Check portfolios for accounting diversification

The last thing on anyone’s mind after the June 2016 Brexit vote was its impact on accounting rules, especially in Canada. A few months later, it’s time to consider the global consequences of the U.K.’s decision to leave the EU and the unforeseen impact on Canadian investment portfolios.

The market might be preoccupied with general economic concerns and trade negotiations, but once that dust settles, more practical concerns will surface—including how weakened European cohesion will impact a relatively nascent accounting coalition (see “A history of IFRS”).

How Brexit might change the status quo

With the U.K. intending to leave the EU, will continental Europe be happy having its accounting rules run out of a country no longer on its team? The answer might depend on how much acrimony surrounds the U.K.’s departure, but things will likely get heated at some point, and the fate of accounting standards could become a pawn in a much larger political game. If there’s a shift in International Financial Reporting Standards’ (IFRS) rule-setting from Britain to the continent, it could mark a change in ideology and a weakening in the IFRS framework. It wasn’t long ago that countries set their own accounting rules, and some may favour reverting to the old ways that better served their varying national interests.

Some investors, lawmakers and accountants in Europe are concerned that IFRS has diminished the concept of conservatism, applying it inconsistently across the different IFRS rules in an attempt to bolster transparency. Other objections include the amount of volatility that is created in reported income due to the emphasis on adjusting balance sheet values every quarter.

Still others take issue with the fact that IFRS principles are sometimes at odds with legal realities in terms of how the courts might interpret commercial transactions and customer contracts. The IFRS rule-setters based in the U.K. claim that it is not possible to consider every country’s specific legal encumbrances when crafting the guidelines, so it’s better to focus on general (and often vague) economic principles.

While that might be true, the accounting rules issue has the potential to turn into a major point of friction if European lawmakers regard it as something they should change to better their own countries. Harmonizing accounting and legal forms on continental Europe could reduce costs and investor confusion sometimes created by IFRS.

In the end, there could be a push for IFRS to become more Eurocentric and move away from the British style. Despite some claims of global input and composition, IFRS is still immensely hobbled by the fact that the U.S. refuses to adopt the standards because of numerous perceived deficiencies.

A history of IFRS

In 2002, the European Commission mandated that the EU adopt common accounting standards.

Until that point, countries in Europe generally had their own diverse and contradictory rules. Because lawmakers provided little time to cobble together new rules, countries latched onto the option that had some global standing at the time, the self-styled International Accounting Standards (IAS). Those rules were issued between 1973 and 2001 by a committee based in London.

Fast forward many years, and International Financial Reporting Standards (IFRS), which are the rules now followed in Canada, much of Europe, and some other parts of the world, are set by a board still headquartered in London.

This already weak standing could deteriorate further if political interference in accounting rule-making from continental Europe increases beyond what is already an uncomfortable level for outside countries (including Canada). Regardless of outcome, years of squabbling could at least delay major upgrades to IFRS.

Significance for advisors

This unsettling environment should prompt advisors to examine their client holdings from an accounting perspective: How much of the portfolio reports in IFRS?

Advisors are used to monitoring the breakdown of portfolios between Canadian- and U.S.-listed names, for instance, or between companies reporting in Canadian and U.S. dollars.

Rarely, however, do we see investors check the split in holdings between companies following IFRS and the U.S. Generally Accepted Accounting Principles (GAAP).

Investors might take solace in knowing that more than 20% of the companies in the S&P/TSX 60 Index follow U.S. accounting rules (see Table 1). There is also an equal number of large-cap names outside the top 60 that use U.S. GAAP.

U.S. GAAP is the gold standard in accounting, and Canadian companies that use it can sidestep the fundamental weaknesses and political infighting that degrade IFRS reporting.

Portfolio diversification from an accounting perspective has always been important based on the many shortfalls of IFRS that we have addressed in past articles. With further cracks in IFRS developing on the horizon, now might be a good time to make that portfolio check for clients.

Table 1: S&P/TSX companies following U.S. GAAP accounting rules

Within the S&P/TSX 60 Index	Large-cap names outside the top 60
Imperial Oil	Waste Connections
BlackBerry Ltd.	OpenText Corporation
Canadian National Railway	AltaGas Ltd.
Valeant Pharmaceuticals	Hydro One Ltd.
Encana Corporation	Turquoise Hill Resources Ltd.
Restaurant Brands International	Veresen Inc.
Agnico Eagle Mines	Algonquin Power & Utilities
Emera Inc.	Cott Corporation
Magna International	Enerplus Corporation
Transcanada Corporation	FirstService Corporation
Enbridge Inc.	Descartes Systems
Fortis Inc.	Colliers International
Canadian Pacific Railway	Gran Tierra Energy