Attitude of Unlisted Companies Towards IFRS
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SECTION I - INTRODUCTION
The adoption of international financial reporting standards across the European Union from 1st January 2005 is one of the biggest events in the accounting history. This is especially important after the capital markets were rocked by some big accounting frauds in recent years. In the first phase, 7000-plus listed European companies will have to implement new financial reporting standards from January 2005 (Fuller, Jan 2005).
When European Union moved towards one market across Europe, it faced the prospect of different financial reporting regimes across EU participants. To achieve true scale of financial integration, it has become necessary to adopt common financial reporting standards.
In June 2002, the European Commission adopted a regulation requiring all listed EU companies in regulated markets to prepare their financial statements in accordance with International Accounting Standards (IAS) or International Financial Reporting Standards (IFRS). The regulation is applicable only on consolidated accounts and companies are free to choose their national GAAPs for subsidiaries and associate companies. The regulation came into force from January 2005.
Companies Act 1985 governs the use of UK GAAP by UK based companies. Similarly other EU states have their own laws for accounting standards. The EU states have now modified their national laws to include IFRS regulation to offer a common financial reporting standard. Companies Act 1985 (International Accounting Standards and Other Accounting Amendments) Regulations 2004 has extended the application, on a non-compulsory basis, of the EU IFRS regulation to all non-charitable organisations.
In the last quarter of previous century, the world economies have moved towards globalisation. Multinational companies are manufacturing and selling across the world and many of these firms are listed at foreign stock exchanges. Globalisation of markets and establishment of multinationals led to increased desire and awareness about international markets. This was soon followed by globalisation of financial markets which increased the value of understanding of international financial results and reporting formats. Rapid improvement in communication technologies and easy access through internet has further spread the profile of international investor. Now a day international investors are not limited to some portfolio managers in big banks. International investors are now as diverse as sophisticated equity manager to a small investor in a remote town. Investors too have diversified their portfolio by international equities and bonds. This rapid globalisation has fuelled the desire to have common international standards that could be understood and followed across nations.
The ever increasing network of investors has not only opened new financing sources to countries, it has also put some pressure on the financial regulatory authorities to design and improve their financial reporting systems in a manner that is easily understood by wider audiences.
The regulatory authorities have on one hand evolve the financial reporting system to match the ever increasing demands of international investors and on the other hand make sure that companies in their countries are not faced with sudden increase in time, resources and knowledge needed to cope with new regulations.
In 1973, 9 countries included UK formed International Accounting Standards Committee (IASC) with an aim to develop common accounting standards. The membership has now grown well over hundred countries with each country, especially bigger economies, bringing in their own perspectives of accounting standards. IASC had to deal with accounting conflictions in coming up with common acceptable accounting standards.
One would immediately think whether IASC has been successful in resolving all the conflicts with all member countries and the answer would easily be no. To fully satisfy more than hundred accounting bodies from across the world is almost an impossible task. Yet IASC has done a commendable job and from 1 January 2005, International Accounting Standards (IAS) or International Financial Reporting Standards (IFRS) is applicable in more than 90 countries. In EU, IFRS is compulsory only for listed companies.
The standards that UK listed companies will follow are not those issued directly by the International Accounting Standards Board, but are those that have been endorsed by the European Commission. EU has now endorsed IFRS, except for IFRS 6 and some of the IFRIC interpretations, and some changes in IAS 39 relating to the fair value of financial instruments (PwC, 2005a).
While the EU regulation is only enforceable on listed companies, it also says that a member state has an option to extend the use of IFRS to unlisted companies within their jurisdiction. Department of Trade and Industry (DTI), the government trade body responsible for company regulation in UK, has said that while there is no mandatory move to IFRS for unlisted companies, the unlisted companies would still be allowed to adopt IFRS over UK GAAP from 2005 onwards.
The basic aim of new financial reporting standards is same as that of existing standards – to provide information about financial performance and position of a company to different stakeholders. Internal stakeholders – management – normally have a good grip of what’s going in the business. It is external stakeholders like investors, auditors, suppliers and creditors who need to be informed in a succinct and clear manner about financial implications of business decisions.
The IFRS would aim to present a more complete picture of a business by making operating income a more encompassing number. As an example, the financial implications of stock options were kept out of income statements. Companies merely mentioned the number of stock options granted. But now onwards, companies will have to incorporate the fair costs of granting stock options in their income statements. This will allow investors to assess the true costs of executive remuneration.
Though the overall aim is same, the differences in implementation and financial reporting do occur due to social, economic and political backgrounds of different nations.
Will it be a good policy to allow two different accounting standards in UK – one standard for listed companies and another for unlisted companies. UK’s Accounting Standard Board clearly sees there is no merit in having two separate standards. ASB issued a Discussion Paper in March 2004 highlighting its strategy for convergence with IAS and says that convergence of UK accounting standards to IAS is a foregone conclusion. It has already introduced many changes in recent past to bring UK’s GAAP in line with IFRS.
Smaller companies, even listed ones, will find it difficult to cope with extra work due to IFRS. Alternative Investment Market (AIM) realises that most of its companies won’t be in a position to meet IFRS requirements soon. So it changed its regulatory status in October 2004 and is now an “exchange regulated market” and out of purview of European Commission regulation on regulated markets. Now companies listed on AIM have time until January 2007 to implement IFRS.
Accounting Standards Board is also sensitive to the needs placed on business in making a transition from UK accounting standards to IFRS. Big businesses probably have sufficient resources to cope with the change in one year. But the smaller businesses will find it difficult to make all required changes in one year. ASB has proposed a series of changes that would be implemented in 2005 and 2006 which will bring UK financial reporting standards more in line with IFRS. Thereafter ASB will carry out a series of step changes by replacing one or more UK standards. So by the end of 2005-2006, UK standards will almost be in line with IFRS and unlisted companies transition to IFRS in 2007 would be smooth.
