Young and Invested

A study on IFRS showed that 50% of companies demonstrated higher equity under IFRS accounting standards than GAAP, and a huge 65% showed higher earnings. Would that influence your investments? Most investors don’t realize that IFRS will have significant implications on financial statements, and are in danger of using outdated analysis methods and comparison to old benchmarks.

Being one of the few accountants venturing into the financial markets, I thought it would be helpful to provide insight into how the upcoming MASSIVE global shift in accounting standards to IFRS (International Financial Reporting Standards) is going to affect financial statement analysis. The changes, officially being implemented by all publically accountable entities by 2011 are far from being as clear as those in financial reporting would like to see.

Not only is the transition to IFRS pervasive to almost all areas of a company’s operations in terms of data acquisition, but a majority of public companies have been severely affected by the global recession in regards to credit attainment, causing cash flow shortages. Subsequently, it has been an unsuccessful effort to provoke company-wide transition to the IFRS system. On a similar note, investors have paid less than deserved attention to survey the IFRS terrain.

In regards to current accounting standards in the US and Canada (called GAAP; mostly similar between the two countries), there are a few significant IFRS and GAAP differences that will affect your analysis of financial statements, and therefore investments and profitability. The first IFRS-compliant financial statements you will see will be for the 3 months ended March 31, 2011 (with comparatives of March 31, 2010.

Here are a few of the most significant (upon more) differences you can expect:

Disclosure

On a good note, disclosure requirements under IFRS are heavier and will require companies to provide a higher degree of transparency (more fun reading materials). Although companies reporting in Canada and USA currently follow GAAP disclosure requirements, they tend to limit the number of financial statement subtotals used and disclosure provided in the notes for competitive reasons. IFRS requires more broken down income statements and balance sheets, so be prepared to see more subtotals and categories.

MD&A will also require escalating amounts of detail. Interim reports during 2010 must have quantified information about how IFRS will affect the financial statements and company. Reconciliations between GAAP and IFRS must also be provided.

Financial Instruments

This should be an interesting one! Entities will have to evaluate the significance of financial instruments for their financial position and performance, as well as present the nature of related risks to which the entity is exposed to during the reporting period and how management handles those risks (qualitatively and quantitatively). Interestingly, this is coupled with a disclosure requirement for management to assess the company’s going concern assumption in MD&A.

Hmm… I wonder if this rule to assess impact of financial instruments would have made a difference before 2008?

But on a serious note, I hope this really serious standard is addressed with strict measures by auditors and companies. By the way, this applies to ALL companies owning financial instruments, even if it’s as simple as receivables and payables.

Capital Assets

Whereas GAAP does not allow revaluation to fair value (except write-downs due to impairment), IFRS allows companies to revalue assets at fair value if reliable measures allow to do so. For example, under current GAAP, buying a company Ferrari F430 at $160,000 would require me to record it at cost and take annual depreciation on it (less any additional impairments). Under IFRS, if my Ferrari F430 were suddenly considered rare, I can actually write it up in value to $200,000 or even $1,000,000 if the values are reliable. Although the revaluations can only be recognized in other comprehensive income (not part of continuing operations on the income statement), you can definitely expect A LOT more volatility on balance sheets and financial statements. Even if revaluations won’t be seen in continuing operations, the final total on the income statement will be affected by this, as will asset classes on the balance sheet.

Make sure that your investment analysis scouts for any revaluations to fair value and accounts for it accordingly, giving it enough skeptical criticism to understand that sometimes it may not be as meaningful as it seems or an indicator of a solid competitive advantage.

Revenue

In general, revenue treatment in IFRS is similar to GAAP. It may be reasonable to use the same investing implications for revenue figures as current practice dictates.

Other Major Differences

Other major differences you will see pertain to measurement of capital assets, provisions such as allowance for doubtful accounts, accounting for leases, pension accounting and much more. This article cannot afford to be technically exhaustive, so I urge you to study the effects of IFRS further. Take a course, read a pamphlet, talk to your local CA/CPA – just be aware that the changes will be significant. I’d recommend to visit http://www.iasb.org/Home.htm.

Although addressing these changes will be technically demanding, the risk of not doing so is high. Most investors will underestimate the impact of IFRS on their investing processes – a process that’s challenging enough already. Taking a proactive approach to IFRS’ effect on your investing analysis should help minimize the risks and maximize the benefits that a majority of investors won’t see coming.

Image Credit: thinkpanama under a Creative Commons license.

Last 3 posts by Daniel Eskin

• Expert Interview - Puru Saxena - March 9th, 2010
• Memory of a Crisis - March 8th, 2010
• Blogger Interview - Babak - March 2nd, 2010