Globalization of the business community poses complex issues for fundamental analysis. To understand a company's fundamentals, you should first determine what accounting rules might have been used to compile its financial reports. You'll also want to know whose laws define the company's governance practices.
For US investors, 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 US 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. US operations and parent company governance are typically determined by US laws, and the parent company accounting normally follows GAAP. But non-US 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 US parent companies should be disclosed in the parent-company's 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 US investors, but more commonly, the primary parent-company's reports adhere to IFRS.
IFRS vs. GAAP
The International Financial Reporting Standards (IFRS) and the generally accepted accounting principles (GAAP) share the goal of providing a common set of rules to create transparent financial reporting. Nonetheless, there are differences between them. Here's how they define themselves:
IFRS: "Our mission is to develop IFRS standards that bring transparency, accountability and efficiency to financial markets around the world. Our work serves the public interest by fostering trust, growth, and long-term financial stability in the global economy...IFRS are currently required in more than 140 jurisdictions and permitted in many more."1
GAAP: “Generally Accepted Accounting Principles (GAAP) are accounting standards, conventions, and rules. It is what companies use to measure their financial results. These results include net income as well as how companies record assets and liabilities. In the US, the SEC has the authority to establish GAAP. However, the SEC has historically allowed the private sector to establish the guidance.”2
The 2 accounting standards have similarities as well as differences. Here's an overview:
- Financial statements prepared under GAAP and SEC rules and those prepared under IFRS appear generally similar and use the same terminology. But there are many detail differences. For example, in the US, 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 the required information. IFRS reports might 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 can be based on whether the parent entity has the power to control the subsidiary.
- Inventory cost under GAAP can differ significantly from cost under IFRS. GAAP allows valuation based on last-in, first-out accounting (LIFO). This accounting practice is banned under the IFRS. 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, can be reported separately under GAAP but not under IFRS.
- Minority interests can 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 can 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 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 might need to monitor the evolution of IFRS case law carefully.
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