For fiscal years commencing in 2011 and thereafter, Canadian Generally Accepted Accounting Principles (GAAP) will transition to International Financial Reporting Standards (IFRS). This is a changeover which the CICA has stated should improve international financial reporting comparability in an increasingly global business environment. The authors of a study on the effects of the changeover on financial reporting, Peter Chant, FCA, partner, Deloitte & Touche LLP Canada and Anthony Scilipoti, CA, CPA, founding partner, Veritas Investment Research, recently addressed a Toronto CFA Society seminar on this major change.

Global scope of IFRS

IFRS are now required or permitted in over 100 countries including the EU and Pacific Rim. In the U.S., the SEC has reaffirmed its longstanding commitment to the goal of a single set of high quality global accounting standards and acknowledged that the International Accounting Standards Board (IASB) is in the best position to set these standards. However, it has not yet decided to incorporate IFRS into the financial reporting system for U.S. companies. In Canada, the conversion to IFRS for publicly accountable enterprises is proceeding ahead of the US, our principal trading and investment partner, although Canadian public companies that are also SEC issuers can elect to continue to use U.S. GAAP. Eight of the TSX 60 companies have so elected. Also, regulated utilities have received a one-year reprieve due to rate-regulated accounting (some might elect to use U.S. GAAP) as have investment companies.

Emphasis on the balance sheet

In their comprehensive review, Messrs. Chant and Scilipoti noted that, in broad terms, IFRS tend to focus on the balance sheet while U.S. GAAP and the former Canadian GAAP centre more on the income statement.

Watch for flexible accounting

They noted that there are more choices of accounting policies available to companies under IFRS, particularly with respect to accounting for fixed assets, and certain exemptions available at the time of transition (e.g., transferring unrecognized actuarial gains and losses in defined benefit pension plans to opening retained earnings) that can materially affect income and inter-company comparability.

Effects on M&A

They also observed that under IFRS acquisition costs are treated as an expense and are not capitalized as they are under U.S. GAAP and former Canadian GAAP, a change that will materially affect accounting for mergers and acquisitions.

Disappointing transition reporting rules

Canadian transition reporting rules were described as disappointing, with only one year of historic comparable information required and a consequent loss of longer-term trend information (if the U.S. changes to IFRS it is believed the SEC would likely require 3 years of restated financials).

Effect on cash flow statements

Although most differences between IFRS and the former Canadian GAAP will not affect cash flows, there may be differences within a section of the statement of cash flows e.g. a change in revenue recognition would not affect the IFRS measure of cash flows from operating activities but may affect the non-GAAP measure of cash flows from operations or funds from operations that excludes changes in working capital.

Under IFRS the ability to reverse impairment charges taken on many assets if circumstances change is a noteworthy difference and may tend to encourage management to be more interested in taking remedial action on underperforming assets rather than selling them.

Among the changes that are most relevant for specific industries are:

Financial services: securitizations are more likely to be treated as collateralized borrowings under IFRS; variable interest entities not consolidated under Canadian GAAP may be consolidated as special purpose entities and vice versa; different treatment of stock compensation programs may affect income, liabilities and equity.

Technology: less detailed revenue-recognition guidance under IFRS may result in differences in revenue, income and other items, although total cash flows should not be changed; different treatment of stock compensation programs may affect income, liabilities and equity.

Manufacturing and capital-intensive industries: operating leases are more likely to be capitalized under IFRS; fair value of property plant and equipment may be used; depreciation charges may change.

Mining: variable interest entities not consolidated under Canadian GAAP may be consolidated as special purpose entities and vice versa; the functional currency may change due to requirement to look to currency that mainly influences sales and labour, material and other costs rather than using a translation method based on whether foreign operations are integrated or self sustaining; revenue recognition may change under contracts with provisional pricing arrangements; different treatment of stock compensation programs may affect income, liabilities and equity.

Oil and gas: variable interest entities not consolidated under Canadian GAAP may be consolidated as special purpose entities and vice versa; revenue recognition may change under contracts with provisional pricing arrangements; depreciation may change as properties are likely to be grouped into smaller units and calculated on both proved and probable reserves.

Real estate: investment properties have the option of being valued at fair value rather than depreciated cost; joint ventures may be accounted for using the equity method, rather than the proportionate consolidation method; the value of leases acquired in the acquisition of a business involving a building will be included in the value of the building; trust units may be viewed as liabilities rather than equity unless mandatory redemption and distribution requirements are amended.

Retailing: revenue from customer loyalty programs must be deferred; leases are more likely to be capitalized; franchisees are more likely to be consolidated.

Other: actuarial gains and losses in defined benefit pension plans can be reported in other comprehensive income, not necessarily in regular income; new deferred tax assets and liabilities may be recognized on adopting IFRS, increasing the complexity of financial statements.

Widespread effects of transition to IFRS

The effects of the IFRS changeover are not confined to public investors. Information derived from financial statements is often used in debt covenants and management compensation and employee incentive agreements, requiring changes as a result of the transition.

Although the changeover will require investors to be mindful of the effects of the changes in reporting practices and of the new accounting choices available to companies, it is hoped that companies will provide more disclosure and information on key performance indicators that will compensate for the distortions in trends.

IFRS are still in the process of being refined and revised, a consideration that has contributed to the slow pace of progress of U.S. efforts to adopt them to date. The Canadian experience with IFRS changeover and its effects on Canadian capital markets is certain to be watched very closely by investors and regulators alike in both countries.

The IFRS Changeover: A Guide for Users of Financial Reports is published by the Canadian Institute of Chartered Accountants.