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International Financial Accounting Standards Versus Generally Accepted Accounting Principals
Although we have known about the spherical dimensions of the globe for centuries, in the last few decades it has been proven that the Earth could be “flat” after all. People are communicating around the world like never before, allowing transactions to flow freely from country to country. Because this is happening for the first time like never seen in history, people are quickly adapting to new kinds of problems or ways we could make these interactions more efficient. One problem is that due to the free flow of business transactions across different countries and different law enforcement agencies, it is necessary to establish a single set of accounting standards to facilitate access to financial information. International Financial Reporting Standards are a set of accounting standards, established by the International Accounting Standards Board, which become the global standard for the preparation of financial statements of public companies. The current lack of a single set of accounting standards creates problems for preparers and users. Many multinational companies, creditors and investors support the idea of a global set of accounting standards, which would make it easier to compare the financial reports of a foreign competitor, better understand opportunities and reduce costs by using one company for accounting procedures-wide.
Currently, more than 12,000 companies in 113 countries have adopted International Financial Reporting Standards as their new accounting standards. The SEC believes that number will continue to increase. Japan, Brazil, Canada and Indian countries plan to start using IFRS in 2010 and 2011. Mexico will adopt IFRS in 2012. This same year, the US will include IFRS questions on its CPA exams. President Obama announced financial regulatory reform proposals on June 17, 2009, which called on accounting standard setters to “make significant progress toward developing a single set of high-quality global accounting standards” by the end of 2009. The United States is expected to converge and/or adopting international standards, IFRS, and ceasing to use their current generally accepted accounting principles, as early as 2012. The proposed deadline, requiring US public companies to use IFRS, has been pushed back to 2015. In order to do so, it is necessary to recognize and eliminate differences between GAAP and IFRS.
There are several major differences between GAAP and IFRS, which cause significant delays in their convergence. Some major differences between the two standards are that IFRS does not allow LIFO, uses a one-step method for writing off impairments, has different rules for the rehabilitation of debt contracts, reports business segments differently, has different consolidation requirements, and is less comprehensive in its guidance on recognition of income from GAAP. At the very least, the FASB must study these variations extensively to determine the broad impacts on United States companies.
The first major difference between these two sets of standards is inventory handling. Currently US GAAP allows FIFO, average cost and LIFO inventory costing methods. IFRS has banned LIFO and companies will have major changes in inventory valuation to match the new standards. Also, GAAP does not specify specific rules for livestock or crops, while IAS 41 specifies the use of fair value less estimated costs to sell for biological assets. Another important change in inventory accounting is that IFRS will show inventory at the lower of cost or net realizable value rather than market. IFRS will also require that lower prices or mark-to-market adjustments be reversed under defined conditions, whereas US GAAP does not permit this reversal.
Second, IFRS has different measurement procedures for impairment of goodwill and other intangible fixed assets. US GAAP measures goodwill impairment using a two-step process that first compares the estimated fair value of the reporting unit to the carrying amount of the unit. If the book value is greater than the fair value, goodwill is impaired and a second step must be performed. In this next step, the fair value of the net identifiable assets is determined and subtracted from the fair value of the reporting unit. The excess in the fair value of net identifiable assets is considered a reduction of goodwill. IFRS will not use this measurement process and will instead use a one-step calculation similar to other non-current assets. This measurement for fixed assets will be made in relation to the higher of value in use or fair value less costs to sell. When this impairment for fixed assets (not goodwill) is measured, it is allowed to reverse it under certain conditions under IFRS.
Third, GAAP and IFRS have different rules when dealing with remedying debt covenant violations. When a debt covenant has been breached, it must be rectified before the year-end balance sheet date, as international standards do not allow this to occur after the year-end. This will have a major impact on the way companies choose to finance their operations. There will be more pressure on companies to renegotiate their debt or have to raise capital through equity issuance. Debt covenant violations will clearly show which companies are not financially strong and will continue to indicate future problems.
The final major difference between GAAP and IFRS is that the revenue recognition guidance is less extensive for IFRS. IFRS guidance on this topic fits into a single book about two inches thick, while US GAAP has approximately 17,000 pages of rules and guidance. (IASB) One reason for this is that GAAP contains industry-specific guidance, for example, revenue generated from software development. IFRS has relatively low regulations on how certain industries recognize revenue. Some other differences between GAAP and IFRS are the differences in segment reporting and consolidations.
Segment reporting differs slightly between the two standards because GAAP is flexible about how a company defines its segments through the management approach. Internal management selects certain segments even if they differ from the financial statements, when following GAAP, because these segments correspond to internal operations. IFRS will not allow the management approach, and the segments used must correspond to the financial statements. IFRS no. 8 “Operating segments” requires reportable segments to be disclosed in annual financial statements and in interim financial statements, which include business and geographic segments. Another difference is that two different segmentation bases will be required, a primary base and a secondary base.
Another difference between the two standards is that consolidation will be handled differently. First, GAAP requires consolidation for majority-owned subsidiaries, while IFRS will view control as a factor for consolidation. Some other differences are that variable interest entities and qualifying SPEs are not covered by IFRS, parent and subsidiary accounting policies will need to be aligned, and minority equity interests will be required. When it comes to consolidating foreign subsidiaries, there are additional differences to consider. In order to consolidate the foreign subsidy, the parent company needs to receive the foreign financial statements and conform to US GAAP before translating the foreign currency. This step will be eliminated and will facilitate this type of consolidation. However, more emphasis will be placed on the currency of the economy in which business actually takes place to determine the functional currency, while GAAP is open to judgment with a large consideration of cash flows. And finally, under GAAP equity accounts are translated at historical value, but not specified under IFRS.
There are many differences between US GAAP and international financial reporting standards, including but not limited to topics such as inventories, impairment measurements, debt handling, revenue recognition, segment reporting, and financial statement consolidation. Along with the determination for a single set of reporting standards, the elimination of these differences will be seen through ongoing efforts between the FASB and the IASB. Most importantly, accountants in the United States must be prepared for this inevitable event, because the world is flat after all.
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