Chapter 13: CFA Level 1 Financial Statement Analysis
Understanding critical differences between international accounting standards
Principles-based approach with broad frameworks requiring significant professional judgment
Issued by IASB
Rules-based approach with detailed, prescriptive guidance for specific transactions
Issued by FASB
Understanding the foundational differences in standard-setting and philosophy is key to interpreting financial statements accurately.
| Topic | IFRS | U.S. GAAP |
|---|---|---|
| Standard-Setting Bodies | Issued by the International Accounting Standards Board (IASB). | Issued by the Financial Accounting Standards Board (FASB). |
| Underlying Approach | Principles-based: Provides broad frameworks requiring significant professional judgment. | Rules-based: Offers detailed, prescriptive guidance for specific transactions. |
Key Difference: This is the most fundamental difference. IFRS allows more flexibility but requires deeper judgment. U.S. GAAP reduces ambiguity but can lead to mechanical application.
Key differences in revenue recognition and expense treatment impact profitability reporting.
| Topic | IFRS | U.S. GAAP |
|---|---|---|
| Revenue Recognition | Uses the converged 5-step model. "Probable" collection is generally interpreted as >50% likelihood. | Same 5-step model, but "probable" may be interpreted more strictly (e.g., >75%), leading to delayed recognition in some cases. |
| Development Costs | Capitalized if criteria (e.g., technical feasibility) are met. Treated as an intangible asset. | Expensed as incurred, except for software development costs after technological feasibility. |
| Non-Recurring Items | Discloses "significant" or "exceptional" items. Discontinued operations shown net of tax below continuing income. | No "extraordinary items." Discontinued operations presented similarly. |
IFRS companies may report higher profits and stronger balance sheets due to capitalization of development costs. Revenue timing differences are usually minor but can affect growth trends.
Differences in asset valuation and impairment rules affect reported equity and asset quality.
| Topic | IFRS | U.S. GAAP |
|---|---|---|
| Inventory Valuation | LIFO prohibited. Uses FIFO or weighted average. Measured at lower of cost or Net Realizable Value (NRV). | LIFO permitted. Measured at lower of cost or "market" (replacement cost). |
| Reversal of Write-Downs | Allowed if inventory value recovers (up to original cost). | Prohibited. Write-downs are permanent. |
| Revaluation of PPE & Intangibles | Permitted. Gains go to revaluation surplus in equity. | Not allowed. Historical cost model only. |
| Impairment of Long-Lived Assets | One-step test (carrying amount vs. recoverable amount). Reversals allowed (except goodwill). | Two-step test. Reversals prohibited. |
| Goodwill |
Not amortized under either standard. Tested annually for impairment.
Impairment losses cannot be reversed under both standards. |
|
| Deferred Taxes | All deferred tax assets/liabilities classified as non-current. Netted by jurisdiction. | Now aligned: also non-current and netted. |
In inflation, U.S. GAAP LIFO users show lower profits and inventory values. IFRS companies can boost profits later via reversal of write-downs. Revaluation can inflate asset values on IFRS balance sheets.
Classification differences affect comparability of operating cash flow.
| Topic | IFRS | U.S. GAAP |
|---|---|---|
| Interest Paid | Can be classified as Operating or Financing (policy must be consistent). | Mandatory Operating activity. |
| Interest Received | Can be Operating or Investing. | Mandatory Operating. |
| Dividends Paid | Can be Operating or Financing. | Mandatory Financing. |
| Dividends Received | Can be Operating or Investing. | Mandatory Operating. |
| Bank Overdrafts | Can be part of cash and cash equivalents if part of cash management. | Treated as short-term borrowing (liability). |
Analyst Adjustment: These differences make CFO less comparable. Analysts often reclassify interest/dividends to ensure consistency. Overdraft treatment affects reported cash balances.
Additional differences that impact financial analysis and comparability.
| Topic | IFRS | U.S. GAAP |
|---|---|---|
| Lease Accounting (Lessee) | Single model: All leases (except short-term) recognized on balance sheet. Expense is split into interest and amortization. | Dual model: Finance and operating leases treated differently. Operating leases show straight-line total expense. |
| Pension Accounting | Remeasurements (gains/losses) go directly to Other Comprehensive Income (OCI). | Gains/losses go to OCI but may be amortized into income via the "corridor" method. |
Lease differences affect income statement expense patterns. Pension differences can cause smoother reported pension expense under U.S. GAAP due to amortization.
