The price of an open market
IFRS is a gigantic step to address the two fundamental worries of investors, bankers, and auditors everywhere who read a company's financial statement: Is there anything not reported on the balance sheet that could represent a hidden benefit or detriment to investors and other stakeholders? And, is there anything not reported on the profit and loss statement that could represent a hidden benefit or detriment to investors and other stakeholders?
To put it most simply, IFRS just takes benefits or detriments that are currently not reported, and reports them. Sounds simple, doesn't it? But in this simplicity lie a devilish number of details.
A simple example may best illustrate the problem that IFRS is trying to address. Under most previous versions of GAAP, a large real-estate asset (let's say land and buildings) was recorded at its cost, or its purchase price. The buildings would be depreciated over a fixed period of time, so the value reported on the balance sheet would be decreasing over the years. Over a period of 10 years, the value of that real estate on the balance sheet shrank considerably.
Of course, all businesspeople that take the time to think about it know that this is usually an inaccurate representation, insofar as real estate generally appreciates in value over 10 years. The difference between the reported value and the actual value is the troubling problem for investors. The average person unfamiliar with the company's assets would not be able to readily tell the size of this discrepancy just by reading the financial statement.
As obvious as this may seem, there have been entrepreneurs who have made fortunes on just such a discrepancy in reporting, purchasing up publicly traded companies from unwary shareholders, and capitalizing on the value hidden in the real estate on the balance sheet.
With IFRS, that hidden discrepancy will now be revealed and reported. Starting with reports issued after January 1, 2005, many companies will be obliged to adjust the value of that asset and show it for its true value (IFRS refers to it as "fair value," a departure from the lexicon used universally by appraisers and valuation experts of "fair market value"). All is disclosed and the shareholder wins. Right?
Changing values
Well, yes, but not quite. The question of "fair value" is loaded with problems. Those same assets may also decrease in value. Any downward or upward adjustment of assets or liabilities must be offset by an adjustment to shareholders' equity in order for the balance sheet to balance, and that adjustment will go into the statement of retained earnings. Here things start to get complicated, perhaps creating unwanted surprises.
Historically, such true economic appreciation or depreciation in value was reported under a principle in accounting called "recognition". The principle of recognition states that the appreciation or depreciation inherent in an asset should be only recognized when there is a "recognition event".
The most straightforward example of a recognition event is the sale of an asset for cash. The rationale behind recording the changed value of an asset at a recognition event was that, in a presumably arm's length transaction, the company had the best and most accurate measure of exactly how much the value of the asset had changed, so the recording of the change in value was assured to be precise. In addition, a recognition event provided the cash to pay taxes and distribute dividends. With the advent of IFRS, such adjustments will now not await the occurrence of a recognition event, but will be estimated by the company or its advisors and periodically adjusted.
So what happens when an adjustment to "fair value" results in a decrease in the retained earnings, the only source out of which dividends may be legally paid? Nobody is really sure. If it in fact reduces retained earnings, that will mean less money for dividends, resulting in a potential change in the company's dividend policy, as well as the tax and accounting treatment of distributions to shareholders, all rather significant issues.
A real-estate asset is a simple example. IFRS extends to all assets or liabilities that are on the balance sheet, be they tangible or intangible, including equity securities, derivatives, options, hedges, commercial loans, and pension-fund liabilities. It will revise how mergers and acquisitions are recorded. When one takes into account the erratic nature of markets and market values, the principle of consistency and predictability in reporting has given way to the less predictable forces of the market place.
How to choose
How will companies determine which values to report? Where there is a ready and active market for the asset (such as a stock exchange), the answer is simple. Where no such ready market exists, the answer becomes more complicated and potentially expensive. IFRS itself prescribes the discounted cash-flow method of determining value, that favorite spreadsheet toy of financial analysts everywhere. You can see the consultants' mouths watering at the sight of this.
Some of the methods of accounting introduced by IFRS will result in changes that are material and often drastic.
Paweł Wojciechowski, president of the management board of Allianz Fundusz Emerytalny, a member of Allianz's Polish group of financial services companies, and an expert on financial services and capital markets, illustrates it quite simply: "Gross premiums written for unit-linked products, such as universal life-insurance policies, which is quite a popular product, used to be reported as premium revenue under all prevalent accounting standards. Now, under IFRS, the unit-linked revenue must be allocated between premium component and investment component. Since the investment revenue portion of the premium can be as high as 90 percent or 95 percent, this could have a considerable effect on the revenue of the company."
Reverse reporting
One case, submitted by a consultant who wished not to be identified in order to preserve the confidentiality of the transaction, described a transaction that under previous Polish principles would be reported as an acquisition, but would now have to be reported in reverse under IFRS. In other words, the acquired company would have to be designated as the acquiring company. Not a small difference.
As one can tell from this brief analysis of the implications of determining "fair value," the drawback of IFRS, at least in the transition phase, is its complexity. Although many differentiate IFRS from U.S. standards by describing IFRS as "principles" based, and US standards as "rules" based, one just has to look at the cinder block-sized volume that represents IFRS to know that this is far more than a series of principles. IFRS is not going to be easy to understand or apply, even for experts. IFRS is so complicated that many experts believe that it will be impossible to be an IFRS 'generalist'.
