Since January 2005 around 7,000 listed companies across the EU have had to adopt international financial reporting standards (IFRS). This has been a topic of much controversy and, in some cases, confusion as European issuers make the transition from national reporting standards to IFRS.
The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (Fasb) are working to combine their standards with the ultimate goal of eliminating differences between IFRS and US Gaap. That project is ongoing, but North American companies have also had to adopt many of the new reporting standards laid out in IFRS.
While the move to international reporting standards is meant to increase transparency, the transition period is currently causing some concern in the market because companies are adopting the new rules at different times depending on their reporting cycle. While not intrinsically involved in the accounting changes, IR can play an important role by clarifying the switch for investors and analysts.
Over the last 18 months, companies have been educating investors, analysts and employees about the transition in an attempt to avoid any confusion. ‘I am happy to say the issue that proved to be key was to communicate early and on a regular basis with investors, so there were no surprises when the numbers were finally published,’ says Darren Jones, an investor relations representative at Vodafone.
Spelling out the difference
But the move from local Gaap to IFRS needs to be very clearly explained in order for these audiences to understand the differences between the two standards. ‘Quality of disclosure and reconciliation from previous Gaap figures has varied greatly and in some cases has left certain questions unanswered or unclear,’ notes Steven Brice, head of IFRS at London-based accounting firm Mazars.
One issue is that there is a lack of consistency in the interpretation of IFRS across EU countries, Brice explains. ‘Also, some firms – particularly UK property companies – have continued to emphasize Gaap numbers instead of IFRS numbers,’ he adds. ‘Overall, however, the transition has largely been smooth for companies that have worked hard on conversion.’
One sure sign of good IFRS communication efforts is the lack of adverse share price reactions when earnings announcements come out, notes Peter Elwin, head of accounting and valuation research for London-based Cazenove.
On the whole, bigger companies have done a better job of explaining the change. ‘Larger companies have obviously been able to devote more time and resources to the communication process than smaller ones,’ Elwin observes. Brice agrees, noting that some of the larger pharmaceutical companies, such as GlaxoSmithKline and AstraZeneca, have strong and informative communications on the issue of IFRS.
Ofex, the UK-based independent market that serves small and mid-cap companies, generally supports IFRS but will not be mandating it for member companies. ‘There are some serious disadvantages for smaller companies of the type we serve,’ explains Simon Brickles, Ofex’s CEO. While having a universal accounting standard may simplify things, Brickles feels smaller companies generally have a harder time with regulatory and accounting changes, and IFRS is no exception.
Beyond the cost issue, smaller firms may not wish to disclose additional information about geographic turnover, as required under the new standards. ‘The Quoted Companies Alliance (QCA) has already heard concerns on this,’ Brickles says. ‘In particular, such disclosures may not suit certain businesses that have to highlight where their profits are made to their larger competitors.’
Word on the Street
Philipp Mettler, an equity analyst with SAM Research, says most companies have done a good job in communicating the change. ‘One should also remember that this is merely a change in accounting practice – the underlying business and cash flows do not change,’ he points out.
‘Investors are likely to punish companies only where unexpected bad news comes to light, not for the usual expected IFRS adjustments,’ notes Brice.
Still, when companies fail to explain the transition, problems may arise. ‘There is no information [about the change] in some cases,’ says Mettler. And, when information is scarce, there is a possibility analysts and investors will misinterpret a company’s financials. ‘Transparency in this respect is very important, as market participants do not like uncertainty and surprises, especially negative ones,’ Mettler adds.
Elwin notes that there have been cases where the market has responded to IFRS changes. ‘While it is difficult to isolate the impact of IFRS from other factors, the market reaction to IFRS announcements by Cattles and Compass Group both illustrate the potential for an adverse share price reaction following an IFRS announcement that was not well understood by the market,’ he says. ‘Compass announced its results and outlined the impact of IFRS on May 18; its shares fell 5 percent on the day, from 235p to 220p. It subsequently recovered all these losses but has recently fallen back to similar levels.
‘As for Cattles, it announced results and outlined the impact of IFRS on March 18. Its shares fell 20 percent over the following month, and remained within a depressed range until the end of September. It has still not recovered to its previous value and the true impact of converting to IFRS will not be seen until it reports results next year.’
According to Elwin, investors and analysts are well aware the switch to IFRS is an exercise in presentation and standardization that has no impact on cash flows or business strategy. As such, he says, most are unlikely to sell based on an IFRS change, and some investors may even view an adverse reaction to IFRS as a buying opportunity.
While IROs don’t calculate the numbers for IFRS, they may get questions from analysts and investors about the new standards. The best advice is to be prepared by learning how the transition affects their company’s financials.
Brice feels IR’s biggest challenge with IFRS has yet to surface. ‘We are still only at the interim [reports] stage and full audited year-end accounts may still bring a few late surprises,’ he notes. ‘Many of the IFRS adjustments reduce earnings per share but don’t actually impact cash flow, so how the IRO presents things is important.’
‘The scale of change is rather large and therefore demands a good understanding from IR,’ adds Mettler. IR practitioners are wise to pay attention to additional disclosures under IFRS as well as the move to a fair value-style accounting under IFRS, which basically values assets at current or market value.
‘Some of the rules under IFRS will be very different from the local Gaap rules IROs are used to, and getting to grips with the new standards will take time and effort,’ says Elwin. ‘To some extent, analysts and investors will be looking to companies and, therefore, IROs for guidance on how to interpret IFRS figures, particularly in comparison with old, non-IFRS figures from previous periods. There is significant potential for confusion during the transition phase, and the IRO is a key figure in preventing this.’
Growing pains
Another issue IR needs to be aware of, according to Elwin, is that analysts aren’t all switching their estimates to IFRS figures simultaneously, so consensus estimates are a mix of IFRS and non-IFRS numbers.
One of the challenges for analysts is that they can’t switch to IFRS without a detailed IFRS restatement from companies. ‘One analyst may have some models that incorporate IFRS while others for companies in the same sector might not,’ says Elwin. ‘In many cases analysts will be running IFRS numbers behind the scenes but will defer switching their formal estimates to IFRS or will provide two sets of figures to ensure they are comparing like with like.’
In other words, there is no consensus on how analysts are treating the new rules. ‘Generally, IFRS is being taken into consideration but analysts will continue to make adjustments to results,‘ says Brice. With analysts updating their models at different times, investors may be confused when comparing companies in the same sector.
Because fair value adjustments do not represent cash flow and can’t be forecast, analysts are excluding them from underlying earnings estimates. ‘As most analysts previously excluded goodwill amortization from their underlying earnings estimates, the switch to a US Gaap-style impairment approach, where goodwill is no longer amortized, has not had any impact on analysts’ estimates,’ explains Elwin. ‘Amortization of other intangibles is also generally being excluded. Stock option expenses are generally being included as an operating expense and thus are depressing underlying earnings in some cases.’
Analysts and companies will have to adjust to this new accounting method. ‘In my experience, many analysts still have a lot to learn on IFRS but should remember that the underlying business has not changed,’ Brice says. ‘It is only potential new information that could change their interpretation.’
There are still challenges for the market as companies make the transition to universal accounting standards. For IROs, the primary goal is to continue to communicate the effects of the change to analysts and investors to avoid any concern or adverse reactions in the marketplace. As with any change that affects how companies report financials, being proactive with investors and analysts is key. By delivering timely, concise information to these key audiences, IR will likely avoid any adverse reaction to IFRS.
