Setting standards

From 1 January 2005, a rapidly approaching deadline, all companies listed on regulated stock exchanges in the EU will be required to follow International Financial Reporting Standards (IFRS) in their group financial statements, under the so-called International Accounting Standards (IAS) Regulation. If they wish to, unlisted companies will also be able to switch to IFRS from the same date in their single entity and group accounts. This will potentially have a major impact on companies’ banking and other legal documentation as they will have to refer to international standards instead of UK Generally Accepted Accounting Practice (GAAP).

These issues are pervasive. Many companies will face higher gearing in their balance sheets, as well as much greater volatility in their earnings, affecting earnings before interest and tax, earnings before interest, tax, depreciation and amortisation and net asset numbers.
These have traditionally been used as the basis of financial covenants in a company’s banking documents and they commonly use UK GAAP and the Companies Act format for accounts as fundamental reference points. Similarly, listed companies’ borrowing powers in their Articles of Association are tied to the consolidated financial statements.

The major areas of change

Although UK standards are similar to IFRS in many ways, there are some major differences, and several new standards will be mandatory in 2005 for UK GAAP and IFRS. The UK Accounting Standards Board has stated that it will converge UK standards with IFRS in the medium term and some of the biggest moves to achieve this will happen in 2005. Because of this, unlisted companies that do not switch to IFRS will still have to face many of these issues next year.

Perhaps the most significant change is that many financial instruments, including derivatives such as options and futures, will be shown at fair, usually market, value on company balance sheets and this will introduce new volatility into financial statements. In many cases, the changes in value from one year to the next will be reported against profits, affecting earnings figures. Most of the rules in the relevant international standards – IAS 32 and 39 – will be introduced into UK standards in 2005, thus affecting unlisted companies.

Another standard, IFRS 2 ‘Share-based Payment’, requires the full fair value of shares and share options awarded to directors and employees to be taken against profits. For some companies this could depress earnings significantly. The average impact on UK companies has been quoted at anywhere between 5 per cent and 15 per cent of earnings. All listed companies will have to follow the standard in 2005, with unlisted companies following in 2006 through an equivalent UK standard, Financial Reporting Standard (FRS) 20.

The EC regulation on IFRS overrides the Accounting Directives, and hence company law in relation to company accounts, so the Companies Act formats we are used to seeing in the UK for both the balance sheet and profit and loss account will disappear. Instead, the relevant international standard will apply, but this does not give such specific formats. New terminology will have to be used to identify the relevant items in the accounts for the purpose of precisely defining financial covenants.

There will also be changes in accounting for pension costs. International standard IAS 19 is likely to be revised shortly to allow accounting similar to the UK’s FRS 17, which has proved so controversial. Surpluses and deficits could come on to company balance sheets, thus affecting net worth and operating profit and interest payable will also be affected. IAS 19, even as it stands, will change accounting significantly from the old UK standard Statements of Standard Accounting Practice 24. For non-IFRS companies, FRS 17 will apply in full in 2005 and is likely to have an even greater impact.

Possible problems and solutions

The extent to which a company is affected by the move to international standards will depend on its industry and the characteristics of its business. Companies that are most severely affected will be heavy users of derivative financial instruments, but companies in all sectors will be affected to a greater or lesser extent.

A real risk for companies is that they might breach financial covenants or borrowing limits simply due to market movements because so many new fair values are coming into financial statements. Listed companies with debt facilities, which include financial covenants outstanding through to 2005, should be thinking about how to deal with the calculation of those covenants under IFRS.
There will be particular concern if renegotiation is required to deal with the issues thrown up, depending on how the agreement is drafted.

So, what are the options when dealing with such a significant change in accounting and its effect on financial covenants? Many borrowers will, in their existing finance documentation, be entitled to calculate financial covenants on the basis of ‘frozen GAAP’, allowing the original UK GAAP to be used for the calculation, even after the switch to IFRS is made, until the term of the facility is over. It is likely that for many borrowers seeking to renew facilities in the near future, this approach will remain the most attractive. The obvious disadvantage is that parallel accounting will have to be carried on for the length of the facility’s term and if a sign-off is required from the auditors, the costs involved could be substantial. There are a couple of other options available to borrowers. One option is to carry on in the short term calculating by reference to UK GAAP, but retain the option to renegotiate in future. Another route might be to move to an IFRS compliant basis now, which may mean changing the quantum of the covenants to reflect the step change.

It is too early to say what approach the general market will take. Resetting and substantial recrafting of financial covenants will almost certainly be required and it may be that a combination of approaches will be adopted by borrowers to mitigate the effects of certain accounting-related, rather than performance-related, changes. One approach would be to build in sufficient headroom to deal with anticipated volatility. Another might be to exclude certain limited items of concern, such as pension costs or financial instruments, from the financial covenant calculation.

In relation to borrowing powers, companies will have to consider whether they need early shareholder approval for changes. Other issues to consider include resetting management and staff remuneration targets where these are based on financial results, searching legal contracts for embedded derivatives that might have to be accounted for separately from the host contract, and deciding how companies communicate such major accounting changes to their investors. Distributable profit and tax issues will also need to be considered at the individual entity accounts level.

There is anecdotal evidence that some companies are not preparing adequately for the change to IFRS. If so, these companies could be running significant risks, such as breaching financial covenants or borrowing power limits through a failure to anticipate the changes.

Kathryn Cearns is the consultant accountant at Herbert Smith and Ewen Fergusson is a partner in the finance division of Herbert Smith