"In the end, we are going to get experts on the standards. In the old days there were 10 or 15 basic standards, but now you have something like IFRS 39, on derivatives. You really have to be an expert on that standard. That's what it's all moving to," says David Pozzecco, audit partner at KPMG.
Thick issue
One example that this writer noticed, by randomly opening a copy of the official edition of IFRS, which is about as thick as a London phone directory (assuming they still print phone directories in London) is: In order to do one thing or another, one must first determine whether the reporting company is reporting in the currency of a "hyperinflationary economy" (according to a particular provision). In order to understand what a "hyperinflationary economy" is you must go back to a list of definitions. IFRS appears to have all the complexity of the U.S. Internal Revenue Code, and requires expertise in what lawyers refer to as "statutory construction," i.e. the proper and effective interpretation of complex statutory language.
Implications all around
Changes to what is reported on the balance sheet and the profit-and-loss statement will have implications not only for shareholders, but also for others who are stakeholders in the company's business.
"A lot of companies have debt," says Aleksander Domaradzki, transportation and logistics industry leader for Central and Eastern Europe, at PricewaterhouseCoopers. "They'll have a loan from a bank, and normal operating procedure for a bank is that they will write debt covenants where the bank will request certain information, certain ratios to be presented, so the bank can monitor if it needs to start worrying about recoverability of its loan or not."
After IFRS, those figures may change dramatically, but the terms of the loan agreement will not. There may be companies who find themselves technically in default, for no other reason than reporting under IFRS has changed their earnings before interest and taxes ("EBIT") as a percentage of revenue.
These are the general issues with IFRS; we have not even come yet to the implications for Poland. Fortunately, the issues concerning treatment of stock options as executive compensation as well as treatment of derivatives is less of an issue, insofar as these types of instruments are not as widely used in Poland as in other countries. However, the reported value of assets is a bit trickier.
Bad old days
Many advisers who remember the days of Poland's hyperinflation in the early 1990s will recall that fixed assets inside Polish companies, which were reported at cost in złoty using currency values from the 1980s, went through many rounds of revaluation in the early 1990s as a means of helping those companies avoid the negative impact of such hyperinflation.
Although well intentioned and in many ways necessary, these valuations were statutorily prescribed and formulaic. What will happen to them now that they are to be adjusted with respect to market values, nobody knows. "These valuations do not meet the requirements of IFRS," notes Mirosław Matusik, senior audit manager at KPMG.
The lists of issues could go on, but the understanding and proper use of the IFRS provisions will take time. Lots of time.
By Robert Michaels
To put it most simply, IFRS just takes benefits or detriments that are currently not reported, and reports them. Sounds simple, doesn't it? But in this simplicity lie a devilish number of details.
A simple example may best illustrate the problem that IFRS is trying to address. Under most previous versions of GAAP, a large real-estate asset (let's say land and buildings) was recorded at its cost, or its purchase price. The buildings would be depreciated over a fixed period of time, so the value reported on the balance sheet would be decreasing over the years. Over a period of 10 years, the value of that real estate on the balance sheet shrank considerably.
Of course, all businesspeople that take the time to think about it know that this is usually an inaccurate representation, insofar as real estate generally appreciates in value over 10 years. The difference between the reported value and the actual value is the troubling problem for investors. The average person unfamiliar with the company's assets would not be able to readily tell the size of this discrepancy just by reading the financial statement.
As obvious as this may seem, there have been entrepreneurs who have made fortunes on just such a discrepancy in reporting, purchasing up publicly traded companies from unwary shareholders, and capitalizing on the value hidden in the real estate on the balance sheet.
With IFRS, that hidden discrepancy will now be revealed and reported. Starting with reports issued after January 1, 2005, many companies will be obliged to adjust the value of that asset and show it for its true value (IFRS refers to it as "fair value," a departure from the lexicon used universally by appraisers and valuation experts of "fair market value"). All is disclosed and the shareholder wins. Right?
Changing values
Well, yes, but not quite. The question of "fair value" is loaded with problems. Those same assets may also decrease in value. Any downward or upward adjustment of assets or liabilities must be offset by an adjustment to shareholders' equity in order for the balance sheet to balance, and that adjustment will go into the statement of retained earnings. Here things start to get complicated, perhaps creating unwanted surprises.
Historically, such true economic appreciation or depreciation in value was reported under a principle in accounting called "recognition". The principle of recognition states that the appreciation or depreciation inherent in an asset should be only recognized when there is a "recognition event".
The most straightforward example of a recognition event is the sale of an asset for cash. The rationale behind recording the changed value of an asset at a recognition event was that, in a presumably arm's length transaction, the company had the best and most accurate measure of exactly how much the value of the asset had changed, so the recording of the change in value was assured to be precise. In addition, a recognition event provided the cash to pay taxes and distribute dividends. With the advent of IFRS, such adjustments will now not await the occurrence of a recognition event, but will be estimated by the company or its advisors and periodically adjusted.
