Numerous accounting standards are considered by different nations as generally accepted accounting principles. They are briefly abbreviated as (GAAP). Such principles enable various firms within a nation to prepare and present their financial statements in accordance with the established guidelines provided under a nation’s GAAP standards. However, even though GAAP may provide a means of harmonizing accounting practices adopted by companies within a certain geographical demarcation, challenges emanate when a company engages in international business. This means that it becomes a challenge for any organization to handle multiple standards within preferred levels of accounting accuracy. It is for this reason that international financial reporting standards (IFSR) were established. Precisely, many nations are shifting from GAAP to IFRS especially in the age where many firms are seeking to establish a global presence. IFRS is the standard developed and widely advocated for by IASB (international accounting standard board). By April 2011, about 120 nations across the globe had adopted IFRS. With the enormous popularity of IFRS, it is vital for accountants to have ample knowledge of how IFRS standards influence the GAAP standards adopted by their companies. From this perspective, the focus of this paper is to introspect and compare the U.S. GAAP standards with IFRS with a particular interest in establishing the challenges associated with the conversion of the U.S. GAAP codification into IFRS codifications. Since both the U.S. GAAP and IFRS are broad subjects, the discussions of this paper are restricted to codifications related to inventory costing.
In the international accounting language, the term inventory is used synonymously with the term stocks. It “describes goods and material that business holds for the ultimate purpose of resale” (Horst, 2011, p.15). Inventory costing is therefore used to refer to stock control. Nevertheless, it is crucial to note that, under the American accounting language, the term stock refers to “capital invested in business” (Horst, 2011, p.16). Bearing in mind these differences in the applicability of terminologies under differing GAAPs, one of the concerns of IFRS is to harmonize the terminologies of inventory costing. The idea behind inventory costing rests on the need to make specifications of the number of stocked goods within firms’ premises so that losses of sales are not encountered due to the limited availability of goods ready for sale. Inventory costing is also significant to ensure a limitation of the costs of stocking. This means that certain levels of stocks are not preferred since they increase the costs associated with taking care of goods, which may result in obsolescence and or increment of costs of damaged goods. Some of the approaches of inventory costing include “LIFO perpetual (last in first out), FIFO perpetual (first in first out), weighted average perpetual, LIFO periodic, and FIFO periodic” (Horst, 2011, p.60).
The central premise for the operation of the above ways of costing inventory rests on three fundamental concerns. The first concern is time. To this end, Horst (2011) argues, “the time lags present in the supply chain, from supplier to user at every stage, requires maintenance of certain amounts of inventory to use in this lead time” (p.61). Nevertheless, in the real application, stock takings are observed to cater for expenditure during the lead-time fluctuations. Therefore, it is possible to address the question of lead times by ensuring the inventories are ordered in advance. The second concern of inventory costing is economies of scale. When inventories are ordered on large scale, low costs associated with the handling of stocks are encountered. Arguably, this occurs since delivering a single unit at the right place and within the stipulated time introduces higher logistical costs. Consequently, a compromise is required between the costs likely to be experienced due to handling large stocks and a reduction in cost associated with economies of scale related to bulk buying, bulk storage, and bulk transportation. Lastly, maintenance of inventories within a firm is critical to make sure that stocks buffer is available in an attempt to minimize the cost encountered due to the need to replenish inventories. Adopting either the U.S. GAAP or IFRS introduces differing impacts on these three fundamental concerns of inventory costing.
The U.S GAAP inventory costing standards
The U.S. GAAP encompasses the accounting rules deployed in the preparation and presentation coupled with reporting of various financial statements among the public, private, nonprofit making organizations, and even the government within the U.S’ territorial boundaries. However, in the discipline of accounting, the U.S. GAAP is theoretically considered as encompassing a codification that provides guidelines in the preparation of financial statements not only within the U.S. but also across the entire accounting industry. However, it is crucial to note that, since GAAP standards applicable within the U.S. differ from similar standards used in other nations, international companies established in the U.S. have challenges associated with the need to harmonize their home-based accounting standards with those in other nations where they have established businesses. Under the U.S. GAAP codification 330, titled inventory, inventories are defined as “tangible personal property that are held for sale, in the course of production and personal properties meant “to be consumed in the production” (FASB, 2012, pp.10-20).
