IFRS stands for International Financial Reporting Standards, which are drafted and issued by a body called the International Accounting Standards Board (IASB). Historically, European Union (EU) countries such as Germany, the UK, France and Spain had their own national GAAP (generally accepted accounting principles). When the EU was formed, its member-states had to be brought under one financial reporting framework. That led to the birth of IFRS, which all EU countries adopted starting in 2005.
Practically the whole world, other than the US, adopted or converged with IFRS over a period of time. Even the US allows IFRS in limited circumstances; foreign private insurers, for instance, are allowed to file IFRS financial statements rather than follow US GAAP standards. In 2011, the US will announce its position on IFRS adoption/convergence for local US filers. In a nutshell, IFRS is the biggest accounting change in a generation for many countries and companies around the world.
GAAP differences can completely obscure comparisons. In 1993, under German GAAP, auto maker Daimler-Benz AG reported a profit of 168 million deutsche marks, but under US GAAP for the same period, the company reported a loss of nearly a billion deutsche marks. Such differences confuse investors. A uniform set of high-quality, globally accepted standards will facilitate comparison and reduce confusion. That’s why investors have been supporting uniform global financial reporting standards across the world.
IFRS has numerous disclosure requirements and would provide a lot more information than Indian GAAP. Increased transparency can prompt managers to act more in the interests of shareholders. In particular, timely loss recognition in financial statements increases the incentive for managers to attend to existing loss-making investments and strategies more quickly, and to make fewer new investments with negative net present value (NPV).
There are numerous accounting differences between IFRS and Indian GAAP. For example, under Indian GAAP, in the case of foreign currency convertible bonds (FCCBs), the issuer company does not value the option to convert to shares the holder has, and redemption premium is generally charged to the securities premium account. Consequently, there is no charge to the income statement. Under IFRS, the accounting results in a significant impact on the income statement as the option is fairly valued in each reporting period and the redemption premium is considered at the market rate of interest.
As India moves to IFRS, starting from 2011, companies will be impacted by such GAAP differences. The impact could range from minimal to significant. The follow-on question, therefore, is: will the IFRS adjustments impact the market valuation of a company. Many companies do not anticipate that IFRS compliance should/would alter investors’ opinions and beliefs, given that IFRS has no effect on their firm’s strategy, business performance or free cash flows.
However, a study in the UK suggested that markets responded to IFRS adjustments. This response was mainly towards firms reporting lower earnings under IFRS compared with UK GAAP. The conservative nature of investors may be giving rise to this phenomenon. Positive earnings adjustment may signal opportunistic behaviour and, therefore, investors are reluctant to trade upon it. However, a negative adjustment is enough to trigger negative sentiment among investors.
IFRS may provide new information about a company, positive or negative. For example, under Indian GAAP, structured entities were not consolidated or hedge losses were carried forward, and those are accounted under IFRS. This would have a bearing on the investors’ perception of the value of the company. In the past, the market value of companies that reported huge financial losses on account of their derivative portfolio took a significant beating.
Companies reporting under IFRS for the first time should communicate the impact of IFRS conversion to investors much in advance so as to keep them prepared. Any last-minute negative news to an investor who is not prepared in advance will certainly trigger an adverse reaction. In Australia, companies prepared their investors months ahead of the formal reporting under IFRS. As a result, IFRS reporting did not have any significant impact on the market value of many Australian companies.
In conclusion, the extent of market impact that will be caused by IFRS adjustments and the extensive disclosures therein would depend on the nature of the adjustment/disclosure and how value-sensitive it is. Nevertheless, it is always a good strategy for companies to keep their investors prepared by communicating early.
Small investors may not have the skill sets or the ability to interpret IFRS financial statements when compared to a sophisticated investor. Such investors should seek high-level training in IFRS and become better informed. Companies should also ensure that their investors are appropriately trained in IFRS and generally have a better understanding of what is being reported under it.
Beginning today, Mint is running a three-part series on IFRS. India is committed to starting the first phase of convergence with IFRS in the quarter beginning April. The convergence will bring about several changes in the way the balance sheets of companies are presented.
The series, written by Dolphy D’Souza, a partner and national IFRS leader at consultancy firm Ernst and Young, will focus on what company promoters and investors should look for.
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