Globalization of the business community poses complex issues for fundamental analysis. In order to understand a company's fundamentals, an investor should first determine what accounting rules might have been used to compile reports and whose laws define the company's governance practices. From the perspective of an investor in the United States, there are 3 broad categories of companies, each subject to different legal and accounting regimes:
- Domestic firms operate mostly or completely within the United States. They may import supplies or export products, but these activities normally represent a comparatively small share of total business activity. Domestic companies are typically governed by U.S. securities laws. Their financial reports are normally constructed according to generally accepted accounting principles (GAAP).
- International firms are headquartered in the United States but maintain significant investments outside the country and have geographically diverse profit centers. U.S. operations and parent company governance are typically determined by U.S. laws, and parent company accounting normally follows GAAP. But non-U.S. subsidiaries may be governed according to policies dictated by their host countries. Accounting structures in many jurisdictions outside the United States are determined by the International Financial Reporting Standards (IFRS). Any specific differences in accounting or governance between foreign subsidiaries and U.S. parent companies should be disclosed in the parent-company financial reports.
- Global firms have significant investments and profit centers in many countries, with no single center of dominance. Governance rules for global firms are generally determined by the laws of the official domicile of the parent company. Some global firms create financial statements according to GAAP for U.S. investors, but more commonly, primary parent-company reports adhere to IFRS.
International Financial Reporting Standards (IFRS): A new approach to disclosure
The International Financial Reporting Standard (IFRS) is rooted in the drive to build a common, standardized international financial infrastructure that grew out of World War II. It took official multinational form when the European Union dictated IFRS as its common accounting standard in 2002, and has since been designated as the theoretical accounting framework by more than 100 countries. The U.S. Securities and Exchange Commission is considering a move to adopt IFRS standards in this decade. With that in mind, here is a brief overview of key similarities and differences for a U.S. investor:
- Financial statements prepared under GAAP and SEC rules in the United States and those prepared under IFRS elsewhere may appear generally similar and use the same terminology. However, there will be many detail differences. For example, the layout and format of public company reports are determined by detailed SEC regulations, so most such reports tend to look the same. IFRS reports, by contrast, may differ significantly as long as they include required information. IFRS reports may also provide greater detail about prior-period results.
- Interim financial reports created under IFRS generally allow fewer kinds of costs to be deferred from one period to another.
- Guidelines for consolidation of subsidiaries under GAAP allow the determination to be based on controlling financial interests. Under IFRS, however, the determination may be based on whether the parent entity has the power to control the subsidiary.
- Inventory cost under GAAP may differ significantly from cost under IFRS. GAAP allows valuation based on last-in, first-out accounting. IFRS bars that practice. GAAP allows inventory to be valued at market value; IFRS relies instead on net realizable value. GAAP does not allow inventory write-downs to be reversed, while IFRS permits the practice if the reason for the impairment no longer exists.
- Extraordinary items, that is, items that are unusual or infrequent, may be reported separately under GAAP but not under IFRS.
- Minority interests may be accounted for as a component of equity under IFRS, but as a liability under GAAP.
- Rules for revenue recognition differ in many important but arcane details, so that total revenue for a company under IFRS may be noticeably different than it would be under GAAP.
GAAP has served as the framework for financial accounting in the United States for decades. Many elements of GAAP evolved from cases brought by companies or industries seeking differentiated treatment for their circumstances. IFRS has a much shorter history of case law, and so has had fewer opportunities to develop exceptional treatment issues. Investors who need to take action based on IFRS reports may need to monitor the evolution of IFRS case law as carefully as they now read new financial accounting standards issued by U.S. authorities.