Does Europe’s accounts overhaul add up?

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Like the "Y2K" conversion of computer systems for the turn of the millennium, the impending adoption by the European Union of international accounting standards is a hugely ambitious project whose success or failure cannot be judged until it "goes live" in six weeks' time. But it will be a minor miracle if everything goes as smoothly from January 1 2005 as it did on January 1 2000.

More than 7,000 listed companies in the EU will have to move from a patchwork of national accounting regulations and publish their accounts according to standards set by the International Accounting Standards Board (IASB). The potential for confusion is immense.

Even in the UK, one of the least affected countries, the Financial Services Authority has acknowledged the transitional problem by allowing companies an extra 30 days to prepare their interim accounts next year. Frits Bolkestein, the EU financial services commissioner, has predicted that businesses face up to two years of confusion as international financial reporting standards (IFRS) are implemented.

Will it be worth it? Yes, say those who believe that extra disclosure and improved comparability will help investors identify the best homes for their capital. Multinational companies, which will have fewer different sets of rules to comply with, agree. No, say those who believe the public accounts have become too technical, too far removed from everyday business practice and too difficult to understand.

The EU's decision to insist that all publicly quoted companies use common accounting standards is meant to improve competitiveness and assist cross-border investment. More transparent accounts should reduce investment risk and lower the cost of capital for businesses.

In global terms, having the EU on board is a boost for the movement towards one set of standards. Standard setters are already working to achieve convergence between IFRS and US generally accepted accounting principles (see below). For multinational companies with US-listed stock, this would be the biggest prize in terms of cutting tedious reconciliations between one set of accounts and another.

But Sir David Tweedie, chairman of the IASB and a veteran standards-setter from the UK,underestimated the potential for political interference once businesses started lobbying.

One standard, known as IAS39 and used to show the impact of derivatives on accounts, has been seriously compromised by objections, notably from French banks. They dislike the way traditional hedging practices are excluded from the hedge accounting definitions. As a result, the European parliament has bowed to business pressure and allowed "carve-outs", or exemptions, from the mark-to-market requirements. The ability to compare companies across borders has been diluted and a dangerous precedent has been set that political pressure can force changes to standards that are supposed to be set independently.

Some believe that more domestically oriented European companies - and some governments - would not be unhappy to see a European set of standards, rather than IFRS. After all, most of the 7,000 companies concerned do not have securities listed in the US and so are less motivated by convergence.

Companies have started to tell the markets what the changes will mean. The impact varies from sector to sector and country to country: technology companies, for example, have been big users of stock options and so will be hit by the need to treat them as expenses - one of the standards being adopted.

AstraZeneca, the international drugs company with headquarters in the UK, has provided a breakdown of the pluses and minuses that result from switching its 2003 accounts to the new standards. There are no bombshells but plenty of pointers to the standards with the most impact. These include: stock options expensing - a $136m extra cost - and the abolition of goodwill amortisation (under the new standard on "business combinations" - mergers and acquisitions) - a $59m gain.

But while the overall effect on AstraZeneca's $4bn of operating profits is not significant, Jon Symonds, its chief financial officer, stresses that the change is not just a technical accounting exercise. It has prompted management to review practices: "We, like many other companies, are looking at the value we get from the share option programme," he says.

Other companies will see much bigger swings in their numbers. Vodafone, the British mobile phone group, hit the headlines in 2002 with a pre-tax loss of £13.5bn, a UK record. But that included a goodwill amortisation charge of similar proportions related to its acquisition of Mannesmann. Such a loss would not have happened under the new standards, which say that goodwill should be left on the balance sheet and subjected to an annual "impairment test", based on forecast cashflows, to check whether the valuation holds up.

Last year Vodafone's amortisation charges amounted to about £15bn. Remove them and its operating profits swing from minus £8.9bn to plus £6bn. (The changes have no impact on cashflow and analysts and investors had in any case largely disregarded the amortisation charges.)

It was the potential impact of IAS39 on valuing financial instruments that most perturbed banks and insurers. French banks have led the protests against this standard. Gilles de Margerie, chief financial officer of Crédit Agricole, says banks hedge interest rate risk on the basis that 80 per cent of deposits are "core" and so will not be withdrawn overnight. But this does not qualify under IAS 39 as an effective hedge and so unaccustomed volatility would have been introduced into the accounts.

Hence the fuss and the resulting carve-outs. Exceptions for one group, however, make life difficult for another. Danes complain that the carve-outs cut across their "fair value" - or mark-to-market - accounting method for mortgage bonds. The UK's Accounting Standards Board has urged compliance by British companies with the unexpurgated version of IAS39.

Meanwhile accounting standards related to the building and operation of infrastructure, such as roads, will affect construction companies.These projects involve big upfront spending with revenues due over future decades. Loyola de Palacio, the outgoing European transport commissioner, wrote to the Financial Times last month complaining that "enormous accounting losses in the first years of exploitation . . . will limit the interest of entrepreneurs' and financiers' groups in this type of activity."

Academic considerations, she contends, "may be taking priority over the realities". This negative view of standard-setting has gained ground in continental Europe, fuelled by disagreements over IAS 39 and suspicion of Anglo-American dominance (see right).

The question after all the effort and controversy is whether the resultant accounts will be understandable, relevant, reliable and comparable.

The easy bit is comparability - which, in spite of the concerns over IAS 39, will be improved along with transparency. The adoption by European companies of IFRS will shine a light on such opaque areas as their provisions, off-balance sheet vehicles, use of financial instruments and segmental performance.

Pat McConnell, senior managing director at Bear Stearns in New York, says that it will be "easier to compare European companies across an industry or sector". She also sees less work for companies in reconciling their numbers with US GAAP. "It may not be necessary for the SEC [Securities and Exchange Commission] to actually rescind the reconciliation requirement. Over time, it will simply become [irrelevant]," she says.

