Finance & Accounting
In this section, the advisors of this firm propose some issues to ponder over in Q&A format. As IR covers topics of strategic importance, companies must recognize changes in their operating environment that may have a direct or indirect impact on their business model. Investors will, at all times, assess companies’ preparedness and steering policy in light of such market forces at work (referring to Darwin’s theory). The dates for uploading are as shown.
IFRS Update on Change in IAS 19 (Pension Valuation Disclosure on Post-employment Benefits)[effective in fiscal year starting anytime from January 1, 2013; earlier application is permitted]
- What is the significance of the revision?
- In the short-term, major companies will most likely report lower net profits, which may put downward pressure on their share prices. That is because they will need to disclose actuarial losses on pension assets, which had been kept off the balance sheets. Longer-term, stock markets in general could become less vigorous, as pension funds will probably need to reduce their higher-risk investments in stocks. Ultimately, the revised rule should enhance fairer comparisons and a more faithful disclosure of pension asset valuations among different companies.
- How were pension valuations disclosed up to now?
- Up to now, corporate earnings gave a flattering picture based on the so-called “corridor rule”. This deferred the recognition of gains or, more importantly, losses to later periods. These gains or losses can vary significantly from period to period as they include changes in estimates of employee turnover and life expectancy. So companies were able to smooth and reduce volatility in their published figures by using the “corridor rule”, and make their pension deficits seem more modest and manageable.
- In detail, what will be banned?
- The ban will abolish the use of expected return on assets, which may never materialize. That is recording a “profit” each year equal to the expected, rather than actual, return on pension plan investments. For higher risk assets such as stocks, this has meant companies could inflate the pension asset valuation to create a “magic money” credit, which was reflected in company profits.
- How will this misrepresentation be rectified ?
- The revised rule will replace the expected return credit with a more objective credit that is based on “AA” corporate bond yields used to discount liabilities. Under current market conditions in the UK, that is on average about 1% lower than expected asset returns. The final pension asset valuation will be reported under Other Comprehensive Income, not Net Income.
Inflation Impact and Related Problems
- Why should we think about inflation ?
- Global companies have operations in emerging countries. After becoming accustomed to a couple of decades of disinflation (=low inflation), it seems almost inconceivable we may see a turn in direction toward inflation. But, these emerging economies have been showing higher producer and consumer prices that could, if not tamed, lead to runaway inflation rates. In 2010, the rates were over 25% in Venezuela, more than 10% in Vietnam, India and Argentina, while in China and Brazil, they exceeded 5%. Clearly, in real terms, upward tendencies in prices will distort values recorded in past financial accounts.
- What factors are fueling inflation ?
- Growth and the resulting elevation in living standards in emerging countries. At a macro level, economic growth leads to more demand for oil, basic materials, etc., and then at a more micro level, with increased wages, people buy homes, cars and consumer durables for the first time. Personal consumption receives a big boost.
- How should companies deal with inflation ?
- Companies need to adjust figures in their financial statements to reflect real value. That means after higher input costs have been factored in. The adjustments should aim to show how higher prices, and hence lower purchasing power of the local currency, affect the borrowing costs for assets held. The changes should also demonstrate the firms’ ability to produce an adequate return for shareholders. One of 2 methods can be used: adjust every figure in the balance sheet based on an official price measure e.g. consumer price index (=general purchasing power accounting), or, revalue tangible assets at replacement cost (=current cost accounting).
- How are reported figures distorted by inflation ?
- Distortion comes from (1) depreciation, (2) inventories, and (3) monetary assets or liabilities.
(1) If machinery is depreciated over 5 years, yet its replacement cost increases in line with inflation, then clearly profits are overstated, as the book values do not reflect the true economic value to the enterprise.
(2) For inventories, if they cost more to replace, then reported profits will be boosted. So there will be a higher tax burden, and a drain on net cash flow. Shareholders will likely demand a higher dividend payout, assuming such a cash distribution does not impair ongoing operations.
(3) For monetary assets or liabilities, historical costs are usually adopted, but they do not reflect the reality of current market valuations. So value changes would not be clear, and shareholders’ interests would be ignored. These monetary assets or liabilities need to be updated to prices prevailing in the markets (=mark-to-market valuation).
- How does inflation affect future activities ?
- Companies will find it more difficult to forecast future earnings based on past performance. Capital budgeting will not be easy to estimate, so there may be less investment in plant and equipment. Also, as inflation pushes up costs, exports will become less competitive, leading to less demand from overseas. In the home market, business confidence may decline, leading to fewer orders from customers. All of this, in turn, could lead to less money coming from overseas, putting downward pressure on stock prices. Hence, a vicious circle is formed.
- What might be the impact on the economy from such distortions ?
- Enterprises may be damaged when real economic performances are distorted. At a macro level, governments may implement poor tax policies that discourage expansion or foreign direct investment. At a micro level, companies may increase leverage, which will lead to higher risks for the business, and eventually the economy. The public may then misunderstand and criticize corporate behavior when things go wrong, such as a decline in living standards, and government bailouts for ailing companies.
- Does IFRS make it mandatory to reflect inflation ?
- Under IAS 29, only for hyperinflation economies. The hyperinflation rate is set at 100% over 3 years. That works out to be about 25% per year compounded. For tangible assets or liabilities, a general price index is used to restate their values, bringing them closer to fair value. So if real estate values change drastically, the difference would be recorded under the profit/ loss statement. But for monetary assets or liabilities, historical cost is used. It is questionable whether this represents a fair picture for shareholders.
