Concerns on Comparability for IFRS Statements

Comparability is vital to the folks who use financial statements to make investment decisions—but those people may be forced to lower their expectations when U.S. companies ultimately adopt international accounting rules.

A recent study from Moody’s Investors Service took a deep dive into the financial statement of 30 large European companies to see how their reporting changed when the companies scrapped their national accounting systems for International Financial Reporting Standards, which the European Union adopted in 2005.

Moody’s conclusion: Profits rose, balance sheets deteriorated, and comparability suffered.

Those are unsettling words for U.S. investors, who have given the Securities and Exchange Commission a long list of worries should the SEC decide to allow companies to adopt IFRS sometime in the future. The Financial Accounting Standards Board and International Accounting Standards Board have been trying to improve and unify IFRS and U.S. Generally Accepted Accounting Principles for years, but many in the investor community fear that the march to adopt IFRS here is outpacing the convergence effort.

The Moody’s report goes on to say that transparency at the EU companies improved because IFRS’ more comprehensive reporting paints a better picture of a company’s underlying economics. At the same time, however, the wiggle room in IFRS principles provides a wide berth that breeds inconsistent interpretation. “While we have certainly benefited from the adoption of a single set of accounting standards in the EU, the downside of IFRS is that significant accounting expertise is often required in order to ‘work around’ some of its less-helpful features,” the report says.

To prevent a repeat of that here, investor advocates want accounting rulemakers to improve four specific areas: revenue recognition, fair-value measurement, consolidation, and derecognition. “From an investor perspective, these four areas, at a minimum, must be improved so as to result in reporting that meets the needs of investors,” says Jeff Mahoney, general counsel for the Council of Institutional Investors.

Roper

Barbara Roper, director of investor protection for the Consumer Federation of America, says she worries about comparability under a principles-based accounting rulebook such as IFRS. “The flexibility that IFRS provides is, in our view, likely to be taken advantage of by executives seeking to put their companies’ financial statements in the most positive light,” she says. “There is significant evidence that IFRS is not consistently applied from country to country, let alone from company to company.”

Trevor Pijper, vice president and accounting specialist at Moody’s, attributes those differences to two basic problems. First, the standards themselves don’t mandate comparability, although that is “a temporary problem” that will vanish as IASB revises the IFRS literature, he says.

“The flexibility that IFRS provides is, in our view, likely to be taken advantage of by executives seeking to put their companies’ financial statements in the most positive light.”

— Barbara Roper,

Director of Investor Protection,

Consumer Federation of America

The Moody’s report gives several examples of where comparability is suffering today. Some companies have difficulty sorting out whether borrowing costs related to acquiring, constructing, or producing a qualifying asset are capitalized or expensed. In its analysis, half of companies opted to capitalize such borrowing costs, and the other half chose to expense them immediately. Rule changes will take effect in 2009 that will prohibit expensing such costs, Pijper says, resolving this particular point of confusion.

Resolving confusion over the cash-flow statement may take longer. Among the 30 companies it studied, Moody’s found 10 different ways to report dividends, interest, and taxes in the cash flow statement. There are various views on whether these cash flows should be classified as operating, investing, or financing categories, so IFRS allow companies to decide for themselves.

Pijper

“The layout of the cash flow statement reflects a lot of theoretical differences on the board of IASB,” Pijper says. “You can scatter items all over the statement, as long as you report in a way that allows people to put it together in a way that suits them.” He also adds: “This is something they are not looking to fix immediately.”

Problem No. 2

A bigger concern, however, is an inconsistent interpretation of accounting standards. “Even if we had standards that stipulated only one treatment, would people actually implement them in a way that produces comparable statements?” Pijper asks.

IFRS INSIGHTS

Below is an excerpt of the Moody's study on financial statements filed in IFRS, noting some of the positive developments in European companies that adopted IFRS in 2005.

Cash flow statements are now mandatory.

Cash flow statements can be helpful in assessing whether the reporting entity is generating sufficient cash from its operations to service its debts, and a number of Moody’s financial ratios are derived from the cash flow statement. However, prior to the adoption of IFRS, companies in Italy and Spain were not required to include a cash flow statement in their annual reports.

Pension obligations are now more comprehensively disclosed.

Under IFRS, companies are required to provide significantly more information about their pension obligations than was often the case under local GAAP. This helps Moody’s assessment of the debt-like obligation for pensions, which can be an important factor in judging the relative creditworthiness of companies.

Obligations relating to leased assets are now more easily assessed.

The additional information provided under IFRS in relation to leased assets provides new insight into the scale and extent of the off-balance-sheet obligation.

Changes in the judgmental amounts set aside for uncertain liabilities are now more apparent.