This research analyses the attitude of unlisted companies towards IFRS. Many research and surveys have been carried out on the acceptance and readiness of listed companies for transition to IFRS. But the issue has not been explored in depth with respect to unlisted companies.
The research is based on primary and secondary data. Primary data is collected via interviews and questionnaires with companies and their auditors. A total of  interviews –  with companies and  with their auditors – were conducted to obtain primary data.  questionnaire responses by postal survey were also analysed.
The results show that there is definitely a much scope in improving International Financial Reporting Standards for unlisted companies. Respondents were concerned about the costs associated with transition to IFRS and also the additional burden that will come with regular enhanced reporting. That IFRS will help in globalisation of capital markets and probably cheaper costs of capital is not of much significance for unlisted companies registered in UK.
This research would be useful for institutes and associations framing accounting standards for unlisted companies. Mostly accounting standards have been framed with an eye for listed and large companies. But unlisted companies have much lesser resources to spend on large regulatory requirements and hence should have different reporting requirements that match the benefits obtained from such reporting.
The time limitation and resource constraint mean that the primary data via interviews and questionnaire surveys could only be collected through a limited number of respondents. It would be useful to cover a larger data base before implementing the changes. Also more users of data in unlisted companies like banks and creditors should be contacted before policy formulation.
The remaining paper is divided in the following sections. Section II is a literature review on justification and applicability of IFRS, and state of readiness in companies. Section III discusses the methodology used in this research. Section IV covers analysis of data obtained through the primary data collection and its interpretation. The paper concludes with section V.
SECTION II - LITERATURE REVIEW
In June 2000, the European Commission proposed a new directive requiring that all publicly traded companies in the member states to adopt International Accounting Standards Board (IASB) standards by no later than January 2005. On 19 July 2002, the European Parliament and the Council approved the IAS regulation (EC) 1606/2002 which said ‘For each financial year starting on or after 1 January 2005, companies governed by the law of a Member State shall prepare their consolidated accounts in conformity with the international accounting standards adopted … if, at their balance sheet date, their securities are admitted to trading on a regulated market of any Member State’ (EU, 2002).
Rationale for EU’s adoption of International Financial Reporting Standards
The main aim of International Financial reporting Standards is to bring convergence among different national financial reporting standards. Over time, the evolution of different national financial reporting standards has been influenced by local social, political and economic environments. Some of the major reasons for differences in accounting standards are:
- Political – Capitalist or Communist. Capitalist and communist countries have almost contrasting fundamental economic approach and their accounting standards reflect the same.
- Stage of economic development. Developed countries generally have better accounting standards in terms of transparency and clarity.
- Corporate finance – debt or equity. Companies in continental Europe are financed more by debt than the companies in UK. Accounting standards have over time evolved to reflect the importance placed by different sources of financing on different aspects of financial statements.
- Legal and taxation systems.
Convergence will help investors and analysts to compare companies across borders in a better way. But it also implies that either member countries will lose their independence to make national accounting standards that reflect local economic conditions or if they start introducing some changes, IFRS may slowly lose its main strength of common standard. Local, political and economical conditions may force national accounting bodies to introduce variations in IFRS. EU has already introduced some changes in the IAS 39 dealing with financial instruments. It is beyond the scope of this research to see which member countries have introduced variations in IFRS.
Convergence between UK GAAP and IFRS
ASB has declared its intention to converge UK GAAP with IFRS. It has issued a number of new standards in December 2004 to speed up the convergence of UK GAAP with IFRS. So sooner, even unlisted companies would be following a substantial portion of IFRS due to this convergence.
Comparison of UK GAAP and IFRS
The ultimate goal of UK GAAP and IFRS is same – to present information about financial performance and position to all concerned stakeholders. If the aim is same, then should be the main approach adopted by both accounting standards.
The UK’s Accounting Standard Board’s Statement of Principles for Financial Reporting is a vital contributor at macro level standard setting. It plays almost same role as International Accounting Standards Committee’s ‘Framework for the Preparation and Presentation of Financial Statements’. ‘It is a description of the fundamental approach that the Accounting Standards Board (ASB) believes should, in principle, underpin the financial statements of profit-oriented entities’ (ASB, 1999). The Statement of Principles has true and fair concept at its core, much like the focal point in International Accounting Standards. Also like IAS, Statement of Principles insists on financial information being relevant and comparable.
It is beyond the scope of this research to highlight each and every similarity between UK GAAP and IAS.
Though the overall aim is same, the differences in implementation and financial reporting do occur due to social, economic and political backgrounds of different nations.
Main concepts behind UK GAAP and IFRS are same, but when we look at micro level, we see many differences at the individual standards level. Following are the main differences between UK GAAP and IFRS:
- The Statement of Principles allows use of both historical cost and current value approaches in measuring balance sheet categories. The dual use of historical and current value methods is known as modified historical cost basis (ASB, 1999). Under historical cost, the carrying values of assets and liabilities are stated at the lower of cost and recoverable amount. This approach is more conservative as compared to IAS approach which uses fair value method. Also the choice of historical or current value method is based on subjective analysis of a company’s management and hence it is open to some manipulation.
- Fair value. If we look at global level, both UK GAAP and IFRS have adopted fair value method as the foundation of their accounting standards. IFRS takes fair value adoption even higher when it says that income statement will include the changes in the fair value of items that have not been yet traded like derivatives. The emphasis in new accounting standards is on mark-to-market fair value of assets and liabilities rather than on actual market price based fair values. Now both realised and unrealised changes in fair values would be incorporated in income statements. The first year of transition will see high volatility in earnings and balance sheet statements. Though this brings higher volatility, it will also test the management skills in proper presentation and explanation of changes. It may also change the benchmarks of success for managements.
