Are the financial statement effects of switching to international financial reporting standards really just a grand illusion? A new report from Moody’s Investor Service suggests that might be the case.
Moody’s says that, in general, companies making the change from local generally accepted accounting principles to IFRS record a 25-percent boost in net income and a “significant” rise in earnings before interest, taxes, depreciation, and amortization. But, says the credit rating agency, both adjustments are “largely illusory” and somewhat misleading.
In a study released this week, Moody’s examined the 30 largest European corporations it rates, and found that moving to IFRS generated a profit increase of an aggregate $30 billion. However, much of that boost was attributed to discontinuing goodwill amortization, which is allowed under IFRS. To be sure, the report says that goodwill amortization alone added an aggregate $42 billion to the bottom lines of the sample companies. Yet the credit rating agency explained that when goodwill amortization is stripped out, the 25 percent total boost actually swings to a decline of about 7 percent — and the number of companies reporting materially higher net income falls from 16 to seven.
Even the 7 percent decline is a “deceptive” number, though, according to the report’s authors. When three items that skew the profit picture are tossed out of the 30-company mix, the aggregate bottom-line results as reported under IFRS is only 2 percent lower than previously reported under local GAAP. Meanwhile, aggregate revenue remains virtually unchanged. The three items tossed out: impairment charges net of reversals recorded by Deutsche Telekom; changes to Electricite de France’s pension arrangements and the manner in which they are accounted for; and changes to France Telecom’s accounting for deferred tax under IFRS.
In its 23-page report — “Are We Better Off Under IFRS?” — Moody’s found that while there are benefits to using a single set of accounting standards, the financial statements prepared using IFRS are not necessarily any easier to compare. In some circumstances, the lack of comparability is blamed on a deficiency in standardization. In other instances, Moody’s cites several “seemingly inconsistent interpretations by companies and their auditors.”
What’s more, IFRS loses some of its usefulness because it can create false volatility and undue complexity. Consider, for example, that the amounts reported as “financial expense” are too often “unintelligible, and finding the ‘true’ level of debt can be like searching for a black cat in a dark room,” the authors wrote.
But plans to adopt IFRS seem to be moving forward. In 2002, the European Union adopted a regulation requiring listed companies in its 17 member states to prepare their consolidated financial statements using IFRS as endorsed by the International Accounting Standards Board. The mandate applied to fiscal years beginning on or after Jan. 1, 2005, but implementation was deferred until 2007 for some categories of companies — including those in Germany reporting under U.S. GAAP.
In 2004, when Moody’s first began to study the effects of the IFRS switch on the companies it rated, only 10 percent of the companies in the Europe/Middle East/Africa region used IFRS. Today, about 75 percent of the corporations in the same region use the single standard. According to the International Accounting Standards Board, more than 120 countries either require IFRS or have committed to mandating the practice for public companies.
Still, Moody’s said that the reporting adjustments that companies say are linked to their shift to IFRS should not be taken at face value. For example, a cursory look at the changes to EBITDA can be “misleading”, says the report. In aggregate, the 30 companies reported a $9 billion boost to EBITDA, to $443 billion, when IFRS was used. The boost was mostly brought on by nearly a 40 percent reduction in pension expenses and the reclassification of operating expenditures to capex and interest.
Pension expenses were cut by eliminating unrecognized actuarial losses against equity in the opening IFRS balance sheet, which helped companies avoid the need to amortize deficits against EBITDA. Further, other pension expenses were split between the “operating” and “interest” categories. In addition, IFRS requires that the cost of developing new products be capitalized and recorded as intangible assets and reported as capex in some circumstances. What’s more, when there is a significant delay between incurring a long-term liability and its settlement in cash, the related expense must appear partly as interest in the income statement under IFRS.
The report also revealed that balance sheets deteriorate under IFRS, with the ratio of net debt to equity in the 30 companies collectively worsening from 59 percent to 69 percent. Gross debt increased by $92 billion to $830 billion, with 12 companies reporting a materially higher outcome. Net debt increased by 18 percent to $642 billion.
But what does the rise in debt really telling Moody’s? No much, said the credit rating agency. The report asserts that Moody’s already factors in much of the IFRS-induced deterioration when doing a credit analysis, so there was no surprise when the balance sheets took the hit.
