Hidden Depths of IAS

National accounting standards now probably rank as the biggest administrative headache for FDs of quoted companies. The transition from an old, familiar rule book to one that hasn’t even been finished yet is causing a certain amount of difficulty – and a great drain on resources – for even the largest quoted companies. Most effort is going into finding out what the rules actually are and how they will affect the reported profit & loss, balance sheet and cash-flow numbers.

But that’s just the tip of the iceberg. While most companies have at least started to look at how their reported financials will be affected by IASs – and the most enlightened are working on their financial systems, too – the fact is that the IAS project is much bigger than most FDs think, and there are things that FDs have to do now that can’t wait until 2005.

Deadlines
The first thing to get sorted out is the deadline. Unlike either the euro or Y2K, there isn’t a do-or-die deadline for international accounting standards. Yes, it starts to affect companies whose financial period begins on or after 1 January 2005, but the reality is that the deadline is actually later than that – and sooner.

Companies with 31 March year-ends, for example, will have a little more time in hand. Moreover, there is no sense in which “failure” to have full IAS numbers in place by, say, 2 January 2005 will result in the sort of disaster that might have befallen a millennium bug-stricken company. Seen in this light, companies actually have until early 2006 to get their 2005 IAS results audited and published.

Of course, that’s not good enough. In fact, as the Financial Services Authority recently reminded quoted companies in a letter to company secretaries, UK listed companies are required under Listing Rule 12.47a to produce interim results using the accounting policies to be followed in the subsequent annual financial statements. However, companies that report quarterly – and, if the EC Transparency Directive is enacted in time, that will pretty much include everyone – will have to produce their 2005 Q1 results using IASs, so we should start to see the first UK IAS results announcements some time in April 2005.

Such announcements won’t, strictly speaking, be audited (though auditors invariably review the interims or quarterlies), so there is at least some possibility that “imperfect” Q1 or H1 IAS results will have their errors unwound and smoothed into subsequent quarters, with no one being any the wiser when the annual report is signed off in early 2006.

But in terms of being properly prepared, the deadline is, in effect, in 2004, as companies issuing IAS-compliant results for 2005 will also produce prior-year comparatives, which means that businesses will have to be able to produce an opening 1 January 2004 balance sheet under IAS in order to construct their accounts properly. Hence, the deadline is really no more than about three months away. However, European companies listed on Wall Street are already nine months behind, as US requirements call for two prior years’ comparatives: as we approach October 2003, we are already three-quarters of the way through the first of those years.

One seriously complicating factor is that the body of international accounting standards with which companies will have to comply in 2005 won’t be finalised by the IASB until March 2004 – a quarter of the way through the prior year comparable. To be fair, however, the IASB works to a ‘no surprises’ strategy, ensuring the business community knows which way its thinking is heading on standards being drafted or revised.

Education
How any one company’s reported earnings and balance sheet will be affected by IASs will depend on a great number of variables – the size and nature of goodwill, the use of financial instruments, the importance of leases as a method of finance, deferred tax and so on. Even sophisticated users of financial statements, such as City analysts and institutional shareholders, will have to be briefed properly on the impact of IASs on each company.

It would make sense to start as soon as possible so that analysts can get a clearer picture of how to reconfigure the financial models they use to prepare their forecasts and evaluate share ratings.

Analysts will be particularly concerned about earnings volatility, which may affect how they discount back future profits to arrive at a fair value for the business. Leaving the education programme until the last minute may raise doubts in investors’ minds about management’s ability to master the numbers. In any event, analysts are likely to start asking questions soon, anyway. Many are already estimating the impact of IASs on the quoted companies they follow. But it would be sensible to take advice on whether any particular pieces of information would be regarded as price-sensitive.

Nearer to home, senior managers will have to be properly briefed as to how their monthly management accounts are affected by the transition to IASs. Managers will have to be made to understand what variances they will be responsible for and what variances will arise simply from the use of new rules. Managers’ budgets may need to be revised if they are built upon assumptions about growth in UK GAAP earnings per share, for example.

Employees, too, will have a vested interest in the reported numbers and want to be reassured that their employer isn’t “pulling a fast one”, especially when the 2004 comparatives are restated – whether sharply upwards or downwards.

FDs must also ensure that their chief executive and chairman are thoroughly prepared and stick to the script, especially when they are about to speak to the press or shareholders. A clumsy, ill-informed explanation could easily damage credibility in the company and top management. The sales and HR directors won’t want to be left out, either.

Of course, it should go without saying that the finance function staff, the internal auditors and the audit committee – to say nothing of the external auditors – should all be taking part in programmes to make sure they understand how IASs will affect the company. One particularly interesting problem is how global audit firms will apply IASs to their global clients, given that there are going to be differences in how national authorities interpret and apply the standards.

Triggers
Reported earnings are used as trigger points for a variety of real-world actions – a genuine case of the tail wagging the dog. Profit-related bonuses, performance-related share option schemes, banking covenants, bond covenants and earn-out clauses may all have triggers related to UK GAAP earnings, interest cover, capital payments and so on. All will have to be renegotiated and rewritten to provide for IAS figures so that companies won’t have to carry two sets of books.

Under IAS, a company’s distributable reserves will change: whether the change is material enough to affect projected dividends will depend on the extent to which the numbers – and the interpretations of the numbers – encroach on the legal limits. For example, does the company have significant leases that will be interpreted as finance leases under IAS17, and will they be regarded as increasing gearing? Likewise, will unrealised foreign exchange losses impact on reserves? What about the “cost” of share options?