So what happens when an adjustment to "fair value" results in a decrease in the retained earnings, the only source out of which dividends may be legally paid? Nobody is really sure. If it in fact reduces retained earnings, that will mean less money for dividends, resulting in a potential change in the company's dividend policy, as well as the tax and accounting treatment of distributions to shareholders, all rather significant issues.
A real-estate asset is a simple example. IFRS extends to all assets or liabilities that are on the balance sheet, be they tangible or intangible, including equity securities, derivatives, options, hedges, commercial loans, and pension-fund liabilities. It will revise how mergers and acquisitions are recorded. When one takes into account the erratic nature of markets and market values, the principle of consistency and predictability in reporting has given way to the less predictable forces of the market place.
How to choose
How will companies determine which values to report? Where there is a ready and active market for the asset (such as a stock exchange), the answer is simple. Where no such ready market exists, the answer becomes more complicated and potentially expensive. IFRS itself prescribes the discounted cash-flow method of determining value, that favorite spreadsheet toy of financial analysts everywhere. You can see the consultants' mouths watering at the sight of this.
Some of the methods of accounting introduced by IFRS will result in changes that are material and often drastic.
Paweł Wojciechowski, president of the management board of Allianz Fundusz Emerytalny, a member of Allianz's Polish group of financial services companies, and an expert on financial services and capital markets, illustrates it quite simply: "Gross premiums written for unit-linked products, such as universal life-insurance policies, which is quite a popular product, used to be reported as premium revenue under all prevalent accounting standards. Now, under IFRS, the unit-linked revenue must be allocated between premium component and investment component. Since the investment revenue portion of the premium can be as high as 90 percent or 95 percent, this could have a considerable effect on the revenue of the company."
Reverse reporting
One case, submitted by a consultant who wished not to be identified in order to preserve the confidentiality of the transaction, described a transaction that under previous Polish principles would be reported as an acquisition, but would now have to be reported in reverse under IFRS. In other words, the acquired company would have to be designated as the acquiring company. Not a small difference.
As one can tell from this brief analysis of the implications of determining "fair value," the drawback of IFRS, at least in the transition phase, is its complexity. Although many differentiate IFRS from U.S. standards by describing IFRS as "principles" based, and US standards as "rules" based, one just has to look at the cinder block-sized volume that represents IFRS to know that this is far more than a series of principles. IFRS is not going to be easy to understand or apply, even for experts. IFRS is so complicated that many experts believe that it will be impossible to be an IFRS 'generalist'.
"In the end, we are going to get experts on the standards. In the old days there were 10 or 15 basic standards, but now you have something like IFRS 39, on derivatives. You really have to be an expert on that standard. That's what it's all moving to," says David Pozzecco, audit partner at KPMG.
Thick issue
One example that this writer noticed, by randomly opening a copy of the official edition of IFRS, which is about as thick as a London phone directory (assuming they still print phone directories in London) is: In order to do one thing or another, one must first determine whether the reporting company is reporting in the currency of a "hyperinflationary economy" (according to a particular provision). In order to understand what a "hyperinflationary economy" is you must go back to a list of definitions. IFRS appears to have all the complexity of the U.S. Internal Revenue Code, and requires expertise in what lawyers refer to as "statutory construction," i.e. the proper and effective interpretation of complex statutory language.
Implications all around
Changes to what is reported on the balance sheet and the profit-and-loss statement will have implications not only for shareholders, but also for others who are stakeholders in the company's business.
"A lot of companies have debt," says Aleksander Domaradzki, transportation and logistics industry leader for Central and Eastern Europe, at PricewaterhouseCoopers. "They'll have a loan from a bank, and normal operating procedure for a bank is that they will write debt covenants where the bank will request certain information, certain ratios to be presented, so the bank can monitor if it needs to start worrying about recoverability of its loan or not."
After IFRS, those figures may change dramatically, but the terms of the loan agreement will not. There may be companies who find themselves technically in default, for no other reason than reporting under IFRS has changed their earnings before interest and taxes ("EBIT") as a percentage of revenue.
These are the general issues with IFRS; we have not even come yet to the implications for Poland. Fortunately, the issues concerning treatment of stock options as executive compensation as well as treatment of derivatives is less of an issue, insofar as these types of instruments are not as widely used in Poland as in other countries. However, the reported value of assets is a bit trickier.
Bad old days
Many advisers who remember the days of Poland's hyperinflation in the early 1990s will recall that fixed assets inside Polish companies, which were reported at cost in złoty using currency values from the 1980s, went through many rounds of revaluation in the early 1990s as a means of helping those companies avoid the negative impact of such hyperinflation.
Although well intentioned and in many ways necessary, these valuations were statutorily prescribed and formulaic. What will happen to them now that they are to be adjusted with respect to market values, nobody knows. "These valuations do not meet the requirements of IFRS," notes Mirosław Matusik, senior audit manager at KPMG.
The lists of issues could go on, but the understanding and proper use of the IFRS provisions will take time. Lots of time.
By Robert Michaels