This reading typically accounts for 2-4% of Level I exam weight. Focus on:
| Category | Topic | IFRS | U.S. GAAP | Impact |
|---|---|---|---|---|
| INVENTORY | Valuation Methods | FIFO, Weighted Avg ONLY | FIFO, LIFO, Weighted Avg | LIFO users show lower profit in inflation |
| Measurement | Lower of cost or NRV | Lower of cost or market | NRV typically higher than "market" | |
| Write-down Reversals | ALLOWED | PROHIBITED | IFRS can boost future profits | |
| LONG-LIVED ASSETS | PPE Revaluation | PERMITTED | NOT ALLOWED | IFRS can inflate asset values |
| Impairment Test | One-step (carrying vs. recoverable) | Two-step test | IFRS simpler, earlier impairment | |
| Impairment Reversals | ALLOWED (except goodwill) | PROHIBITED | IFRS more volatile asset values | |
| INTANGIBLES | Development Costs | CAPITALIZED if criteria met | EXPENSED | IFRS higher profit & assets |
| Research Costs | BOTH expense as incurred | No difference | ||
| CASH FLOW | Interest Paid | Operating OR Financing | Operating (mandatory) | IFRS can boost CFO |
| Dividends Paid | Operating OR Financing | Financing (mandatory) | IFRS flexibility reduces comparability | |
| Interest Received | Operating OR Investing | Operating (mandatory) | Classification affects CFO | |
| Dividends Received | Operating OR Investing | Operating (mandatory) | IFRS has more flexibility | |
| INCOME STATEMENT | Extraordinary Items | NOT segregated | Prohibited (eliminated 2015) | Now converged |
| Revenue Recognition | BOTH use 5-step model (ASC 606 / IFRS 15) | Converged since 2018 | ||
| LEASES | Lessee Accounting | Single model (all on B/S) | Dual model (finance vs. operating) | Expense pattern differs |
| TAXES | Deferred Tax Classification | BOTH classify as non-current | Now converged | |
Mistake: Thinking all standards have converged post-2018
Reality: While revenue recognition converged, major differences persist in inventory (LIFO), development costs, and reversals. Don't assume similarity!
Mistake: Thinking IFRS allows ALL impairment reversals
Reality: IFRS allows reversals for PPE and inventory, but NOT for goodwill. Goodwill impairment is permanent under BOTH standards.
Mistake: Directly comparing CFO between IFRS and GAAP companies
Reality: IFRS flexibility in classifying interest/dividends means CFO may not be comparable. Analysts must reclassify for apples-to-apples comparison.
Mistake: Thinking IFRS capitalizes ALL R&D
Reality: IFRS capitalizes DEVELOPMENT costs only (after technical feasibility). Research costs are ALWAYS expensed under both standards.
LIFO Prohibition (Most Tested): IFRS prohibits LIFO; U.S. GAAP allows it. During rising prices, LIFO results in higher COGS, lower ending inventory, and lower net income compared to FIFO. This is the #1 tested IFRS/GAAP difference on the exam.
Development Cost Capitalization: IFRS requires capitalization of development costs (after technical feasibility is achieved), while U.S. GAAP expenses all R&D as incurred. Both expense research costs. Exception: Software development costs can be capitalized under GAAP after technological feasibility.
Impairment Reversals: IFRS allows reversal of impairments (except goodwill) if recoverable amount increases, limited to original carrying value. U.S. GAAP prohibits all impairment reversals. Neither standard allows reversal of goodwill impairment.
Cash Flow Classification Flexibility: IFRS allows flexibility in classifying interest and dividends (operating, investing, or financing depending on the item). U.S. GAAP mandates: interest paid/received and dividends received = operating; dividends paid = financing. This can significantly affect CFO comparability.
PPE Revaluation: IFRS allows (but doesn't require) revaluation of PPE to fair value, with gains going to OCI (revaluation surplus) and losses to income statement. U.S. GAAP prohibits PPE revaluation entirely (historical cost model only). Must apply consistently to entire asset class.
Principles vs. Rules-Based: IFRS is principles-based (more judgment required), while U.S. GAAP is rules-based (more detailed guidance). This fundamental difference affects all financial reporting areas and leads to potential comparability issues.
Inventory Write-Down Reversals: IFRS allows reversal of inventory write-downs if circumstances change (NRV increases), limited to original cost. U.S. GAAP prohibits inventory write-down reversals—they are permanent.
Convergence Status: Revenue recognition (IFRS 15 / ASC 606) is FULLY converged using identical 5-step model. Other converged areas: fair value measurement, segment reporting. Major divergences remain: LIFO, development costs, impairment reversals, PPE revaluation.
Financial Statement Presentation: IFRS requires minimum line items but allows flexibility; U.S. GAAP has more prescriptive formatting rules. IFRS uses "statement of financial position" (vs. "balance sheet"), and extraordinary items are prohibited under IFRS but allowed (rarely) under GAAP.