- Acquisitions. Acquisition accounting will change under new accounting standards. Under UK GAAP, companies can choose between purchase and merger accounting. Under IFRS, companies will have to account under purchase method only.
- Goodwill. UK GAAP allowed amortisation of goodwill and companies had the option of not segregating intangible assets from goodwill. Under IFRS, intangible assets have to be separated from goodwill. Goodwill can not be amortised now but companies will have to undertake annual impairment tests to justify the value of goodwill on the balance sheets. BAT’s profits for year 2004 increased by £454m because it no longer had to amortise goodwill of that amount (AccountancyAge, 2005b).
- Consolidation of accounts. Under new accounting rules, companies may have to consolidate certain additional subsidiaries into group accounts. On the other hand companies will have to exclude certain subsidiaries or special purpose vehicles which were not included till now.
- Research and development costs. Under IAS 39, research costs can’t be carried on the balance sheet and would have to write them off as incurred. Companies would still be allowed to capitalise development in line with UK GAAP.
- Stock options. Internet and share market last boom in late 1990s led to rapid increase in share options as a way to reward employees. The new requirements to record an expense on income statement for the value of share options granted to employees could have a significant impact on earnings. AstraZeneca said in its pro forma 2004 IFRS numbers that new accounting rules on stock options has made it re-consider the use of stock options in rewarding its employees (Tricks, 2005).
- Distributable profits. Organisations ability to pay dividends is dependent on their distributable profits. Following are some of the major impacts of IFRS on distributable profits - Inability to discount deferred tax liabilities, higher provisions for deferred tax when companies move from historical costs to fair value and inclusion of pension deficits in income statement. All of the above will reduce distributable profits. Many companies would have to financially restructure themselves in order to have sufficient distributable profits to meet dividends paid in last year.
- Deferred tax credit. Deferred tax credit is available under UK GAAP but not under IFRS. GlaxoSmithKline’s restated its 2004 earning per share by (1.9p) due to non-availability of deferred tax credit under IFRS (AccountancyAge, 2005a).
- Inclusion of business disposals gains in profits from operations. BAT’s profits for year 2004 increased by £1.3bn after it included gains from disposals to operating profits (AccountancyAge, 2005b). Adding disposal gains to operating profits will make it harder for investors and analysts to separate the earnings from continuing businesses.
- Derivative contracts. Under IFRS, some derivative contracts will not qualify as hedges as they wont meet the criteria. UK GAAP allowed deferment of such contracts until transaction took place. IFRS won’t allow the deferment of such contract and would impact the profit and loss account even before the transaction took place. It is better in a way that investors will know the current value of the firm as on date rather than historical costs of such instruments, especially if the duration of financial instruments was long. At the same time, it would increase the burden on the company to calculate the fair value of all such transactions.
- Agricultural. UK GAAP allowed companies to use a cost model for biological assets and all agricultural produce. But under IAS companies would have to use mark to market method for valuing such assets. Now companies would have to use market valuation even for assets in far off countries.
Advantages of IFRS over UK GAAP
- Common financial language. Adopting common financial reporting standards will open up a company to more markets and investors. The growth in telecommunications has made it easier for smaller investors to invest across physical boundaries. Such investors are normally not as financially sophisticated as some big financial institutions. They would also not like to understand more than one accounting standards as they don’t have required resources in hand to do so. With one common accounting standard, more investors would like to explore companies across nations.
- Acquisitions. IFRS 3 is more open and transparent than UK GAAP on acquisitions. It will allow investors and analysts to judge faster the success of an acquisition. Many of the companies that have relied on acquisition as a key cornerstone for growth would now come under intense scrutiny and may have to develop a new strategy for growing business.
- Consolidation. In IFRS, all entities will have to provide a cash flow statement. Additionally there would be more transparency within the group companies and this should make the consolidation process more straight-forward.
- Securitisation by businesses is likely to be impacted by the new ways governing how companies can show assets and liabilities on their financial statements. Companies have used securitisation to cash in assets like trade receivables sitting on their balance sheets. Securitisation helps companies to slim down their balance sheets and hence allows companies to show higher return on assets at same earnings. And it was one of the reasons why companies went for securitisation. But stringent criteria for moving assets and liabilities off balance sheet will threaten securitisation. Sue Harding, chief accountant at Standard & Poor’s in Europe said that new international accounting standards were sweeping a lot of securitised assets back on to balance sheets (Jopson, Feb 2005).
This will help investors compare like to like and avoid companies that have used securitisation only to make-up their balance sheets. There is no harm in using securitisation if used in a proper way and not to deceive stakeholders. But we have seen how corporations like Enron had used securitisation to disguise their true financial position.
- Annual impairment review. Annual impairment review will benefit investors because the companies then won’t like to take big goodwill cuts in one year and not do anything for years. Annual reviews would help investors judging whether the amount paid by companies in acquiring other company was justified or not.
- Access to cheaper capital. Increase in investor profile diversification would most probably lower the cost of capital for most of the companies. This is especially true for smaller companies which don’t have financial muscles and resources to tap international investors.
- Expensing research costs gives better information to investors and other stakeholders because at research stage the chances of success are quite uncertain. Investors can only be sure of development costs bringing in some returns in future. Also by segregating research and development costs, external stakeholders will now have a better chance to differentiate the suitability of costs incurred in developing new products.
- Multiple listings. Many companies now have multiple listings across different countries. Companies need to prepare financial statements as per each local accounting standard to meet listing requirements. With one accounting standard only it will save a lot of botheration for companies with multiple listings.
- Dividends. Under IFRS dividends are not provided for until the dividend recommended by the Board is approved by shareholders. This move will bring more convergence between accounting profits and cash flows.
