Question

The United States uses accounting standards developed by the Financial Accounting Standards Board (FASB) known as the generally accepted accounting principles (GAAP). This system relies on rules and regulations and thus is said to be a rules-based system. The rest of the world follows accounting standards developed by the International Accounting Standards Board (IASB) known as the international accounting financial reporting standards (IFRS). This system relies more on principles than rules. There is a movement to have one global standard, which would combine GAAP and IFRS.

a) What are the differences between GAAP and IFRS?

b) How does each standard handle research and development costs?

c) What issues might arise with combining a rules-based with a principles-based system?

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Answer 1

a) The following are the main differences between GAAP & IFRS:-

1. Rules Vs Principle:- GAAP is rule based, Company has to follow strictly the industry specific rules or guidelines . While IFRS give more freedom where the companies need to apply the judgement and interpretation of the principles to the given situation.

2. Inventory Related :- GAAP allows the Last in First out method also for inventory valuation along with the First in First out Method where as IFRS allows only the First in First Out method only.. Further in IFRS reversal of the impairment of the inventory is allowed if the market value of the inventory increases but under GAAP reversal of impairment of inventory is not allowed

3. Impairment loss:- IFRS allows the reversal of the impairment loss of the Fixes assets if the condition changes except the goodwill , but under GAAP it is not allowed

4. Intangible expenses:- Under IFRS, the internal expenses (Eg. Development Cost) incurred for creating intangible assets can be capitalised subject to some criteria. But GAAP does not permit the same , all the development cost need to be written off as expenses.

5.   Area of coverage:- IFRS is more popular where as using in more than 100 countries including EU, South Asia etc. Whereas GAAP used only in United States

b) Handling of Research & Development cost:-

1. Research cost:- As per  both IFRS & GAAP all the research expenses need to be expenses

2. Development cost :- Under GAAP, the development cost need to be expensed, but under IFRS the development cost can be capitalised provided the company is able to demonstrate the following:-

a) The technical feasibility of completing the intangible assets

b) Company's intention to complete the same

c) Company's ability to use or sell the asset

d) How the intangible asset will generate the future economic benefits

e) Availability of necessary resources both Technical and Financial

f) Company's ability to measure the expenditure attributable to the intangible assets reliably

C)  

Principles based accounting follows the "comply or explain" policy means each company need to follow the principle as per framework and if it fails to comply the principle it need to explain  why it could not follow the principle. Whereas rule based accounting follow the "tick box" approach where the company need to follow strictly the rules and regulations and there is no scope for violating the rules.

So In the principle based accounting system , there is possibility of different interpretations for similar transactions and creates uncertainity and requires extensive diclosures in financial statements. In rule based system exhaustive disclosures are not necessary as there is not alternative treatment of the transactions , but simply follow the rule.

The main issue for combining these systems will be striking a balance between these two extreme features of the two systems. The flexibility in the principle based system may not easily adaptive in the rule based system and the rigidity in the rule based system can be easily  adaptive with the principle based system.