One of the biggest problems is that IAS profits are certain to be much more volatile than under UK GAAP, increasing the risk of any covenant being breached. Remedial action can be taken now by preparing resolutions for the next AGM to make any necessary alterations to the articles of association or to propose a capital restructuring that would reduce share capital and build up distributable reserves. Companies may also seek to specifically define away the effect of particular accounting standards in redrafting covenants or articles, so as, for example, to “adjust” distributable reserves by ignoring any pensions deficit impact.

Moreover, note that there will be differences in how some types of capital are treated: preference shares, for example, will be treated as debt, thereby affecting gearing.

Remuneration
With equity markets in a depressed state, arguments about expensing share options took something of a back seat. But share options and other share-based payments will come back into favour.

The immediate problem is that the international standards will directly affect the profit & loss account as the fair value is expensed over the life of the option, even though there is a high degree of dissatisfaction with the method of determining that value.

A second problem is that, as with covenants, current performance criteria that trigger release of share options and other share-based or cash-based remuneration are probably based on UK GAAP and will have to be renegotiated and rewritten, or else the company will have to run two sets of books.

Moreover, any reference to a peer group will also have to make allowance for their reported figures. For example, a criteria such as “100% of potential award if earnings per share growth exceeds that of at least seven out of top 10 competitors” will have to be drafted in full awareness as to what might happen in rivals’ accounts. Volatility will be a particular factor here, with items such as derivatives and pensions funding affecting reported earnings in a way that has little to do with the underlying financial performance of the businesses.

Because of the volatility in IAS earnings, companies will also have to be aware of how IAS-based performance triggers will impact on variable or open-ended bonus or other incentive arrangements, particularly given the furore and press attention on surrounding executive pay. A one-off spike in earnings arising from an unrealised gain on a derivative may not be the best basis on which to award millions of shares to the chief executive.

Acquisitions
Traditionally, the difference between the purchase price of an acquisition and the value of the net assets is goodwill, written off over 20 years, perhaps. Much of that will now have to be identified as certain types of intangible assets – patents, databases, customer lists, know-how – raising the question, ‘How do you value each of those?’ And do you have the systems in place now to identify those components of any acquisitions that you make between now and 2005?

Any remaining goodwill is not to be written off, but annually impairment-tested, so systems will have to be put in place to ensure that such values can be verified or modified.

Morgan Stanley recently estimated that the impact of this on GlaxoSmithKline’s financials would have been (had the company applied IAS all along) to increase its assets by over 500% and reduce profits by 73%.

Whether or not a company actually plans to make any acquisitions, it would do well to engage in some IAS analysis of its competitors. This will not only help understanding about how IASs change reported numbers – as well as providing fresh impetus to re-examine the strengths and weaknesses of rivals – it can give the company competitive advantage, whether through more informed communication with shareholders or in spotting potential hostile bidders.

Derivatives
Like share-based payments, this is another area that simply cannot be left until 2005 to sort out. Put the wrong sort of hedging mechanism in place and the accounting treatment for it may affect reported profits and, more importantly, distributable reserves.

The basic idea in IAS39 is that virtually everything is to be marked to market – in other words, measured at fair value – and that changes in value will go through the profit & loss account. The allowable exception is derivatives that are held as hedges. But the definition of what constitutes a hedge is narrow and requires the right sort of hedging instruments and supporting documentation.

Companies’ existing derivatives and swap arrangements may not currently satisfy the hedge accounting rules, but it may be that a few minor adjustments will bring them within the requirements.

Attention will also focus on imbedded derivatives so if, for example, a company has a contract to buy products from a European supplier to be paid in dollars, then that will likely be interpreted as two separate elements – a supply chain contract in euros and a hedge against the exchange rate. Companies will, therefore, have to ensure they have full knowledge of their existing contracts and, if necessary, restructure future contracts.

Assets that are intended to be held-to-maturity (HTM) will receive harsh treatment if, in the meantime, a company changes its mind and decides to sell some of those assets. In such a case, all of its other HTM assets must be treated in the accounts for the next two years as available-for-sale. Again, this instance highlights the importance of making the right business decision long before trying to work out the accounting treatment in 2005.

Companies should also be aware that the Inland Revenue is said to be thinking about taxing some of the unrealised gains that IAS will require to be disclosed – and, if necessary, engage in the debate.

Pensions may not be related to derivatives, but their volatility does derive from securities markets. The IASB is currently reviewing IAS19, and what comes out of that may well look like FRS17. Companies will have to decide whether to live with the volatility (as well as any deficit itself) or restructure their pension scheme offering to employees.

Comply or …?
Now that the DTI has said it will allow unquoted companies to use IASs, such businesses will have to decide whether that is the right thing for them to do. Relevant questions include:

– How difficult, expensive or time-consuming would such a transition be, particularly given the Accounting Standards Board’s programme to converge UK GAAP towards IASs?

– Does this business have any plans to float on the stock market?

– Is there any likelihood of a trade sale to a listed company?

– Would venture capital backers want IASs to be used to aid comparability?

– Does the business have key competitors who will be using IASs, and will it therefore help to be able to publish comparable results?

Making the right decisions now can provide competitive advantage later.

Alternatively, move to Canada, which is one of the few countries not to have any current plans to allow domestic companies to use IASs rather than local GAAP.

We are grateful to many people and organisations for source material and comment: ASB; Ashurst Morris Crisp; Association of Corporate Treasurers; John Taylor, UK MD of Cartesis; Richard Olver of Deloitte & Touche, who spoke at the Oracle AppsWorld Executive Summit in June; Isobel Sharp of Deloitte & Touche, who spoke at the Richmond Events Finance Directors’ Forum; DTI; FSA; IASB; David Tilston, FD of OverNet Data plc.