Disadvantages of IFRS
- Fair value. While fair value in a way conveys more up to date value of a company as compared to historic costs, it also puts a question mark on the methods used and the reliability of fair value. Derivative instruments which are commonly traded on various stock exchanges can be easily assigned value. So while valuing some of the assets or liabilities may not be difficult, the question still remains what impact such valuations will have on companies’ business models. Many companies use hedging instruments as a strategic tool rather than for intentional gains. Any short-term swings in such instruments may have a significant impact on income statement and probably adverse market reactions may deter companies’ from using such instruments.
Then comes the more important issue of valuing assets and liabilities that don’t have a proper market. The companies may use some valuation model, which itself may not be the right way, to value an asset or liability. The model will incorporate some subjective assumptions. An example would be brand value. A same brand can have two different values for two different companies because of its strategic importance. So at one hand, investors and other external stakeholders are getting more objective information about a companies’ assets and liabilities, they are also getting valuation based on more subjective assessments. Only time will tell whether some individuals or companies will use it to manipulate results.
An interesting thing to observe would be the treatment and importance given by analysts to unrealised fair value of assets and liabilities. Some investors may try to separate unrealised gains and losses from other operational performance. It may also prompt companies to issue adjusted earnings excluding unrealised gains and losses.
An important point to note about fair value principle is that the financial statements should not be seen as perfect prediction of things to come. That depends on the strategic and business decisions management will take in future. Just having a fair value of assets and liabilities doesn’t mean that the company will be able to extract those values in future.
- Dividend. New accounting standards promote payment of dividend from distributable reserves. With the inclusion of unrealised gains and losses and pension deficits, the first few years of new accounting standards may not leave enough of distributable reserves for dividend payments.
- Securitisation. Securitising assets into special purpose vehicles and re-financing them through had also helped companies raise funds at lower costs. The new accounting standards by restricting the use of special purpose vehicles, would diminish some sources of cheap financing. It is question yet to be fully tested in the practical world that since the assets are same, change in financing options shouldn’t change the returns on total assets. By refinancing at lower rates through securitisation should result in higher financing cost for remaining assets such that the overall costs remain same. But examination of this hypothesis is beyond the scope of this dissertation. But what is mostly observed in capital markets is that when companies announce refinancing, the share price rises. How much of the rise is from relief that company will survive and how much from the fact that the overall costs have lowered is not known.
- Annual impairment tests. Annual impairment tests are easier said than done. Companies would not only have to devote substantial resources to do that first would have to train its personnel to do that. Assessing true value of a goodwill is not easy. If there is a comparable market then companies can easily value it. Even then it may differ from case to case as it would be very unusual to see exactly two similar companies. Goodwill is very different from tangible assets or technologies and depends a lot on market perception and strategy. Companies would have to review the whole process of valuing goodwill and would have to review the valuation process at constant intervals.
- Net pension liability. The inclusion of net pension liability on the balance sheet may have severe impact on the shareholders funds. Companies will be required to have annual actuarial valuation of their pension liabilities and the same would be reflected in financial statements. Most of the pension funds invest in equity markets, which have been quite volatile in the recent years. So though over a longer period, the movements in pension liabilities may even out but in short to medium term, it may have a dramatic effect on balance sheets and earning statements.
- Segmental information. IAS 14 requires companies to report information on their business segments and on a scale more detail than UK GAAP. As of date, no agreed accounting practices have emerged on how much should be disclosed because companies may end up revealing sensitive information to its competitors. If companies disclose the turnover, earnings and expenditure for each segment, its profitable operations may come under intense competition. Ian Dilks of PwC said that “some companies have found they’re giving much more information than they’re comfortable with on sales and the profitability of product areas” (Tricks, 2005)
- Expensing research costs may result in listed companies focusing more on products in development stage than in research stage. This will keep their balance sheets healthy but may harm long term prospects.
- Complex and long IFRS compliant reports. PricewaterhouseCoopers estimates that an IFRS compliant financial report for insurance companies could be up to twice as long as those prepared under existing UK GAAP (Finn & Zoon, 2004). The requirement for other industry sectors though may not be as intensive as for insurance sector, their IFRS compliant financial may also be longer and resource intensive than under UK GAAP. Any company that has makes an acquisition will have to do annual goodwill impairment analysis and most of them would like to explain the results also.
- Comparable formats. IAS 1 is less prescriptive than the UK GAAP when it comes to the format of the balance sheet and income statement. It just distinguishes current and non-current assets and liabilities. Investors, when faced with different formats, may find it difficult to compare companies.
- Modify organisation structures. Meall (2003) suggested that the additional burden of more financial reporting along different segments may force companies to modify their existing organisational structures within their financial systems to collect and analyse data.
Impact of IFRS on different industries
IFRS will have different impact on different industries. For some, most of the applied UK GAAP is almost same as IFRS and won’t feel the difference. But for some industries, the difference in accounting standards may have a substantial impact. Financial services and insurance companies are among them. Financial services companies would be affected by substantial change in recognition and measurement of financial instruments under IAS 39. UK GAAP has no equivalent to IAS 4 which deals with insurance contracts. Insurance companies would now have to account for this in their financial statements.
Under IFRS, insurance companies would have to book financial instruments such as derivatives at market value rather than historical value allowed under UK GAAP. Many insurers have said that this will distort their earnings (Reuters, 2005a). IFRS will put more stringent criteria for classification of insurance products and this may lead to reclassification of some insurance products as investment products.
Other industries that might face higher impact are the ones that heavily use hedging instruments in their day to day operations. Mostly companies using commodity materials like oil as a significant part of their input costs use hedging to smooth over the volatile changes in commodity markets.
