Morris Manning & Martin, LLP

Corporate Bulletin: IFRS is Coming. Are you Prepared?

02.13.2009

Just when you thought it might be safe to go back in the water.

In this current environment of extraordinary turmoil in the credit and capital markets, one might wonder why one should be concerned about a major accounting change which is pending. Allow me to answer that question.

First, What is IFRS and Why will it Matter to You?

Since 2002, the U.S.-based Financial Accounting Standards Board (FASB) has been moving in the direction of harmonizing U.S. Generally Accepted Accounting Principles (a/k/a GAAP), which are the accounting rules used in the U.S., with accounting practices in the rest of the world.

Simultaneously, the International Accounting Standards Board (IASB), which is based in Europe, has been spear-heading the drive to achieve a global harmonization of financial accounting standards. To that end it has developed and propounded International Financial Reporting Standards (IFRS) as a comprehensive basis for accounting. The IASB’s goal is to have IFRS adopted internationally and universally.

More than a hundred countries now use IFRS or are moving to IFRS in the next few years. This includes all of the European Union, Australia, Russia, Canada, China, Brazil and India.

In November of 2007, the Securities and Exchange Commission adopted a rule which allows foreign registrants to file IFRS based financial statements. Most recently and most importantly, on August 27, 2008, the SEC approved for public comment its long-awaited proposed “road map” which would result in the eventual adoption and use of International Financial Reporting Standards by U.S. companies.

The road map anticipates mandatory reporting under IFRS by American companies beginning in 2014, 2015 or 2016 depending on the size of the issuer. Specifically, it is anticipated that IFRS reporting will be required to be phased in, and therefore GAAP to be phased out, for large accelerated filers in 2014, accelerated filers in 2015 and non-accelerated filers in 2016.

So Why do We Need to be Concerned About IFRS Here in 2009?

The answer is that the opening balance sheet for the first IFRS reports will be the key milestone. Under current practice, the United States requires two years of comparative data for companies that file with the SEC. So public filers required to adopt IFRS in 2014 must have opening balance sheets prepared using IFRS for 2012. Stated a bit differently, in effect, the closing balance sheet for 2011 will be required to be prepared under IFRS. So this conversion process is potentially much sooner than you might think. Systems will need to be put in place well before 2014 to implement the changes in an orderly and timely manner.

Why Does IFRS Matter to Non-Listed Companies?

Not only will IFRS affect SEC reporting companies, it will affect every contract that uses accounting concepts. So, for example, any long-term agreement, even one entered into in 2009 between private parties, that stretches past the adoption date for IFRS could be affected by IFRS. These could include agreements such as bank lending arrangements, long-term employment or collective bargaining agreements, or various transaction agreements with earn-out provisions that are tied to GAAP or GAAP concepts.

What are Some of the Major Differences Between IFRS and GAAP?

Much has been made of the differences between GAAP and IFRS. As an overview, IFRS requires a shift from the use of a “rule-based” to more of a “principles-based” accounting method.

Unquestionably, the 900-pound gorilla change the IFRS will bring to real estate companies is the IFRS requirement that real estate assets must be marked-to-market annually using so-called “Fair Value Accounting.” Even more remarkably, these adjustments to fair market accounting values of real estate will now flow through the income statement as profits or losses.

Needless to say, this will have an extraordinary impact on the real estate industry or companies that own significant real estate assets and the presentation of financials for such companies. Historically, the methodology used for accounting for real estate is the lower of cost or fair market value. That means real estate has almost always been carried on financial statements at depreciated book value. Under IFRS, that will completely change.

Another major area where IFRS will have an impact on balance sheets and financial statements of all companies, including real estate companies, will be that under IFRS, preferred stock is not treated as stock but rather is listed as a debt instrument. This could have significant implications for loan covenants and other agreements where debt equity ratios are important.

Are there Major Changes that will Occur Prior to 2012?

Another set of changes, which will actually take effect even sooner than the adoption of IFRS, are changes to the method for accounting for lease incentives. Under general accounting convergence principles that are already well under way, these expenses will now be completely capitalized.

So What are the Major Issues and Planning Points?

  1. Companies should recognize that IFRS will likely “trickle down” not only to public companies but private companies and will become standard reporting methodology.
  2. Any contract or agreement that includes accounting concepts (GAAP, EBITDA, coverage ratios, etc.) is potentially affected by the adoption of IFRS in the U.S.
  3. During of the transition, over the next few years many companies will find themselves in the unenviable position of literally needing three distinct sets of accounting records during the transaction:

        (a) GAAP;
        (b) IFRS; and
        (c) Tax.

    For instance, in a recent article, Frank Y. Ng, Commissioner of the Large and Mid-Size Division for the IRS, focused on the significant complexities that maintaining multiple systems of accounting records for GAAP, IFRS and tax will entail.
  4. Education is the order of the day, not only for accounting professionals, but for accounting staff for companies. The move to IFRS will also necessitate changes in terms of internal control methodology.

Finally, keep your eyes open. In the current maelstrom of economic uncertainty, pressure is being brought on accounting standards in a way that is quite remarkable.

For those who have the patience to engage in such minutia, there has been a terrific swirl of activity concerning pressure that was brought to bear on the International Accounting Standards Board that caused it to tinker with its rules regarding the fair value accounting in October of 2008. This has provoked withering criticism in certain quarters. See, for example, “Accounting Standards Wilt Under Pressure,” by Glenn Kessler, Washington Post Staff Writer, December 27, 2008.

And most recently, during her confirmation testimony, Mary Schapiro, President Obama’s nominee to head the SEC, expressed concern about the impact of IFRS and the timing for adoption laid out in the SEC Road Map.

So stay tuned for further developments.