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Jane Fuller, the FT’s Senior Financial Writer, responds to readers’ questions on the implications of new international accounting standards.
From Matthew Gill, resident of Hextable in Kent:
I understand that British Airways has a large pension deficit. What effects will the new standards have on its balance sheet and P&L and its ability to pay future dividends?
British Airways, like other quoted companies with a large defined benefit pension scheme, has a considerable amount of information about its pension liabilities in its annual report, which you can find on its website.
Its two pension schemes had a deficit of almost £1bn under it latest three-year actuarial valuation, requiring an extra £133m a year in contributions. This takes the total annual contribution to £250m. The aim is to close the deficit over 10 years. (Both of BA’s defined benefit pension schemes, where benefits are linked to final salaries, are closed to new members.)
Under the FRS 17 accounting standard, which is similar to the international standard IAS 19, the deficit at the March 31 year-end would have been £1.69bn, or £1.16bn after a tax credit and other provisions.
If brought on to the balance sheet, the net pension liability would have almost halved BA’s net assets to £1.26bn. BA, which had net debt of £3.29bn at the end of September (half its peak level), has not paid a dividend since 2002 because of its need to conserve cash.
The board intends to resume payouts, but there is no timeframe. Factors likely to influence this include a continued improvement in profitability, despite the headwind of high fuel costs, and further debt reduction.
Your question touches on some interesting general issues surrounding accounting standards and dividend payments. Dividends are payable out of distributable reserves. The most important of these is the profit and loss reserve. In the case of companies like BA, with large legacy pension funds, the deficit may wipe out these accumulated profits.
But the law refers to distributable reserves at the company level, not the group, whose consolidated accounts are presented to investors for information purposes. So a dividend may be paid out of the distributable reserves of the company.
Companies that want to pay a dividend but have no P&L reserves can reconstruct that part of the balance sheet by tapping into other reserves such as the share premium account.
These matters are governed by company law, not accounting standards. But the interplay between the two is important. Indeed, the review of company law in the UK is looking at whether distributable reserves is the best determinant of capacity to pay a dividend.
The international pensions standard is, in any case, not set in concrete. Companies will be able to choose whether to spread deficits or surpluses forward over the estimated average working life of members, or take it through to reserves as one hit. And will that route be via the profit and loss account, or the separate statement of recognised gains and losses?
One of the biggest debates on performance reporting is whether changes in valuations of assets/liabilities should be taken through the P&L. Snapshot valuations of the pension fund are a good example of the problem because of the fund’s long-term nature and differing ways of calculating the gap.
From Ivan Grixti, lecturer in Financial Accounting at the University of Malta:
1. Since 1995 Malta has adopted International Financial Reporting Standards (IFRS) as the norm and has even entrenched them into our Companies Act. They are, therefore, obligatory both for listed and non-listed companies. Do you think that there will be a level playing field amongst EU-member states?
The playing field will be much more level than it is now because it will be so much easier to compare company accounts. However, the response to the European Commission’s “carve-outs” on IAS 39 means that there will be a variety of ways of applying this standard on financial instruments within the European Union, which will mar comparability.
Elsewhere, and there are about 70 countries outside the EU that have been or will soon be using international standards, the full standard will apply. It is also worth remembering that the unexpurgated version of IAS 39 is similar to FAS 133 in the US, so those applying the full version will have accounts that are easier for American investors to understand.
It is to be hoped that companies providing the best transparency on their exposure to derivatives will be given credit for it by investors.
A more general caveat is that all the standards must be implemented in a consistent way. The International Financial Reporting Interpretations Committee, as its name suggests, has its work cut out to provide guidance. But policing of companies’ compliance with standards tends to be done on a national level.
2. Those who have been reading a lot about IFRSs know that there will be a certain degree of volatility. We are also aware that most financial analysts, let alone the common investors, are not aware of this issue and its implications. Do you feel that shareholder societies or government agencies should be conducting some sort of educational campaign directed towards this issue?