This means that inventory costing calls for the incorporation of the finished goods, the work in progresses, and the raw materials in the inventory costing techniques acceptable under the U.S. GAAP. The acceptable inventory costing techniques are LIFO, FIFO, and weighted average methods. These techniques are referred to as ‘costs flow assumption’ under codification topic 330 of the U.S. GAAP, which also provides that initial measurement of costs needs to be executed the moment the costs are recognized. The U.S. GAAP also permits other approaches in inventory costing among them being the retail inventory method. In situations whereby the cost is higher than the market, the approach adopted by GAAP is to measure inventories at the prevailing market conditions. In the codifications, the market refers to the prevailing costs of stock replenishment. Precisely, the market value of inventories is “limited to an amount that is not more than the net realizable value or less than the net realizable value less the normal profit” (FASB, 2012, pp.10-20). The main objective of doing this is to make sure that the inventories remain important assets to an organization.
IFRS inventory costing standards
IFSR codifications are engineered to facilitate the enactment of a common language for accounting across the globe, which can be understood by global accountants. Initial endeavors for harmonization of inventory costing standards were initiated in Europe. However, as Bloom and Cenker (2009) reckon, “the value of harmonization quickly made the concept attractive around the world” (p.214). Following the constitution of IASB, the body adopted all the accounting standards that were developed by IAS. These IAS standards for accounting together with the newly developed accounting standards by the IASB are collectively termed as international financial reporting standards (IFRS). Since 2001, many nations have switched from their GAAP to IFR S standards. Some of these nations include Australia, Hong Kong, and the European Union among many others (Bloom & Cenker, 2009, p.212). IASB immensely believes that, when all firms adopt IFRS across the globe, many investors coupled with other people who make use of organizations’ financial statements would benefit enormously from them.
Some of these benefits include “reduction in the costs of investments and increased accessibility of quality information” (Kieso, Weygandt & Warfield, 2011, p.499). Arguably, therefore, large numbers of investors will feel at ease while making provisions for the financing of firms since the utmost goal of IFRS is not only in providing a means for the comparative basis for firms’ financial statements, inventory costing being one of them but also on fostering transparency. The fact that IFRS establishes similar standards in all nations means that international companies would save an immense amount of money while they report on a single standard. One of the key departures of the IFRS standard from the U.S. GAAP standards is that IFRS only uses the weighted-average method and FIFO as the main ways of costing inventories while GAAP also makes use of LIFO (FASB, 2012, pp. 30-9). In the next section, these and other differences are considered in the attempt to lay a foundation for examining the areas where organizations that have been following the U.S. GAAP standards will need to make changes.
Comparisons of the U.S. GAAP with IFRS
In August 2008, SEC (securities exchange commission) placed a requirement that companies need to shift from the U.S GAAP to IFRS. Since then, myriads of people charged with making policies within the organization have been caught on the dilemma of how to converge the two standards of accounting reporting. However, the aim of the SEC and IASB is clear. It entails introducing an accounting-reporting standard that is consistent in all companies. Such an attempt is critical since it provides avenues for shareholders and managers of the companies without negating the analysts to evaluate all companies that operate in competition with their firms irrespective of their geographical locations across the world. Corliss and LeGault (2011) amplify the significance of switching to IFRS. They say, “Those who are using the financial statements to evaluate a company would find it difficult to judge how well a company is doing alone as well as compare them to other businesses in the industry if they reported using different methods for each period” (Corliss & LeGault, 2011, p.10). Arguably, this follows because inventory values that are reported for the cases of cost of goods sold coupled with closing values for inventories may give the wrong impression of the position of the company in terms of net losses or even incomes (FASB, 2012, pp. 30-14).
Both GAAP and IFRS differ and coincide in terms of their treatment of some aspects of inventory control. Both IFRS and the GAAP version adopted by the U.S. see inventories from a similar angle. They define inventories as encompassing all assets that are held by an organization for the purposes of being sold, assets in the process of production, and or assets in the form of raw materials meant for producing goods for sale (FASB, 2012, pp. 10-20). Precisely, in both standards, inventories are treated as current assets while incorporated in the balance sheet. Additionally, the standards also demand companies to disclose their inventory values in their financial statements. Since inventories are treated as current assets under both standards, they must have cost values attached to them. In the costing process of inventories, similar to GAAP, IFRS measures cost the moment it is encountered (FASB, 2012, pp. 30-1). The costs of inventories that are included under both standards include purchases costs, costs associated with the conversion of raw material into finished goods, and the costs that are encountered in the process of transportation of inventories (FASB, 2012, pp. 30-8). As discussed before, IFRS also incorporates the IAS standards. Therefore, since IAS includes design expenses in the costs associated with giving inventories that place utility and the condition they are in during the time of costing, IFRS has similar concerns. On the other hand, the “U.S. GAAP does not include design costs in the process of calculation of inventory costs” (Horst, 2012, p.62). One of the striking differences for IFRS in comparison to the US. GAAP is the manner they treat costs flow assumptions. In this context, Fay et al (2010) lament, “Under the U.S. GAAP and IFRS, specific identification should be used to assign costs for inventory items that are not interchangeable” (p.26). In the case of interchangeable items in the inventory list, IAS permits companies to deploy either the weighted average approach of inventory costing or alternatively the FIFO approach.
