March 23, 2006 4:40 pm

Europe’s transition to IFRS

Europe is in the midst of the greatest accounting change process in history. As of 2005, every publicly traded company in the European Union, over 8,000 in all, is required to provide financial statements compliant with International Financial Reporting Standards (IFRS). While companies have been producing IFRS-compliant interim statements since early last year, a mass wave of annual reports is just now reaching the capital markets as companies report full-year results for the first time under the new standards.

What impact are these numbers having on share prices? So far, the effects appear rather muted, at least for most businesses. A recent survey of nearly 200 European fund managers by PricewaterhouseCoopers, the professional services firm, and pollsters Ipsos MORI reveals that only 6 per cent believe that IFRS has had a big impact on their perceptions of value for individual companies, while another 21 per cent claim that the standards have impacted their perception “a fair amount.” That leaves nearly three-quarters of the respondents saying that IFRS has had little or no impact.

So is it all smoke and no fire? Not really. Impacts are highly variable, with some industries, such as those touched most by IAS 39 (derivatives and financial instruments), feeling the bite more than others. Still, we may have to wait a few months for the first rigorous econometric studies before we know with any confidence what the pricing effects have been.

Big changes in balance sheets and profit and loss statements do not necessarily transfer into big pricing effects. For differences between IFRS and old Generally Accepted Accounting Principles (GAAP) to mean anything, the numbers have to convey surprise. In other words, they have to reveal things that the markets did not already know. Otherwise, the value implications of the information will already have been impounded in the share price.

Three decades of academic research show that cosmetic changes to a company’s accounting have little or no effect on value. Accounting changes that reveal previously unknown insights about a company’s ability to generate future cash flows are a different matter, however. The challenge for companies and investors is to determine which changes fall into the former category, and which into the latter.

The effects so far

Although the picture is still forming, a few general conclusions can be made about which financial statement elements have been impacted the most: disclosure levels, reported debt and earnings volatility.

IFRS and disclosure

IFRS leads to much greater disclosure than national GAAPs, a difference felt most acutely in Italy, Spain, Greece and other countries where disclosure rules have always fallen short of capital market demands. Among other things, IFRS requires expanded disclosure on business segments, an area where most European GAAPs provided data of limited practical use. Related party transactions, which refer to transactions between two parties that were linked prior to the transaction, have long been an area rife with potential conflicts of interest. Under the new standards, these are now subject to dramatic increases in disclosure levels. Transactions that were largely obscured under the ancien regime are now required to be discussed openly in public documents.

Even in northern Europe, GAAP-based accounting systems were often not up to the task of greater disclosure. For some companies, the control environment required under IFRS has required at least twice as many data points as the accounting system was used to providing. As a result, the sheer effort demanded by the transition has often been daunting. Anecdotal evidence suggests that senior finance staff at most UK companies now believe that the changes required by IFRS were substantially greater than originally expected.

For starters, disclosure of any assets or liabilities required by IFRS but not recognised under national GAAPs (such as derivatives appearing at fair, and not notional, values) had to be identified and valued. Assets and liabilities not allowed under IFRS (such as provisions without legal or constructive obligation and deferred tax assets if recovery was unlikely) had to be derecognised. Also, selected items had to be reclassified – for example, some financing sources shown as equity under national GAAPs had to be reclassified as debt. And finally, all assets and liabilities had to be measured in accordance with IFRS. In many cases, the last of these requirements means the use of fair value, a radical departure for companies used to operating under strict historical cost regimes. This one aspect of IFRS has proven to be by far the single greatest headache for companies undergoing the transition.

IFRS and debt

Merely changing accounting regimes does not affect a company’s debt, but it can have a huge effect on how debts are reported. One important consequence of IFRS is that many European companies now report higher debts than they did under their national GAAPs. Several reasons account for this development.

Unfunded pension obligations. IFRS pension accounting has its flaws, but at least it compels companies to report shortfalls that might have been ignored under national GAAPs. The discount rates used to calculate the value of pension benefits earned by employees must now be tied to high-grade corporate bonds, instead of the artificially high rates often used by companies pre-IFRS. The result is an increase in the present value of pension obligations which, in turn, increases the likelihood of a shortfall in the value of pension fund assets. Fiat, Groupe Danone, and ICI all took big hits because of the new pension accounting. ICI even became a negative shareholders’-equity company (total assets less than total liabilities) largely because of pensions. Furthermore, the transition to IFRS has been an important factor behind a growing number of European companies scaling back, or even abandoning, their defined benefit plans.

