Along with US Generally Accepted Accounting Principles (GAAP), IFRS is emerging as a sound basis for international financial reporting. As already stated, the European Union has made IFRS obligatory for financial reporting by listed companies in its member states, replacing the current parochial national accounting standards. A total of 90 countries around the world will either per- mit or require the use of the new accounting standard. Among them are Australia and Switzerland, who have decided to implement IFRS,2 while other countries like Japan and China announced their intention to move in the same direction.
As is always the case when different interests exist, and several lobbies, there has been some criticism of the IFRS rules while they were shaping up and thereafter (see the case study in Chapter 2). For instance, mid-2003, some French banks repeatedly signalled their opposition to the principle of reporting on derivatives at their fair value. And there have been, as well, plenty of arguments regarding the hedge accounting regime (see Chapter 5).
Because of the uncertainty prevailing in the early years of this century around conversion to the new accounting system, several experts implored businesses to get ‘in at the beginning’ of the implementation of the International Accounting Standard (now IFRS). Also, in collaboration with IASB’s standard setters, to seek a valid application methodology. (A case study on IFRS project management is presented in Chapter 6.)
In September 2004, Jon Symonds, chief financial officer at AstraZeneca, the pharmaceutical company, and chairman of the 100 group of directors, gave his full support to the IFRS project, but criticized political ambiguities undermining its creditability. ‘It is a sad event when we see the politicization of accounting,’
Symonds said, referring to derivative financial instruments.3
Symonds believes the decision by the European Commission to only give partial endorsement to IAS 39 forgoes the chance to gain a ‘better understanding of volatility’ as opposed to the present situation where it is ignored ‘in the profit and loss’. And he called on business leaders for a concerted effort to make the market aware of what IFRS will mean to:
● Their accounts, and
● Their company.
Many central banks have been supportive of the work accomplished by IASB. In mid-2000 the Deutsche Bundesbank stated, in its monthly report, that: ‘IAS 39 ultimately represents the first concrete reflection of efforts undertaken by the IASB to advance the use of fair value accounting for financial instruments. The original all-embracing concept of full fair value accounting had encountered open criticism and reservations. The more specific provisions in IAS 39 were then developed as an interim solution, albeit without any set expiry date.’4 Some parties also expressed concern about the potential IFRS impact on credit risk. In late 2004, Moody’s Investors Service published a Special Comment which addressed this issue. Several factors could potentially impact the credit rating of an individual issuer converting to IFRS, Moody’s suggested.5
Issues singled out by Moody’s include disclosure of risks or financial character- istics not previously evident from the reporting under local/national accounting standards; market perceptions changing to the detriment of the issuer, restrictive banking or other covenants being breached when the numbers are restated.
Moody’s also mentioned adverse regulator behaviour in response to the new financial metrics as well as changes in behaviour of issuers in regard to:
● Managing risk
● Remunerating staff, or
● Designing and selling particular types of financial instruments.
According to prevailing expert opinion prior to the introduction of IFRS, the new rules were going to have a substantial impact not just on accounting but also on
the way business is conducted. Pessimists spoke of ‘great implications’ for a number of business segments, and of major implementation costs because of aligning reporting systems. Others expressed concerns that the IFRS implemen- tation will mean different philosophies at each side of the balance sheet:
● Assets being reported at fair value
● While liabilities of long duration remain at nominal value, computed through the accruals method.
We have briefly spoken of this A/L criterion in Chapter 2. The asset side of a bank’s balance sheet typically consists of cash holdings, but also financial assets, trading assets, loans and receivables, investments in property, and goodwill.
Financial assets must be measured at fair value. Assets are created by the bank providing money, goods or services directly to the debtor like originated loans and collection of receivables. These are:
● Initially recognized at cost
● But subsequently measured at amortized cost to impairment.
Critics said that by marking to market their assets, while using the accruals method for their liabilities, companies may face a substantial mismatch between these two classes. While the majority of assets will be measured at fair value, the accounting basis for liabilities will remain amortized cost under accounting requirements that may vary by jurisdiction. (Indeed, part of the phase shift with the new standard is that the balance sheet will no more balance the way it used to. See Chapter 13.) The pros answered that these points presented no real problems, and that the way to bet is market prices will in all likelihood reserve surprises. For instance, a change in interest rates will lead to volatility in the value of assets even if liabil- ities remain at nominal value. Adjustments will therefore be necessary through the P&L account. The truth however is that companies have an option in respond- ing to the potential mismatches. Take insurance firms as an example.
To align the duration of assets and liabilities, insurers may value a substantial part of their bond portfolio as held-to-maturity. The challenge is that the held-to- maturity hypothesis will not be sustained if the insurer needs to sell financial assets classified as held-to-maturity at an early stage. In this case, the company:
● Needs to reclassify all held-to-maturity assets as available-for-sale, and
● It would not be allowed to classify any financial assets as held-to-maturity for the following two years.
This can be carried further into other instruments held in the asset side of the bal- ance sheet, affected by the fair value methodology. A dynamic accounting system ensures that companies will have to adjust their books in response to changes in stock market prices, credit default probabilities and other factors.
One unwanted consequence may be that companies become keen users of finan- cial hedges. On the other hand, because IFRS requires all firms to price and describe separately the features of the hedges in place, the efficiency of such hedges will be scrutinized more closely. Some experts suggest that investment management companies will have to develop new financial products to respond to these challenges. We shall see.
According to the opinion of other experts, the new accounting framework will have further reaching consequences for the financial industry, when considered together with major regulatory changes embedded in Basel II,6 and a renewed focus on corporate governance. The reason is that the new accounting framework:
● Helps to improve investors’ understanding of the dynamics of modern business
● But might also entail higher volatility of earnings and, in consequence, of equity prices.
For their part, financial analysis generally welcomed the move to IFRS because they believe that the introduction of the new standards will increase manage- ment’s sensitivity to assumed exposure. They also looked very positively at greater disclosure requirements. Investors, too, hope that IFRS dynamics will improve their understanding of numbers reported by industrial and financial companies, while at the same time revealing some of the nature of underlying assumptions.
Similar comments also characterize the reaction of credit rating agencies.