SECTION I – INTRODUCTION
The adoption of international financial reporting standards across the European Union from 1st January 2005 is one of the biggest events in the accounting history. This is especially important after the capital markets were rocked by some big accounting frauds in recent years. In the first phase, 7000-plus listed European companies will have to implement new financial reporting standards from January 2005 (Fuller, Jan 2005).
When European Union moved towards one market across Europe, it faced the prospect of different financial reporting regimes across EU participants. To achieve true scale of financial integration, it has become necessary to adopt common financial reporting standards.
In June 2002, the European Commission adopted a regulation requiring all listed EU companies in regulated markets to prepare their financial statements in accordance with International Accounting Standards (IAS) or International Financial Reporting Standards (IFRS). The regulation is applicable only on consolidated accounts and companies are free to choose their national GAAPs for subsidiaries and associate companies. The regulation came into force from January 2005.
Companies Act 1985 governs the use of UK GAAP by UK based companies. Similarly other EU states have their own laws for accounting standards. The EU states have now modified their national laws to include IFRS regulation to offer a common financial reporting standard. Companies Act 1985 (International Accounting Standards and Other Accounting Amendments) Regulations 2004 has extended the application, on a non-compulsory basis, of the EU IFRS regulation to all non-charitable organisations.
In the last quarter of previous century, the world economies have moved towards globalisation. Multinational companies are manufacturing and selling across the world and many of these firms are listed at foreign stock exchanges. Globalisation of markets and establishment of multinationals led to increased desire and awareness about international markets. This was soon followed by globalisation of financial markets which increased the value of understanding of international financial results and reporting formats. Rapid improvement in communication technologies and easy access through internet has further spread the profile of international investor. Now a day international investors are not limited to some portfolio managers in big banks. International investors are now as diverse as sophisticated equity manager to a small investor in a remote town. Investors too have diversified their portfolio by international equities and bonds. This rapid globalisation has fuelled the desire to have common international standards that could be understood and followed across nations.
The ever increasing network of investors has not only opened new financing sources to countries, it has also put some pressure on the financial regulatory authorities to design and improve their financial reporting systems in a manner that is easily understood by wider audiences.
The regulatory authorities have on one hand evolve the financial reporting system to match the ever increasing demands of international investors and on the other hand make sure that companies in their countries are not faced with sudden increase in time, resources and knowledge needed to cope with new regulations.
In 1973, 9 countries included UK formed International Accounting Standards Committee (IASC) with an aim to develop common accounting standards. The membership has now grown well over hundred countries with each country, especially bigger economies, bringing in their own perspectives of accounting standards. IASC had to deal with accounting conflictions in coming up with common acceptable accounting standards.
One would immediately think whether IASC has been successful in resolving all the conflicts with all member countries and the answer would easily be no. To fully satisfy more than hundred accounting bodies from across the world is almost an impossible task. Yet IASC has done a commendable job and from 1 January 2005, International Accounting Standards (IAS) or International Financial Reporting Standards (IFRS) is applicable in more than 90 countries. In EU, IFRS is compulsory only for listed companies.
The standards that UK listed companies will follow are not those issued directly by the International Accounting Standards Board, but are those that have been endorsed by the European Commission. EU has now endorsed IFRS, except for IFRS 6 and some of the IFRIC interpretations, and some changes in IAS 39 relating to the fair value of financial instruments (PwC, 2005a).
While the EU regulation is only enforceable on listed companies, it also says that a member state has an option to extend the use of IFRS to unlisted companies within their jurisdiction. Department of Trade and Industry (DTI), the government trade body responsible for company regulation in UK, has said that while there is no mandatory move to IFRS for unlisted companies, the unlisted companies would still be allowed to adopt IFRS over UK GAAP from 2005 onwards.
