Ever since investors first diversified their investments across borders, common accounting standards have been something of a Holy Grail: greatly desired, but seemingly out of reach. International financial reporting standards (IFRS), introduced to the EU on January 1 this year, are intended to provide the accounting transparency investors yearn for and facilitate the comparison of financial performance across sectors, industries and nations.
‘The aim is to improve the overall quality of financial communications,’ notes Ian Dilks, lead IFRS conversion partner at PricewaterhouseCoopers. ‘Increasingly, IFRS, as the name implies, is concerned with overall financial reporting, rather than just accounting.’
While the original international accounting standards (IAS) have been around for some time, ‘they weren’t widely used until the EU asked for consistent accounting with the aim of creating a Europe-wide capital market capable of rivaling the US,’ says Dilks.
IFRS has been greeted with varying degrees of enthusiasm. A recent survey by Citigate Dewe Rogerson, in association with Fallon Stewart, notes that half the UK analysts questioned have not adapted their valuation models to allow for the effects of IFRS, and less than 20 percent say they have received sufficient data from companies to enable the necessary modifications. Even so, many of them note the potential impact on enterprise value ratios and dividend payments. The Citigate research concludes that, lacking a consistent approach to valuations under IFRS, the range of earnings estimates may broaden, thus increasing the short-term volatility of the markets.
Change in mentality
Less difficulty is expected in Germany. ‘Our members say IFRS is already widely recognized as the common standard of reporting, although it applies only to consolidated accounts, with the accounts of the separate companies in the group still based on German Gaap,’ says Jella Benner-Heinacher, managing director of German shareholder association DSW. ‘In general the standards are expected to give more transparency to investors, as they limit the possibilities of creating hidden reserves.’
Italian observers, however, are more wary. ‘The principles are very innovative for Italy, and will require a significant change in mentality,’ notes Dario Colombo, board member at AIAF (the Italian financial analysts’ association) and at audit firm GDA. ‘Many colleagues fear there might be more space for creative accounting in some areas. For example, valuing assets at fair value is more discretionary than reporting them at historic cost.’
Meanwhile, Romain Burnand, fund manager at Paris-based Moneta Asset Management, doesn’t see specific problems in France as yet, but doesn’t rule out their development. ‘This is a primary level of preparation, in which most companies are trying a soft introduction to IFRS,’ he says, referring to the fact that the EU has allowed some flexibility in the application of the standards at this initial stage. ‘Further along, as IFRS becomes more entrenched, options will be reduced.’
The challenges of change
In order to prepare shareholders for the changes, the Committee of European Securities Regulators (CESR) has advised companies to outline their plans regarding IFRS, inform the markets as to their progress and illustrate the main differences on their statements between their domestic Gaap and IFRS. Furthermore, while the SEC initially required European companies with US listings to provide three years’ restatements under the new standards, this has been lowered to two years, indicating that US regulators are willing to contribute toward the convergence of standards.
At the end of 2004 pharmaceuticals giants AstraZeneca and GlaxoSmithKline estimated how IFRS would affect their results and balance sheets going forward. In the same sector, Roche provided forward-looking statements describing how goodwill-impairment tests – rather than the currently used amortization and options expensing – would affect its figures this year.
Restatements of 2004 accounts under IFRS have already led to market fluctuations. In early 2005 UK mortgage lender Northern Rock noted that while IFRS introduces greater volatility in profits, it is less than under US reporting ‘where hedge effectiveness for our fixed rate mortgages is not achieved.’ However, the company saw its share price fall sharply – although it has since recovered – on revelations that 2004 earnings would have been 10 percent to 12 percent lower under IFRS. ‘Stock prices are currently moving as a function of whether what companies disclose under IFRS is expected or not, and whether it is well explained,’ says Dilks.
As one example of the discrepancies, Finland’s YIT said net 2004 EPS would have been Ä1.60 ($2.07) under IFRS, against Ä1.37 under Finnish accounting standards (FAS), a substantial enhancement. On the flip side, IFRS would have considered the company’s net debt to be almost Ä350 mn, as opposed to the Ä226.6 mn reported under FAS.
