Chapter 6
Collateral Impact of a Transition to IFRS
A conversion to IFRS is a paradigm change that impacts not only the Finance and Accounting functions of an entity but also the information technology systems, legal contracts and employee policies. It has the potential to have a spin-off and collateral impact on the working of an organisation in various ways. A few such areas are discussed below.
6.1 Significant Assumptions and Judgement
The notes to the financial statements prepared by the management start off with a statement, which goes somewhat like this:
The preparation of financial statements in conformity with IFRS requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. A discussion on the Group's critical accounting judgements and key sources of estimation uncertainty is detailed below. Actual results could differ from those estimates. The estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognised in the period in which the estimate is revised if the revision affects only that period or in the period of the revision and future periods if the revision affects both current and future periods.
A novice reading this could be forgiven if he assumes that the financial statements are estimated financial statements. It is a fact though that such a disclaimer is needed because in the real world the estimates could change very fast. In 2014, petroleum companies who have been estimating the price of Brent Crude at around $100 had to revise their estimates to $60 within one quarter. Even $60 proved erroneous as the price soon slid to $50.
With its focus on Fair Value, the importance of the above statement in IFRS financial statements can never be over-emphasised. Any error in these estimates will have a significant impact on the reported numbers.
6.2 The Going Concern Concept
Apart from other concepts, the concept of Going Concern is an integral part of the Framework to International Financial Reporting Standards. Though as a concept it is simple, applying this concept in practice can pose numerous challenges. What is the trigger-point for raising a red flag that an entity may not be a going concern? Based on present auditing literature and practical experience, two trigger-points seem to stand out- availability of credit and budgets and forecasts. In a few countries, it has been observed that auditors question the Going Concern concept in case banks do not renew large loans to an entity that is dependent on the loan.
6.2.1 Availability of Credit
One major effect of the credit crisis and economic downturn is the lack of available credit to entities of all sizes. Turmoil in the banking sector has led to a general tightening of credit, which may have a pervasive effect on an entity's ability to continue as a going concern. In addition, as an entity's financial health changes, contractual terms in loans and other obligations, including debt covenants and guarantees, and an entity's compliance with such terms, are likely to be under greater scrutiny from lenders, and also from management and auditors. There are a number of factors that may, in the circumstances of the entity, need to be considered, including:
- Whether banks may withdraw credit from entities that had previously had easy access to credit whenever necessary;
- Whether reductions in asset values or trading losses have led to breaches in lending covenants;
- Whether failure to comply with the respective covenants has resulted, or will result, in immediate demands from the lenders, or changes in the terms on which finance is available;
- Whether on-demand clauses in term loans affect the classification of such liabilities on an entity's balance sheet and whether the lenders may in fact invoke such clauses, rather than continuing a practice of granting waivers;
- Whether it is reasonable to assume that lenders will roll over existing credit facilities on similar terms, if at all;
- Whether banks are likely to be unwilling to commit to future renewal of credit facilities.
6.2.2 Forecasts and Budgets
An important component of the going concern assessment relates to an entity's ongoing forecasts and budgeting. Factors that may be relevant in evaluating forecasts prepared by management include:
- whether senior management and those charged with governance have been appropriately involved and have given appropriate attention to forecasts;
- whether the assumptions used in the forecasts are consistent with assumptions that have been used in asset valuations and models for impairment;
- whether the forecasts have been prepared on a monthly basis and, if so, how the forecasts reflect expected payment patterns (e.g., quarterly cash outflows such as tax installments, and variable cash inflows such as expected proceeds from the sale of assets);
- whether the forecasts indicate months of insufficient cash and, if so, management's plans to deal with any shortfalls;
- whether forecasts reflect an inappropriate management bias, in particular as broadly compared to others in a particular industry;
- how management's budget for the current period compares with results achieved to date;
- whether the forecasts consider potential losses of revenue, including whether an inability of an entity to obtain letters of credit affects its international trade;
- whether increases in the cost of borrowing have been factored into management's analysis, including potential increases in margin sought by banks and the effect of alternative sources of financing;
- whether the forecasts account for trends typically noted in recessionary periods, such as reduced revenues, increased bad debts (because of trading conditions or the withdrawal of credit insurance), and extended credit terms to customers;
- whether management has performed an appropriate sensitivity analysis, such as considering the effect of the loss of key customers or key suppliers due to bankruptcies;
- how the forecast deals with asset realisations, including whether these realisations are practicable and realistic in amount; and
- whether the forecasts imply any future concerns over the entity's ability to meet debt covenant requirements.
6.3 Information Technology
One is frequently asked the question “Which is the best ERP Accounting Package for IFRS?” Well, the honest answer should be “none”. While all the reputed ERP Accounting packages are robust, flexible and scalable, it is a fact that most of these packages cannot ascertain the exact fair value of an Asset or test it for impairment. Many of such adjustments have to be made outside the ERP system and true-up entries should be passed later.
