There are two dominant systems of accounting used by corporations around the world. In the U.S., companies use the generally accepted accounting principles, or GAAP, while international companies use the International Financial Reporting Standards, or IFRS.
One of the many significant differences between the two systems is their treatment of revenue recognition. Let's explore the key differences.
General principles vs. industry-specific rules
In terms of revenue recognition, the IFRS guidelines are much more general in their requirements than GAAP. IFRS revenue recognition is guided by two primary standards and four general interpretations. GAAP, on the other hand, has highly specific rules and procedures codified for a huge variety of industries on a case-by-case basis.
For example, under GAAP, a construction company can elect to defer revenue recognition until a contract is completed. This rule, which is specific to construction companies, allows them to delay showing any revenue during the period of time in which they are actually providing value to a customer.
Under IFRS rules, however, this is prohibited. Instead, the company has two methods of revenue recognition to choose from:
- Recognize contract revenue based on the value of the contract, the estimated total cost, and the percentage of the contract that has been completed. Through this method, known as the "percentage-of-completion method," the revenue recognized is proportional to the relative completion of the contract.
- Recognize revenue as the recoverable costs incurred over the reportable period.
IFRS sticks more closely to the principle that revenue should be recognized as value delivered, while the industry-specific rules under GAAP give the construction company another option outside that broad principle.
Getting into the weeds a bit more
All revenue recognition with IFRS is categorized as either a sale of goods, a rendering of services, construction contracts, or the use of another's assets (think interest on financial assets, royalties, intellectual property licensing, and similar use cases). There are specific rules that come into consideration once a sale has been defined as one of these four categories, but in general the rules are consistent and straightforward regardless of industry.
GAAP, on the other hand, starts by determining whether a sale is realized or realizable and then whether it has been earned. Revenue is not recognized until the exchange of value has actually occurred. However, after that seemingly simple categorization, GAAP rules require the accountant to then dive into an exhaustive list of rules specific to the industry in which the business operates.
In this way, IFRS rules can be seen as principle-driven across all industries, while GAAP rules are highly specific and can vary widely with each case. This fundamental difference makes a true comparison between the two possible only by going through IFRS and GAAP on a transaction-by-transaction, industry-by-industry basis.
Why the IFRS vs. GAAP question matters
Over the past several years, U.S. and international regulators and accounting policymakers have been working to merge these two systems as much as possible. The ultimate goal is to have a single, robust accounting system that corporations around the world can use. This would be to the benefit of all parties once implemented, as corporations, investors, and regulators could view financial results on a comparable basis.
This undertaking poses many big challenges. Because of the major differences in the accounting rules, many companies' financials could look far different under a new, integrated system. Changes in revenue recognition could dramatically affect top-line sales numbers, which could in turn trickle down to net income. Other differences between IFRS and GAAP could impact the balance sheet, financial ratios, loan covenants, taxes, and a host of other important financial measures.
The differences between IFRS and GAAP may seem like an accountant's nitpicking, but they are big enough that merging the two systems could have meaningful effects on businesses and investors all over the world.
To learn more about stocks and how to find the right broker for you, head over to The Motley Fool's Broker Center and get started today.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.