Financial accounting: Number crunch

New accounting rules should give investors more information, but are crooks jumping for joy?

Canada’s accounting regulators will meet this February to decide on one of the biggest changes in this country’s accounting history: When to throw out the current Canadian accounting rule book and adopt new international financial reporting standards (IFRS). The move has broad implications for investors and every Canadian public company since the new rules will force companies to recalculate just about every line in their financial statements to ensure compliance with the new accounting rules.

“This is certainly one of the largest and most significant changes in Canadian accounting in recent memory,” says Ian Hague, principal with Canada’s Accounting Standards Board (AcSB) — an independent body that sets and oversees this country’s accounting rules.

The decision to abandon current generally accepted accounting principles (GAAP) in favour of IFRS was made in 2006 by the AcSB. The board hopes to implement the switch by 2011, but will meet in February to determine whether that deadline is reachable. Supporters hail IFRS as a great step toward a harmonized global accounting system that will lead to increased comparability between companies around the world. However, some critics charge IFRS actually lowers accounting standards and makes it easier for unscrupulous managers to manipulate their financial results, because they have more leeway to interpret financial data.

While there are many similarities between Canada’s current rules and IFRS, there are substantial differences in how they account for business combinations, valuing assets on the balance sheet, handling foreign currency transactions and a host of other financial arrangements. And while the biggest impact will occur on financial statements, the transition to IFRS will require companies to re-examine just about every contract, agreement and bank covenant currently linked to their finances, says Don Newell, a partner at Toronto-based Deloitte & Touche and national leader of the accounting firm’s IFRS implementation team. “Companies are going to have to evaluate how the move to IFRS is going to impact things like executive compensation that are linked to financial performance or contracts, loans and debt covenants that are linked to the company’s finances,” says Newell.

Companies whose finances are dealt with similarly under both current Canadian GAAP and IFRS may only experience minor changes, but others could see a dramatic makeover. For instance, unlike current accounting rules, IFRS calls for more assets to be valued at fair market value. That means a real estate company could see the value of its property rise much higher or fall much lower than it would under current accounting rules, says Newell. “That increased volatility could have a big impact on how executive compensation is calculated or even how investors look at the stock,” he says.

Even small changes in accounting rules could have a profound impact on the companies that are governed by those rules. “The devil is really in the details,” says Hague. “Even if a Canadian accounting rule and IFRS are 90% similar, if you are a company whose transactions fall in that 10%, it’s going to have a big impact.” As a result, it’s imperative that Canadian companies start evaluating the effect of the change as early as possible.

Canada is just the latest country to adopt the new IFRS standard. More than 100 countries — representing about 45% of the world’s capital markets — have adopted or stated their intention to switch to IFRS. Currently, Japan and the United States are the only countries in the G8 that have not adopted IFRS. But the U.S. Securities and Exchange Commission last year ruled foreign companies that report their financial results in IFRS will no longer have to reconcile their results with American GAAP.

The move to IFRS in other countries has not been without some birthing pains. For example, London-based Barclays Bank PLC spent more than $100 million to bring its financial reporting in line with IFRS. And while the change in accounting did not alter the economics or risks of the bank’s key businesses, it did result in lower earnings per share that resulted in a $4.4-billion drop in the bank’s total shareholder equity.

That variation in financial results is not unusual for companies switching to IFRS. A survey of 2006 financial results by 130 companies currently reporting in both U.S. GAAP and IFRS found that only two of the companies had the same earnings under both accounting regimes. Earnings were lower under IFRS for 44 of the firms, according to the study by R. G. Associates Inc., an investment research firm based in Baltimore, Md.

That said, there are several advantages for Canadian firms adopting IFRS, says Hague. For one, IFRS is often simpler and less complex than current Canadian accounting rules, and it may help attract more global investment by harmonizing Canada’s accounting rules with major markets in Europe and Asia. “Investors around the world are unlikely to be studying Canadian GAAP when so much of the rest of the world is adopting IFRS,” Hague says. One major drawback is that Canadians will no longer set their own accounting rules. Those will be set by the London-based International Accounting Standards Board (IASB).

The IASB is not without its critics. At a recent regulatory conference held in Toronto, former U.S. Securities and Exchange Commission chairman Arthur Levitt said plans for the U.S. to allow foreign companies that trade on U.S. stock exchanges to file their financial results in IFRS without reconciling them to U.S. GAAP could “bring significant risks to investors and capital market participants [and] increase the likelihood of future scandals.” One of the main reasons for his apprehension is the potential lack of independence of the IASB and the danger that decisions made by the accounting regulator could be vulnerable to political lobbying. Currently, most of the IASB’s funding comes from major international accounting firms — the very group the accounting regulator oversees. As well, IASB decisions do not have full authority until passed by the European Parliament — a process that leaves the standards open to lobbying from special interest groups. “Without an effective, well-funded and independent accounting standard standard-setter…IFRS standards will be substandard,” Levitt said at the Dialogue with the OSC conference in November.

Both criticisms are being addressed by the IASB, says Hague. The accounting body is currently working on a funding formula to reduce its reliance on the world’s major accounting firms that will likely be in place by the time Canada adopts the new standard. And while it may be true that IFRS rules could potentially be watered down by the European parliament, it is Canada’s intention to adopt the international standards written by the IASB, and not any subsequent variations on those standards that the European parliament may pass.

Despite those assurances, one of the most vocal critics of Canada’s current accounting standards warns that the adoption of IFRS will lead to more financial scandals. “The crooks are jumping for joy,” says Al Rosen, a forensic accountant and founder of Toronto-based Rosen & Associates. Compared to current GAAP accounting standards, IFRS has fewer hard-and-fast rules that dictate how transactions must be accounted for on the company’s books. As a result, managers have greater leeway to choose the type of accounting they feel is most appropriate. Those choices may give dishonest managers more opportunity to hide bad behaviour, says Rosen.

The adoption of a harmonized global accounting standard — like IFRS — is supposed to make it easier for investors to compare businesses. However, the increased latitude IFRS currently gives corporate managers will make it more difficult to compare businesses that are across the street from one another, let around the globe, says Rosen. “IFRS turns investing into a roulette wheel,” he says.

Of course, no accounting system is impervious to manipulation by managers that want to cook the books, says Hague. And while it may be true that IFRS gives corporate managers greater latitude, that makes sense in an increasingly complex world where no two transactions are exactly the same. Managers will have to disclose and justify those decisions in much more detailed and comprehensive disclosure required under IFRS, he adds. “Under IFRS, we expect investors will have more information — not less — on which to make their decisions,” Hague says. Some investors, though, may not recognize the companies in their portfolios after the switch in 2011, because of the fundamental differences between current Canadian accounting and IFRS. But with accounting change still at least three years away, investors will have to wait and see if the new accounting regime can live up to its promise of creating more accurate and investor-friendly financial filings.