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Posted: T ue, Dec 28 2010. 9:14 PM IST

What investors should

know
Practically the whole world, other than the US,
adopted or converged with IFRS over a period
of time

Implementing IFRS | Dolphy D’Souza

IFRS stands for International Financial Reporting Standards, which are drafted
and issued by a body c alled 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 acc epted accounting
princ iples). 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.

Prac tically the whole world, other than the US, adopted or converged with
IFRS over a period of time. Even the US allows IFRS in limited circ umstanc es;
foreign private insurers, for instance, are allowed to file IFRS financ ial
statements rather than follow US GAAP standards. In 2011, the US will
announce its position on IFRS adoption/c onvergence for local US filers. In a
nutshell, IFRS is the biggest ac counting change in a generation for many
c ountries and c ompanies around the world.

GAAP differences can completely obscure c omparisons. In 1993, under German

GAAP, auto maker Daimler-Benz AG reported a profit of 168 million deutsc he
marks, but under US GAAP for the same period, the company reported a loss of
nearly a billion deutsche marks. Such differenc es confuse investors. A uniform
set of high-quality, globally acc epted standards will facilitate c omparison and
reduce c onfusion. That’s why investors have been supporting uniform global
financial reporting standards across the world.

IFRS has numerous disc losure 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 quic kly, and to make
fewer new investments with negative net present value (NPV).

There are numerous accounting differenc es between IFRS and Indian GAAP. For
example, under Indian GAAP, in the c ase of foreign c urrenc y c onvertible 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 c harge to the inc ome statement.
Under IFRS, the accounting results in a significant impact on the income
statement as the option is fairly valued in eac h reporting period and the
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redemption premium is c onsidered at the market rate of interest.

As India moves to IFRS, starting from 2011, companies will be impacted by

suc h GAAP differences. The impact c ould range from minimal to significant. The
follow-on question, therefore, is: will the IFRS adjustments impact the market
valuation of a company. Many c ompanies do not anticipate that IFRS
c ompliance 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 c ompared 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 c ompany, positive or negative. For
example, under Indian GAAP, structured entities were not c onsolidated or
hedge losses were carried forward, and those are accounted under IFRS. This
would have a bearing on the investors’ perc eption of the value of the c ompany.
In the past, the market value of companies that reported huge financ ial losses
on account of their derivative portfolio took a significant beating.

Companies reporting under IFRS for the first time should communicate the
impac t 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 c ertainly trigger an adverse reac tion. In Australia, c ompanies
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 c ompanies.

In c onclusion, 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/disc losure and how value-sensitive it is. Nevertheless, it is
always a good strategy for companies to keep their investors prepared by
c ommunicating early.

Small investors may not have the skill sets or the ability to interpret IFRS
financial statements when compared to a sophistic ated investor. Suc h
investors should seek high-level training in IFRS and bec ome 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

c ommitted to starting the first phase of convergence with IFRS in the quarter
beginning April. The convergenc e will bring about several changes in the way
the balanc e sheets of companies are presented.

The series, written by Dolphy D’Souza, a partner and national IFRS leader at
c onsultancy firm Ernst and Young, will focus on what company promoters and
investors should look for.

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