1.2 Standard Setting and GAAP vs. IFRS
Key Takeaways
- The SEC holds statutory authority over standard-setting under the Exchange Act of 1934, but delegates rulemaking to the private sector (FASB).
- The FASB Accounting Standards Codification (ASC) is the sole source of authoritative U.S. GAAP for non-governmental entities.
- The FASB standard-setting process is a transparent due-process system requiring research, public exposure drafts, and a majority vote of 7 members.
- IFRS is principles-based and prohibits the LIFO cost flow method, whereas US GAAP is rules-based and permits LIFO.
- Foreign private issuers can file IFRS statements with the SEC without reconciliation, but must reconcile if using non-IFRS local GAAP (Form 20-F).
Standard Setting and GAAP vs. IFRS
The development of financial accounting standards in the United States has evolved from a decentralized, profession-led process to a highly structured, independent, and public due-process system. Today, the Financial Accounting Standards Board (FASB) serves as the primary private-sector body authorized to establish accounting standards, operating under the oversight of the Securities and Exchange Commission (SEC). Understanding the historical evolution of standard-setting, the formal process of amending the Accounting Standards Codification (ASC), and the primary structural differences between US GAAP and International Financial Reporting Standards (IFRS) is critical for financial statement preparers and auditors.
History of U.S. Standard-Setting Bodies
The authority to set accounting standards in the United States was statutorily granted to the Securities and Exchange Commission (SEC) under the Securities Exchange Act of 1934. However, the SEC has historically delegated its standard-setting authority to the private sector while maintaining ultimate oversight and enforcement capabilities. The private sector standard-setting responsibility has transitioned through three distinct historical phases:
- Committee on Accounting Procedure (CAP) [1938–1959]: A committee established by the American Institute of Accountants (later the AICPA) that issued 51 Accounting Research Bulletins (ARBs). This approach was heavily criticized for its piecemeal, problem-by-problem methodology.
- Accounting Principles Board (APB) [1959–1973]: Also established by the AICPA, this board issued 31 Accounting Principles Board Opinions (APBOs). The APB was criticized for lack of independence, slow response times to emerging transactions, and susceptibility to lobbying by large corporations.
- Financial Accounting Standards Board (FASB) [1973–Present]: An independent, full-time board sponsored by the Financial Accounting Foundation (FAF). Unlike its predecessors, the FASB is not part of the AICPA and consists of seven full-time, independent members who must sever all ties with previous employers.
The Financial Accounting Standards Codification (ASC)
On July 1, 2009, the FASB established the FASB Accounting Standards Codification (ASC) as the single source of authoritative nongovernmental US GAAP. The Codification reorganized thousands of scattered GAAP pronouncements (ARBs, APBOs, FASB Statements, and EITF abstracts) into a unified, searchable database of roughly 90 topics. If an accounting treatment is not contained within the Codification, it is not authoritative US GAAP.
The FASB Standard-Setting Process
The FASB follows a rigorous, open due-process system to ensure transparency and stakeholder participation when amending the Codification. The standard-setting process proceeds through the following sequential steps:
- Identify the Issue: The FASB receives suggestions from stakeholders, the SEC, or emerging issues groups (such as the Emerging Issues Task Force, or EITF).
- Agenda Decisions: The FASB evaluates whether to add the project to its active agenda based on the prevalence of the issue, alternative treatments, and feasibility.
- Research & Deliberation: The board holds public meetings to discuss the technical accounting issues and analyze feedback from staff researchers.
- Issue an Exposure Draft (ED): The board publishes a proposed standard (Exposure Draft) requesting public comment.
- Analyze Comments & Public Hearings: The board evaluates comment letters and may conduct public roundtables to gather additional feedback.
- Final Consensus & Vote: The board deliberates changes to the proposed standard. A simple majority vote (4 out of 7 board members) is required to approve the standard.
- Issue an Accounting Standards Update (ASU): The board issues an ASU to formally amend the ASC. ASUs are not independent authoritative literature; they serve strictly to update the Codification.
US GAAP vs. IFRS: Key Structural and Technical Differences
Although the FASB and the International Accounting Standards Board (IASB) engaged in a multi-year convergence project, significant divergence remains between US GAAP and IFRS.
| Accounting Area | US GAAP Rules | IFRS Rules |
|---|---|---|
| Philosophical Orientation | Rules-based, with extensive industry-specific guidance and bright-line rules. | Principles-based, relying heavily on professional judgment and limited bright-line tests. |
| Inventory Cost Flow (LIFO) | Permitted. Under the IRS LIFO Conformity Rule, if LIFO is used for tax purposes, it must be used for financial reporting. | Prohibited. Only FIFO or Weighted-Average cost formulas are allowed. |
| Inventory Write-down Reversals | Prohibited. Once inventory is written down to lower of cost or net realizable value (LCNRV) or lower of cost or market (LCM), the new cost basis becomes the permanent floor. | Permitted. If the net realizable value of written-down inventory subsequently increases, the write-down can be reversed up to the original cost. |
| R&D Costs | All research and development costs must be expensed as incurred (except for certain software development and web costs). | Research costs must be expensed. Development costs must be capitalized once technological feasibility, intent to complete, and economic viability are established. |
| Asset Impairment Testing | Two-step test: Step 1 compares carrying value to undiscounted cash flows (recoverability test). If failed, Step 2 measures impairment as the excess of carrying value over fair value. Reversals of impairments on long-lived assets are prohibited. | One-step test: Compare carrying value to recoverable amount (the higher of fair value less costs to sell and value in use). Reversal of impairment losses is permitted if economic conditions improve (except for Goodwill). |
SEC Transition Regulations for Foreign Private Issuers
To lower financial reporting barriers in U.S. capital markets, the SEC permits foreign private issuers (FPIs) to file financial statements prepared in accordance with IFRS (as issued by the IASB) without reconciling their accounts to US GAAP. However, if an FPI uses a local or national version of GAAP (e.g., Japanese GAAP), they must file Form 20-F, which contains a quantitative reconciliation of Net Income and Stockholders' Equity from their local GAAP to US GAAP.
Which of the following historical U.S. standard-setting bodies issued Accounting Research Bulletins (ARBs)?
In the FASB's due-process standard-setting model, what is the role of an Accounting Standards Update (ASU)?
A manufacturing company writes down its inventory of raw materials from $50,000 to $40,000 due to a temporary decline in market prices. In the subsequent year, market conditions recover and the net realizable value of the inventory rises to $48,000. How should the recovery be accounted for under US GAAP and IFRS?
A pharmaceutical firm spends $500,000 on research to discover a new drug compound, and $800,000 on development activities after establishing technological feasibility and commercial viability. How should these costs be treated under US GAAP and IFRS?