39 steps
For most, the biggest question mark is IAS 39, which European Central Bank president Jean-Claude Trichet wants redrafted after vociferous opposition, particularly from a number of European banks and insurance companies. ’It is probably the most complex standard, but most of the IAS 39 document relates to exceptions,’ explains Dilks. ‘The fundamental rule – that derivative instruments should be marked to market – could probably be summed up in one page.’
Net profits will in some cases be affected by stock option expensing. Net debt may increase because it will include, among other items, securitization – the expensing of the equity component of convertible bonds and pensions-linked liabilities. The latter are particularly difficult to measure because of the volatility of return on pension plan investments, especially equities. ’IFRS requires liabilities in [pension] scheme funding to be taken into the balance sheet, subject to various conditions,’ observes Peter Vipond, director of financial regulation and taxation at the Association of British Insurers (ABI). ‘This is clearly creating issues, not least in M&A deals.’
Options accounting and goodwill-impairment testing are also proving controversial. ‘There is widening criticism that rules such as the subjection of goodwill to regular impairment testing support short-termism and are not useful to the investors in the long run,’ says Benner-Heinacher. Some analysts disagree, claiming that regular goodwill-impairment testing will limit the huge write-downs rendered necessary, for example, in the telecom sector after the heavy 3G license spending and M&A flurry of a few years ago.
Work ahead
But the general attitude toward IFRS is one of optimism. ‘If we achieve more transparency and accountability in the short term and improved accounting quality in the long term, this can only be good for the capital markets,’ points out Dilks.
‘For the insurance sector, IFRS should lead to a greater understanding of insurance companies’ balance sheets, which can only be positive,’ agrees Vipond. ’Investors should be better placed to draw comparisons between insurance companies, though there is still much to do.’
‘Our investors haven’t raised any major question marks,’ says Steve Trowbridge, investor relations officer at UK-based Reuters. ’Shareholders and the sell side generally want to see that management is in control, aware of and able to quantify the potential impacts of IFRS on the business, and capable of anticipating them.’ Reuters has taken steps to prepare staff and investors for the changes. ‘Our IFRS team has been in place for many months now,’ Trowbridge notes. ’Last summer key financial staff, including the IR team, underwent a period of training regarding the general impacts of IFRS and how they relate to Reuters specifically.’
In France, ‘nearly all the CAC 40 companies have held or arranged to hold investor days to analyze the impacts of IFRS,’ notes Burnand. ’And French financial analysts seem to be on top of the sessions organized by companies.’ Not so in Italy, where ‘very few companies, such as Fiat and Telecom Italia, have reconciled their earnings and shareholder equity under Italian Gaap with IFRS,’ observes Colombo. ’Others have noted the type of change that will be necessary to their current accounting procedures, but without reconciling the numbers.’
In the initial stages of IFRS introduction, companies, analysts and investors are finding themselves on a steep learning curve. In the immediate future, an important part of the investor relations function will be to ensure an appropriate flow of information. ’The challenge for companies is not just what to announce but when,’ says Dilks. ’Too early and they may find themselves out of line with their peers; too late and others may have already driven market expectations. There is no substitute for spending time with analysts and briefing them.’
Trowbridge agrees. ‘Analysts are increasingly aware of the impacts for specific industries,’ he says. ‘They are seeking support and guidance through this period, with the investor relations department acting as the interface. IROs should keep abreast of which issues are reported elsewhere, and how they’re reported. Most importantly, their auditors should be able to provide them with support and guidance.’
For Colombo, ‘there will be a competitive advantage for companies that can explain clearly what the effects of IFRS will be.’
The standards are not set in stone, and there will no doubt be further modifications over the next few years, although transparency and comparability will continue to be the main priorities. ‘One of the key aims is a convergence between international and US standards,’ Dilks advises. ‘You’re not going to achieve that if you water down standards on either side.’
With the SEC watching closely, IFRS has set the convergence ball rolling. Companies will need to show they are up to the challenge.