I think knowledge of IFRS is wider than you suggest. Companies have started to explain the changes and will have to do so alongside their 2005 results announcements. Analysts at investment banks such as UBS are bringing out extensive notes on the subject. Investment institutions with a research capability are doing their own homework.
But there will still be some surprises. These will occur with numbers that are revealed for the first time. Even something as simple as a segmental breakdown might show that a company is making more money than was thought in one arm of the business and less in another. The onus will be on the companies to explain what is happening.
You are also right to say that increased transparency might reveal more volatility in the numbers, which will make a company look more risky. This is part of the process of “telling it how it is”, as Sir David Tweedie, head of the International Accounting Standards Board, would say. It prevents companies from presenting something as smooth and predictable when it is not.
If the surprises are not unpleasant and are simply revealing what was always there, it should reduce investment risk. This would lower the cost of capital.
For companies that have been hiding bad news, or keeping important economic interests - such as pension fund deficits - off the balance sheet, there will be an uncomfortable period of readjustment.
The difficulty for users of accounts is in judging how important the new information is, particularly if it involves unrealised gains or losses in the market values of long-term assets or liabilities. Evidence that investors can shrug off paper losses was evident at Vodafone, where goodwill amortisation charges related to acquisitions ran into billions of pounds.
From Christos Papachristouh:
What about the non-listed EU companies? Will they follow one way or another?
The requirement to use IFRS applies to publicly traded companies, of which there are more than 7,000. Outside the main stockmarkets, use of IFRS will depend on listing rules, or it may be optional. Aim, the UK’s alternative investment market, plans to bring it in 2006.
The IASB expects thousands of unlisted companies also to adopt IFRS, depending on national rules. It also has a project to develop simplified standards for small and medium-sized companies. It is to be hoped that some of this simplification work will be retrofitted to the existing standards.
Leaving aside the issue of compulsion, under national or EU law, or market listing rules, smaller companies may choose to follow IFRS standards. If they intend to sell shares to the public in the future, this would help prepare them.
Don’t forget that many of these companies have simpler operations than their larger counterparts. They will not be making the same use of derivatives or off-balance sheet financing, for instance. If a company’s operations are straightforward and they are not under pressure to manage their earnings, the task of implementing accounting standards is easier.
Companies that adopt the standards will be easier to understand for a variety of users. Equity investors can be regarded as the defining users because if they have sufficient information, so will most others. The framework for the standards also refers to employees, lenders, suppliers, customers, governments and the public as users.
Of course, for unlisted companies the accounts will be less accessible and the implementation of the standards will be less well policed. Companies sometimes claim they are following international standards but do not fully obey them. The credibility of what is shown is an important issue.
From Christophe Kasolowsky:
How prepared is the analyst community for interpreting IFRS financials correctly, in particular financials from banks which have been heavily impacted by IAS39?
First, I refer you to an article by my colleagues Kevin Allison, Deborah Hargreaves and Henry Tricks, published on November 16. It reported on a survey conducted by KPMG, the accounting firm. Here is an extract:
“Nearly half the City’s financial analysts are unprepared for the introduction of International Financial Reporting Standards next year, raising fears of market instability, KPMG has found.
Mark Vaessen, head of KPMG’s global IFRS team, said: “With 2005 nearly upon us, there is a real concern that the analysts don’t feel equipped to understand the changes brought about by IFRS and how they will relate to the financial reports of the companies they track.”
The big four accountancy firm surveyed 100 buy-and-sell-side investment analysts about their level of readiness for the EU-wide accounting reforms, and 53 per cent thought they would have an impact on the value of company share that was not yet reflected in the price.
About 40 per cent rated their knowledge of IFRS as poor. Only 8 per cent said they knew a lot about it.
Analysts found the companies they tracked were more than twice as helpful in preparing them for the new regime as their employers. More than two-thirds had not received any training.”
This could be a glass half empty/glass half full result. At this stage no-one can claim to be fully prepared. It will take at least a year for companies to work through all the consequences and for auditors, helped by the work of IFRIC, to settle on correct interpretations of all the standards. And judgment will always be involved, especially if the system manages to remain principles based, avoiding too much detailed and prescriptive guidance.