The basic aim of new financial reporting standards is same as that of existing standards – to provide information about financial performance and position of a company to different stakeholders. Internal stakeholders – management – normally have a good grip of what’s going in the business. It is external stakeholders like investors, auditors, suppliers and creditors who need to be informed in a succinct and clear manner about financial implications of business decisions.
The IFRS would aim to present a more complete picture of a business by making operating income a more encompassing number. As an example, the financial implications of stock options were kept out of income statements. Companies merely mentioned the number of stock options granted. But now onwards, companies will have to incorporate the fair costs of granting stock options in their income statements. This will allow investors to assess the true costs of executive remuneration.
Though the overall aim is same, the differences in implementation and financial reporting do occur due to social, economic and political backgrounds of different nations.
Will it be a good policy to allow two different accounting standards in UK – one standard for listed companies and another for unlisted companies. UK’s Accounting Standard Board clearly sees there is no merit in having two separate standards. ASB issued a Discussion Paper in March 2004 highlighting its strategy for convergence with IAS and says that convergence of UK accounting standards to IAS is a foregone conclusion. It has already introduced many changes in recent past to bring UK’s GAAP in line with IFRS.
Smaller companies, even listed ones, will find it difficult to cope with extra work due to IFRS. Alternative Investment Market (AIM) realises that most of its companies won’t be in a position to meet IFRS requirements soon. So it changed its regulatory status in October 2004 and is now an “exchange regulated market” and out of purview of European Commission regulation on regulated markets. Now companies listed on AIM have time until January 2007 to implement IFRS.
Accounting Standards Board is also sensitive to the needs placed on business in making a transition from UK accounting standards to IFRS. Big businesses probably have sufficient resources to cope with the change in one year. But the smaller businesses will find it difficult to make all required changes in one year. ASB has proposed a series of changes that would be implemented in 2005 and 2006 which will bring UK financial reporting standards more in line with IFRS. Thereafter ASB will carry out a series of step changes by replacing one or more UK standards. So by the end of 2005-2006, UK standards will almost be in line with IFRS and unlisted companies transition to IFRS in 2007 would be smooth.
This research analyses the attitude of unlisted companies towards IFRS. Many research and surveys have been carried out on the acceptance and readiness of listed companies for transition to IFRS. But the issue has not been explored in depth with respect to unlisted companies.
The research is based on primary and secondary data. Primary data is collected via interviews and questionnaires with companies and their auditors. A total of  interviews –  with companies and  with their auditors – were conducted to obtain primary data.  questionnaire responses by postal survey were also analysed.
The results show that there is definitely a much scope in improving International Financial Reporting Standards for unlisted companies. Respondents were concerned about the costs associated with transition to IFRS and also the additional burden that will come with regular enhanced reporting. That IFRS will help in globalisation of capital markets and probably cheaper costs of capital is not of much significance for unlisted companies registered in UK.
This research would be useful for institutes and associations framing accounting standards for unlisted companies. Mostly accounting standards have been framed with an eye for listed and large companies. But unlisted companies have much lesser resources to spend on large regulatory requirements and hence should have different reporting requirements that match the benefits obtained from such reporting.
The time limitation and resource constraint mean that the primary data via interviews and questionnaire surveys could only be collected through a limited number of respondents. It would be useful to cover a larger data base before implementing the changes. Also more users of data in unlisted companies like banks and creditors should be contacted before policy formulation.
The remaining paper is divided in the following sections. Section II is a literature review on justification and applicability of IFRS, and state of readiness in companies. Section III discusses the methodology used in this research. Section IV covers analysis of data obtained through the primary data collection and its interpretation. The paper concludes with section V.
SECTION II – LITERATURE REVIEW
In June 2000, the European Commission proposed a new directive requiring that all publicly traded companies in the member states to adopt International Accounting Standards Board (IASB) standards by no later than January 2005. On 19 July 2002, the European Parliament and the Council approved the IAS regulation (EC) 1606/2002 which said ‘For each financial year starting on or after 1 January 2005, companies governed by the law of a Member State shall prepare their consolidated accounts in conformity with the international accounting standards adopted … if, at their balance sheet date, their securities are admitted to trading on a regulated market of any Member State’ (EU, 2002).
