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Week 1: U.S. GAAP - Lecture

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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 Information for Decision Making | Rules of Accounting | Some Definitions | The Accounting Cycle | Test Your Knowledge | Tutorials

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

What is 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 as an 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 during the course and how they will impact financial statement presentation.

U.S. GAAP? For U.S. GAAP purposes, the standards that govern accounting are set by the Securities and Exchange Commission (SEC) for public companies. The standards that are required by the SEC require public companies to file a variety of forms with the SEC, the most important being the annual reporting Form 10-K. This report, as well as 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, staff interpretations 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. The FASB's website is http://www.fasb.org You will be extensively studying the accounting rules passed by this organization 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 discuss research during the term in our Threaded Discussions and readings.

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 for having a universal set of accounting standards, versus several different ones. Advocates for the convergence of accounting standards state that by using one set of accounting rules, there would be uniformity in reporting practices, 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 and IFRS.

Differences Between U.S. GAAP and IFRS Some of the significant differences include the fact that the U.S. GAAP model is rules-based and IFRS is based on broad principles. As a result, IFRS's rules application is more interpretative by management than U.S. GAAP is. Also, U.S. GAAP uses historical cost for asset valuation for most assets, especially in the area of long-term assets, 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 historical cost to fair value methodology will create artificial increase, or decreases, in the profits of a company. The exact methodology of how to change to fair value accounting is currently one of the issues that that not been overcome by 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 unduly enhance the financial statements. In other words, assets could be overstated at the directive of a corporation's unethical management team under IFRS. Nonetheless, the FASB and the IASB have been closely working on one set of standards through a process referred to as convergence. We will discuss this process throughout the term as we examine the similarities and 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? (Click to Hide.) One is based more on specific rules (U.S. GAAP) the other is based more on broad principles (IFRS). How tall would the authoritative accounting rules stand for IFRS and U.S. GAAP, respectively? (Click to Hide.) The accounting rules for IFRS rules are two inches high. U.S. GAAP has rules that are nine inches high, plus additional supplementary materials from a variety of other sources as well. Which set of rules allows companies more discretion on what information is placed on the financial statements? (Click to Hide.) Under IFRS, companies have more discretion in what information is placed on their financial statements than under U.S. GAAP, since IFRS is based on broad principles that 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? (Click to Hide.) 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. GAAP and IFRS. What does the income statement look like? (Click to Hide.) The income statement under U.S. GAAP is either a single-step or multiple-step format. Under IFRS, expenses are classified by nature or function. For example, by nature, wages would be classified. By function, descriptions such as manufacturing would 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 classifies comprehensive income as part of equity. What does the balance sheet look like? (Click to Hide.) On the balance sheet under U.S. GAAP, we usually list current assets first, and then go down the asset side in the order of liquidity. Also, we use historical cost for purchases and the recording of long-term assets. Under IFRS, specific items are required to be reported on the balance sheet; regarding U.S. GAAP, this is not a requirement. For IFRS, non-current assets are typically listed first, and often at fair value. The term net assets, which are total assets-total liabilities, may be placed on the financials as well. What about the term "reserve"? (Click to Hide.) The term "reserve" is common under IFRS. The use of reserve is discouraged using U.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. GAAP purposes, property, plant, and equipment accounts are recorded at historical cost, and when required, written down for impairment. No subsequent write-up to cost is available under U.S. GAAP, but IFRS allows the write-up of impaired assets. This is a major 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? (Click to Hide.) The statement of cash flows is required under both methods. The operating, investing, and financing sections are required under both, although the presentation may differ under U.S. GAAP and IFRS. For instance, the disclosure rules for the statement of cash flows are much more detailed under U.S. GAAP than IFRS.

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How are cash and receivables accounted for? (Click to Hide.) 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, or factoring receivables. This gives the financial statement issuer a great deal of leeway in how this information is presented. How about fair value accounting? (Click to Hide.) 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 of financial statement instruments.