Leases. Most European GAAPs were lenient on lease accounting, allowing many contracts to be classified as operating leases, even for core assets leased over long periods. IFRS, on the other hand, requires the capitalisation of such leases, meaning that the present value of future lease payments must appear on the balance sheet as debt. Also, the land and building components of property leases must now be valued separately. Whereas before the entire lease might have fallen below the capitalisation threshold, the building component will, in many cases, have to be treated as a finance lease even if the land component is not.

Fair value. Derivatives (options, futures, swaps, etc.) are coming into balance sheets at fair values, instead of historical cost, the effect of which is to increase both assets and liabilities. In addition, companies now have to identify options, some of which carry potential obligations, that might be embedded in contracts with customers or suppliers. These options too must be measured and reported at fair value.

Deferred taxes. Under UK, French, and other European GAAPs, deferred tax liabilities (arising mainly from depreciation on fixed assets) were discounted to a present value. IFRS does not permit this treatment, forcing companies to report nominal (and therefore higher) amounts on the balance sheet. The logic of the IFRS treatment is that companies should report how much they would owe in taxes if the assets were to be sold immediately. More controversially, additional deferred taxes must be recognised whenever assets are revalued (on the assumption that future capital gains will arise when the assets are sold), which is likely be a frequent occurrence under fair-value rules. Several large UK companies, including Sainsbury’s, Reed Elsevier, and Cadbury Schweppes have already taken big hits because of this standard.

Expanded consolidation. IFRS has forced many companies to expand the scope of consolidation. In effect, the boundary markers that separate a company from its business and financing partners are changing. All subsidiaries must be consolidated (including full consolidation of financing arms) and many off-balance-sheet financing vehicles have had to be brought into balance sheets.

As with other IFRS effects, no direct effect on equity valuations should be felt unless the increase in reported debt contains surprises not anticipated by the capital markets prior to the IFRS transition. If debt levels are truly higher than expected, more of the company’s free cash flow belongs to debtholders than previously thought, in which case equity prices might suffer. At this point, the extent to which this has happened remains unclear.

IFRS and earnings volatility

Perhaps the single greatest concern among companies undergoing the transition to IFRS is its impact on earnings volatility. IFRS disallows most of the practices commonly employed by managers to obscure the volatility of their businesses. Also, the IFRS obsession with fair value will undoubtedly lead to more volatile earnings streams in the future. What many managers find so alarming is that, while higher volatility is a certainty, it may take a few years before most companies discover just how serious the effects will be. Several factors contribute to this concern.

Goodwill. Under IFRS, goodwill is not amortised, but instead is subjected to annual impairment charges. Vodafone, for example, turned a pre-tax loss of £2.2bn for the first six months of fiscal year 2005 into a pre-tax profit of £4.5bn, simply because the company no longer amortises goodwill. This does not mean that goodwill charges have disappeared, however. The difference is that, instead of gradual write-offs, goodwill is now written off in batches.

If auditors find evidence that the goodwill is worth significantly less than the balance sheet value, a one-time write-off ensues. Therefore, goodwill charges will become lumpier, in contrast to the steady amortisation charges of the past. In fact, Vodafone recently announced that it will cut at least £23bn of goodwill from its balance sheet, owing to increased competition and tougher regulation. So, while periodic amortisation charges have disappeared, Vodafone will be showing a massive goodwill-related loss on its 2006 income statement.

Amortising goodwill was easy and predictable. Impairment testing, which involves determining whether or not an asset is worth less than its current balance sheet value, is not so easy, and is anything but predictable. Before IFRS, European companies were inclined to recognise very few non-goodwill intangibles when making acquisitions, preferring instead to put the entire premium in goodwill. But acquiring companies must now assign as much of the purchase price as possible to other intangibles, leaving goodwill as a true residual. Where before, companies might bury trademarks, customer lists, usage rights and other intangibles in goodwill, the expectation now is that these elements will be valued separately. Putting aside the contentious question of how such assets can be valued (sometimes they cannot), this practice will result in new sources of goodwill having no identifying markers to help managers and their auditors determine what the goodwill might actually represent. In such cases, how can we know whether or not its value is impaired?