Rationale for EU’s adoption of International Financial Reporting Standards
The main aim of International Financial reporting Standards is to bring convergence among different national financial reporting standards. Over time, the evolution of different national financial reporting standards has been influenced by local social, political and economic environments. Some of the major reasons for differences in accounting standards are:
- Political – Capitalist or Communist. Capitalist and communist countries have almost contrasting fundamental economic approach and their accounting standards reflect the same.
- Stage of economic development. Developed countries generally have better accounting standards in terms of transparency and clarity.
- Corporate finance – debt or equity. Companies in continental Europe are financed more by debt than the companies in UK. Accounting standards have over time evolved to reflect the importance placed by different sources of financing on different aspects of financial statements.
- Legal and taxation systems.
Convergence will help investors and analysts to compare companies across borders in a better way. But it also implies that either member countries will lose their independence to make national accounting standards that reflect local economic conditions or if they start introducing some changes, IFRS may slowly lose its main strength of common standard. Local, political and economical conditions may force national accounting bodies to introduce variations in IFRS. EU has already introduced some changes in the IAS 39 dealing with financial instruments. It is beyond the scope of this research to see which member countries have introduced variations in IFRS.
Convergence between UK GAAP and IFRS
ASB has declared its intention to converge UK GAAP with IFRS. It has issued a number of new standards in December 2004 to speed up the convergence of UK GAAP with IFRS. So sooner, even unlisted companies would be following a substantial portion of IFRS due to this convergence.
Comparison of UK GAAP and IFRS
The ultimate goal of UK GAAP and IFRS is same – to present information about financial performance and position to all concerned stakeholders. If the aim is same, then should be the main approach adopted by both accounting standards.
The UK’s Accounting Standard Board’s Statement of Principles for Financial Reporting is a vital contributor at macro level standard setting. It plays almost same role as International Accounting Standards Committee’s ‘Framework for the Preparation and Presentation of Financial Statements’. ‘It is a description of the fundamental approach that the Accounting Standards Board (ASB) believes should, in principle, underpin the financial statements of profit-oriented entities’ (ASB, 1999). The Statement of Principles has true and fair concept at its core, much like the focal point in International Accounting Standards. Also like IAS, Statement of Principles insists on financial information being relevant and comparable.
It is beyond the scope of this research to highlight each and every similarity between UK GAAP and IAS.
Though the overall aim is same, the differences in implementation and financial reporting do occur due to social, economic and political backgrounds of different nations.
Main concepts behind UK GAAP and IFRS are same, but when we look at micro level, we see many differences at the individual standards level. Following are the main differences between UK GAAP and IFRS:
- The Statement of Principles allows use of both historical cost and current value approaches in measuring balance sheet categories. The dual use of historical and current value methods is known as modified historical cost basis (ASB, 1999). Under historical cost, the carrying values of assets and liabilities are stated at the lower of cost and recoverable amount. This approach is more conservative as compared to IAS approach which uses fair value method. Also the choice of historical or current value method is based on subjective analysis of a company’s management and hence it is open to some manipulation.
- Fair value. If we look at global level, both UK GAAP and IFRS have adopted fair value method as the foundation of their accounting standards. IFRS takes fair value adoption even higher when it says that income statement will include the changes in the fair value of items that have not been yet traded like derivatives. The emphasis in new accounting standards is on mark-to-market fair value of assets and liabilities rather than on actual market price based fair values. Now both realised and unrealised changes in fair values would be incorporated in income statements. The first year of transition will see high volatility in earnings and balance sheet statements. Though this brings higher volatility, it will also test the management skills in proper presentation and explanation of changes. It may also change the benchmarks of success for managements.
