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GAAP vs. IFRS and comparing IRR, NPV, and payback approaches

GAAP vs. IFRS

The United States uses Generally Accepted Accounting Principles (GAAP) as the basis of financial reporting. The International Financial Accounting Standards (IFRS) is an alternative way to report financials. This article from Ernst and Young compares the two methods of financial reporting.

Ernst & Young's US GAAP vs. IFRS: The Basics http://www.ey.com/Publication/vwLUAssets/IFRS_vs_US_GAAP_Basics_March_2010/$FILE/IFRS_vs_US_GAAP_Basics_March_2010.pdf

After reading the article from Ernst and Young, answer the following questions:

- How does the GAAP reporting method cause cash flows to differ from net income?
- How are the features of the Income Statement, Balance Sheet, and Statement of Cash Flow utilized in both the GAAP and the IFRS reporting methods?
- Does it make sense to adapt a worldwide standard for financial reporting? Should this be mandated or voluntary?
- Calculate some of the potential costs and benefits of switching from GAAP to IFRS.

Capital Rationing

Compare and contrast the Internal Rate of Return (IRR), the Net Present Value (NPV), and Payback approaches to capital rationing. Which do you think is better? Why?

Solution Preview

How does the GAAP reporting method cause cash flows to differ from net income?

One of the main differences is in the reporting of interest and dividends, and it affects the total cash flow, causing a difference in net income. Under GAAP, companies can list total dividends and/or interest paid or received as a part of operating cash flow or they can list it under financing activities and investing activities. Under IFRS, companies must list interest paid and dividends received as a part of operating cash flows, and dividends paid must be listed as a financing activity. This automatically creates a difference in the total for operating, financing, and investing activities on the statement of cash flows. Additional adjustments would then be necessary, based on the method selected under GAAP which allows additional choices, to reconcile to net income. Another issue deals with overdrafts. Under IFRS, overdrafts are never considered a part of cash flow and cannot be included in operating activities. All overdrafts must be listed as a financing activity. Under GAAP, overdrafts are typically listed as a part of operating cash flows.

- We can see a Statement of Cash Flows prepared under GAAP here: http://www.understand-accounting.net/FinancialStatementPreparation.html
- Although I could not locate a prepared Statement of Cash Flows under IFRS online, here are the exact technical specifications for the SCF: http://www.ifrs.org/Documents/IAS7.pdf

How are the features of the Income Statement, Balance Sheet, and Statement of Cash Flow utilized in both the GAAP and the IFRS reporting methods?

This is based upon how each method deals with the accounting principles, in their most basic format. GAAP has always been a very rule-based system. Under GAAP, we have accounting rules that stipulate how to treat almost any accounting item, transaction, or adjustment conceivable, in almost all situations. IFRS is very principle based. The difference can be compared to reading a book about accounting that shows how to actually calculate certain issues (GAAP), or a book that discusses theory (IFRS). This is not to say that one system is better than the other. They both have their advantages and disadvantages, and they both treat various items the same in different instances.

Considering this, the features of the income statement, balance sheet, and statement of cash flows are utilized in GAAP to tie-in to each other. The changes that are listed in the company's balance sheet for the year, which are derived from operating, financing, and investing activities, flow onto the statement of cash flows. The numbers found on the income statement coincide with both the statement of cash ...

Solution Summary

This solution addresses the following questions:

- How does the GAAP reporting method cause cash flows to differ from net income?
- How are the features of the Income Statement, Balance Sheet, and Statement of Cash Flow utilized in both the GAAP and the IFRS reporting methods?
- Does it make sense to adapt a worldwide standard for financial reporting? Should this be mandated or voluntary?
- Calculate some of the potential costs and benefits of switching from GAAP to IFRS.
- Compare and contrast the Internal Rate of Return (IRR), the Net Present Value (NPV), and Payback approaches to capital rationing. Which do you think is better? Why?

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