A Death Knell for Creative Accounting? - January 2010

A new accounting standard has recently been published, which has significant implications for companies, analysts and investors.

Many large companies owned privately, including those controlled by private equity funds, are likely to adopt the new standard, which goes by the name of ‘IFRS for SME’s’. Don’t be fooled by the name though - about 95% of companies worldwide, including US firms, could apply the new rules when they come into force.

Currently in the EU alone there are 55 sets of accounting standards being used, and the use of just one set of agreed rules should make life easier for investors and lender

Technically, the new rules apply to all companies that are not ‘publicly accountable’. A company is publicly accountable if it either:

1. Has debt or equity publicly traded or
2. Is a bank (including investment banks), insurance company, security brokers/dealers and mutual funds

Why?

The rules were introduced to:

1. Reduce complexity for both preparers and readers of accounts
2. Reduce compliance costs
3. Make life easier for emerging economies that have no background in producing accounts
4. Increase comparability

What?

The main changes can be split as follows:

(a) Topics not covered in IFRS for SME’s

1. EPS
2. Interim financial statements
3. Segment reporting
4. Assets held for sale

(b) Options removed when accounting

1. Use of revaluation model for PPE and intangibles
2. Different classifications of financial instruments
3. Treatment of grants

(c) Simplification when measuring assets

1. Financial instruments are valued at amortised historic cost, except for listed investments which are valued at fair value. This should reduce volatility in the accounts.
2. Goodwill is amortised, usually over a maximum of ten years, instead of being subject to impairment reviews. This will reduce EBIT but have no impact on EBITDA.
3. Associates and Joint Ventures can be valued at cost instead of using the equity (or proportionate consolidation) method.
4. Borrowing costs must be written off instead of the option to capitalise.
5. R&D costs MUST be charged to the income statement. This has implications for unlisted high tech stocks and pharmaceutical companies with large R&D budgets, especially if they are considering an IPO.
6. Actuarial gains in defined benefit schemes must be recognised immediately.

(d) Disclosures

1. The footnote requirements for SME’s are significantly fewer than under regular IFRS

When?

IFRS for SME’s can be applied whenever individual governments give them approval, In the US companies can adopt the rules immediately.

In the UK the rules are due to come into force in 2012, which means that companies will need their 2011 accounts as comparatives to comply too. This means that for many companies the closing balance sheet at the end of 2010 should also be prepared under IFRS.

The Downside

Although the benefits seem considerable, there are some disadvantages to a global adoption of IFRS for SME’s, and these include:

1. Changeover costs in terms of systems and training
2. A one size fits all approach may be inappropriate in some countries due to cultural issues
3. Local tax authorities may reject the rules if they result in lower profits (and therefore lower tax revenues)
4. Until the rules are accepted as best practice by lenders, access to capital may be restricted.
5. Listed companies with unlisted subsidiaries may have to convert the subsidiaries’ results from SME to full IFRS. However may prove to be preferable to the current situation where subsidiaries are producing results under a myriad of local accounting rules.