As an essential part of commercial activity, financial reporting is becoming increasingly necessary and complicated. Especially, the advancement of world economy raises the problem of incomparable financial statements between firms following different standards. As a result, it is more important to understand the distinctions of different reporting conventions. From an academic point of view, it helps to improve existing standards. From a practical view, a comprehensive understanding of global standards facilitates both international trade and the development of multinational corporations (Nobes & Parker, 2002). This article deals with an eminent case of U.S. and U.K. It will first look into the financial relevant environments of the two countries, including political, economic and legal systems. The comparison tries to locate the reasons behind reporting differences of the two countries. Following this, a more detailed description is given on the major distinctions of the two reporting systems. The article then presents a practical case of IBM Company. The example will further illustrate the differences and highlight ways of potential adjustment. Finally, a conclusion is reached about the two principles’ differences.
Relevant Financial Environments
Generally speaking, U.S. and U.K. are very similar in many aspects. The historical links between the two countries result in similar political, economic and legal systems. Both as democratic countries, U.S. and U.K. share similar political values. Although it is also important to note that U.S. operates under a federal list system while UK’s political structure is more concentrated. As a result, U.S. companies are more likely to be subject to two levels of regulation, the federal level and the state level. From an economic perspective, the essential spirits of the two countries are both to create a relatively liberal market and minimize the role of government involved, which is often referred to as a hands-off economy. To ensure equality of opportunity and competition is the foundation of a liberal market framework. In such economies, it is less likely that government will set up a uniform compulsory accounting regulation. Instead, this power is delegated to the market level, which also has strong incentive to insure a proper development of accounting profession. This is actually exactly the case in U.S. and U.K. The law systems in U.S. and U.K. are under common law framework, which means they rely more on precedential cases rather than established statutes. Under the common law system, the emphasis is usually on shareholders and legislative has less influence on accounting profession.
In spite of the fact that U.S. and U.K. have very similar financial environments, the process of European integration also has large influences on the accounting development of U.K. Unlike U.K., continental Europe adopts a different set of accounting principles. To better fit into the European Union, U.K. is making many changes to its financial reporting systems.
A conceptual framework refers to a coherent system of objectives and principles. A framework will clarify the nature, the function and limits of financial accounting. The existence of a coherent framework is important to assure consistent financial reporting in commercial practice. In the United States, companies generally follow GAAP, which is short for Generally Accepted Accounting Principles. GAAP includes the standards, conventions, and rules accountants follow in recording and summarizing, and in the preparation of financial statements. Its rules and announcement mostly come from a non-profit organization: Financial Accounting Standards Board, which is established by the private sector to promote the development of a consistent reporting system (FASB, 2011). In U.K., before 2005, all companies adopt the UK GAAP, whose primary setter is Accounting Standards Board. However, after 2005, the dominance of UK GAAP is diminished as European Law requires that all listed European companies should report under International Financial Reporting Standards (IFRSs) (Jermakowicza & Gornik-Tomaszewski, 2006). Companies that are not listed have the option to choose between IFRS and UK GAAP. It is important to note that recently issued UK GAAP has largely moved towards IFRSs, which greatly reduced their differences.
IFRS and GAAP are very different in many aspects. Conceptually, IFRSs’ primary goal is to insure understandability, comparability, relevance and reliability of financial statements (IFRS, 2011) while US GAAP concentrates more on relevance and reliability. US GAAP is more rule-based that it provides specific guidance in many cases. But IFRS is more principle-based. More specific definition differences include that IFRS only define income and expenses while GAAP differentiates between revenue, expenses, gains and losses.
