IFRS: Is your financial reporting sustainable
Author:
John McDonnell
Companies who adopted IFRS in 2005 should not be tempted to rest on their laurels. They should first consider whether they have merely changed the numbers or whether they have managed to embed sustainable reporting, and are able to weather the challenges ahead. IFRS financial reporting needs to be core to how companies look at and think about their operations, not just an adjunct to the finance function. If IFRS does not yet permeate the decision-making and financial reporting of the organisation, companies may find themselves on the defensive in the coming months. Many of the larger companies have been proactive in communicating the impact of IFRS on their business to the market. There have not been significant market movements in share price as a result of the initial reporting. However, the evidence we have seen in the market suggests that there is not yet full acceptance of the message that the business economics are unchanged. Companies should never under-estimate the sheer difficulty, from a technical viewpoint, of getting the numbers and the process right, particularly with regard to complex issues such as hedge accounting. There will be ongoing interpretative difficulties of the present rules, and these rules will continue to undergo future changes. IFRS is a journey, not a step change. Companies, regulators, and other shareholders need to work closely together to manage this change to avoid uncertainty and damage to corporate reputation. Changes in reporting need to be properly disclosed to ensure full transparency. After years of familiarity with Irish / UK GAAP, companies, analysts and investors are looking at the numbers afresh (without the benefit of trend data) under IFRS. As companies struggle to understand and work with the complex new standards, some changes of interpretation are inevitable as the rules are embedded. It is not yet widely recognised in the market that under IFRS the threshold requiring restatement is lower; that is, while under Irish / UK GAAP, for example, only fundamental errors need to be restated, under IFRS any material error necessitates a restatement. Given that restatements were a rare occurrence under Irish/UK GAAP and usually accompanied by negative connotations, will the market be able to suspend traditional prejudices when restatements occur because of these IFRS policy or interpretation differences? Could a flurry of restatements even precipitate a wider crisis in confidence in financial reporting? Recent market experience of restatements in the US shows that they have created uncertainty and shareholder concern. Thus there is no room for complacency. The management of market expectations by companies needs to be ongoing, and those responsible for the finance function and financial reporting should anticipate that confusion over IFRS may put them under significant scrutiny. To establish credibility and demonstrate resilience, companies must have sustainable IFRS reporting embedded in their organisations, with the finance function demonstrating effective leadership, in relation to both internal and external reporting.
FROM TACTICAL TO SUSTAINABLE TO FLEXIBLE
To the outside world an organisation may well appear to be coping adequately with IFRS. In reality, some organisations are straining to cope with current IFRS challenges, not to mention those that lie ahead, not only in financial reporting but also in regulation. In truth, IFRS has been approached tactically by many organisations, albeit out of necessity due to the uncertainty surrounding the final form of the set of IFRS standards, particularly IAS 39. This is particularly relevant with regards to cash flow hedging - easy to designate relationships but proving very hard to run in practice. The short-term tactical fixes may prove unsuitable in the long run. The preparation of IFRS external reporting to date may have been largely preformed by an operationally independent project team at the centre, often staffed by contractors. There is, therefore, reduced long-term sustainability or knowledge transfer within the organisation, making it extremely difficult to effectively embed the process into ‘business as usual’. This data was more often than not produced outside the normal reporting systems, with limited knowledge transfer to ‘business as usual’ staff. This might be sufficient for a one-time snapshot of the business, but it is not what will be needed for ongoing IFRS reporting, and the monitoring and explanation of results much less for a ‘fit for purpose’ finance function going forward. Given that there are usually only one or two windows a year when significant change in finance can be readily implemented, careful planning is needed. What an organisation should seek to embed is external and internal reporting disciplines which are easily replicated period after period, in a reliable, efficient and robust manner without reliance on resources, processes and systems that can be assured in the short to medium term. Compliance with the new reporting standards must become business as usual. Organisations must also consider other challenges, such as the complex regulatory and compliance framework being introduced over the next few years through Sarbanes-Oxley and Basel II, as well as a host of International Accounting Standards Board (IASB) financial reporting improvements and research projects. The IASB has an ambitious agenda and many of the present solutions are short-term interim fixes that arose from the improvement projects. Companies must have the flexibility to change their IFRS approach to accommodate both minor and major future changes. For an organisation to cope, it will need to be moving toward a flexible approach where it is not just embedding reporting, but also embedding the ability to change. Under this scenario the necessary organisational structure, systems, data capabilities and people will need to be in place so that future changes can be factored into the activities of the finance function without undue stress. But this is easier said than done. This is a huge task for any organisation-requiring a highly effective and integrated change and development plan. It may be enough in the short term to embed the requirements of IFRS, moving on to these structural changes in due course.