New accounting standards will reduce Tesco’s projected annual profit of £2,000m by £30m only, a reduction of 1.5%. But for some companies the impact would be much more. Royal & Sun Alliance said that new accounting rules would reduce its net assets by £400m (Reuters, 2005a). This is a big number by any standards and shareholders of Royal & Sun Alliance would surely be concerned. Even though the company may classify it just an accounting issue, it casts certain doubt on the business practices and assumptions followed in past by the company.
The movement in assets and profits is not unidirectional for all companies. ICI, the chemicals company, said that its 2004 year profits were boosted by 6 per cent due to the changes introduced by new accounting standards (Smith, 2005). So while the underlying business has remained same for companies, introduction of new standards has the potential to increase or decrease the value of companies.
Moving from UK GAAP to IFRS is not just same as adjusting numbers. Many companies and their managements view move to IFRS as just an accounting issue. Andrew Higginson, Tesco's director of finance and strategy said "The adoption of IFRS is an important issue for all EU listed companies and one that we take seriously, but ultimately, it is an accounting, not an operational change," (Reuters, 2005b).
New accounting standards can also lead to confusion, at least in the short term till accounting practices are well agreed by different parties. An example of this was the recent comment about Northern Rock by Credit Suisse First Boston (Smith, 2005). Credit Suisse First Boston claimed profits at the UK bank would fall by 10 per cent due to the effects of IFRS. This led to a fall in Northern Rock’s share price. But Northern Rock’s management didn’t agree with the analysis and issued a rebuttal of the claims. Both Northern Rock and Credit Suisse First Boston are well established financial firms and if their accounting departments can have such significant differences over interpretation of IFRS, it can be imagined that smaller companies with less resources will face tougher choices.
Restatement of previous year financial statements has sometimes led to increase in profits also. British American Tobacco reported that its 2004 profits increased by £1.7bn under IFRS as compared to UK GAAP (AccountancyAge, 2005b). The increased profits have not resulted in higher valuation of the company. Jonathan Fell, analyst at Morgan Stanley commented ‘The increased figures are mainly a result of changes to the accounting for disposals. They do not affect the overall view of BAT’ (AccountancyAge, 2005b). It is a case of high movements in profits without a change in value of the firm.
While it may just be an accounting issue only but companies can still benefit from the change by looking at the ways of information collection and also at what data is collected and how it is analysed. Additional reporting will mean that some of the companies may now have to collect more data. Internal management reporting will be looked at to confirm to new accounting standards.
Adopting accounting policies and identifying the required financial data seems to be the approach taken by many companies. Introduction of IFRS is yet to see a change in business behaviour except in some areas like grant of share options. PwC said ‘companies are limiting the scope of their transition project in the short term and putting all their resources into finding fast solutions to provide the appropriate information for their 2005 reporting deadline’ (PwC, 2004b). Providing relevant numbers may meet the regulatory requirements but the full benefit of IFRS will only come when the principle behind its formulation are also incorporated into business thinking.
IFRS 1, First-time adoption of International Financial Reporting Standards, was published by the International Accounting Standards Board to guide organisations through their transition from national GAAPs to IAS. IFRS 1 would make the transition process easier.
But still the work required to convert from UK GAAP to IFRS won’t reduce substantially. Companies would have to spend considerable resources and time in analysing and making significant changes to existing accounting policies.
Readiness of businesses
ICAEW acknowledges that companies won’t be ready for IFRS in the first year of transition. In a press release dated 26 July 2004 it said that it is inevitable that some audit reports will require qualification next year given the number of companies who are lagging behind in their preparation of IFRS (ICAEW, 2004b). Andrew Ratcliffe, Chairman of the Institute of Chartered Accountants’ Audit and Assurance Faculty has warned that some companies may delay publication of their financial statements due to transition to IFRS.
ICAEW carried out a survey of UK companies on the preparedness of companies for transition to IAS (ICAEW, 2004a). The survey received 661 responses from businesses and accounting practices in 2004. ICAEW had previously also carried out survey of British businesses on the same. The main outcomes of the latest survey and their analysis are as below:
- 81 percent of respondents were either “very aware” or “fairly aware” of the publication of the EU regulation. This is good news because in the previous survey only 61 percent of respondents were aware of EU regulations. The bad part is that even when EU regulations were so close to being coming into force, not all respondents were aware of it. Only half of respondents were aware of the IAS timetable. By mid 2004, the time of ICAEW survey, it was expected that respondents would not only be fully aware of the timetable but would have also started implementing changes in the reporting system.
- Only 38 percent of respondents were aware of ASB’s plan of convergence to IAS. It is not of much concern as of now. It would have been better if more respondents knew about ASB’s plan because then they could have started working on changes right now rather than waiting for the moment when ASB announces them.
- About 30 percent of respondents were not sure of any significant impact on their companies’ key performance indicators due to a move from ASB to IFRS. This only confirms that companies have yet not analysed fully the differences between IFRS and UK GAAP. It also shows that organisations are way behind in developing an implementation, and internal and external communication strategy to their stakeholders.
- Only 45 percent of respondents in business section were either on scale “very good” or “good” when asked about their organisation’s understanding of the implications of IFRS. IFRS is not just re-formatting of numbers. Organisations will have to look not only at the impact on performance indicators but also analyse the way information is collected at various levels with in the organisation. Managers across different divisions should also learn about how the changes would impact their performance measurement.
- Only 39 percent of respondents noted that their organisation is prepared for the introduction of IFRS. This number is very less and companies not ready for the change may find themselves in a fix when new regulations come into force.
- Another area of concern observed in the survey was the speed at which organisations were carrying out their IAS implementation programmes. The survey noted that implementation rate was slower than predicted in previous survey. About a quarter of respondents who mentioned that an implementation programme is required for their organisation already had one in place and another 27 per cent said that they would have one in place. About half of respondents who stated they need a programme didn’t have any plans then. So first of all not all respondents knew whether they need an implementation programme or not and even of those who thought they need one, only half had concrete plans.
