If money is the lifeblood of an economy then financial statements represent the equivalent in the field of investment analysis. Accordingly, it is fair to say that the next two years in our profession will witness the body analytic undergoing a complete transfusion. International Financial Reporting Standards (IFRS)–the topic of much debate over the past five years—will become Canadian Generally Accepted Accounting Principles (GAAP) for public companies in 2011 (2009 or 2010 for those electing early conversion) and investors and analysts will have the opportunity to decide for themselves whether or not IFRS represent better financial disclosure. For its part, the Ontario Securities Commission (OSC) has vowed to help make the new standards work for the best interests of public investors.

Marion Kirsh, FCA, associate chief accountant of the OSC, told a recent Toronto CFA Society luncheon seminar that during the changeover to IFRS the OSC will maintain its continuous disclosure review of filings. This will include: Scrutiny of the key areas of managements’ discussion and analysis (MD&As); analysis of financial performance, liquidity, capital resources, off-balance sheet arrangements; transactions with related parties; critical accounting estimates and changes in accounting policies. The increase in choices under IFRS will make it important for investors to look more closely at the disclosures in the notes to financial statements to see what policies and assumptions managements have adopted. The wider range of choices available may result in some reduction in comparability of financial statements amongst companies in the same industry. However it is expected to lead to new disclosures, for example of fair value for investment properties in the real estate industry, which will be disclosed under IFRS whether or not fair value is chosen as an accounting policy.

The proponents of IFRS argue that they will provide investors with more comprehensive financial information and, because they are based more on principles than on rigid rules, they will accord managements more flexibility to provide relevant financial reporting. The display of traditional items in the financial statements will change somewhat but, it is maintained, the new cash flow statement will show more clearly and concisely the sources and uses of cash in a company. The notes to the financial statements will become considerably more extensive as managements explain their accounting choices and assumptions.

However, opponents to the adoption of IFRS have maintained that the range of accounting choices available to management will tend to reduce comparability. In Canada’s case, comparability with U.S. counterparts may be further diminished by the latter’s continuing adherence to U.S. GAAP. However, U.S. GAAP is being substantially harmonized with IFRS and new standards are being debated at joint U.S. and International Accounting Standards Board meetings and are being issued jointly. Some opponents argue that the description of IFRS as “more principles-based” is a mischaracterization, as IFRS principles are in large part the same as those in Canadian and U.S. GAAP, but without “bright line” rules. Critics argue that the consistency and clarity of Canadian–and especially U.S.–GAAP are absent in IFRS. By increasing reliance on managements’ honesty and judgment in an environment that has seen instances of weakness in managements’ preparation of financial statements, securities regulation and accountants’ auditing, the risks of investors being mislead will be increased. Fair value measurements and disclosures under IFRS are also criticized, as these may be loose and variable, particularly when there are no liquid markets. Opponents also cite IFRS’ weak revenue recognition and related-party disclosure standards.

In the U.S., opponents to IFRS have argued that the evolution of U.S. GAAP – the most developed and extensive set of accounting standards in the world, which some maintain has been an important factor in making U.S. capital markets the most attractive to issuers and public investors over the years – has been shaped by the need for detailed rules. These have minimized the role of management judgment because of managements’ strong self interest in reporting earnings and financial positions. Hence IFRS-style reporting with its greater reliance on managements’ judgment increases the risk of earnings management and misrepresentation of companies’ financial positions. Critics have even suggested that the adoption of IFRS, rather than U.S. GAAP, was to a significant extent politically driven. It received its crucial impetus in 1998 when German law allowed public companies to choose between outmoded German GAAP, U.S. GAAP and International Accounting Standards (IAS), following which instances of German companies switching were split roughly evenly between U.S. GAAP and IAS. The EU reacted by promptly mandating IFRS (a re-written version of IAS) for all public companies by 2005.

So will adoption of IFRS in Canada bring better disclosure and measurement of financial items? Or, until IFRS addresses some of its own shortcomings and the U.S. either largely converges its GAAP with IFRS or converts to IFRS, will IFRS represent a misstep in the evolution of general purpose financial statements in Canada?

The next two years provide an answer, but a few things are already clear.

There will be some dislocations for quantitative and fundamental analysts and investors alike, as the continuity and at times inter-company comparability on the same basis of financial statements will be lost (although 2010 financial statements will have to be restated and provided with the first IFRS financial statements in 2011). Moreover, in order to ensure the comparability that users find important in their investment decision-making, users and regulators will need to provide feedback to managements, and at times may need to exert pressure on them to ensure accounting and disclosure policy choices reflect users’ needs and industry best practices. Also there is a risk that the persisting gap between many users’ expectations of auditors and their actual role in auditing financial statements (i.e. attesting to their fair representation in accordance with the accounting framework, a phenomenon which comes to light most frequently in instances of corporate failures) could widen if managements’ choices of policies and assumptions prove to be deficient. As for Canadian securities regulators, both sides of the IFRS debate would agree that their job will become more important and demanding than ever in the next two years, as IFRS is adopted in Canada and another important step is taken on the path toward achieving international harmonization of accounting standards.

Background to the adoption of IFRS in Canada

The Canadian Accounting Standards Board (AcSB) has determined that International Financial Reporting Standards (IFRS) will become Canadian GAAP for publicly accountable enterprises effective for financial years beginning on or after 1 January 2011. The securities acts of the Canadian provinces and territories mandate the use of Canadian GAAP for financial statements filed with securities regulators. Canada is the first jurisdiction with certification requirements to implement IFRS. These controls mandate certification of internal control over financial reporting (ICFR) and disclosure control and procedures for issuers. The Ontario Securities Act mandates civil liability for misrepresentations in filing.

The timing of the introduction of IFRS in Canada has been a controversial issue. The AcSB provided five years notice of the proposed change, and its approval of IFRS was not based on changes to U.S. GAAP. The U.S. is Canada’s dominant source of foreign capital and trade. The SEC has proposed a road map for conversion to IFRS by 2014-2016, while the Financial Accounting Standards Board (FASB), the U.S. standards-setter, has been focused on the harmonization of IFRS and U.S. GAAP. Acknowledging the progress of harmonization, in 2007 the SEC removed the requirement for a reconciliation between IFRS and U.S. GAAP. The OSC has stated that the timing of IFRS conversion in Canada is necessary, as current Canadian GAAP is no longer being updated and no longer tracks U.S. GAAP or IFRS. The alternatives of adopting U.S. GAAP or some other form of GAAP, or of securities regulators becoming accounting standards setters, was judged by the Canadian Securities Administrators (CSA) and the OSC to be both undesirable and unmanageable. (IFRS and U.S. GAAP are already permitted for foreign issuers in Canada). The OSC and the other CSA members believe that the provision of high-quality financial information for investors will be best accomplished through moving to a globally accepted, high-quality set of accounting standards, which over a hundred countries, including the U.K., E.U., Australia and China, have adopted. To accommodate the change, the OSC will continue to permit inter-listed Canadian companies to report in U.S. GAAP.