IFRS – A Fairy Tale Ending
Author: Terry O'Rourke
In this final article in the current series on IFRS, John McDonnell and Terry O’Rourke look at the future of IFRS from the perspective of both current IFRS users and those that may use IFRS in the future.
THE STORY SO FAR….
Once upon a time, life was very simple in the accounting world of the EU. Every year company directors prepared their accounts for the shareholders using the accounting rules set by the local standard setters. Only in some parts of the world were there regulators that examined the accounts to see if they were in order.
There followed a period of unrest and the European Commission decided that company directors would have to use the more onerous accounting rules of the International Accounting Standards Board.
At the same time, more and more accounting regulators throughout the world started to bare their teeth. As a result company directors had to be much more careful to ensure that their accounts complied with the new rules and auditors had to be equally vigilant.
2005 was a tough year for listed groups producing their first IFRS group accounts and considerable work went into transitioning from Irish GAAP to IFRS. Having gone though the process, what lies ahead for those companies and for others that may make the change to IFRS?
WHAT COMPANIES WILL HAVE TO USE IFRS?
Up to now, only the consolidated accounts of listed groups have been required to use IFRS.
The Accounting Standards Board has been actively consulting on the extent to which additional companies of various types should have to switch to IFRS. Its most recent proposal is that:
• all quoted and publicly accountable companies should use IFRS
• all subsidiaries of quoted companies should use IFRS but with a lesser degree of disclosures (as yet undefined)
• small and medium sized companies could use ‘IFRS for SME’, the alternative set of standards being developed by the IASB for this constituency.
The ASB has not yet proposed a regime for companies other than the above, and has not ruled out the option of continuing to set standards for them.
Some years ago, the ASB adopted a policy of converging with IFRS, and, in particular, of not introducing any new standards that are different to IFRS. Consequently, UK/Irish GAAP has already gone quite some distance toward convergence in a number of areas, including:
• share based payment
• financial instruments and hedge accounting
• foreign currency.
However, ASB has made the revised accounting for foreign currency and the measurement of financial instruments mandatory for only certain companies; principally those that are already engaged in the practice of fair value or mark to market accounting, and those with listed securities.
Meanwhile, the IASB project on developing an IFRS accounting regime specifically for small and medium sized companies (SME’s) is well advanced. The IASB appears to be aiming at a compendium of IFRS standards for SMEs that will be a fraction of the length of full IFRS and much less complicated. For example, the rules on accounting for financial instruments would be more straightforward, and deferred tax may be based on the “timing difference” method, rather than the complex “temporary difference” basis of IAS 12. The IASB has suggested that it is for national regulators and standard setters to make the final decision on what companies would be entitled to use this alternative IFRS regime.
The proposal for lesser disclosure in the accounts of subsidiaries would be extremely useful. Full IFRS demands substantial additional disclosures compared to Irish/UK GAAP and the effort required to draft the narrative disclosures has been considerable.
Figure 1 – Six questions for the IFRS user:
• Have we embedded reliable IFRS data capture in our systems?
• Are we ready for any new IFRS standards or interpretations?
• Are we safe from the probing of the accounting regulators?
• Are we well prepared to explain any volatility in our IFRS results to the market?
• When should we extend IFRS to the statutory accounts of all our subsidiaries?
• Are we managing to extract benefits from our use of IFRS?
Figure 2 – Four questions for the non-IFRS user
• When will we have to adopt IFRS or ASB standards that are based on IFRS?
• What areas of our accounts will be most affected?
• Will our systems and personnel be able to produce reliable numbers?
• Will the new numbers affect our tax bill or our distributable profits?
AREAS OF MAJOR CHANGE
Switching to IFRS inevitably involves a change in numbers reported by companies, and considerable effort in producing the new numbers and disclosures. The silver lining in this cloud, however, is that switching to IFRS is now well trodden ground.
As shown in Figure 3, the areas most affected tend to vary by industry. Most industries have been affected in the areas of financial instruments, derivatives, hedge accounting, deferred tax and share options. Not surprisingly, the banking and insurance sectors have been significantly affected by financial instruments accounting, giving rise to costly and time-consuming system changes. Industries that rely on intangibles, such as consumer goods and pharmaceutical, have been particularly affected in areas such as accounting for brands, other customer-related intangibles and R&D costs. Technology companies have carefully examined their customer contracts to ensure they comply with the revenue recognition rules of IFRS. Acquisitive companies across all sectors have had to identify and value the intangibles they have acquired, and to test the value of their acquired goodwill annually for impairment.
As regards the effort involved in switching to IFRS, many listed groups throughout the EU have found it quite a rough ride. As well as internal staff training, amendments to consolidation processes and data capture systems, and significant liaison with the external auditors, companies have had to ensure that the effects of IFRS were properly communicated both internally to the Board and the Audit Committee, and externally to the market.