The challenge should help sort good research teams from bad. UBS, for instance, has been in the vanguard of work identifying what the impact will be on companies from different countries and in different sectors. Other investment banks with IFRS experts include Morgan Stanley and JP Morgan.
On banks, it will continue to be difficult to compare them across borders because of the varied implementation of IAS 39. But the move to the new standards will reveal useful information - there was no standard covering derivatives before.
Within the UK, CSFB has predicted that Northern Rock’s profits will be reduced by 10 per cent, while HBOS and Alliance and Leicester could see them rise by a similar amount.
From James Adams:
The IASB has announced the composition of an international working group. I noticed there are no members from China. They have a couple of members on the SAC, but they don’t currently have what would seem like adequate representation on any of the associated committees or boards. Could this be expected to cause any difficulty in Chinese corporate compliance?
China has a policy of pursuing convergence with IFRS. It may gain representation through changes proposed to the constitution of the International Accounting Standards Committee Foundation. These were published on November 23 and the consultation period lasts until February 23.
Among the proposals were that the number of trustees of the foundation be increased from 19 to 22. This would comprise six from North America, six from Europe, six (up from four) from Asia/Oceania (changed from Asia/Pacific to make clear that American countries on the Pacific are excluded), and four (up from three) from any area. The changes offer more opportunities to Asia including China.
The IASB will still have 12 full-time and two part-time members. While the emphasis on technical expertise has been reduced, members must have professional competence and practical expertise. This opens the door a bit further to those not steeped in capital markets-based standards-setting traditions, but the bar remains high to those from other backgrounds. The board does liaise with national standards setters, which provides an opportunity for input.
The Standards Advisory Council has at least 30 members from diverse geographical and professional backgrounds which, as you mention, gives more scope for Chinese representation.
You are right to link a country’s feeling of involvement with the project to its enthusiasm for adopting IFRS. One reason for some European disenchantment is that continental countries have seen the IASB as being dominated by Britons and Americans.
The IASB’s consultation process was also found wanting. It has been improved and further progress should also be made through the constitutional changes.
From John MacAyeal:
Now that Bermuda seems to be tightening standards, where might companies be fleeing for lax standards?
Sorry, I’m not going to answer that directly. But here are a few observations: There will always be varied regulatory regimes and off-shore centres, such as Bermuda, have attractions for certain business activities because they are more lightly taxed and regulated.
The main reason that most of these “havens” have been tightening up on what goes on under their regimes is the international effort to combat money laundering. Market forces are also at work. If they have a reputation for attracting shady businesses that simply want to dodge taxes and laws, they might prove unattractive to legitimate organisations worried about reputational risk.
Motives for “regime shopping” vary and not all of them are dubious. In the US, many companies incorporate in Delaware because it is perceived to have the most business (or management) friendly regulation eg on “poison pill” protection against hostile bids. Royal Dutch Shell’s plans finally to unite the British and Dutch parts of the business represent a very clever picking of whichever of the two countries’ regimes best suits the business. Shell has gone for a primary listing in London, for instance, and will fall under the UK Combined Code on corporate governance. Hence, its switch from a dual board structure to a unitary one.
In the US, the Sarbanes-Oxley Act has brought in draconian requirements for companies to reform and document their internal financial controls. The time and expense involved in this has led some foreign issuers to wish they had never listed there. Backing out is difficult and, in any case, begs a question about their reasons for wanting to avoid tough regulation.
In the same way as you can tell a lot about a person by the company he or she keeps, an investor can tell a lot about a company by the regulatory regimes it submits itself to.
One last point. It is not just the rules that matter but the enforcement of those rules. Some countries allow companies to choose to report under IFRS but do not enforce it strictly. Companies given that degree of latitude might claim to report under IFRS but actually follow the standards selectively. And how good and independent is the auditing profession in that country? The question of form, or public relations, over verified content will never go away.
Email Jane Fuller:firstname.lastname@example.org
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