Introduction of IFRS would have an impact not only on the final financial position of the entity but also at the individual invoice level. For instance, with the adoption of IFRS-15, an entity may decide that the performance obligations in a contract are spread to later years and may allocate a portion of the consideration towards that. The entry for this would have to be done by the Sales Accountant who would need to be trained as he is used to passing a single entry and not hiving off individual components. Similarly, the need for componentisation of Property, Plant and Equipment in IAS 16 would add a lot of work to the Accountant in charge of Property, Plant and Equipment. The Fixed Assets Register would need to be updated and tracked for changes in the useful lives of the Assets. Enterprises would do well to:
- Identify the areas where moving over to IFRS could impact ERP and IT systems.
- Formulate Accounting Policies in line with IFRS in these specific areas.
- Train all the Accounting staff on the implications of shifting over to IFRS.
6.4 Costs
Whenever an entity is asked to undergo a major change, one of the points for debate that surfaces is the cost vs. the benefits. For instance, when Section 404 of the Sarbanes Oxley Act (SOX) was introduced in the USA, there was a criticism that the costs to revisit all internal controls over financial reporting and other compliance requirements of SOX far exceeded the benefits.
A transition to IFRS costs money. Major costs that would be incurred in a transition to IFRS would include:
- Impact Assessment Study;
- First time conversion to IFRS;
- Information Technology Costs;
- Training Costs.
Due to the intricacies involved in an IFRS conversion, entities normally employ consultants to assist them in the first time adoption of IFRS. There could also be a sense of security in outsourcing these to a consultant since they would have had a lot of experience in doing the conversion to IFRS. However, there are no free consultants in IFRS and hence the cost of a Consultant would be a direct cost on the enterprise. As we have seen above, an entity will have to bear the costs of additional or revamped information technology systems once the transition to IFRS is done. However, it has to be stated that most of these costs are one-time costs that are not expected to recur. While the cost-benefit ratio may be skewed in the year of transition to IFRS, these costs should be looked on more as investments for the future.
The Impact Assessment is meant to give the top management a summary view of what the impact of a transition to IFRS would do to the financials of an entity. The actual conversion exercise would involve preparing the IFRS Opening Balance Sheet on the date of transition to IFRS as per the procedures laid out in IFRS 1 First Time Conversion to International Financial Reporting Standards. Training Costs are the costs involved to bring all the accountants up to speed on what IFRS accounting involves. Due to the extensive disclosure requirements of IFRS, a considerable amount of time would need to be spent on providing detailed disclosures as per the requirements of each and every IFRS Standard. Entities for whom IAS 34 Interim Financial Reporting applies would need to do this transition quickly as the next interim financial statements would need to be as per IFRS Standards.
6.5 Accounting Manual
Entities that have an Accounting Manual under their previous GAAP would need to make a new one as per IFRS. There could be new heads of account (such as Unbilled Revenue in view of IFRS 15) or there could be additions to line items in the Fixed Assets due to componentisation. The revised Accounting Manual would have to be comprehensive enough to cover all the intricacies of IFRS.
6.6 Taxes
A transition to IFRS would have an impact on Taxes. Unless otherwise specified, IFRS thrives on the concept of Fair Value. The tax department may not bless the concept of Fair Value. The impact of this could be that entities could end up paying higher taxes due to the transition to IFRS and the Deferred Taxes on the Balance Sheet would also change. There could be recognition issues. For instance under IAS 18 and IFRS 15, there is an imputed interest for credit sales. This is shown as a financing component, which raises the question of how the tax department would view it – as Sales or Interest? If it were recognised as Interest, would there have to be a withholding tax done? Applying IFRS 9 would mean that there would be notional gains or losses hitting the Profit or Loss Account – would the tax department bless these notional amounts? Entities that are operating in different geographies would have established transfer-pricing agreements amongst themselves. Implementation of IFRS will impact the financials. These entities may have to revisit their transfer pricing agreements to see if the transactions with the associated enterprise are still at an arm's length. In case the answer is no, agreements would need to be revised which would result in a change in the tax outflow of the entity.
6.7 Presentation of Financial Statements
IAS 1 Presentation of Financial Statements specifies the overall requirements for financial statements, including how they should be structured, the minimum requirements for their content and overriding concepts such as going concern, the accrual basis of accounting and the current/non-current distinction. The standard requires a complete set of financial statements to comprise a statement of financial position, a statement of profit or loss and other comprehensive income, a statement of changes in equity and a statement of cash flows.
Entities who are moving over to IFRS may have different ways of presenting their financial statements and will have to change their accounting and reporting systems as per the new presentation requirements of IFRS. In some geographies (India being a good example) regulators may specify the format in which financial statements have to be presented. In such circumstances, the entity should assume that the format specified by the regulator complies with the provisions of IAS 1.