For instance, Moody’s typically treats securitization transactions as collateralized loans, and adjusts debt accordingly. It also routinely capitalizes all operating leases and recognizes a related debt obligation. In the study, the largest absolute increases in gross debt — excluding derivatives — under IFRS were reported by Daimler ($27 billion), Fiat ($17.2 billion), Deutsche Telekom ($9.3 billion), and and France Telecom ($7.6 billion).
Nevertheless, three factors explain nearly 90 percent of the $60.8 billion increase in debt reported by the four companies, said the report: The consolidation of $45 billion in previously off-balance-sheet borrowings linked to securitization and factored receivables; $3.2 billion worth of liabilities related to leased asset; and the reclassification of $5 billion worth of hybrid financing instruments.
Moody’s also pointed out that while underlying cash flows were unaffected by the choice of accounting method, many cash flow statements were restated under IFRS because of how transactions with third-parties are classified and reported. In fact, Moody’s attributed material cash-flow-statement changes reported by 11 companies to “special factors.”
For example, five carmakers — Daimler, Fiat, PSA Peugeot Citroen, Renault, and Volvo — saw major changes to their cash flow statements after converting to IFRS. But the special reasons for the adjustments were similar, and included the consolidation of previously off-balance-sheet receivables, the capitalization of product development costs, and the reversal of some sales with buyback commitments.
On the plus side, IFRS provided more comprehensive and transparent reporting, said Moody’s. Under the single reporting standard, cash flow statements are mandatory, which is helpful in assessing whether a company is generating sufficient cash from operations to service its debt, noted the authors. Prior to the adoption of IFRS, Italy and Spain were not required to include a cash-flow statement in their annual reports.
Further, pension obligations are “more comprehensively disclosed” under IFRS, as are obligations related to leased assets. IFRS also mandates additional disclosures, as compared to some local GAAP, related to changes in reserve amounts related to contingent liabilities.
What’s more, balance sheets prepared under IFRS probably will not include as many “questionable” pension assets as financial statements prepared under local GAAP. Moody’s explained that while “smoothing” still exists under the accounting rule known as IAS 19, balance sheets prepared under IFRS are less likely to include assets that result from delayed recognition of pension-related actuarial losses.
It is also likely that under IFRS more companies will report financing transactions as loans because, under the global standards, special-purpose entities used to securitize assets must be consolidated when the substance of the relationship indicates that the assets are controlled by the transferor. In addition, if the sale of a financial asset leaves substantially all the risks and rewards of ownership with the seller, the seller must continue to recognize the asset on its balance sheet with the sale proceeds being reported as a liability.
The report emphasized that IFRS still has some overarching problems that need to be addressed. That includes a lack of standardization, especially with regard to companies choosing one of two consolidation standards — proportionate consolidation or the so-called “one-line” equity method. A revised standard from IASB sorting out the discrepancy is due out in 2009.
Standardization problems also exist with regard to the way some companies capitalize interest, when others expense it. And cash flow can be presented under different headings in the cash flow statements, depending on which local GAAP is being used.
Moody’s has also encountered diverse practice interpretations, in which the same underlying accounting principle is applied differently. For instance, one of the thornier issues is trying to define “control”, says Moody’s, referring to IAS 27 and the guiding principle that says consolidated financial statements should include all the entities that are controlled by the parent company.
In one instance, Moody’s found that two French companies applied IAS 27 differently regarding de facto control, with one company claiming that an entity that was less than 50 percent owned by the parent could be fully consolidated if the parent had de facto control of the business. The other French company said that because IFRS does not recognize de facto control, the subsidiaries’ results were not consolidated.
Lease accounting is another problem area, as Moody’s pointed out that deciding what constitutes a lease under IFRS is still up in the air. Under IAS 17, and its supporting guidance IFRIC 4, a lease is defined based on the substance of the arrangement. But since this requires judgment based on case-specific facts and circumstances, Moody’s contended that some arrangements that appear broadly similar are dealt with differently.
Indeed, UK energy provider Centrica includes the payments for long-term power agreements with renewable providers as contingent rents. But German energy provider RWE, which is audited by the same firm as Centrica, does not include purchase-power agreements in its lease disclosures. The same disparity can be seen with regard to ship leases. UK-based BP classifies bareboat charters, time charters and spot charters for ships as operating leases, while the Australian mining company BHP Billiton concludes that ship chargers are “other expenditure commitment” that are not part of operating leases under IAS 17.