Bridging the GAAP

Come January 1, 2011, every Canadian company is supposed to have switched its accounting from Canadian GAAP to international financial reporting standards (IFRS). But this isn’t just a technical exercise for the accounting department. Instead, the effort starts at the top with the board, and directors have a mountain of work ahead of them that could rival, or even exceed, the Sarbanes-Oxley compliance effort of US-listed companies. Now time is running out. Many companies could be dangerously behind and there is not yet any allowance for size or straggling.

Ask experts and you’ll hear that the main reason for switching fundamental accounting principles is to provide Canadian companies and investors with better access to capital markets. With equity investment becoming a global activity, and more than 100 countries already having moved to IFRS, the assumption is that investors will be more likely to concentrate their cash where they can easily make informed decisions and better comparisons of the numbers. Comparing investment options is, in theory, easier when the potential vehicles use the same accounting standards, allowing for direct comparison.

But IFRS is a significant change from GAAP, which has been in place for about four decades. The new standards are largely expositions of principles, not lists of rules, and they demand significant choices that can affect balance sheets, income statements, asset treatments, revenue recognition and company valuation – all subjects of great concern to corporate boards and management, to say nothing of shareholders.

‘Insofar as IFRS leads to a change in any of those areas, [directors] need to be involved to exercise an oversight role to ensure that management has discharged its responsibilities and executed an effective conversion,’ says Rafik Greiss, Canadian IFRS market leader and partner at Ernst & Young. ‘The changes can be pretty pervasive, and this affects many areas.’

Preparation needed now

Those changes are coming up faster than many realize. The 2011 deadline is just for the switch. By the end of 2008 companies need to disclose their IFRS convergence plan and anticipated effects. By the end of 2009 they need to disclose their progress along with quantification of anticipated effects of the IFRS convergence plan. And in 2010, companies must generate comparative numbers under both GAAP and IFRS. An Ernst & Young study released in May shows only 30 percent of companies had even begun the first stages of their conversion processes. (Greiss notes that more companies have started since then, but that his firm has not gathered additional data.)

‘Most of the companies are in the early stages,’ agrees Chris Wright, a managing director of Protiviti, a consulting firm that has been active in working with Canadian companies on the transition. ‘The significant part of the effort … is looking at the differences in accounting flow, writing policies and procedures, and making all of the system changes that will be required to do that.’

‘Most companies are saying they wish they had started earlier, because once they start they realize the volume of work ahead of them,’ Greiss says. The pain can be enormous, no matter how large the company is or the resources it can bring to bear. ‘You might have a large company that requires 50,000 hours of effort to convert and a small company that requires 5,000 hours.’ As with Sarbanes-Oxley adoption in the US, the time needed is proportionate to the size of the company, but all companies will suffer excess resource use. The task tends to expand to meet the extent of the available resources.

Harder for some than others

There is also no reliable predictor of the scope of the challenge for any one given company. Experts tend to agree that the difficulty is a factor of individual corporate practices and choices as well as the type of industry. Some industries – oil and gas, forestry, mining, financial services and high tech, for instance – will tend to find that they must overhaul long-established business practices.

One major area of change can be revenue and cost recognition, according to Karen Higgins, Deloitte’s national director of accounting services in Canada. An example would be regulated utilities. Under GAAP, these companies immediately recognize regulatory assets that are essentially future rate increases regulators grant to cover current increased expenses. ‘Under IFRS, a lot of those regulatory assets would not be allowed to be recorded, which would significantly change the profit profile of those organizations,’ Higgins says. For a software company, timing of licensing revenue recognition could change. Depending on the circumstances, a company might find that it has to delay recognition, or even advance it.

Depreciation picks up the concept of asset componentization. ‘You’re required to look at your individual assets and essentially componentize them, breaking them up into pieces,’ explains DJ Gannon, who leads Deloitte’s IFRS solutions center in the US. Under GAAP, a building will have a single amount of time over which a company would depreciate the asset. But under IFRS, the business might have to separately consider such components as the building and its foundation, the roof, wiring, plumbing and HVAC system if they have different life expectancies. As a result, depreciation can become a fiercely difficult calculation.