- IFRS will also impact how investors perceive an organisations’ performance. Only about one-third of respondents who thought that they need a communication plan to convey impact of IFRS to external stakeholders had either put a plan in place or was going to put one in short time. Rest two-thirds had not thought about formulating any communication strategy yet.
Accountancy Age’s survey in the last quarter of 2004 showed that companies across European Union were well short of being ready for the IFRS transition (AccountancyAge, 2004a). In a poll of 1000 companies, 42 % of the respondents were yet to start their preparation for the impact of international accounting standards. Only 15% of the companies reported that they have finished their preparations (AccountancyAge, 2004a). The level of preparedness is so low that ultimately UK’s Financial Services Authority agreed to give companies additional 30 days to report their financials in line with IFRS.
Among non-listed companies, only 5.9% said that their preparation for IFRS is good and almost one-third said that their preparation is very poor (AccountancyAge, 2004b).
In a survey conducted by PricewaterhouseCoopers, 323 companies from 18 European countries and Australia and New Zealand responded to their readiness to start reporting under International Financial reporting Standards by 2005 (PwC, 2004b). The survey reported that companies are finding change to IFRS is much more than what they had anticipated. The change is not just reformatting numbers. Companies need to adopt systems and processes in their organisations to make IFRS a part of ‘business as usual’ rather than just data collecting exercise.
The survey reported that most of the companies have probably missed the chance of incorporating IFRS in their internal reporting by the start of 2005 and progress to IFRS has been slow. Companies have a long path to travel before IFRS becomes an integral part of their businesses. PwC had also conducted a survey in March 2004 on the same topic and the latest survey in December 2004 showed that issues that were causing concern in the first survey were still an area of concern.
Major highlights and findings of the PwC’s December 2004 survey are (PwC, 2004b):
- Larger companies better prepared than mid-cap companies. Larger companies are better prepared than mid-cap companies on almost all issues relating to IFRS transition. 83 percent of companies with market cap more than 10 billion euro had a training strategy in place where as the corresponding figure for companies with market cap less than 1 billion euro was only 33 percent. This result comes as no surprise because large companies probably have more resources than mid or low cap companies to be put on IFRS transition project without having a significant negative impact on day to day operations. Also large companies are more concerned about the capital market implications of non-conformity with IFRS. Additionally it also highlights the lack of attention being given by low and mid cap companies to IFRS transition process – an area of grave concern for financial regulators and capital markets.
- Scant communication of IFRS impact on businesses to the market. Only 4 percent of companies surveyed had communicated any broad picture of IFRS impact on their businesses to the market and about 29 percent had completed and approved a communication strategy. A large number of companies had not yet made any progress on external communication and the main reason could be that they themselves have yet to fully analyse the impact of IFRS on their financial performance and position.
- The above hypothesis is confirmed when survey reported that even near the end of 2004 only 88 percent of companies were assessing the impact of IFRS on their reporting and key performance indicators. And only about 45 percent of the sample have completed the assessment and reported the findings to their boards. So though many companies have started the work, the percentage of companies where board is fully aware of impact is still less. This means that many boards will end up with insufficient time to form a proper strategy to respond to the changes.
- IFRS conversion projects. Only 42 percent of respondents reported that their IFRS conversion project is up and running. 30 percent had either made limited progress on setting up a project framework or have made no progress at all. Small companies with one or few divisions could still squeeze through within deadline. But bigger companies with many divisions and multinational locations would find it hard to complete IFRS conversion if they haven’t started yet.
- Shortage of resources. Only 19 percent respondents said that they are confident that they have sufficient resources allocated to complete the conversion in time. It is the other 81 percent who now have to get additional resources for IFRS projects. Many of such companies might have planned to procure additional resources in house. But those who have plans for outside sourcing may find it difficult to get required personnel due to shortage of such personnel.
- Internal IFRS training. 39 percent of respondents were addressing the issue of internal IFRS training. Even within that only 13 percent were implementing strategies and rest 26 percent were still analysing the needs.
- Short-term fixes. Many companies were focusing only on a core group of people to implement necessary changes that would see them through the transition phase. Improper understanding of new reporting standards by other relevant personnel may result in errors or even much longer implementation delays. 45 percent of respondents said that their approach is based on short-term fixes rather than applying a more company wide approach.
- Poor company wide embedding of change requirements. Only about one-fifth of the companies had made necessary IT system and process changes to make IFRS a part of normal business. Even fewer were the companies who had put internal checks in place to ensure the robustness of data collection process.
The results also showed that many companies were focused solely on short-term quick fix solution to data capture and reporting. A half-hearted exercise like this could result in unintentional wrong reporting or even delayed reporting. A miss or a wrong guidance could be costly. Wrong numbers will not only lead to wrong valuations but would also reflect on the poor sate of internal systems – a signal that wont be much appreciated by the capital markets.
An interesting comparison would be to evaluate IFRS preparedness in different industries. Normally firms look at their peers rather than at whole market when deciding their strategies and practices. This is due to higher comparison within peer industry as compared to with whole of capital markets. In the survey conducted by PwC, companies in the financial services, technology and entertainment were ahead of organisations in the consumer and industrial products and services (PwC, 2004b). Financial and technology organisations were leading consumer and industrial companies at almost all the stages of IFRS implementation with differences not huge but significant.
One probable reason for such cross-industry differences would be the level of globalisation in sectors. Companies in more global sectors have to live up to international standards and some of their bigger customers are international companies. IFRS would help them win more international credibility.
Another interesting but obvious observation was the attention paid by different sectors on different IFRS. PwC reported that technology companies were ahead in terms of readiness in the areas of employee benefits, foreign entities whereas financial services companies have paid more attention to IAS 32 and IAS 39 which deal with financial instruments (PwC, 2004b).
