While many treasurers and chief financial officers (CFOs) may have felt that International Financial Reporting Standards (IFRS) are best left to the accountants, upcoming changes in IFRS will in fact have a major impact on the strategy and financial outlook for almost any company.
One key change that will impact all companies, he said, is a contract-based approach of the proposed model that focuses on the assets and liabilities that are created when an entity enters into and performs under a contract. The proposed model requires that revenue is recognised when an entity satisfies its obligations to its customer (performance obligations). Performance obligations are satisfied when control of a good or service transfers to the customer, which is when the customer is able to use, and receive benefits from, the good or service.
According to this model there are the following issues that companies will struggle with:
- Identifying the performance obligations in a contract will be critical in applying the proposed model and will require significant judgment. This may be particularly challenging for service arrangements and long-term contracts. For most companies, this will require that they look at the product and the warranty separately. Instead of simply valuing the sale of one product when they recognise revenue, companies will now have to value two products – the product itself and also the warranty – separately.
- The transaction price will include variable or contingent consideration when such amounts can be reasonably estimated, which is a fundamental change from most current practice. In those cases, the transaction price is measured using a probability-weighted estimate of the consideration expected to be received. The transaction price should also reflect the customer’s credit risk by recognising only a probability-weighted estimate of the expected receipts and the impact of the time value of money, when material. This means companies will also need to estimate their credit losses and make a provision for them at the time of sale. The proposal will generally require greater use of estimates than under existing guidance.
Accounting for Financial Assets
Another key effect will result from changes in IFRS 9, which is scheduled to be implemented in three phases.
The first phase, finalised in November 2009 and effective on 1 January 2013, deals with classification and measurement of financial assets. The key change is a reduction in asset categories from four to two. Now, companies will need to classify financial assets as at fair value or amortised cost on the basis of the company’s business model for managing the financial assets and the contractual cash flow characteristics of the financial asset. CFOs and treasurers will thus need to understand the business model and cash flow for any financial asset in order to select the correct category, and accountants will need to account for the asset accordingly. While the intention is to make accounting for financial assets simpler, the change will reduce the flexibility companies have in determining how to account for them. Internal processes may also need to change significantly.
This first phase is already available for early adoption in some countries in the Asia Pacific region, including Australia, Hong Kong and New Zealand. According to Chen, some companies in Australia, for example, have already adopted the standard. Other countries, similar to those in Europe and including Singapore, have not adopted it yet because they prefer to wait for phases two and three to be finalised.
The impact of phase one is quite significant. Currently, a lot of companies would classify their financial assets, especially equity investments, as available for sale. This category allows the volatility in the fair value to be booked in reserves instead of profit and loss (P&L) and companies could book the gain when they sold these securities. When companies have to choose between the two new options for equity investments, Chen said, selecting the fair value through the P&L method means they are likely to face volatility in financial assets, while choosing the fair value through other comprehensive income means that they may not be able to show a gain when they sell the asset. Understandably, neither option is necessarily appealing.
Chen said that phase two, which may still change, relates to impairment and banks will face the biggest impact. Today, banks make provisions for losses based on an incurred loss model. In the future, Chen said that banks would have to estimate what the expected loss will be up front and recognise the expected loss over the life of the loan. This would mean that initial expected losses would affect the interest income line, resulting in a decrease in interest income. However, subsequent changes in estimates would be reflected as provisions for loan losses. While the requirements are still an ‘exposure draft’ and could change, the impact of the proposed changes would be quite large. Currently, based upon IASB’s project work plan, the target date for completion of phase two is 4Q10.
Phase three relates to hedge accounting, which has always been an issue for treasurers. For example, companies currently have to apply hedge accounting on the full price of the commodity rather than a specific component of the commodity price risk, except for the foreign currency risk component. Furthermore, the hedge has to be highly effective and therefore they have to test hedging effectiveness at inception of the hedge and at each balance sheet date. Chen said he hopes that phase three will simplify effectiveness testing and hopefully allow hedge accounting for a specific component of the commodity price.