Asset impairments in the past might have required a single write-off. Under IFRS, the conditions that brought about the lowered value might one day change, restoring part of the lost assessment. Companies will now have to track impairments over time to be sure that they list assets at fair values, and this could require multiple write-downs and write-ups over time. All could apply to past impairments. Companies will need process and historic data to track the conditions that led to the impairment and monitor any necessary changes.

One of the thorniest areas will be metrics used in any legal agreement, whether executive compensation, arrangements with a business partner or financial covenant for a loan or insurance. If the metrics call for an action based on a number from financial reporting, such as revenue or earnings per share, there could be trouble if the definition changes during the switch to IFRS. A bank might revoke a line of credit as of January 2011 because the company did not meet specified financial ratios, even if there is no fundamental difference in the operations of the borrower.

‘By now every company that will convert should have done an impact analysis,’ says Ilya Bogorad, a principal with management consulting firm Bizvortex Consulting Group. ‘If they haven’t done an impact analysis by now, they should do it as soon as possible.’ Understanding the potential impact of IFRS changes on shareholders, legal agreements, strategy and operations is the only way to leave enough time to perform the necessary planning and preparation.

Not just an accounting problem

It is also important to watch for snares that can trap a company, and many exist. Perhaps the largest, particularly under the 2011 deadline pressure, is understanding that overall the conversion to IFRS is a corporate, not accounting, responsibility.

‘In many cases, while people in Europe mainly use external resources, you still have staff who have to do their day jobs while they go through the conversion,’ says Jeremy Roche, chief executive of UK-based financial software company CODA, who went through the British conversion to IFRS before CODA was acquired by Unit 4 Agresso and was still a separate public company. ‘It goes beyond the finance department to the way data is collected throughout the business. IFRS should be a board agenda item.’

Next is the desire of the people doing the bulk of the actual conversion to avoid as much substantive change as possible. ‘I think companies are approaching IFRS transition in a practical way, asking first, Where is IFRS different from Canadian GAAP?,’ Higgins says. ‘I think sometimes people read the words of IFRS and think, I can get [the same result as under GAAP] if I read the words this way.’ He advises those managing the process to ‘make sure that choices between valid alternatives are made at the senior management or audit committee level as appropriate.’

Software is another consideration. There are many internationally marketed accounting systems, like the major enterprise resource management (ERM) systems, that have either built-in or optional support for IFRS. But locally focused packages and software developed in-house might have support only for GAAP, requiring modification or replacement. In addition, there might be applications for such specialized areas as inventory control or asset management that store and compile data in ways that will be incompatible with IFRS. Only a detailed audit can reveal the extent of any problem.

Another major challenge that will affect companies is a lack of personnel with experience in IFRS. ‘We’ve seen companies recruiting from Europe,’ says Diane Kazarian, national IFRS practice leader for PricewaterhouseCoopers. ‘These people are not readily available here in Canada. The longer you wait, the [more] resources will be an issue, and if you don’t devote the right attention to this, it could definitely be a struggle.’

Finally, for companies that waded through the controls reviews and issues of SOX, further changes might be necessary because when the accounting foundation changes, specific controls might as well. ‘Things have just settled down and after the initial cost of implementing the changes under Sarbanes-Oxley, they’re looking at their processes yet again,’ says Stephen Linker, managing director of the Canadian office of professional services firm Jefferson Wells. ‘Some processes may well have to change. In certain areas, they may be lacking or may need to reconfigure information that’s flowing up to financial statements. Because of that, this could have an impact on financial reporting controls.’

Clearly IFRS presents a significant challenge to companies, and to the boards that are ultimately responsible for compliance and shareholder interests. ‘It’s more pervasive than Sarbanes-Oxley,’ Gannon says. ‘When you have pervasive changes to accounting systems, those changes take a while to implement.’ But disaster is hardly a foregone conclusion. Even if a company is late to the gate, the board can help guide it into compliance by avoiding surprises with proper focus and adequate communications internally and with shareholders. And given the opportunity to reassess a company’s needs and strategy at the most basic of levels, boards could find the experience beneficial. If you have to go, you might as well make the trip worthwhile.