What you need to know about IFRS

You’ve heard about International Financial Reporting Standards (IFRS), the biggest-ever change to accounting rules. Is it going to rock your world, or is it just a bunch of propeller-headed bean counters making much ado about nothing?

Some advisors think accounting is only relevant when a crooked executive is cooking the books, or when regulators are asleep at the switch. But pretend for a moment that we live in a world where everyone is honest when it comes to financial reporting. Executives don’t stretch loose accounting rules to meet targets in their bonus plans. Securities commissions and corporate auditors do a good job of keeping everyone in line. In essence, let’s act as if Nortel and the like never happened. Now, within this fantasy, let’s examine the problems you will encounter with IFRS anyway. But first, let’s dispense with some of the nonsense floating around concerning IFRS.

MYTH 1 Without IFRS, Canada will be left behind

Canada did not need to adopt IFRS. Our largest trading partner, the U.S., certainly hasn’t bothered. The decision to adopt IFRS in Canada was made about five years ago. But the road started even earlier when the European Commission forced Europe, under a very tight deadline, to adopt common accounting standards.

While the fact that Europe uses IFRS tends to legitimize it in people’s minds, Europe had no choice. There were many nations in close proximity with disparate (and deficient) accounting rules. The region needed common accounting standards like it needed a common currency. To get all the countries to agree in such a short time frame, loose, broad and inclusive accounting standards were set.

MYTH 2 IFRS is principles-based

IFRS was sold to Europe (and later, Canada) as being based on principles that would ensnare anyone who attempted to circumvent more specific rules. But despite the fact that the creators of IFRS have admitted the principles-versus-rules argument was just smoke and mirrors, the misconception persists.

Unfortunately, the vague compromises contained in IFRS are merely compromises. Instead of protecting investors, the creators of IFRS have been too busy spreading the compromise to every country possible.

MYTH 3 IFRS allows comparison of companies around the world

This is the most disturbing myth. Let’s lay this major misconception to rest for good: IFRS destroys much more comparability than it creates. Two companies in the same industry in Canada are now less comparable under IFRS than they were under Canadian GAAP.

Take Brookfield Properties and RioCan REIT as an example. Brookfield converted to IFRS in 2010, and its profit every quarter is impacted by an estimated change in the value of its property portfolio. In Q1, Q2 and Q3 of 2010, Brookfield estimated increases in property value of $48 million, $19 million, and $36 million respectively. These are not realized profits from properties sold, just management estimates of changes in the value of the properties they own. The estimates boosted reported profit by 19%, 11% and 20%, respectively. By comparison, RioCan does not record such gains in reported quarterly profit.

Needless to say, when you start comparing two companies in different countries and industries, the comparability does not increase. When you introduce choices on how to measure profit, for instance, you are going to lose much of the precision you once had.

Like most advisors, you’re wondering why we needed all these myths in the first place. For the answer, you have to follow the money. Canadian auditing firms successfully converted the task of setting accounting rules from a cost centre into a profit centre by turning the task over to an international body, and then raking in the bucks by switching Canadian companies over to IFRS. But that’s a story for another day.

Here are ways advisors can address the IFRS.

TRUTH 1 Accounting impacts every investment

IFRS represents a massive disruption to the financial statements of most companies in Canada. It will have the greatest impact on financials, energy, mining, real estate, industrials, and telecom (roughly in that order). However, not even consumer discretionary and staples will escape unscathed.

Changing a system inevitably leads to problems. But the one thing that always stays the same is that investors at all levels take analytical shortcuts and rely on others when it comes to their investment process.

All advisors have heard stories from fund managers who claim they could never be tripped up by mere accounting issues. Having met all the top money managers in the country, and having heard their approach to investing, I can say they all eventually get tripped up by accounting issues. Even managers who claim to build discounted cash flow models from scratch all rely on financial statement inputs or cues, and those financial statements are built using accounting rules. They also usually rely on financial statement databases for screening and for relative valuation. IFRS has unfortunately thrown a major wrench into all of this. The Brookfield/RioCan contrast is the perfect example why, and there are dozens more where that came from.

For example, IFRS brings pension deficits onto the balance sheet, impacting the likes of BCE and Telus. IFRS eliminates full cost accounting for oil and gas companies, affecting entities like Canadian Natural Resources and Canadian Oil Sands. IFRS triggers the need for higher asset retirement obligations, impacting Barrick, Kinross, and others. The list goes on, and the changes can impact target prices by 10% or more, easily turning potential Buys into Holds, or even Sells.

TRUTH 2 IFRS is an investment opportunity

Where there’s a threat, there’s often an opportunity. Take TMX Group, for example. At the same time it became the focus of a potential merger with the LSE, it noted in its financial disclosures that IFRS will result in its reporting much higher revenue than it would have under Canadian GAAP.

Fourth-quarter 2010 revenue, for example, would have been 15% higher under IFRS, with much of that flowing straight to the bottom line. The market as a whole is not aware of this, and EPS targets and models have not been fully adjusted to reflect the upcoming impact. Thus, advisors in the know could easily take advantage of the fact the company’s earnings will get a significant boost in 2011.

In searching for such investment opportunities, advisors should start reading financial statements, MD&As, and other IFRS disclosures of their biggest investments. While companies will not show results under IFRS until the Q1 2011 earnings season, many have disclosed potential impacts of major changes under IFRS, just like TMX Group.

Some people will never change; they will continue to believe that accounting could not possibly impact their investments. It’s time to take them to the cleaners. Paying attention to IFRS will put you and your clients on the winning side of trades at the expense of those who ignore the impacts of the biggest-ever accounting change in Canada.

Dr. Al Rosen, FCA, FCMA, CIP, CFE, CPA and Mark Rosen, MBA, CFA run Accountability Research Corp., providing independent research to investment advisors across Canada.

Dr. Al Rosen