The implications of IFRS for nonaccountants accountancy

  • Date:01 Aug 2005
  • Type:CompanyDirectorMagazine
The adoption of IFRS will have significant impacts on some companies’ reported profits and net assets position, warns Wayne Lonergan

accountancy

The implications of IFRS for non-accountants

The adoption of IFRS will have significant impacts on some companies' reported profits and net assets position, warns Wayne Lonergan*

Most people consider that Australia's adoption of International Financial Reporting Standards (IFRS) is a bean counters' problem. Consequently, it has, to date, received relatively little, if any, attention from other than accountants and finance directors.

The reality is, however, that the adoption of IFRS for reporting entities has significant implications in many other areas of business.

What IFRS impacts

Many contracts, agreements, articles of association etc contain profit and/or net assets based provisions. These, in turn, rely on accounting based numbers.

Examples of areas that will be affected by the introduction of the new accounting rules include, but are by no means limited to: prospectus disclosure, annual reports, business sale contracts, shareholder agreements, profit and asset warranties, thin capitalisation rules for tax, borrowing covenants, negative pledges, employee share schemes, employment contracts (eg determination of bonuses), auditor negligence and business combinations.

The impact

can be large

Obviously, the net impact of IFRS will vary from entity to entity. However, these changes are not play money, for example industry commentators have estimated that up to $17 billion of intangible asset values which were previously recorded as assets may have to be derecognised under IFRS.

Profit and balance

sheet impacts

IFRS rules will alter the reported level of annual profits of many companies with consequent significant impact on profit warranties, share value formula, executive remuneration etc.

IFRS rules will also alter asset values with consequent impact on borrowing covenants, asset based formula, vendor warranties etc.

Cumulative differences

lost in reserves

To complicate matters further, the impact of adopting IFRS on reported results is not just a timing difference where one years profit reduction will be offset by a higher profit in later years (or vice versa) with the effects often averaging out over time.

The IFRS accounting standards contain first time adoption provisions, the net effect of which is that the cumulative profit and/or net asset effect of changing from what was previously generally accepted accounting practice to IFRS will go straight to reserves and will bypass the profit and loss statement altogether.

Hidden and recycled items

The potential implications of these transitional provisions have serious implications including:

  • Some write downs and losses will never be reflected in annual reported results
  • Some previously booked profits or losses may be recycled ie booked a second time
  • Some write ups may never be reflected in annual reported results.

Formulaic provisions

The underlying problem is that contractual rights and/or obligations, net worth and annual income may be significantly increased or diminished as a result of the windfall impact of the new accounting rules on reported results and financial position.

This problem is exacerbated by the fact that many contracts and other legal agreements are strictly formulaic. For example, share value equals ten times reported profit after tax. Many agreements do not contain any overriding "fair value" clauses which might otherwise have largely, or entirely ameliorated the impact of adopting different accounting rules.

Previously, positions were generally reasonably (but not always) protected by the inclusion of clauses such as "in accordance with generally accepted accounting practices consistently applied". The new IFRS rules however require, inter alia:

  • the immediate prior years results calculated under Australian Accounting Rules to be restated on an IFRS basis when shown as comparative figures in accounts
  • the closing financial position at the 30 June 2005 year end calculated under Australian Accounting rules to be restated on the IFRS basis so that the closing balance sheet financial position will differ from the opening balance sheet financial position on 1 July 2005
  • both results and financial position will reflect "generally accepted accounting practice".
In simple terms there will be a statutorily imposed requirement to present two significantly different views of profit and financial position for the 2005 financial year, one for year end purposes and one for comparative purposes.

Even if there are "fair value" overriders in agreement etc, to complicate matters even further, IFRS uses the term "fair value" in different contexts. It is not necessarily synonymous with "market value". The inevitable result will be more litigation over what is "fair value".

New phenomena

The adoption of IFRS will result in wholesale changes in accounting. As a result many legal agreements, articles of association, etc never contemplated that reported profits and net asset values would be so significantly changed by the wholesale adoption of new accounting rules, let alone that the initial cumulative effect of such changes might bypass the profit and loss account and thus never be recognised for accounting purposes.

The impact of adopting IFRS is magnified by the fact that the timing of adoption is coinciding with very high equity values and a unprecedented high level of value being attributed in the market place to goodwill and identifiable intangible assets (two of the areas most impacted by the new rules).

Worse still, in some cases if asset values fall, but subsequently recover, the intangible asset write downs made under IFRS rules when asset values fall are prohibited under IFRS from being reversed even when those values subsequently recover. (A discussion of why such asymmetric treatment is wrong in principle - and wrong as a matter of common sense - is outside the scope of this article). The consequence being that for agreements based on reported results or financial position, a temporary value drop can lead to a permanent wealth transfer (perhaps even at a multiple of the fall in value).

Winners and losers

Those on the winning end of the IFRS induced changes on their net income or net worth (eg a higher formula based consideration for their shares, or a larger "performance" based bonus), are likely to insist on their contractual rights.

However those on the losing end of IFRS induced changes will seek to negotiate their entitlements claiming fairness, equity and that "this was not what the parties intended".

Pre-emptive review

There is considerable merit in reviewing existing contractual arrangements before the final outcome of adopting IFRS is known. The risk being that once parties' actual entitlements under contracts, agreements, etc which are impacted by IFRS are clarified, their views are likely to polarise.

A mutually acceptable compromise, possibly even including renegotiation of key contract terms, is much more likely while the intent of the original agreement is clear in the parties' minds. It is also much more likely to be achievable while both parties are still at risk as to the final outcome of adopting IFRS.

Summary

The adoption of IFRS will have significant impacts on some companies' reported profits and net assets position.

Furthermore, the catch up effect of the initial transition to IFRS based accounts will bypass the profit and loss statements and go direct to reserves. In other cases some past profits and losses may be booked again.

Any contracts or agreements containing profit or net asset based rights or obligations should be reviewed and potential problems identified.

* Wayne Lonergan is managing director of specialist valuation firm Lonergan Edwards & Associates. He was formerly a board member of the AASB (seven years) and IFRIC (two years)

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