- Acquisitions. Acquisition accounting will change under new accounting standards. Under UK GAAP, companies can choose between purchase and merger accounting. Under IFRS, companies will have to account under purchase method only.
- Goodwill. UK GAAP allowed amortisation of goodwill and companies had the option of not segregating intangible assets from goodwill. Under IFRS, intangible assets have to be separated from goodwill. Goodwill can not be amortised now but companies will have to undertake annual impairment tests to justify the value of goodwill on the balance sheets. BAT’s profits for year 2004 increased by £454m because it no longer had to amortise goodwill of that amount (AccountancyAge, 2005b).
- Consolidation of accounts. Under new accounting rules, companies may have to consolidate certain additional subsidiaries into group accounts. On the other hand companies will have to exclude certain subsidiaries or special purpose vehicles which were not included till now.
- Research and development costs. Under IAS 39, research costs can’t be carried on the balance sheet and would have to write them off as incurred. Companies would still be allowed to capitalise development in line with UK GAAP.
- Stock options. Internet and share market last boom in late 1990s led to rapid increase in share options as a way to reward employees. The new requirements to record an expense on income statement for the value of share options granted to employees could have a significant impact on earnings. AstraZeneca said in its pro forma 2004 IFRS numbers that new accounting rules on stock options has made it re-consider the use of stock options in rewarding its employees (Tricks, 2005).
- Distributable profits. Organisations ability to pay dividends is dependent on their distributable profits. Following are some of the major impacts of IFRS on distributable profits – Inability to discount deferred tax liabilities, higher provisions for deferred tax when companies move from historical costs to fair value and inclusion of pension deficits in income statement. All of the above will reduce distributable profits. Many companies would have to financially restructure themselves in order to have sufficient distributable profits to meet dividends paid in last year.
- Deferred tax credit. Deferred tax credit is available under UK GAAP but not under IFRS. GlaxoSmithKline’s restated its 2004 earning per share by (1.9p) due to non-availability of deferred tax credit under IFRS (AccountancyAge, 2005a).
- Inclusion of business disposals gains in profits from operations. BAT’s profits for year 2004 increased by £1.3bn after it included gains from disposals to operating profits (AccountancyAge, 2005b). Adding disposal gains to operating profits will make it harder for investors and analysts to separate the earnings from continuing businesses.
- Derivative contracts. Under IFRS, some derivative contracts will not qualify as hedges as they wont meet the criteria. UK GAAP allowed deferment of such contracts until transaction took place. IFRS won’t allow the deferment of such contract and would impact the profit and loss account even before the transaction took place. It is better in a way that investors will know the current value of the firm as on date rather than historical costs of such instruments, especially if the duration of financial instruments was long. At the same time, it would increase the burden on the company to calculate the fair value of all such transactions.
- Agricultural. UK GAAP allowed companies to use a cost model for biological assets and all agricultural produce. But under IAS companies would have to use mark to market method for valuing such assets. Now companies would have to use market valuation even for assets in far off countries.
Advantages of IFRS over UK GAAP
- Common financial language. Adopting common financial reporting standards will open up a company to more markets and investors. The growth in telecommunications has made it easier for smaller investors to invest across physical boundaries. Such investors are normally not as financially sophisticated as some big financial institutions. They would also not like to understand more than one accounting standards as they don’t have required resources in hand to do so. With one common accounting standard, more investors would like to explore companies across nations.
- Acquisitions. IFRS 3 is more open and transparent than UK GAAP on acquisitions. It will allow investors and analysts to judge faster the success of an acquisition. Many of the companies that have relied on acquisition as a key cornerstone for growth would now come under intense scrutiny and may have to develop a new strategy for growing business.
- Consolidation. In IFRS, all entities will have to provide a cash flow statement. Additionally there would be more transparency within the group companies and this should make the consolidation process more straight-forward.