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

What are the differences in the area of inventory accounting? (Click to Hide.) For inventory purposes, the average method and FIFO method are both allowed for U.S. GAAP. Both methods are required under IFRS. However, LIFO, which is used extensively in the U.S., is not allowed under IFRS. This is a significant difference between 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 written up (but only to cost). How does Property, Plant, and Equipment Accounting differ under U.S. GAAP and IFRS? (Click to Hide.) For purposes of property, plant, and equipment, interest expense is capitalized under both methods. Non-monetary asset exchanges are accounted for in a similar fashion as well. The same methods of depreciation are allowed for both. Impairment rules are different. Property, plant, and equipment can be written up under the "Revaluation" to fair value method under IFRS. The U.S. uses historical cost which does not allow write-ups. Research and Development Differences (Click to Hide.) Research and development costs under U.S. GAAP are expensed. However, under IFRS, during the research phase, the R & D is expensed. When an asset becomes technologically 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, in some cases, the items can be capitalized. What to do about impaired assets? (Click to Hide.) Impairment tests are required under both U.S. GAAP and IFRS. They do vary in procedure. Impairment losses are written off for purposes of intangibles; reversals are not allowed under U.S. GAAP but are allowable under IFRS. Intangible Assets and Goodwill; how are they accounted for on the balance sheet? (Click to Hide.) Under both methods, the treatment for intangibles and goodwill on a purchase between two parties are similar in nature. Intangibles assets are separated from goodwill. In addition, in-process research and development are recorded as a separate asset. The Accounting for LiabilitiesAre they the same? (Click to Hide.) For liabilities, both U.S. GAAP and IFRS require that they be classified as current and noncurrent. The definitions of liabilities and debts are closely related as well under both methods. How to Account for Restructuring Losses? (Click to Hide.) 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 a restructuring loss. Contingencies: What are the differences? (Click to Hide.) Contingencies under U.S. GAAP differ from contingencies under IFRS. IFRS requires a "midpoint" for recognizing a loss, where under U.S. GAAP, the minimum amount of the possible range of outcomes is used. The Differences in Stockholders' Equity (Click to Hide.) 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 of assets), which is not allowed under U.S. GAAP. Under IFRS, a company can prepare either a stockholder equity statement that is similar to the U.S. version, or one that is called a statement of recognized income and expense, where various items are added back to arrive at total recognized income and expense.

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Convertible Debt is different under IFRS! (Click to Hide.) 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 conversion option is recorded as an equity amount.

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

EPS, a financial ratio of importance! (Click to Hide.) 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 use of EPS, don't be surprised if an agreement is reached on this subject in the future. How are marketable securities accounted for? (Click to Hide.) Accounting or trading available-for-sale and held-to-investment maturities are pretty much the same under both methods. Gains and losses related to available for sale securities are reported in comprehensive income under U.S. GAAP, in the equity account under IFRS. The Equity Method is known by another name. (Click to Hide.) The equity method under U.S. GAAP is called the associate investment under IFRS. Consolidations and Control (Click to Hide.) Consolidation rules differ between both methods. In general however, for consolidation to occur, 50% of the voting stock must be owned by the parent company under U.S. GAAP and IFRS. Revenue recognition: a complex area. (Click to Hide.) 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 revenue recognition. Completed Contract Method is Not Allowed.

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(Click to Hide.) The completed contract method is not allowed under IFRS for long-term construction contracts. U.S. GAAP allows for its use. Pension Accounting Differences (Click to Hide.) For pension plans, the rules are similar. However, there are differences in the areas of reporting for prior service costs, actuarial gains and losses, and other technical areas of defined benefit plans. Leases-Convergence Talks (Click to Hide.) For leases, although there are similarities, there are major differences between how U.S. GAAP and IFRS report their operating and capital leases. U.S. GAAP has extensive rules on what to report; IFRS gives broad discretion to how a company reports its assets on the books. There are discussions currently undergoing in this area regarding convergence of a common position on lease accounting rules. How to Account for Errors? (Click to Hide.) Accounting changes and errors are similar. However, there are some differences. For example, under U.S. GAAP, errors must be disclosed and financial statements restated; under IFRS, that's not absolutely required. Again, there is more discretion on the part of the issuer under IFRS than U.S. GAAP. The Final Word (Click to Hide.) Regarding disclosure, there are many similarities between the two. Also, there exist a number of differences. U.S. GAAP has significant reporting requirements for the financials; IFRS tends to have less rules. When will the U.S. adopt IFRS? Time will tell.