It is in the other three areas - ease of understanding, relevance and reliability - that there is more argument.

Even senior accountants are unsure of whether the new standards will produce more easily understandable accounts. Kieran Poynter, UK chairman of PricewaterhouseCoopers, the world's biggest accounting firm, said recently: "The regulatory reporting model has been driven by technicians for far too long . . . I am not convinced that, despite the volume of information which is reported, the financial reporting model is actually doing its job of communicating financial performance all that well."

Sir David counters that complications are the result of making exceptions to the principles on which standards are based. IAS39 could be written in one line, he declares: mark the instruments to market. "It's the same with leases: put them all on the balance sheet. The tougher the standard, the less complex it is," Sir David says. It is accountants, he says, who clamour for lots of interpretation.

As for the views of investors, Iain Richards, head of governance at Morley Fund Management, a leading UK institution, says the standards will mean "greater honesty and clarity" from companies. "Accounting standards do not create problems, they may reveal those that are there anyway," he says.

What of reliability and relevance? These two desirable aspects of financial statements can be contradictory: the historic cost of an asset is a reliable number but its relevance is debatable. Graham Ward, president of the International Federation of Accountants, says using the historic cost of an asset is like describing him as being 18 inches tall and weighing 5kg.

"Fair value" accounting, using current market values, is about using up-to-date values for items in a set of accounts. Take stock options: they have a value and not to recognise that would be misleading, Mr Ward says.

But market values do not mix well with historic values. And a requirement to mark to market disturbs some companies because it can make accounts more volatile. Managements - at French banks, for instance - are reluctant to give up techniques that help them "smooth" earnings from one year to another. Their assumption is that users of accounts prefer smoothed outcomes. Companies also question the relevance of showing gyrations in the value of an asset or liability intended to be held to maturity.

Those who want to see these calculations, however, say it enables them to ask some important questions: what happens if the item has to be liquidated early? What is a company's exposure to volatile price movements? If an asset has shot up in value, should it be sold?

As for smoothing the accounts, that was one of the motives that led Fannie Mae, the US mortgage finance provider, allegedly to flout FAS 133, the US equivalent of IAS 39. According to Fannie's regulator, smoothing became manipulation of earnings - to which executive bonuses were related. Fannie has had to beef up its capital base because of the additional risk exposed.

The knock-on effects of IFRS on capital requirements and banking covenants are unclear: it depends whether regulators are bothered by what is revealed. This is the sort of issue that makes companies nervous.

The heated nature of the debate would not matter so much if the standards to be introduced on January 1 were the end of the process. In many ways they are only t he beginning.

Renewing other standards on leasing and pensions are on the IASB's "to do" list. There needs to be fuller debate on the role of fair value in accounts and the extent to which value changes are realised as profits or losses.

At the heart of such arguments is the question of the best measure of a company's performance. Is it earnings per share - based on operating income, expenses and financing costs? Or is it "comprehensive income", including all the company's gains and losses during the period?

Many users already adopt an eclectic approach: dismantling and reassembling the information in a company's accounts according to their differing purposes. That information is continually evolving as standards are changed or created to show up hidden areas of activity and keep abreast of business practice.

AstraZeneca's Mr Symonds says: "All we have achieved is first base . . . if it is so difficult to get to this point, how will we deal with more controversial areas?"

Convergence plan revives controversies

Amid the controversy surrounding the European Union’s adoption of international accounting standards it is easy to forget that more than 90 countries will either require or permit their use from next year.

Australia and Norway will soon be among those adopting six new international financial reporting standards (IFRS) - denoting either a new standard or one that has been fundamentally reworked - and 32 existing standards known as IAS. The International Accounting Standards Board (IASB) has been involved in drawing up or revising both.

IFRS will gradually replace many existing standards. Those to be replaced include the infamous IAS39 on financial instruments such as derivatives, which caused a breach between the IASB and the European Commission after complaints from banks in continental Europe.

The project to impose a set of standards across the European Union by 2005 became EU law in 2002 but the work of the IASB and its predecessors goes back more than 30 years.

The aim of convergence between the internationally used standards and US generally accepted accounting principles (GAAP) was given impetus in 2002 when Robert Herz, British-trained and a senior partner with PwC in the US, became chairman of the Financial Accounting Standards Board, the US standard-setter.

The immediate target is that by 2007 the IASB and FASB should reduce the need for companies to reconcile differing sets of accounts. More fundamentally, the two now have a joint programme to work on future standards. In Europe the work of the IASB has stirred controversies and run into opposition from some business sectors and policymakers.

One old disagreement is that between “principles-based” standards, which leave more to the judgment of companies and auditors, and the more prescriptive and complex “rules-based” US system. Convergence has heightened fears within Europe that this will lead to the import of prescriptive US standards.

Another long-running controversy is over the trend towards “fair value” accounting: the use of market values rather than historic cost to account for assets and liabilities. Marking to market produces a running score card of paper gains and losses.

Fair value accounting is unpalatable for some European constituencies, notably banks and insurers. It has sparked accusations that the standard setters are out of touch with real business practice.

Other friction has been caused by the composition of the IASB. Eight board members are British or North American, with one each from Australia and South Africa - countries that also have Anglo-Saxon accounting traditions. There is one board member from Japan and only three from the rest of Europe.

One of IASB’s main aims has been to produce accounts that help investors to make decisions. Much of continental Europe has been at a disadvantage in this process because of its shorter history of setting standards aimed at capital markets rather than lenders and tax authorities.

Coupled with the IASB’s tardiness in consulting widely in Europe, a perception has grown that the board has taken insufficient account of differing national practices.

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