- Securitisation by businesses is likely to be impacted by the new ways governing how companies can show assets and liabilities on their financial statements. Companies have used securitisation to cash in assets like trade receivables sitting on their balance sheets. Securitisation helps companies to slim down their balance sheets and hence allows companies to show higher return on assets at same earnings. And it was one of the reasons why companies went for securitisation. But stringent criteria for moving assets and liabilities off balance sheet will threaten securitisation. Sue Harding, chief accountant at Standard & Poor’s in Europe said that new international accounting standards were sweeping a lot of securitised assets back on to balance sheets (Jopson, Feb 2005).
This will help investors compare like to like and avoid companies that have used securitisation only to make-up their balance sheets. There is no harm in using securitisation if used in a proper way and not to deceive stakeholders. But we have seen how corporations like Enron had used securitisation to disguise their true financial position.
- Annual impairment review. Annual impairment review will benefit investors because the companies then won’t like to take big goodwill cuts in one year and not do anything for years. Annual reviews would help investors judging whether the amount paid by companies in acquiring other company was justified or not.
- Access to cheaper capital. Increase in investor profile diversification would most probably lower the cost of capital for most of the companies. This is especially true for smaller companies which don’t have financial muscles and resources to tap international investors.
- Expensing research costs gives better information to investors and other stakeholders because at research stage the chances of success are quite uncertain. Investors can only be sure of development costs bringing in some returns in future. Also by segregating research and development costs, external stakeholders will now have a better chance to differentiate the suitability of costs incurred in developing new products.
- Multiple listings. Many companies now have multiple listings across different countries. Companies need to prepare financial statements as per each local accounting standard to meet listing requirements. With one accounting standard only it will save a lot of botheration for companies with multiple listings.
- Dividends. Under IFRS dividends are not provided for until the dividend recommended by the Board is approved by shareholders. This move will bring more convergence between accounting profits and cash flows.
Disadvantages of IFRS
- Fair value. While fair value in a way conveys more up to date value of a company as compared to historic costs, it also puts a question mark on the methods used and the reliability of fair value. Derivative instruments which are commonly traded on various stock exchanges can be easily assigned value. So while valuing some of the assets or liabilities may not be difficult, the question still remains what impact such valuations will have on companies’ business models. Many companies use hedging instruments as a strategic tool rather than for intentional gains. Any short-term swings in such instruments may have a significant impact on income statement and probably adverse market reactions may deter companies’ from using such instruments.
Then comes the more important issue of valuing assets and liabilities that don’t have a proper market. The companies may use some valuation model, which itself may not be the right way, to value an asset or liability. The model will incorporate some subjective assumptions. An example would be brand value. A same brand can have two different values for two different companies because of its strategic importance. So at one hand, investors and other external stakeholders are getting more objective information about a companies’ assets and liabilities, they are also getting valuation based on more subjective assessments. Only time will tell whether some individuals or companies will use it to manipulate results.
An interesting thing to observe would be the treatment and importance given by analysts to unrealised fair value of assets and liabilities. Some investors may try to separate unrealised gains and losses from other operational performance. It may also prompt companies to issue adjusted earnings excluding unrealised gains and losses.
An important point to note about fair value principle is that the financial statements should not be seen as perfect prediction of things to come. That depends on the strategic and business decisions management will take in future. Just having a fair value of assets and liabilities doesn’t mean that the company will be able to extract those values in future.
- Dividend. New accounting standards promote payment of dividend from distributable reserves. With the inclusion of unrealised gains and losses and pension deficits, the first few years of new accounting standards may not leave enough of distributable reserves for dividend payments.
- Securitisation. Securitising assets into special purpose vehicles and re-financing them through had also helped companies raise funds at lower costs. The new accounting standards by restricting the use of special purpose vehicles, would diminish some sources of cheap financing. It is question yet to be fully tested in the practical world that since the assets are same, change in financing options shouldn’t change the returns on total assets. By refinancing at lower rates through securitisation should result in higher financing cost for remaining assets such that the overall costs remain same. But examination of this hypothesis is beyond the scope of this dissertation. But what is mostly observed in capital markets is that when companies announce refinancing, the share price rises. How much of the rise is from relief that company will survive and how much from the fact that the overall costs have lowered is not known.
