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Richard Martin looks at the impact of International Financial Reporting Standards (IFRS) on small and medium-sized enterprises (SMEs).

Many will be aware that from 2005, an EU regulation will require listed companies to prepare their consolidated accounts in compliance with IFRS. Little attention, if any, has been directed to the impact the regulation will have on all other sorts of companies across the existing 15 EU states and the ten accession states, including several million SMEs.

On the key question of whether there should be a separate set of standards for unlisted companies, there seems to be general agreement that this would not be feasible. National systems of accounting should converge on IFRS in the medium-term and it would be too problematic to have different systems within countries for listed and unlisted companies. This is welcome, as it will take forward the harmonisation of company financial information across the EU and present an opportunity to raise the quality and reliability of accounting throughout the area.

While the European Commission accepts that individual member states will progress towards convergence to IFRS at different speeds, it wants Europe to move along this road. The Commission has removed some of the legal obstacles to convergence, but the main responsibility for delivering this has been left to the national standard-setters. The risk is that the convergence process might be slow and fall well short of its objective in some countries. Substantial active monitoring from the Commission will, therefore, be essential if accounting is to make a positive contribution to enhancing the EU single market.

IFRS and SMEs
Another unresolved issue is the extent to which IFRS should be adopted. The main objective of IFRS is to meet the information needs of the investors in international capital markets and the standards are designed increasingly to fulfil that role alone. However, the vast majority of the 6m companies in Europe are small and privately-owned and any system of reporting ought to be relevant to their needs and understandable to their users.

Again, there is much common thinking in Europe on this issue. At ACCA’s conference in Brussels in January this year the consensus was that the concepts and the principles of the standards for unlisted companies must use IFRS as the common base. There could, however, be disclosure reductions for unlisted companies and some of the complex measurements in IFRS (for instance on embedded derivatives) need not be imposed on them.

In the UK
In the UK context, the Accounting Standards Board (ASB) seems likely to replace UK standards with their IFRS equivalent but, in difficult areas, to leave options to follow a more traditional approach. For example, its exposure draft of how the dreaded IAS39 on financial instruments would be applied in the UK and Ireland allows companies the option to ignore its market value measurement requirements. Speaking at the conference, the French standard-setter envisaged a comparable system but with the very smallest entities simply reporting summaries of their cash receipts and payments. A gradual convergence of national rules with IFRS seems the most likely route.

There is plenty of scope for the debate on the extent of the differences which should be allowed. The outcome will need to balance a number of factors, namely: retaining comparability with listed companies, keeping the burdens on SMEs within reasonable bounds and progressing EU convergence.

Obstacles in the path to IFRS
Further obstacles remain which may hinder progress towards IFRS. First, the legal controls on capital maintenance rely on restricting dividends to realised profits shown in the profit and loss account. This approach might be unworkable under IFRS because that system has no concept of realisation built into its standards, nor may it provide a recognisable profit and loss account in the future.

Secondly, there is a strong link in many countries between the results shown in the financial report and the income subject to tax. This could mean that concerns about taxation get in the way of good financial reporting to other users and the level of government income could be in the hands of accounting standard-setters – neither of which seems a desirable outcome.

These obstacles are not, however, insurmountable. The European Commission will have to reform the rules on dividends with a solvency test, looking at what the company can afford to pay while still meeting its liabilities. National standard-setters will have to address the differences between financial reporting and reporting for fiscal purposes.

There is another route to SMEs using IFRS. As mentioned previously, while the regulation applies to the consolidated accounts of publicly traded companies, member states have the option to extend this to any other sorts of accounts and any other type of company. At present, this means that all company types will have to comply with IFRS in its entirety, including, for example, the full standards on deferred tax and financial instruments. Such a requirement would be needlessly complex and costly for small enterprises.

The International Accounting Standards Board (IASB) is currently running a research project on SME accounting and emerging economies, and so in the future an IASB standard for SMEs based on IFRS is possible. This is, however, only an initial project to determine whether or not a full project should go ahead, and many grey areas remain. These include consideration of whether the output will be a standard, when it might be introduced and how a SME would be defined.

No separate standards for SMEs
The only thing which does seem clear at present is that recognition and measurement differences between the standards used by SMEs and the full version will not be tolerated. This might still leave SMEs wrestling, for example, with the problems of embedded derivatives, estimating risk-adjusted pre-tax discount rates and recognising “trade dress” as an intangible asset. It is therefore unclear how useful and workable any IASB output is going to be. It risks being the wrong product and arriving far too late.

Whichever route is chosen by a country, there will be a major education and training requirement to familiarise with IFRS the companies preparing accounts, the auditors reporting on them and the users interpreting them. In many European countries, the differences between national systems and IFRS are extensive. A change of mindset will have to accompany the mastering of new rules. Of the EU’s listed companies, it is estimated that only 5% have experience of IFRS. One can be sure that within unlisted companies the percentage cannot be much above zero.

Whatever the outcome, it is clear that there is much unfinished, yet essential, business for the European Commission, IASB, national standard-setters and the professional accountancy bodies.

Richard Martin – Head of Financial Reporting, ACCA

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