Changes in fair value. Many assets and liabilities are now marked to market, and most (but not all) changes in fair value will be sent straight to earnings. In the long run, this practice might have the greatest impact of all on financial statements. Much of this volatility will arise from the highly subjective nature of valuation estimates for assets that do not have observable market prices.

Provisions and hidden reserves. It was common practice among European companies to overprovision in good times for restructuring costs, bad debts, warranties and litigation to create hidden reserves, or what Americans like to call “cookie jar reserves”. In mediocre years, these reserves could be unlocked, either by direct reversal or by simply recognising lower expenses. For example, if a company overstates its warranty expense in one year, it can understate it in a future year. Companies did this to smooth earnings.

Although the practice of smoothing has not disappeared entirely, IFRS makes it harder for companies to engage in it. The standards clearly state that provisions cannot be recognised unless there is a legal or constructive obligation to transfer economic benefits to others in the future (for example, redundancy payments to former employees). The practice of taking provisions because something bad might happen is no longer permitted.

The continued use of conservatism, or prudence, in financial reporting provides some modest ability to create hidden reserves, but it will clearly be much harder to do this in the future. For this reason alone, we should expect to see more volatile earnings, especially in Germany where the manipulation of hidden reserves was practically a national sport.

Annual impairment reviews. Not only does IFRS require annual reviews for goodwill, but companies are also expected to subject routine, non-financial operating assets to annual reviews if there is any evidence of impairment. Any resulting loss in value must then appear in earnings. Investment property (that is, property held for investment purposes, in contrast to assets used in operating activities) must also be reported at fair value, and again any changes appear in that period’s income statement.

The same applies for biological assets, such as sheep, trees or vines. For example, paper companies have had to revalue their vast holdings of forest land. StoraEnso, a large Finnish paper company, more than doubled its shareholders’ equity because of large write-ups for its land. Future volatility will come from having to update values each year, and taking any changes straight to earnings.

Tougher rules on hedge accounting. GAAP regimes in Europe tended to give companies broad leeway in designing risk management programmes that would qualify for hedge accounting treatment. The rules under IFRS, heavily influenced by US practice, are much stricter, meaning that many positions that qualified for hedge accounting in the past no longer do so. This means that changes in fair value for such derivatives must be recognised in earnings immediately.

Previously, when these positions were classified as hedges, unrealised gains and losses were often deferred, not hitting the income statement until the positions were unwound. With fewer positions qualifying for hedge treatment, financial institutions and other heavy users of swaps, options and futures, will find their earnings whipsawed by changes in interest rates, exchange rates, commodity prices and any other factor that might influence the fair value of derivative instruments.

The expensing of share-based compensation. In contrast to national GAAPs, which required nothing more than footnote disclosures (if that) of share-based payments, such as stock option grants, IFRS requires that payments be charged at fair value over the vesting period. The use of share-based awards are common across most industries, but no more so than in the technology sector. Early reports show that, while most companies report relatively modest effects, there are several technology companies reporting charges in their first IFRS-compliant statement greater than 15 per cent of total earnings, and in some cases even higher. Future earnings volatility will come from the relatively choppy nature of option grants (in contrast to cash salaries and bonuses), and from changes in assumptions that management must make to value the options.

Increased earnings volatility means that companies must devote more attention than ever to how results are communicated to the capital markets. Special care will have to be given to isolating those elements of volatility with real consequences on cash flows, and to carefully explaining why other elements will not affect cash flows.

Where do we go from here?

While IFRS has proven to be a jolt for companies used to reporting under lenient national GAAP regimes, IFRS itself will be undergoing important changes of its own, thanks largely to a re-energised effort at convergence with US GAAP. At the time of writing, the International Accounting Standards Board, the body responsible for promulgating IFRS, and the US Financial Accounting Standards Board, have just announced that they intend to make significant progress within the next two years towards writing joint standards for 11 issues and reviewing standards in several others. Some of these issues are among the most contentious in corporate financial reporting, including pensions and business combinations. If the boards pull it off, the effects could be revolutionary, but what this means for company managers and investors is that the accounting change process has only just begun.

AUTHOR INFORMATION

S. David Young is professor of accounting and control at Insead, in Fontainebleau, France and Singapore. His research interests include corporate financial reporting, value based management, and executive compensation.

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