Under IFRS, companies are required to disclose additional information about changes in the amounts they have set aside for liabilities of uncertain timing or amount. This can provide valuable insight into the judgments and estimates that underpin the accounting in this area.

Balance sheets are now less likely to include questionable pension assets.

Although the “smoothing mechanism” has not yet been abolished by IAS 19, balance sheets prepared under IFRS are less likely to include assets resulting from the delayed recognition of actuarial losses related to pensions.

Financing transactions are now more likely to be reported as borrowings.

Under IFRS, special purpose entities used for securitization transactions are consolidated when the substance of the relationship indicates that they are controlled by the transferor of the asset. In addition, whenever the sale of a financial asset leaves substantially all the risks and rewards of ownership with the seller, it must continue to recognize the asset on its balance sheet with the sale proceeds being reported as a liability.

Put options held by minority shareholders are no longer off balance sheet.

Under local GAAP, when minority shareholders in a subsidiary had a put option or similar right to sell their interest to the majority shareholder, the possible future outflow of cash was typically disclosed in a footnote dealing with off-balance-sheet commitments. Under IFRS, these instruments are regarded as financial liabilities and they are reported on the balance sheet.

Distortions caused by overly prudent accounting are now less likely.

Prior to the adoption of IFRS, it was not uncommon for certain companies to use overly conservative depreciation rates set by the tax authorities. Using an artificially short useful life appears to be a prudent approach at first, but profits are flattered in subsequent periods when the assets are still in use without a related expense being reported in the income statement.

Certain revenues are more appropriately no longer recognized upfront.

Our research shows that the vast majority of companies (90 percent) were able to report essentially unchanged revenue on adopting IFRS, probably because the principles-based IAS 18 allowed the existing accounting to be retained. After stripping out the adjustment required by IFRS for previously grossed-up revenue, the aggregate “top-line” reported under local GAAP by the 30 companies in our study declined by a mere 0.25 percent.

Full consolidation is no longer permitted when other shareholders have important veto rights.

IFRS draws a distinction between entities that are under the exclusive control of the parent company, and others (“jointly controlled entities”) where control is shared because strategic financial and operating decisions require the unanimous consent of the shareholders. Full consolidation is permitted only for entities in the former category.

Treasury shares are no longer presented as cash-like assets.

Under local GAAP, French companies, including Carrefour, PSA Peugeot Citroën, Renault, TOTAL, and Veolia Environnement presented treasury shares held for share price stabilization purposes and employee share plans as an asset in the balance sheet under a caption such as “marketable securities” or “short-term investments.” These assets were typically included in the company’s calculation of net debt. However, all treasury shares must be deducted from shareholders’ equity under IFRS, and this reduced the cash-like assets of the five companies referred to above by approximately €2.5 billion at the end of 2004.

Source

Moody’s Report on IFRS (November 2008).

Danita Ostling, a partner at Ernst & Young and the firm’s Americas IFRS leader, says the principles-based nature of IFRS compared to U.S. GAAP puts some responsibility on companies to establish clear accounting policies. “It means it’s incumbent upon companies to carefully consider the substance of transactions they’re entering into and consider how the principles in IFRS ought to be applied to their fact patterns,” she explains.

Ostling says companies using IFRS will need to devise a more comprehensive accounting policy manual, to ensure IFRS principles are consistently applied across divisions and subsidiaries. That policy manual would give investors visibility into a company’s accounting that will aid comparability, she says. “Once you have accounting policy visibility, investors will be able to understand where there are differences, or if there are differences.”

D.J. Gannon, head of Deloitte’s IFRS Center of Excellence in the United States, says U.S. capital markets tend to think more rigidly about comparability to the point of expecting uniformity—which isn’t precisely what IFRS wants to achieve.

“The goal in mind is for everything to be the same,” he says. “Under IFRS, it’s more from the perspective of transparency. You’re not always going to have the same answer to similar questions, but you’ll have better information in the financial statements that users can use to make financial decisions.”

Gannon

There will logically be an “evolution in practice,” Gannon says, as companies continue using IFRS in other parts of the world and as the United States prepares to move to IFRS. In Europe, where the Moody’s study is focused, many companies adopted IFRS by following a “minimize the differences” approach, where they simply bent their existing accounting practices to make them compliant with IFRS.

As companies continue using IFRS and continue studying what their competitors are reporting, “we may see more herding of cats,” he says. “You’re going to see a lot more comfort around this whole approach.”

Ostling and Gannon acknowledge that consolidation policy is a hot-button area where comparability is a concern under IFRS. Off-balance-sheet activity has come under intense scrutiny as financial markets are reeling over failed assets held in some cases in off-balance-sheet structures.

International rules require an entity to consolidate another entity if the parent is deemed to have “control,” but that can be difficult to establish and define, Ostling says. IASB is working on a new standard, with an exposure draft expected before the end of the year, she adds.