Using FIFO implies that all inventory items that are acquired first need to be issued first so that the ending inventory would be composed of inventories that are purchased within the most recent time to when the financial statements are prepared. On the other hand, weighted average costs inventories an average cost of the prices of all inventory entities acquired within a given period. LIFO is yet another method of costing inventory entities. However, even though this approach is acceptable under GAAP codifications (FASB, 2012, pp. 30-9), it is not acceptable under the IFSR. In the U.S., LIFO is a popular cost flow assumption method especially in times of price hikes since it truncates into escalated costs of goods sold. Nevertheless, amid the call for companies to switch to IFRS standards, some companies in the U.S. have been dropping the LIFO approach to utilize either weighted average or FIFO since LIFO is associated with higher costs of administration. Paramount to note is that, even though IFRS makes provisions for only FIFO and weighted average as the standards for inventories cost flow assumption, it does not prescribe particular groups of companies in a particular industry to make use of any of the methods. Rather, IFRS gives freedom to all companies to select a methodology that best suits a particular company’s periodic incomes (FASB, 2012, pp. 30-9).
IFRS and GAAP demand that companies can use retail methods coupled with standard costs techniques if the results obtained closely profile the actual costs. In particular, under IFSR, firms are required to apply to cost formulas that are similar while dealing with the inventories that are of the same nature and or use. However, in the case of the U.S. GAAP, no similar particular requirement is placed on firms. Nevertheless, this does not mean that firms should apply differing formulae of selected costs under any of the standards (Fay et al, 2010, p.26). Additionally, in the case where inventory value declines in comparison to the original cost, both standards require that this decline be reported in the firms’ financial statements. However, the approaches deployed in the reevaluation of inventories by the U.S. GAAP and IFRS are different. GAAP demands that reevaluation needs to be done such that inventory values are lower-of-cost. On the other hand, IFRS requires that inventories are reevaluated such that “inventory to be reported as lower-of-cost or net realizable value, or the amount that a company expects to realize from the sale of inventory” (Kieso, Weygandt & Warfield, 2011, pp. 545-546). In addition to these differences, between IFRS and the U.S. GAAP, it is essential to note that no peculiar rules are provided under GAAP in relation to biological inventories.
Following the discussions of the above similarities and differences in the IFRS and the U.S. GAAP, it is clear that the two accounting standards are not only similar but also different in the manner in which costing for inventories is conducted. While similarities may not attract scholarly criticism, the differences have created immense concerns on whether the U.S. needs to consider its GAAP approaches in costing inventories to converge with IFRS. The recommendation is that, within the U.S. and other nations, the accounting standards adopted for inventory costing need to reflect the costs of inventories at values, which closely approximate the prevailing market values. While LIFO is an attractive inventory costing technique due to its power of making companies enjoy larger tax benefits, it is not a true reflection of the manner in which goods flow in the actual sense. It also leads to the underrating of inventories. Thus, it is recommendable for the U.S. and other nations to alter their GAAP to conform to the IFRS codification to correct these demerits where the GAAP permits companies to make use of LIFO in the costing of their inventories. This recommendation is made in full realization of the fact that IFRS places tax obligation on companies, which may lead to unplanned sudden cash outflows. This may expose firms shifting to FIFO and weighted average as methods of inventory costing into a competitive demerit in comparison to other companies. The overall effect is to lower market valuations on the firms that scrap their LIFO approach of inventory costing.
Many nations are shifting from their GAAP to IFRS. In the U.S, the GAAP codifications for inventory costing allow three approaches. These are a weighted average, LIFO, and FIFO. On the other hand, IFRS does not permit the LIFO method. Another departure of the IFRS and the U.S. GAAP is the manner in which the reevaluation of inventories is done. From the dimension of these differences, it has been recommended that the current U.S. GAAP needs to shift to IFRS to establish common platforms for making comparisons of different financial statements of companies operating in different parts of the globe. This shift would imply that all people who utilize financial statements of an organization would require to be accustomed to new approaches to inventory costing. Such approaches affect their cash flows, equity, and even their assets among other things.
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