Don't stress over IFRS - Part 2

Read Part 1 here.

It’s official. The first few sets of accounts under Australian International Financial Reporting Standards (AIFRS) have now been issued. Westfield Group has announced its half-yearly result, with the headline profit being materially boosted by the change to new accounting standards.

In Westfield’s case, it was the requirement that upward revaluations of its property holdings be recognised as income, rather than as an addition to a reserve account on the balance sheet, which created the gain. It boosted headline profit by almost $400m and, in fact, made it less useful than the figure under the old system. While this is just one example of a change under AIFRS, it raises the question of how companies make the transition to the new accounting rules.

Standards on adopting standards

Luckily, beancounters are nothing if not a diligent mob, and they’ve issued an entire standard dealing with the first-time adoption of AIFRS, with the main action taking place on a company’s balance sheet. The changes appear when an intangible, which had been an asset under the old system, is no longer to be regarded as such.

For example, the new standard states that no revaluation of an intangible asset is permitted unless an active market exists for that asset. A company like Publishing & Broadcasting, which in previous years has revalued its television licenses by $423m, will have to reduce the value of its intangible assets by that amount.

A basic principle of accounting states that assets minus liabilities equals equity. So if PBL has to reduce its assets by $423m, logic tells you it will also have to reduce either liabilities or equity by the same amount. The new standard dictates that the matching adjustment will typically be taken to retained earnings (which is part of equity). So next time you look at the balance sheet of your favourite media company, be prepared to see significantly smaller figures for assets and equity.

Some other standards that could play havoc with companies’ balance sheets include changes to the way tax assets and liabilities are calculated, and the impact of bringing surpluses and deficits of defined benefit superannuation plans on to the balance sheet. The latter change will be particularly relevant to National Australia Bank, which has a significant superannuation deficit and will more than likely take a big hit to its balance sheet when it adopts the new standards.

Another important change is in the treatment of share-based payments to employees. Under the current standards, any impact from share and option schemes only flows through the balance sheet and doesn’t affect earnings at all. It’s a ludicrous way to treat these payments which, after all, are a transfer of wealth from the company to the employee.

The formula for calculating how these share-based payments will be expensed doesn’t go far enough in our opinion; but it’s a step in the right direction. Companies such as Macquarie Bank, which issues swathes of options, will be most affected by the change, although it’s important to remember that this just enforces adjustments we’ve always made to the company’s reported profits to make them more relevant.

The use of financial instruments for hedging is another area that will alter dramatically. This area has supposedly had rigid standards in place for many years. But, as shareholders in Sons of Gwalia and Pasminco learned, there can be quite a difference between accounting standards and their practical execution. We won’t go into the minutiae but the main point to remember is that it will be much more difficult for an instrument to be classified as a hedge, making it harder to hide ticking time bombs.

While this is good news for investors, the new standard will have an impact on industries other than the obvious candidates of financial services and mining. It will have major repercussions for transport companies such as Qantas, which hedges fuel prices, and retailers which sources inventory internationally.

Accounting for research and development

A final example is included especially for lovers of technology businesses. In the past, many of these companies raised a pile of cash, spent most of it on research and, despite earning little or no revenue, reported surprisingly small losses. This financial miracle was made possible by ‘capitalising’ the costs. This is an accounting technique by which research costs, instead of being taken as an expense which reduces profit, are ‘capitalised’ and included as an asset on the balance sheet. All too often this practice ends in tears, with the research proving unsuccessful and the company being forced to make huge writedowns on the capitalised asset.

To counter this problem, the standard setters have established a set of criteria that distinguishes research from development. The new rule is that companies cannot capitalise costs until they meet the criteria for development, such as having a saleable product in the marketplace. Costs associated with the research stage must be expensed as incurred. This will result in technology companies being forced to provide more conservative accounts in future. It will also crystallise large writedowns of capitalised assets when initial AIFRS balance sheets are prepared.

This is only a brief overview of some of the changes occurring under AIFRS. Some companies will report materially different profit results next reporting period and we’ll endeavour to explain in more detail the nature of any significant changes as they occur.

A final word of warning. Be wary of any company that blames any material decrease in profit over the next year on the impact of AIFRS. Occasionally these claims will be warranted, but we’re sure that some less reputable companies will attempt to cover up a poor performance by blaming changes in accounting standards.