COPING WITH REVISED STANDARDS AND INTERPRETATIONS
There are a number of pressures on the IASB to issue revised standards and interpretations, including:
• the Road-map to convergence with US GAAP, particularly in the areas identified by IASB and the US FASB where convergence could be achieved in the short-term (borrowing costs, segment reporting, income tax, impairment, joint ventures and government grants)
• ongoing requests for clarification and interpretation from preparers and users in areas of existing standards where there is not universal agreement
• |ASB’s own agenda of areas where standards could be improved, such as acquisition accounting and reporting performance.
There are also a number of standards that have already been revised but are becoming mandatory only for 2006 or 2007. For example, IFRS 7 becomes effective for 2007, and will require a greater degree of disclosure about financial instruments and related risks.
Having reached an understanding with the US FASB last February on the areas for short-term convergence, IASB announced in July that it would not make any new major standards effective before 2009. IASB plans to finalise the changes in the areas agreed for short term convergence, but to permit, rather than require, them to be adopted before 2009. This is intended to help to eliminate the need for non US SEC registrants to reconcile to US GAAP, while allowing most IFRS users a four year period of relative stability. This move by IASB has been welcomed by ICAI.
Certain industries such as insurance and leasing may well breathe a sign of relief. There is little doubt that the IASB had accounting practices in these sectors in its sights for some time, but it now looks as though they will not have to adopt revised standards on these areas before 2009.
IASB has noted that the publication of interpretations of existing IFRS standards by its interpretations committee, IFRIC, is likely to continue in the meantime. Since issuing its first interpretation in May 2004, IFRIC’s output has been quite prolific. By July 2006 it has issued ten interpretations, and currently has a raft of issues under consideration on some of which it has already issued its proposed conclusion.
Areas of particularly keen interest to IFRIC have been accounting for service concessions (on which it has a series of three exposure drafts), as well as share-based payment and employee benefits where it has addressed contentious aspects of IFRS 2 and IAS 19. The ongoing activities of IFRIC do pose a significant challenge for IFRS users as it is important that they respond to IFRIC’s pronouncements by ceasing to use any accounting practices that IFRIC deems not to be proper applications of IFRS.
IASB plans to make changes to existing IFRS standards, with mandatory effect before 2009, in only a few areas. These include accounting for puttable financial instruments, an area of keen interest to Irish investment funds. IASB is currently making significant changes to acquisition accounting, but these are not expected to be mandatory before 2009.
Given the relative long-fingering of new standards by IASB, the focus now looks set to be on achieving a more uniform and consistent application of existing IFRS among all its users.
EXTENDING IFRS TO THE WHOLE GROUP
Many listed groups in the UK and Ireland did not apply IFRS throughout the group’s statutory reporting in 2005. Among the reasons for this reticence are concerns about negative effects on distributable profits and on the corporation tax charge.
The Corporation Tax Bill may be immediately affected where IFRS increases cumulative profits, although the Finance Act 2005 allows the additional tax to be spread over five years in many cases. In addition there is the risk that the volatility of results under IFRS will add uncertainty to the amount of the tax charge.
The volatility can also pose a threat to distributable profits which are legally determined by reference to the profits shown in the accounts.
EXTRACTING THE BENEFITS OF IFRS
Among the widely touted benefits of wide use of IFRS were:
• greater comparability of accounts, particularly within the same industry
• consistency of accounting processes within multi-national groups
• greater transparency assisting with cross border transactions, such as acquisitions
• lower cost of capital.
Although it may be premature to assess the effect on cost of capital, companies can now examine whether they have extracted some of the other benefits.
Standardisation of accounting processes within groups has improved, although the reticence to use IFRS throughout groups for statutory reporting has reduced the amount of cost savings actually achieved.
There can be no doubt that comparability of reported performance through the EU has increased substantially. Indeed, investor groups have been positive about the effects of IFRS in making investment decisions. Fund managers have confirmed that IFRS has been helpful in providing a clear picture of both the operational and financial risks facing companies.
Figure 4 – Pros and cons of IFRS
Pros....................................Cons
Comparability........................Complex and complicated
Consistency .........................Costly
Cost of capital.......................Conflicting interpretations
Cross-border transactions........Causes volatility
Convergence
CONCLUDING COMMENTS
It is now timely for users of IFRS to seek to reap its benefits. This may involve a greater degree of embedding of IFRS systems to achieve more consistency of reporting by the various divisions of IFRS groups. The better comparability of reporting within industry sectors should help with cross border transactions. Finally, scrupulous compliance with IFRS and any pronouncements issued by IFRIC should help to guard against challenge by increasingly vigilant accounting regulators.
For ongoing users of Irish/UK GAAP, the influence of IFRS is already quite strong in some areas, and it looks likely that more and more companies will be required to use IFRS over the coming years.
John McDonnell and Terry O’Rourke are Partners in PricewaterhouseCoopers, Dublin.