Major Differences of Accounting Rules and Methods
One distinct difference between the two financial accounting systems is the way inventory is treated. Under IFRS, inventory measurement is based on the actual physical inventory flow. It assumes that inventory that is purchased or produced first is also sold first. Under this assumption, first-in, first-out (FIFO) method and the average cost method can be used (IFRS, 2011). On the contrary, in the United States, last-in, first-out (LIFO) is more popular used, which results in lower revenue and thus fewer taxes (GAAP 2011). But LIFO is prohibited in IFRS. Except for the different ways of measuring inventory flow, GAAP also does not allow the recovery of inventory value (GAAP 2011) once it is written down while IFRS recognizes subsequent recovery in the inventory values (IFRS, 2011).
Another important measurement distinction between IFRS and US GAAP is that GAAP doesn’t allow any upward revaluations of property and equipment. But in the case of IFRS, these fixed assets can be revalued upward. They are reported at fair value at the revaluation date less the accumulated depreciation since revaluation. If the revaluation exceeds the original written down, the exceeding part will be adjusted directly to equity (IFRS, 2011).
In the Income Statement Part, GAAP and IFRS are different in accounting for construction contracts. Under IFRS, if the firm cannot reliably estimate the outcome of the projects, profits can only be recognized at project completion (IFRS, 2011). While under US GAAP, acceptable accounting method includes percentage-of-completion method and completed-contract method. When accounting for depreciation, GAAP does not allow for prospective adjustment if firm chooses to change depreciation method, which is permissible under IFRS. In measuring nonrecurring items, GAAP treats an extraordinary item as both unusual in nature and infrequent in occurrence (GAAP, 2011). They are reported in the income statement, net of tax, below income from continuing operations. But IFRS does not permit the idea of extraordinary items. In the case of R&D, GAAP usually expense R&D costs except for the case of software while IFRS allow capitalizing these casts if certain criteria are met.
There are many other notable differences, like in the cash flow statement, IFRS record interest and dividend received respectively in CFO or CFI and record interest and dividend paid in CFO or CFF while GAAP does not make such subtle distinctions.
IBM Case: potential adjustment for U.K. investors
Take IBM as the specific company, some potential adjustments should be made by a UK user.
First of all, the Balance Sheet is checked. At Dec. 31th, 2010, IBM had inventories valuing ,450 million. It includes raw materials, work in process and finished goods and they are stated at the lower of average cost or market. The market value is the current replacement cost, which falls between net realizable value minus normal profit margin and net realizable value. Under IFRS, inventories should be valued as the lower of cost and net realizable value. Obviously the inventories value should be adjusted.
The Plant, rental machines and other property is another issue which could be adjusted. They are carried at cost in IBM’s financial report and were worth ,289(gross) million At Dec. 31th, 2010. To a UK user, these properties can be valued either based on historical cost or fair value. Since IBM had buildings worth ,414 million (gross) and plant, laboratory and office equipment worth ,676 million (gross) at that time, their fair value can be very different from their historical cost, which should be adjusted.
Cash Flow Statement issues are also very crucial. IBM’s income taxes paid in cash (net of refunds) are ,238 million in 2010. They are all classified in cash flow from operating activities (CFO). But in a UK user’s perspective, expense associated with investment or financing transaction should not be classified as CFO. Also, 1 million interest paid on debt which can be classified as cash flow from financing activities(CFF) by a UK user are put in the CFO category. So CFO should be adjusted higher.
In conclusion, financial reporting in U.K. and U.S. are different from many perspectives.Even though the general environments of the two nations are very similar because of their historical links and close political and economic framework, the integration of European process does cause many disparities between U.S. and U.K. Since 2005, IFRS becomes the dominated accounting principle of U.K. firms. Compared with GAAP, IFRS is not that restrictive in many accounting treatments. It tends to provide guiding principles rather than setting detailed accountancy methods for every scenario. Unlike US GAAP, which is more locally oriented, IFRS takes into account the international convergence of accounting standards. The IBM case is a good example to illustrate their differences. These differences can result in large inconsistencies between different firms and make comparison result more ambiguous (Beuren, Hein & Klann, 2008,). As a result, for U.K. users, it is very important to get a relatively comprehensive understanding of the differences between the two reporting systems.