Costs of IFRS transition
- Retrospective application. Organisations would have to restate financial statements in line with IFRS requirements. This would entail additional resources and costs to make necessary restatements. The companies would have to prepare an opening balance sheet at the date of transition to IFRS. For companies with one year of comparatives, the transition date would be 1 January 2004 and for companies with two years of comparatives, the transition date would be 1 January 2003. First IFRS statement may also need information that was not collected under previous national GAAP. First time adopters can choose from some of the 10 optional exemptions available. This may reduce some transition costs.
- Time spent in understanding and assessing the impact of IFRS on financial performance. As move to IFRS is much more than plain reformatting of numbers, organisations would need to spend time on assessing the impact of IFRS on their financial performance. New regulations on financial instruments, fair value may significantly change income and balance sheets. Management as well as senior managers across divisions would spend considerable time in understanding the implications of new regulations. Such process rarely concludes in one meeting due to its contentious nature.
- Communicating changes to stakeholders. Listed companies have to inform changes in accounting and their implications to their external stakeholders, notably investors. The first statement with IFRS will probably include a longer description of impact of changes. Any significant negative impact may lead to lower valuation and so management would spend time on developing and executing a good communication strategy to minimise negative impact.
- Training of employees. Employees, mainly in the financial departments would need training to become conversant with IFRS.
- Regular costs. Annual impairment costs. Costs incurred in collecting more data and analysing it.
It may be noted from the above points that most of the costs are either applicable in the first year only or are more significant in first year as compared to subsequent years. As companies adopt IFRS, regular costs of applying IFRS may not be significantly different from the costs incurred under national GAAP.
Reasons for apprehension towards IFRS are as follows:
- IFRS will increase the complexity of annual financial reports. This is an area of big concern for the preparers of financial statements as it means more work. It may also result in potentially litigable financial statements.
- There is confusion about applicable standards due to the constant revision of IFRS. EU is also constantly reviewing and revising IFRS. UK companies have to keep a constant watch on revisions being issued by IASB and European Commission. In the first adoption of IFRS, standards as on March 2004 would form a stable platform for first implementation. Companies can also adopt further revisions of reporting standards. So though two companies might both be IFRS compliant on a date, they might be reporting on different versions.
- Less use of summary reports. UK GAAP gives exemption to companies based on their size. Smaller companies utilise such exemptions to prepare just summary reports using less resources, but at the same time they contain most of the relevant information required by the readers of such reports.
- US dominance. It is perceived that IFRS are underpinned by US interests. As an example of this, European Commission has made some changes in IAS 39 before recommending it to its member states. European banks and ministers had raised serious issues on the impact of IAS 39 on their balance sheet. The US bias in accounting standards also comes from the view that International Accounting Standards Committee is dominated by US. Charlie McCreevy, EU Commissioner, in charge of internal markets has demanded a review of IASC (AccountancyAge, 2005c). McCreevy would like to see more number of Europeans at IASC.
- Many people believe that UK’s accounting standards are better than IFRS. UK’s accounting standards describe formats for income statement and balance sheet. IFRS has no such formats and companies would be allowed to choose style that suits them. First of all investors and analysts would have to deal with multiple formats which may make comparison difficult. Second, companies may vary their formats to suit their purpose.
- It is also believed that since IFRS had to take account of many accounting standards prevalent in late 90s and develop a standard which takes care of variations, IASB may have compromised somewhat in setting standards. UK may be made to sacrifice for the greater good of all.
- A major rationale behind IFRS is that it will allow global markets to develop and companies can access cheaper capital. But is there a big need for UK registered companies to raise international finance. Right now international companies, especially those based in developing countries, look for financing in UK. IFRS will certainly help such companies as more UK investors would now finance international companies. It may then happen that UK based companies would be competing against foreign companies for the same basket of UK funds. This may raise the cost of capital for UK based firms.
- First time implementation costs. IFRS will also result in significant implementation costs, especially for smaller companies.
The uncertainty around IFRS is highlighted in the annual financial reports presented by Alliance UniChem, a listed UK based pharmaceutical company. While presenting a summary reconciliation from UK GAAP to IFRS, the company said ‘The financial information has been prepared on the basis of IFRS expectation to be applicable for 2005 reporting’ (Alliance UniChem).
UK’s ICAEW has also said that current IFRS in its entirety is not suitable for smaller companies. ICAEW believes that IFRS will cause too much cost and resources for smaller companies. Also maximum of them are single-person owned and so the extra information and the efforts required to do that is not of any use. IASB is looking at ways to introduce some exemptions for smaller companies.
Variation in IFRS, as applied in different nations may falsely lead investors and analysts to believe that companies are following IFRS in the original and true form whereas they may not be doing so. As the enforcement of accounting standards would still be with national bodies, the local auditors will look only in terms of local IFRS and may not note the differences with the original IFRS as issued by IASB. Also investors and analysts may not be able to take note of local changes coming out time to time.
Internal management reporting
The adoption of International Accounting Standards is more than a simple technical exercise of rearranging formats and presentation of financial statements. The new formats and rationale behind them would throw up more important questions about business models and reasons behind many subjective assumptions in past. Most of the times new ways of analysing information challenges existing practices. The internal management reporting is now going to be more significant.
The detailed internal management reporting will put more pressure on information gathering and it might uncover hidden but important aspects of a business models in addition to increasing costs and time spent on information accumulation. The new formats provide an opportunity to re-examine the importance and effectiveness of internal management reporting.
But the companies have yet to make any significant change in internal controls and processes. PwC said ‘the low level of achievement [on IFRS processes and internal controls] at this stage of the change process should now be ringing bells in boardroom’ (PwC, 2004b). Until companies implement full controls and procedures in line with IFRS requirements, they won’t be able to derive benefits from it.