OPERATIONAL RISK LOOMS LARGE
The price some organisations have paid to meet IFRS deadlines has been a deterioration in the overall robustness of the control environment, underlying processes and systems; and experience of people, as well as a reduction in overall efficiency. There has been heavy reliance on manual intervention, spreadsheets, and ‘back of envelope’ responses. There has been a singled-minded emphasis on external reporting with less emphasis on the less visible. For instance, the operational risk created by business practices, management accounting and incentivisation arrangements not being properly aligned with the new external reporting requirements is potentially significant. Furthermore, and especially for financial institutions, the knowledge and understanding of IFRS must go deeper than just the finance function. Customer relationship managers and credit analysts are now revisiting the way they interpret financial statements, and analyse ratios and covenants of customers. M&A teams and equity analysts are using the new rules to assess targets and proposed business combinations differently pre- and post- deal as the changes in relation to goodwill and intangibles take effect. Recent conversion experience has shown that the impact on distributable reserves can be significant. The skills shortage will be particularly acute in the front office, where understanding of the accounting implications for customers of their proposed ransactions, particularly in relation to derivatives and structured products, will be key.
HOW TO EMBED SUSTAINABLE REPORTING
The challenge for finance functions seeking to make themselves ‘fit for purpose’ requires careful scrutiny of six key enablers: 1 Processes; 2 Controls; 3 Organisational structure; 4 Data systems/technology; 5 People capability; and 6 Planning strategy.
IFRS can be embedded within a broader process improvement strategy, and the sustainability of financial reporting can, of course, be improved incrementally. The focus should be maintained on immediate deliverables, whilst seizing each opportunity for greater effectiveness, efficiency and control, and also building in the capacity for the future developments. Some examples of where effective IFRS change can or should be facilitated include: 1. Reporting needs to be timely and accurate, with minimum human intervention. Reporting disciplines need to be able to cope with increased data collection analysis and disclosure. Technologies like XBRL may be useful to eliminate communication difficulties and duplication between systems.
2. Controls and procedures need to be reviewed to ensure they remain appropriate, with the right policies and procedures in place. These need to be seen to be supported by management. Accounting manuals throughout the organisation are needed to help IFRS be understood and implemented in a consistent way. Where appropriate these should also be Sarbanes-Oxley complaint, a process much easier to do whilst the controls are being put in place. 3. Certain areas of IFRS, for example effective interest rate calculations, fair valuation of derivatives and hedging, create or change intangible assets and liabilities. Therefore companies need to ensure they have rigorous and robust validation procedures in place to establish balances. In addition, controls over such balances must be developed given that as they do not easily lend themselves to traditional controls, such as reconciliation to third party information. They must also be able to explain their volatility, particularly if they use cash flow hedging. Skilled resources are in short supply in the market - a good training regime is a way to mitigate some of the risk.
4. On the people side, specific work needs to be done to motivate personnel to embrace, instead of feel excluded by or from, IFRS. This needs to be built into training, development and reward structures. Critically, resources must be made available for change implementation. Training and updates are the norm, but IFRS needs to be used when and where business is booked, not in a remote central finance function. All of the management, not just those in finance, need to be aware of the requirements of IFRS and their associated implications.
It is entirely possible to implement this sort of finance change, but it does require significant investment of time, resources & commitment.
Experience suggests that the critical success factors include:
1. A clear and sustainable vision at the outset, with the business units included in the design;
2. Genuine executive sponsorship, particularly asserting leadership on priorities and ways to improve controls;
3. Effective, simple governance and programme methodology without bureaucracy;
4. A programme which 'fits' the organisation and addresses culture and behavioural issues, rather than dictating from the centre;
5. Manage accountability by getting those responsible involved early on, and using consultants and contractors appropriately;
6. Not over promising - for the most part this is tactical, not transformational, change; and
7. An effective internal and external communications programme explaining the impact of IFRS on business practices and performance measures.
Companies that are not being required to explicitly adopt IFRS as a result of being publicly listed, may find that regulators, competitors or other stakeholders initiate such a change. In other cases, the adoption of IFRS will result from convergence of Irish / UK GAAP with IFRS. In any event, the only certainty for financial reporting in the coming years is that it will be a time of continuous change. To thrive and succeed in such an environment will require the embedding of sustainable reporting infrastructure, in the finance function and throughout the organisation. Furthermore, as IFRS is amended and re-interpreted, the finance function must have the flexibility and capability to take this in its stride, and exude confidence to the organisation and the market.
John McDonnell is IFRS Services Partner with PricewaterhouseCoopers