A third change which will affect all types of companies and have a “huge impact” relates to leasing. Today, Chen said, if companies lease office space, retail space or an airplane, generally, they account it for as an operating lease and recognise the expense during each period as they pay for the lease.
Going forward, assets currently leased under operating leases will be brought onto the balance sheet, removing the distinction between finance and operating leases. Leasees have to recognise an asset representing its right to use the leased item for the lease term and a corresponding liability for the obligation to pay rentals based on the present value of payments to be made over the term of the lease. The lease term will include optional renewal periods that are ‘more likely than not’ to be exercised. For example, if the company has an extension option they will need to look at the most likely lease term. If it’s more likely to be extended, then the company would take that full term into account in their determination. Whether it is a three-year lease for office space with an option to renew for another three years or a 20-year lease for an industrial site with an option to renew for another 10 years, the company would need to determine the value of the lease for the full six years or 30 years respectively if they are likely to renew. The same principal applies for aircraft, ships and other types of leases.
Furthermore, lease payments used to measure the initial value of the asset and liability will include ‘contingent’ amounts. This means, companies that have a contingent lease, whereby the lease payment also includes a percentage of sales, would have an even more complex task. Contingent rentals are common at retail outlets such as clothing stores or restaurants. The company would have to estimate the probability-weighted expected value of the contingent lease amount, then determine the probability-weighted discounted cash flow that takes the lease terms into account. The determination needs to be done initially and then re-assessed each period. Understandably, retailers have said that it is too complex, that they do not have people with the right knowledge to make the calculation, and reassessing the value every period is extra work. Moreover, retailers are uncomfortable because competitors may be able to use the calculation to gain a competitive advantage, and landlords could well use the information as a bargaining chip to raise rents. According to Chen, the changes have a multitude of impacts:
For one, assets and liabilities will be grossed up. The company’s leverage ratio may increase, and the additional leverage may affect loan covenants. The return on assets (ROA) will most likely go down because assets will go up.
Banks that rent space for a large number of branches or for a large back office would similarly see their assets increase. While it is not certain how regulators would view the increase, since nothing has fundamentally changed, there is a risk that regulators could potentially require increased capital.
There is also a potential effect on tax liability. In theory, the depreciation on the asset plus the interest expense on the liability should equal the amount of the current operating expense for the lease. However, depreciation could be higher in the beginning and taxes could change even though, again, there is no fundamental change in the company’s operations. Companies could have lower taxes initially, or they could potentially face deferred taxes.
Simply finding staff with the expertise to make these calculations is yet another issue. The calculations are very complex, and few people know how to calculate the expected value using probability-weighted discounted cash flows that take the lease terms and extension terms and contingent lease payments into account.
The right-of-use model might change how entities negotiate leases, and it might affect lease-versus-buy decisions.The changes could also have some effect on mergers and acquisitions (M&A). While most M&A is based on a business rationale, some are dependent on using the balance sheet to borrow for the acquisition. Bringing leases onto the balance sheet when a deal is concluded could mean that the company is too highly leveraged to borrow more, or it could affect the entire profitability of the deal.
To handle the changes, companies may need to have more staff familiar with IFRS, discounted cash flow calculations and other requirements. And while accounting firms and auditors do have people with the expertise, even auditors are likely to use more specialists, such as people who understand market risk and valuation.
The Impact on Asia-Pacific
The new standards apply globally, so it is not just companies in Asia that will face these changes. Companies in Asia compared to their counterparts in Europe or North America may face varied challenges. They might have less historical data available to comply with the new IFRS requirements. For the banking sector in particular, banks that already comply with Basel II requirements may be able to leverage on existing historical data whereas those that are not Basel II compliant could face difficulties with having insufficient information.
While some of the effects of the IFRS changes have yet to be assessed fully and, indeed, some of the new standards are in exposure draft form so that they are not even finalised, it is easy to see how the impact on companies is likely to be quite significant. With this information in hand, now is the time for companies both large and small to start building up the capacity and capabilities to meet the requirements of the expected changes.
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