New reporting requirements will allow external stakeholders, especially shareholders, a chance to re-analyse business strategies and management decisions. The adoption of new accounting standards will bring in more transparency for external investors in areas like segmental disclosures and recognition of derivatives on balance sheets at fair value. Investors can then analyse management decisions and check whether the new investments are being made from a strategic point like expanding business or just to earn some additional amount from derivatives. Investors can invest in derivatives on their own and wouldn’t appreciate such investments by companies unless they are from a strategic point of hedging against unwanted currency fluctuations which can substantially harm companies’ balance sheets.
The focus of International Accounting Standards is on better performance measurement and communication of the same to internal and external stakeholders. Adoption of better and more transparent policies in reporting by a company would most probably seep down through to other companies in the sector as they would not like their peers to have an undue competitive advantage. Investors prefer more open companies and reward them by increasing their price multiples, which will tempt other companies to soon join the bandwagon of new reporting standards and formats.
It will be too early to say that new reporting standards will fundamentally change the businesses in the short run but it will definitely change the way success is measured by external stakeholders and information sharing between internal and external stakeholders. It will also have an impact on some of the related aspects – how the company’s financial function is organised and how people are rewarded.
Shortage of skilled manpower
Companies would also face shortage of skilled human resources to not only see them through transition but also to implement IFRS on a constant basis. Skilled staff, qualified enough to deal with IFRS, were in short supply. PwC survey reported the acute shortage of skilled resources (PwC, 2004b). One of the participant said ‘Finding and retaining resources is proving a very significant issue’ (PwC, 2004b). This may be due to most companies focusing on IFRS only in the last minute rather than implementing the change over time. PwC reported that shortage of IFRS skilled resources is a market-wide phenomenon (PwC, 2004b).
Nearly 40% of the respondents reported that they were struggling to find staff with right skills (AccountancyAge, 2004a). This has resulted in higher wages for auditing staff. Auditor’s wages have gone up by 5.3% in the six months to October 2004 (AccountancyAge, 2004a).
The scene is worse when we compare shortage of staff in large and small firms. 44 percent of the largest companies as compared to 15 percent of the smallest companies in the PwC survey were confident that they have all the necessary resources in place (PwC, 2004b). The shortage of skilled manpower might be a big issue for the remaining 56 percent of largest companies. Though lower cap listed will probably need lesser amount of resources as compared to mid or large cap listed firms, they may still find it difficult to locate skilled resources as most of them would have been already grabbed by larger firms.
Transitional phase is always fraught with difficulties and confusion. A number of countries have adopted IFRS. But there is still no single or commonly accepted way of employing IFRS. As of date, there is no single International GAAP. A consensual International GAAP will only emerge after a few years of implementation by companies across different countries. The journey is definitely not short and easy. Companies and auditors interpretation of new financial reporting standards may differ across the cross-section and also may be with in same industry.
Will we see a single accepted International GAAP in short term? Looking at the variations in current national standards and new standards being open to subjective interpretation, it would be naïve to say yes. It would be an ideal scenario to have a single International GAAP at some time but the more important issue is whether we need a single accepted International GAAP immediately. As long as the individual countries commit to implementing IFRS in true sense and allow their companies some time to navigate through the change process, it should be acceptable.
Auditors are the links between IFRS and companies compliance with new accounting standards. Their role is vital in ensuring compliance of IFRS by companies and becomes more in the initial years when there would be some confusion on generally accepted accounting practices. But the things are not so rosy on that front. In a survey carried out by International Accounting Standards in 2000, it was found that major audit firms issued unqualified audit opinions on IAS financial statements that did not comply fully with IAS (Cairns, 2003). If this was the state of major audit firms, it wouldn’t be wrong to imagine that things would be similar or even worse in smaller audit firms. It was also found that auditors sometimes limit their opinion to compliance with national GAAP even when the financial statements of the company asserted compliance with IAS.
While both personnel from companies and accountants agree that IFRS will need more resources and result in higher costs than the implied benefits of it, accountants are more favourable in their opinion about IFRS. It is the companies that will have to incur all costs and on regular basis. Accountants will have to just learn once the differences and they can recover learning costs by charging higher to their clients. Probably more complexities in IFRS will result in higher work for accountants.
Impact on non-financial personnel
Finance personnel would have to learn new accounting standards being introduced under IFRS. They will have to develop new formats for internal reporting. The changes and their impact would also be felt by operational managers. The new formats may impact the profitability of divisions. Managers may be forced to look at the ways business is carried out and explore new ways to maintain or increase profits.
Also since most of the employee bonuses are linked to profits, the application of new accounting standards will also impact performance bonuses. The first year of transition may result in huge variations in bonuses. Employees of insurance companies may find that their bonus packages have been severely impacted by new regulations on financial instruments. Companies may be forced to come up with new bonus packages, an extra and costly burden as bonus packages take long time to evolve.
Non-listed firms and IFRS
Non-listed firms are generally smaller, less diverse in terms of divisions and number of international locations as compared to listed firms. All these factors mean that non-listed firms may find the IFRS transition process less complex and hence can complete it with lesser resources and in lesser time as compared to listed firms.
The central question in this research – justification of IFRS and its implications – means that it is an area dependent upon people’s subjective opinion on various issues related to IFRS. The complexity of the issue means that this research is better approached in an inductive way rather than deductive way. The world of business is too complex and diverse to render itself to generalised assumptions and hence one approach for all should not be adopted. The research collects and analyses both qualitative and quantitative data to see if IFRS is suitable for un-listed companies.
The qualitative approach is a better starting point. It helps in developing a better understanding of the topic and also to explore other issues related to the central question of this research. Quantitative approach lends credibility to the whole approach and to conclusion, if any. To overcome the quality or bias in the quantitative data, the data is analysed from statistical viewpoints also.
Both secondary and prima
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