- So, there are problems with IFRS in reporting inflation adjusted figures ?
- Yes, hybrid presentation. That means a dual standard of historical cost for current assets or liabilities, and fair value, if adopted, for tangible assets or liabilities. This will give a false picture for shareholders, and will not reflect the correct status for the sustainability of an enterprise, which is one objective of the shift toward fair value. Real comparisons between companies will not be possible when one firm voluntarily adopts fair value for tangible assets or liabilities, and another does not.
- What are the deficiencies in IFRS ?
- For initial public offerings and public issues, for example, companies may adopt fair value, which shows higher profits to potential investors. But, revaluations must be done regularly to ensure book value does not differ significantly from market value in subsequent years. Without a mechanism to certify current market prices of fixed assets, the correctness of fair value will be suspect. If true economic value is to be given based on current cost, a complete shift to the fair value concept should take place, and applied to accounting of all resource factors (human, social, inflation, etc.).
Significance of IFRS
[International Financial Reporting Standards]
- How will the global economy benefit from IFRS ?
- Adopting IFRS should lead to greater prosperity and stability. A country neutral, high quality, common standard of accounting will prevail worldwide, so this means cross-border comparisons will become much easier. Companies will go outside their home market to raise capital, and more investors will go overseas to find investment opportunities.
- How will IFRS affect companies ?
- Over the longer term, companies can benefit from a lower cost of capital. IFRS will compel companies to adopt a uniform standard worldwide, and they can list on overseas stock exchanges without complex and costly procedures. Also, we will probably see an expansion in regional bond markets, where companies can issue debt to finance further business expansion.
- Who will be the winners under IFRS ?
- Companies with “hidden value” pre-IFRS will have a golden opportunity. Their share price could potentially take off. They must, of course, present their investment story properly to global investors. Hidden value could be technologies, R&D or patents. These need to be revalued to indicate future cash flows, reflecting a so-called “fair value”
- How about language ?
- For global companies, English is the common language for IFRS. For companies whose everyday language is not English, the finer nuances and meanings of terms and expressions could be a source of problems. Such companies need to prepare well in advance, and seek advice from outside experts.
- How will business plans change ?
- Targets set under IFRS will be very different, so managers must be fully aware of the changes. Under IFRS, sales, for example, will be recorded only when the risks of ownership have passed entirely to the customer. As another case, depreciation will be based on a so-called useful life of an asset. So these may affect company-wide policies, including budgeting.
- How will IFRS be different from existing accounting standards ?
- There will be a switchover from a strict rules based to principles based approach. Companies will then have more discretion. So a standard will be set for the nature of accounting categories, but the details will need to be decided by the company. For example, in defining sales, only the basic concept is given under IFRS. A company will then need to analyze the nature of sales in its industry (risks in collecting receivables, risks in inventories, etc.) and come up with its own accounting process.
- How will key management ratios change ?
- Either the numerator or denominator, or both, will change depending on the IFRS principles. For example, as goodwill will not be subject to depreciation, this could push up profitability and the share price. In another example, as R&D will be recorded under assets rather than expenses, again profitability could go up, but ROA would go down, possibly pushing down the share price. So indicators and their impact on the share price will need to be considered case-by-case.
- How will human resource policy be affected ?
- We will see a globalization of human resources and assessment processes. For global companies, communication in English will become much more important. A global policy will need to be set, which promotes greater fluidity of people inside a corporate group. So we will see more foreigners being appointed to key management posts. Also, compensation will need to move toward global standards. Skilled workers must be rewarded with appropriate pay and given promotion prospects to provide longer term incentives.
- How will IFRS affect global investors ?
- More investors from overseas will enter your home market, and this will lead to greater scrutiny. This means managers will need to explain more about the company’s value proposition (=managers must show greater accountability and transparency). For example, as R&D will be recorded under assets, it would reveal a company’s competitive advantages. This disclosure itself could lead to more M&As, both amicable and hostile. So if a company succeeds in attracting overseas capital, the share price could go up significantly.
- How should organizational culture change under IFRS ?
- On the global stage, speedy decision-making will become very important. Companies that up to now practiced consensus type decision-making will be particularly handicapped. Rather, a much more aggressive and nimble stance will be needed especially in the context of M&As. Takeover bids could come from undesirable parties, including vulture funds, greenmailers, etc.
- How will IFRS affect cross-shareholdings ?
- Managers must be much more transparent and explain more fully the aims of cross-shareholdings to shareholders. Pre-IFRS, these holdings did not reflect the market price changes, and so were “hidden from view”. But under IFRS, cross-shareholdings come under Comprehensive Income, so their marked-to-market valuation needs to be reflected. Clearly, shareholdings that consistently produce losses will come under much more scrutiny by shareholders, as they will demand maximum efficiency of assets employed.
- What should companies do to minimize the impact from sales of cross-shareholdings stemming from IFRS adoption ?
- Companies should actively cultivate individual, long term institutional, and employee shareholders. The IR strategy must place greater importance on these investor groups. The long term benefits for a company’s share price are clear: less downward pressure and less volatility even in adverse market circumstances. Employees can be stable long term investors, if companies adopt employee stock ownership plans that make investments affordable. Employee motivation may also increase, as the incentive to ensure long term corporate success may be spurred as a result of share ownership.