6.8 Impact of IFRS on Financial Ratios
IFRS introduces many new concepts such as Fair Value, Componentisation, Testing Goodwill and other Intangible Assets for Impairment every year etc. There is a general feeling that a transition to IFRS could impact the financial ratios of an entity. Any impact on the financial ratios of an entity could impact its market price and, if the ratios are very adverse, the entity could be perceived as not doing too well.
Balios Dimitrios, Lecturer on Accounting, National and Kapodistrian University of Athens Department of Economics; Eriotis Nikolaos, Associate Professor of Accounting, National and Kapodistrian University of Athens, Department of Economics, Athens; Paraskevopoulos Konstantinos, Master in Banking and Finance, Open University of Cyprus; and Vasiliou Dimitrios, Professor of Bank Management, Hellenic Open University, Patra did some seminal research on this. In their paper, “The impact of IFRS on ratios of listed and new listed companies of Athens Exchange”, (thejournalofbusiness.org/index.php/site/article/download/14/14), they conclude that:
According to the results of these tests, it appears that the ratios of the two groups of companies of the two samples behaved in a similar way during the transition from GAS to IFRS. There is no significant effect from the adoption and implementation of IFRS in Greece on the calculation of the financial ratios. Specifically, to determine more accurately the relationship between the financial ratios of the two accounting standards we applied statistical analysis in all fifteen examined ratios per sample. The results in their majority do not differ significantly. Exceptions for the first sample are the Leverage ratios: Debt Ratio and the Activity ratios: Asset Turnover, Fixed Assets Turnover, Net Profit Margin and Gross Profit Margin. Furthermore, based on regression analysis we demonstrated a strong linear relationship between the ratios of the two different accounting standards in the majority of the two samples, apart from EBITDA margin ratio in the first sample. As far as the comparison of the two samples of listed and new listed companies, it can be argued that there is not a significant difference in the results found, as well as the application of statistical tests to all ratios that were calculated, did not display any significant difference in its percentage of diversification. Comparable outcomes were reached by the application of multiple regression analysis, which displayed that the temporal point of the introduction of a company in AE did not have any significant effect on the diversification of ratios from the transition to IFRS, except for EBIT to invested capital. We conclude that the particular characteristics of each group of companies were not able to significantly affect the differences in the financial statements of companies after the implementation of IFRS.
The results of the above research cannot be questioned. However, it is a fact that the impact of IFRS would be felt when an entity moves over to IFRS for the first time, adopts IFRS 1 and parks the differences arising therefrom in Retained Earnings or another component of equity. After this, since the entity would prepare even it interim financial reports as per IFRS, it is possible that no significant impact is felt at the end of the financial year.
6.9 Challenges in Implementing IFRS
After IFRS became a reality in the European Union, Eva K. Jermakowicz and Sylwia Gornik-Tomaszewski published a paper “Implementing IFRS from the perspective of EU publicly traded companies” in the Journal of International Accounting, Auditing and Taxation 15 (2006) 170–196. In this paper, they conducted a survey which inter-alia, detailed the main challenges that entities faced while moving over to IFRS which is reproduced below:
- Complex nature of IFRS, which is made for big companies
- Lack of IFRS implementation guidance
- Lack of uniform interpretation of IFRS
- Final rules not being ready for the 2005 deadline
- Impact on profit and loss account
- Continuing debate of IAS 39
- Constant change of IFRS, transformation of IASB decisions in EU Regulations
- Running of parallel accounting systems
- Preparation of comparative financial statements for the past years
- Lack of IFRS knowledge among employees and auditors
- Training of accounting staff and management
- To change the mindset of finance personnel
- Change of the IT Structure
While many of these have been addressed, there are some challenges that would appear to never go away. Change of the IT structure, constant change of IFRS and training costs could be some examples.
6.9.1 Where are the Valuers?
One of the major challenges in IFRS could be finding valuers. Companies normally have a panel of qualified valuers to value their Property, Plant and Equipment. In the case of a Financial Instrument, which is quoted on the market, valuation should not pose an issue, as the Quoted Market Price is the best indicator of Fair Value as per IFRS 13. The challenge would like in valuing Intangible Assets and financial instruments which are not quoted in an active market. For instance, in case an entity acquires a Brand that is not related to its main line of business, who is the qualified and independent valuer who would value the Brand? Though the value of the Brand will be tested for Impairment in case any of the impairment indicators indicated by IAS 38 are triggered, the initial recognition cannot be way off the mark. To take another example, who would be the most appropriate person to value an inter-corporate deposit that is over-due for a year? There are press reports that the company that has received the inter-corporate deposits is going through a severe cash crisis and could be acquired.
Valuation involves making significant assumptions and exercising judgement. As required by IFRS 13, if these are disclosed in detail in the Notes on Accounts, there should be no controversies. Like all accountants, it would assist a lot if the valuer opts to err on the side of caution.