Investing

Interactive: The new corporate accounting

How to avoid confusion as new accounting rules hit your investments.

An old adage advises against changing horses in midstream. This year Canadian investors must hop steeds whether they like it or not, because there’s a new set of accounting rules in town. In January most large public companies adopted International Financial Reporting Standards (IFRS), a system already used in more than 100 countries (notably across the European Union and wide swaths of the Pacific Rim). This replaces Canada’s Generally Accepted Accounting Principles (GAAP), in use here since the late 1960s. New reports prepared in accordance with IFRS are now being published in droves. Although the two rule sets are superficially similar, the manner in which they address specific issues can be strikingly different. In particular, IFRS hands a great deal more discretion to management regarding how many items are accounted for.

Below we present a handful of examples of companies whose financial results (or at least isolated portions of them) will look radically different under IFRS. We selected these examples precisely because they’re extreme—most changes will be more subtle.

Many retail investors rarely bother to consult financial statements. Baffling jargon and complexity—or sheer laziness—keep them away. This is a serious oversight. Well-prepared financials provide perhaps the clearest available indications of a company’s health and prospects. Understanding them enables one to ask the right questions and understand how a company is evolving—for better or for worse. Regrettably, a crucial part of that is knowing the often arcane rules governing how they’re prepared.

Regular readers of financial statements will notice the IFRS transition immediately—and not only because companies are highlighting it (albeit to varying degrees.) In most cases IFRS will mean longer reports to wade through, notably in the form of denser footnotes. (PwC claims that based on the European experience, quarterly reports for Canadian banks might grow 40% longer.) In many cases GAAP and IFRS are similar, so many reported numbers may seem comparable. But don’t be deceived: IFRS is a different beast, and key line items may be altered radically and permanently. “The key is to be able to read statements under IFRS and understand that one change occurred because of a business change while another occurred because of an accounting change,” says Anthony Scilipoti, executive vice president at Veritas Research Corp.

You’ll experience IFRS’s effects even if you never crack open an annual report. That’s because when the underlying financials change, so too do key ratios commonly used when making investment decisions. CGA-Canada warns that based on its preliminary research on nine Canadian companies that adopted IFRS early, it seems price-earnings ratios are more volatile under IFRS. Ditto for debt-to-equity, return on assets, and most other crucial measures. (These same ratios are churned out by financial websites and journals—including Canadian Business’s own Investor 500 issue.) Rock Lefebvre, CGA-Canada’s vice president of research and standards, cautions that its sample is small and skewed, as seven of the companies were in the mining sector. “That said, we do think it bears out the impact of IFRS on financial ratios,” he says, “and it does underscore the need to be vigilant, recognizing that in some instances the change in accounting conventions is going to play havoc with comparability and consistentcy.”

Among the relatively small community that truly understands it, IFRS’s adoption is highly controversial. The accounting profession seems broadly supportive. “Canada’s move to international standards is driven by the reality of businesses operating in a globalized economy where investors and analysts compare financial information across borders and capital markets, making a common standard critical,” says CGA-Canada. The main touted benefit is that a common international set of accounting standards will facilitate comparisons across countries—that you’ll be able to stack an Australian mining company against a Canadian counterpart, for instance. However, there are already deep misgivings in countries that adopted IFRS earlier. Britain, for example, switched over in 2005. Recently, Britain’s House of Lords studied IFRS’s role during the financial crisis, which saw prominent banks collapse. Witnesses repeatedly criticized IFRS for stripping auditors of their ability to “exercise prudent judgment”—which is another way of saying it gives management wide discretion when reporting financials. In Canada, forensic accountant Al Rosen warns that in a few years Canadians could witness many frauds they’ve seen in decades passed. “A lot of the loopholes that were plugged in GAAP are now open again,” he warns. For example, Rosen’s firm Accountability Research argues that IFRS makes it easy for unscrupulous companies to recognize revenues when cash has not yet been received—and even in cases where collection may be highly improbable. “People automatically assume that if you come in with new accounting, it’s an improvement,” Rosen says. “This isn’t.”