Will a Single Accounting Standard Help?

Are the financial statement effects of switching to international financial reporting standards really just a grand illusion? A new report from Moody's Investor Service suggests that might be the case.

Moody's says that, in general, companies making the change from local generally accepted accounting principles to IFRS record a 25-percent boost in net income and a "significant" rise in earnings before interest, taxes, depreciation, and amortization. But, says the credit rating agency, both adjustments are "largely illusory" and somewhat misleading.

In a study released this week, Moody's examined the 30 largest European corporations it rates, and found that moving to IFRS generated a profit increase of an aggregate $30 billion. However, much of that boost was attributed to discontinuing goodwill amortization, which is allowed under IFRS. To be sure, the report says that goodwill amortization alone added an aggregate $42 billion to the bottom lines of the sample companies. Yet the credit rating agency explained that when goodwill amortization is stripped out, the 25 percent total boost actually swings to a decline of about 7 percent — and the number of companies reporting materially higher net income falls from 16 to seven.

Even the 7 percent decline is a "deceptive" number, though, according to the report's authors. When three items that skew the profit picture are tossed out of the 30-company mix, the aggregate bottom-line results as reported under IFRS is only 2 percent lower than previously reported under local GAAP. Meanwhile, aggregate revenue remains virtually unchanged. The three items tossed out: impairment charges net of reversals recorded by Deutsche Telekom; changes to Electricite de France's pension arrangements and the manner in which they are accounted for; and changes to France Telecom's accounting for deferred tax under IFRS.

In its 23-page report — "Are We Better Off Under IFRS?" — Moody's found that while there are benefits to using a single set of accounting standards, the financial statements prepared using IFRS are not necessarily any easier to compare. In some circumstances, the lack of comparability is blamed on a deficiency in standardization. In other instances, Moody's cites several "seemingly inconsistent interpretations by companies and their auditors."

What's more, IFRS loses some of its usefulness because it can create false volatility and undue complexity. Consider, for example, that the amounts reported as "financial expense" are too often "unintelligible, and finding the 'true' level of debt can be like searching for a black cat in a dark room," the authors wrote.

But plans to adopt IFRS seem to be moving forward. In 2002, the European Union adopted a regulation requiring listed companies in its 17 member states to prepare their consolidated financial statements using IFRS as endorsed by the International Accounting Standards Board. The mandate applied to fiscal years beginning on or after Jan. 1, 2005, but implementation was deferred until 2007 for some categories of companies — including those in Germany reporting under U.S. GAAP.

In 2004, when Moody's first began to study the effects of the IFRS switch on the companies it rated, only 10 percent of the companies in the Europe/Middle East/Africa region used IFRS. Today, about 75 percent of the corporations in the same region use the single standard. According to the International Accounting Standards Board, more than 120 countries either require IFRS or have committed to mandating the practice for public companies.

Still, Moody's said that the reporting adjustments that companies say are linked to their shift to IFRS should not be taken at face value. For example, a cursory look at the changes to EBITDA can be "misleading", says the report. In aggregate, the 30 companies reported a $9 billion boost to EBITDA, to $443 billion, when IFRS was used. The boost was mostly brought on by nearly a 40 percent reduction in pension expenses and the reclassification of operating expenditures to capex and interest.

Pension expenses were cut by eliminating unrecognized actuarial losses against equity in the opening IFRS balance sheet, which helped companies avoid the need to amortize deficits against EBITDA. Further, other pension expenses were split between the "operating" and "interest" categories. In addition, IFRS requires that the cost of developing new products be capitalized and recorded as intangible assets and reported as capex in some circumstances. What's more, when there is a significant delay between incurring a long-term liability and its settlement in cash, the related expense must appear partly as interest in the income statement under IFRS.

The report also revealed that balance sheets deteriorate under IFRS, with the ratio of net debt to equity in the 30 companies collectively worsening from 59 percent to 69 percent. Gross debt increased by $92 billion to $830 billion, with 12 companies reporting a materially higher outcome. Net debt increased by 18 percent to $642 billion.

But what does the rise in debt really telling Moody's? No much, said the credit rating agency. The report asserts that Moody's already factors in much of the IFRS-induced deterioration when doing a credit analysis, so there was no surprise when the balance sheets took the hit.

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