- Annual impairment tests. Annual impairment tests are easier said than done. Companies would not only have to devote substantial resources to do that first would have to train its personnel to do that. Assessing true value of a goodwill is not easy. If there is a comparable market then companies can easily value it. Even then it may differ from case to case as it would be very unusual to see exactly two similar companies. Goodwill is very different from tangible assets or technologies and depends a lot on market perception and strategy. Companies would have to review the whole process of valuing goodwill and would have to review the valuation process at constant intervals.
- Net pension liability. The inclusion of net pension liability on the balance sheet may have severe impact on the shareholders funds. Companies will be required to have annual actuarial valuation of their pension liabilities and the same would be reflected in financial statements. Most of the pension funds invest in equity markets, which have been quite volatile in the recent years. So though over a longer period, the movements in pension liabilities may even out but in short to medium term, it may have a dramatic effect on balance sheets and earning statements.
- Segmental information. IAS 14 requires companies to report information on their business segments and on a scale more detail than UK GAAP. As of date, no agreed accounting practices have emerged on how much should be disclosed because companies may end up revealing sensitive information to its competitors. If companies disclose the turnover, earnings and expenditure for each segment, its profitable operations may come under intense competition. Ian Dilks of PwC said that “some companies have found they’re giving much more information than they’re comfortable with on sales and the profitability of product areas” (Tricks, 2005)
- Expensing research costs may result in listed companies focusing more on products in development stage than in research stage. This will keep their balance sheets healthy but may harm long term prospects.
- Complex and long IFRS compliant reports. PricewaterhouseCoopers estimates that an IFRS compliant financial report for insurance companies could be up to twice as long as those prepared under existing UK GAAP (Finn & Zoon, 2004). The requirement for other industry sectors though may not be as intensive as for insurance sector, their IFRS compliant financial may also be longer and resource intensive than under UK GAAP. Any company that has makes an acquisition will have to do annual goodwill impairment analysis and most of them would like to explain the results also.
- Comparable formats. IAS 1 is less prescriptive than the UK GAAP when it comes to the format of the balance sheet and income statement. It just distinguishes current and non-current assets and liabilities. Investors, when faced with different formats, may find it difficult to compare companies.
- Modify organisation structures. Meall (2003) suggested that the additional burden of more financial reporting along different segments may force companies to modify their existing organisational structures within their financial systems to collect and analyse data.
Impact of IFRS on different industries
IFRS will have different impact on different industries. For some, most of the applied UK GAAP is almost same as IFRS and won’t feel the difference. But for some industries, the difference in accounting standards may have a substantial impact. Financial services and insurance companies are among them. Financial services companies would be affected by substantial change in recognition and measurement of financial instruments under IAS 39. UK GAAP has no equivalent to IAS 4 which deals with insurance contracts. Insurance companies would now have to account for this in their financial statements.
Under IFRS, insurance companies would have to book financial instruments such as derivatives at market value rather than historical value allowed under UK GAAP. Many insurers have said that this will distort their earnings (Reuters, 2005a). IFRS will put more stringent criteria for classification of insurance products and this may lead to reclassification of some insurance products as investment products.
Other industries that might face higher impact are the ones that heavily use hedging instruments in their day to day operations. Mostly companies using commodity materials like oil as a significant part of their input costs use hedging to smooth over the volatile changes in commodity markets.
New accounting standards will reduce Tesco’s projected annual profit of £2,000m by £30m only, a reduction of 1.5%. But for some companies the impact would be much more. Royal & Sun Alliance said that new accounting rules would reduce its net assets by £400m (Reuters, 2005a). This is a big number by any standards and shareholders