The financial statements of around 7,000 listed companies in the EU are undergoing a profound change in the way they are put together and presented. The introduction of International Financial Reporting Standards (IFRS) on 1 January this year has broad business implications, and as a result, many companies are likely to see:
- greater volatility in earnings and equity
- higher tax provisions
- rise in the apparent cost of executive remuneration
- debt covenant issues
- the appearance of less available capital.
Given the scale of the change, it is surprising that a significant proportion of companies have yet to make any detailed market communication to manage analyst and shareholder expectations. As companies do start to announce their results under the new regime, event-related trading, arbitrage and even hedge fund activity is expected to have a further impact on share prices.
Ian Dilks, IFRS conversions leader at PricewaterhouseCoopers, is keen to stress he does not believe the introduction of IFRS will cause widespread chaos and investor confusion. However, he does emphasise the importance of risk control and the threat which transition to the new standards poses to good corporate governance.
The problem, he says, relates both to volume and complexity. "Over 3,000 pages of guidance have been issued on the new standards since November 2003 - which is three times longer than War and Peace. The new standards also involve different accounting bases, more detailed disclosures, increased use of fair values and a completely new income statement, balance sheet and cash flow. As always, the devil is in the detail and the problems are often unexpected."
AIG vice president of management liability, financial lines division, Hartmut Mai, agrees. "IFRS is a major concern for insurers - shareholders will rely on the reported figures, and if these are subsequently re-stated, it may translate into a loss for shareholders. We anticipate a likely rise in claims and in the incidence of class actions."
Broader business implications
The business implications of IFRS are far-reaching. More detailed disclosure means that much more information will be available on how and where companies make money, creating competitive issues and giving customers a window on pricing structures and margins. At the same time, as the accounts become more sensitive, they will also become more difficult to create, because the big increase in the amount of data required to support enhanced disclosure will have an effect on systems and processes.
Because of the resource needed to manage the technical implementation issues, Dilks estimates that up to 90% of companies will not change the basis of management reporting before they produce their first statements under IFRS. The risk in having two sets of information is that management will be less familiar with the 'new' public numbers and may not spot errors of process or calculation, so the safety net of the gut feel that the statements are broadly right will be removed.
There are also significant issues around tax planning, financing, refinancing, acquisitions and compensation. Training and education will clearly be essential to prepare finance staff for the change, but also for the board and its committees in order that they can understand and explain the new numbers to a sceptical analyst community and anxious shareholders.
Insurers will also need to be involved in this process, believes Hartmut Mai. "Our underwriting process will be thorough as we seek to understand very clearly how well management are prepared both to manage the change and to manage the communication issue."
Where is the risk?
In today's less tolerant investor climate, management is very clearly expected to ensure continuous good governance, financial probity and statement transparency. Their task will be much harder this year because of the scale and technical complexity of the changes, untried systems workarounds, reliance on new data sources and shortage of suitably trained staff.
Further exacerbating the problem, the IFRS restatement rules are different to those which pertained under UK GAAP (Generally Accepted Accounting Principles), requiring restatement of the accounts if errors are found to be 'material' rather than 'fundamental'. This change means that Dilks anticipates a greater risk that companies may have to restate their results, which in turn increases the risk of litigation and class actions.
A leading investment bank has warned investors of confusion and opportunities (mostly short side), more volatility in reported earnings, higher dispersion in stock valuations and short term gaps in value versus price. Dilks adds to these comments, predicting price volatility, uncertainty and hence potential for shareholder dissatisfaction.
What are the implications for corporate governance?
Although underpinned by technical change, the issues at board level relate to risk and governance. The board is responsible for signing off the new statements and, if their company is listed in the US and subject to Sarbanes-Oxley, processes and systems. Managers need to understand key financial and technical issues and their resolutions; the quality of the data, systems and processes used; the risks and the quality of controls.
Having done this, the next steps are to ensure the market understands the specific impact of IFRS, to manage expectations and to ensure an appropriate market communications strategy is in place.
Clearly, many of the issues are complex and require considerable management judgement. Boards and audit committees need to become more engaged, focusing not just on process, but also on risk and its mitigation. "We will be working very closely with our clients," comments Hartmut Mai.
This summarises some of the conclusions of an AIG corporate governance seminar held earlier this year.