capitalized.

What to do about impaired assets?

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Impairment tests are required under both U.S. GAAP and IFRS. They do vary inprocedure. Impairment losses are written off for purposes of intangibles; reversals arenot allowed under U.S. GAAP but are allowable under IFRS.

Intangible Assets and Goodwill; how are they accounted for on the balance sheet?

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Under both methods, the treatment for intangibles and goodwill on a purchasebetween two parties are similar in nature. Intangibles assets are separated fromgoodwill. In addition, in-process research and development are recorded as aseparate asset.

The Accounting for Liabilities Are they the same?

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For liabilities, both U.S. GAAP and IFRS require that they be classified as current andnoncurrent. The definitions of liabilities and debts are closely related as well underboth methods.

How to Account for Restructuring Losses?

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Restructuring losses under U.S. GAAP have more rules and regulations than IFRS,which requires the recognition of a loss once a company has committed to arestructuring loss.

Contingencies: What are the differences?

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Contingencies under U.S. GAAP differ from contingencies under IFRS. IFRS requiresa "midpoint" for recognizing a loss, where under U.S. GAAP, the minimum amount ofthe possible range of outcomes is used.

The Differences in Stockholders' Equity

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There are several differences between stockholder equity for U.S. GAAP and IFRS.Stockholders' equity under IFRS has an asset revaluation reserve (for the write-up ofassets), which is not allowed under U.S. GAAP. Under IFRS, a company can prepareeither a stockholder equity statement that is similar to the U.S. version, or one that iscalled a statement of recognized income and expense, where various items areadded back to arrive at total recognized income and expense.

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Convertible Debt is different under IFRS!

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Under U.S. GAAP, all proceeds of convertible debt are recorded as a long-term debt.Under IFRS, convertible debt is classified as partially debt and equity. The conversionoption is recorded as an equity amount.

Similarities and Differences Between U.S. GAAP and i-GAAP (part 3)

EPS, a financial ratio of importance!

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Earnings per share reporting is similar, but not exact for both. There is movement in

this area to converge the differences between both methods. Due to the common useof EPS, don't be surprised if an agreement is reached on this subject in the future.

How are marketable securities accounted for?

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Accounting or trading available-for-sale and held-to-investment maturities are prettymuch the same under both methods. Gains and losses related to available for salesecurities are reported in comprehensive income under U.S. GAAP, in the equityaccount under IFRS.

The Equity Method is known by another name.

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The equity method under U.S. GAAP is called the associate investment under IFRS.

Consolidations and Control

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Consolidation rules differ between both methods. In general however, forconsolidation to occur, 50% of the voting stock must be owned by the parentcompany under U.S. GAAP and IFRS.

Revenue recognition: a complex area.

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Revenue is recognized the same in most cases under both methods. However, U.S.GAAP has specific rules for recognition of income in many cases; under IFRS,financial statement users have more leeway in applying the concepts of revenuerecognition.

Completed Contract Method is Not Allowed.

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U.S. GAAP is based upon, at its root level, what is referred to as a conceptual framework to be used for thedevelopment of accounting standards. As a result, the FASB developed a system of objectives and fundamentalsthat is basic to rule-making in the area of financial reporting. The basic framework started in 1976 and evolvedover several years with the publication of seven Statements of Financial Accounting Concepts that relate tofinancial reporting for business enterprises. It is essential that students have a good working knowledge of theStatements of Financial Concepts as they prepare for careers in accounting and related fields, such as finance.

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The completed contract method is not allowed under IFRS for long-term constructioncontracts. U.S. GAAP allows for its use.

Pension Accounting Differences

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For pension plans, the rules are similar. However, there are differences in the areasof reporting for prior service costs, actuarial gains and losses, and other technicalareas of defined benefit plans.

Leases-Convergence Talks

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For leases, although there are similarities, there are major differences between howU.S. GAAP and IFRS report their operating and capital leases. U.S. GAAP hasextensive rules on what to report; IFRS gives broad discretion to how a companyreports its assets on the books. There are discussions currently undergoing in thisarea regarding convergence of a common position on lease accounting rules.

How to Account for Errors?

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Accounting changes and errors are similar. However, there are some differences. Forexample, under U.S. GAAP, errors must be disclosed and financial statementsrestated; under IFRS, that's not absolutely required. Again, there is more discretionon the part of the issuer under IFRS than U.S. GAAP.

The Final Word

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Regarding disclosure, there are many similarities between the two. Also, there exist anumber of differences. U.S. GAAP has significant reporting requirements for thefinancials; IFRS tends to have less rules.

When will the U.S. adopt IFRS? Time will tell.

Conceptual Framework

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For purposes of the conceptual framework, the FASB has listed three levels of accounting concepts. They are:

The first level covers the basic goals and purposes of accounting. The basic goals are to provide unbiasedinformation to financial statement readers. As accountants, our customersare financial statement readerswho rely on the information we present to outside users under the accounting rules known as GAAP.

The second level connects the third level, which is the implementation level, with the first. The second levelcovers qualitative accounting information that distinguishes best practices in reporting financial operationsfrom those that are less desirable. Such methods include information that is relevant, reliable, verifiable,and neutral. As accountants, we are primarily referees; we call 'em as we see 'emand report the financialinformation as it occurs, as neutral parties. In the aftermath of Enron and other financial statement frauds,where the numbers were fraudulently made to order, accounting ethics took on greater importance thanever.

The third level consists of basic concepts such as the economic entity, monetary unit, periodicity, and goingconcern considerations.

Please review below for additional details on this topic.

Levels of Accounting Information

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Review of Accounting Basics

TCO B is an important conceptual item that we will cover this week. Although you've covered this information inthe past, a quick review of the rules of debit and credit is in order:

1. If the normal balance for an account is a debit, the account is increased by a debit and decreased by acredit. Examples include: cash, inventory, and salaries expense.

2. If the normal balance for an account is a credit, then the account is increased by a credit and decreased bya debit. Examples include: accounts payable, common stock, and sales.

3. Contra accounts have normal balances that are the opposite of their parent accounts. For example, theAllowance for Doubtful Accounts normally has a credit balance and its parent (general ledger account),Accounts Receivable, has a normal balance of a debit.

Rules of Accounting

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Test Your Knowledge

DefinitionMatching Game

Click on the linkabove to test yourknowledge on thisweek's material.

Note: Theseactivities will open in a new pop-up window, so you mayneed to disable any pop-up blockers.

Tutorials

Journal Entry

For a transaction involving the BalanceSheet accounts, we can record the changesusing a three-step process.

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