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

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Levels of Accounting Information 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 unbiased information to financial statement readers. As accountants, our customers are financial statement readers who 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 level covers qualitative accounting information that distinguishes best practices in reporting financial operations from 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 'em and report the financial information 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 than ever. The third level consists of basic concepts such as the economic entity, monetary unit, periodicity, and going concern considerations.

Please review below for additional details on this topic.

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Accountants Provide Unbiased Information for Decision Making Financial accounting provides financial statement readers with unbiased financial information for decision making. Financial information that is provided by a company, nonprofit organization, or governmental entity presents the information as being in compliance with U.S. GAAP for outside reporting. This compliance is assured as part of a certified audit, which is required for all public companies in the U.S. Certified Public Accounting firms audit clients to assure that they are in compliance with GAAP. This assurance is part of the auditor's opinion that is rendered by the CPA firm on the financial statements of the client. The highest level of an auditor's opinion is referred to as an unqualified opinion. The basic rules of accounting information require that there is a hierarchy of accounting qualities. When reviewing accounting information, it is important to note that the ultimate customer of the financial information is the financial statement reader. Hence, it is important to understand that along with providing this information, as in any process, there are various constraints that are part of the model making process. Two of the constraints are that cost should not exceed the benefit, and the threshold for materiality. For example, the cost of the information should not outweigh the benefit of providing the information. Hence, the use of a large sophisticated accounting reporting system would not be helpful to a small business. In addition, the idea of capitalizing a waste basket over its useful life of ten years versus merely expensing it is an example of the concept of materiality. In addition, financial information should be understandable. That is, the average business person should be able to read and comprehend financial statement information. This is often questionable, since many organizations' financial transactions have become quite complex in recent years and the financial reporting also is complicated by this fact. This is a challenge the profession has been trying to tackle in recent years, but without a great deal of success. The primary financial information should be reliable and relevant. The basic financial statements should have characteristics that reflect predicative value, timeliness, and feedback value. In addition, the information should be verifiable, neutral, and should have representational faithfulness. The information that is presented is essentially unbiased and is presented as is. As a secondary quality, the information needs to be comparable from year to year and it needs to be consistent. Thus, one way to view this is to make sure the same methods of accounting are used from year to year, and are not used to mislead the financial statement reader.

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Rules of Accounting Review of Accounting Basics TCO B is an important conceptual item that we will cover this week. Although you've covered this information in the past, a quick review of the rules of debit and credit is in order: If the normal balance for an account is a debit, the account is increased by a debit and decreased by a credit. 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 by a 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, the Allowance for Doubtful Accounts normally has a credit balance and its parent (general ledger account), Accounts Receivable, has a normal balance of a debit.
1.

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Some Definitions Real or permanent accounts are those accounts which are not closed out at year-end and are found on the balance sheet. They include assets, liabilities, and equity (with the exception of dividends). Nominal or temporary accounts include accounts which are closed out at year end. They include revenues, expenses, gains, losses, and dividends.

The Accounting Cycle The accounting cycle is the start to finish of the accounting transactions for a reporting period. The accounting periods start with the initial journal entries that are recorded. After the journal entries are recorded in the journal, they are then posted in the ledger. After a trial balance is prepared, adjusting entries are made at the end of the period, and subsequently, financial statements are prepared. Please review the basic journal entries and adjustments in detail. The chapter is a good review of the material you learned in your first financial accounting course. Remember that adjusting entries takes place at the end of the period. During the term, we will discuss a number of accounting topics which will require adjusting entries. Now it is time to tackle some homework! Please try to complete your homework before you look at the answers, which can be downloaded from the Doc Sharing area of the course. See you in the threads!

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Test Your Knowledge

Definition Matching Game Click on the link above to test your knowledge on this week's material. Note: These activities will open in a new pop-up window, so you may need to disable any pop-up blockers.

Tutorials

Journal Entry For a transaction involving the Balance Sheet accounts, we can record the changes using a three-step process.

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