Graham Holt discusses the IASB’s application of effects analysis to new standards and any material changes in existing standards
This article was first published in the February 2015 international edition of Accounting and Business magazine.
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The introduction of a new accounting standard or a change in an accounting standard can have a significant impact on an entity from an internal as well as an external perspective. As a result, the International Accounting Standards Board (IASB) has recently agreed to conduct an ‘effects analysis’ before publishing any International Financial Reporting Standard (IFRS).
When the IASB issues a new or significantly amended IFRS, it changes the way in which financial statements show particular transactions or events. Changes in reporting requirements always come with a cost.
"Changes in reporting requirements always come with a cost."
The IASB uses discussion papers and the ‘basis for conclusions’ to explain the steps taken to ensure that a proposed IFRS has taken into account the costs and benefits of the new reporting practice that it introduces.
What’s the impact?
The IASB considers a variety of matters prior to the issue of a standard. These matters include how the changes improve the comparability of financial information and the assessment of the effect on an entity’s future cashflows.
Further considerations include whether the changes will result in better economic decision-making, the likely compliance costs for preparers, and the potential cost for users of extracting the data.
On application of the new IFRS, investors will be provided with different information on which to base their decisions. Investors’ assessment of how management has discharged its stewardship responsibilities could be changed as could the cost of the entity’s capital.
This, in turn, could affect how investors vote at a shareholder meeting or influence their investment decisions. New financial reporting requirements may call for the disclosure of information that is of competitive advantage to third parties, which would be a cost to the entity.
A change in an accounting standard could result in some entities no longer investing in certain assets or change how they contract for some activities. For example, the comment letters on the exposure draft on leases suggest that some entities would change their leasing arrangements if operating leases had to be shown on the balance sheet with ‘adverse economic impacts including the loss of thousands of jobs’.
Further IFRS-based financial statements are used in contracts or regulation. Banking agreements often specify maximum debt levels or financial ratios that refer to figures prepared in accordance with IFRS. New financial reporting requirements can affect those ratios, with potential breach of contracts.
Many jurisdictions have regulation that restricts the amount that can be paid out in dividends, by reference to accounting profit. Further, some governments use IFRS numbers for statistical and economic planning purposes and the data as evidence for constraints on profitability in regulated industries.
Taxation is often calculated on the profit measured for financial reporting purposes. Where IFRS is used as the basis for income tax, a change in a standard can affect the tax base. The economic consequences of the link of accounting with tax liabilities can be significant.
If the US Financial Accounting Standards Board (FASB) were no longer to permit use of the last-in first-out (LIFO) method, companies using LIFO would have to pay income taxes sooner because of the higher cost of sales under LIFO. The impact has been estimated to be greater than US$80bn if the tax law was not changed. However, neither the FASB nor the IASB base accounting policy decisions on tax consequences.
Some jurisdictions require an impact assessment before a new standard, or an amendment to a standard, is incorporated into the law. Such a review may take into account the increased administrative burden on entities in that country or its consistency with local company law.
On a micro level, where new and revised pronouncements are applied for the first time, there can be an impact on the drafting of the financial statements. The financial statements will need to reflect the new recognition, measurement and disclosure requirements. For example IFRS 10, Consolidated financial statements, was amended for annual periods beginning on or after 1 January 2014.
This amendment provides an exemption from consolidation of subsidiaries for entities that meet the definition of an ‘investment entity’, such as some investment funds. Instead, such entities measure their investment in certain subsidiaries at fair value through profit or loss in accordance with IFRS 9, Financial instruments, or IAS 39, Financial instruments: recognition and measurement. The consequences of this amendment will be far-reaching for those entities.
"The consequences... will be far-reaching."
IAS 8, Accounting policies, changes in accounting estimates and errors, contains a general requirement that changes in accounting policies are fully retrospectively applied. However, this does not apply where there are specific transitional provisions.
For example, when first applying IFRS 15, Revenue from contracts with customers, entities should apply the standard in full for the current period, including retrospective application to all contracts that were not yet complete at the beginning of that period.
For prior periods, the transition guidance allows entities an option to either:
- apply IFRS 15 in full to prior periods (some limited practical expedients are available)
- retain prior period figures as reported under the previous standards, recognising the cumulative effect of applying IFRS 15 as an adjustment to the opening balance of equity as at the date of the beginning of the current reporting period.
Further, IAS 8 requires the disclosure of a number of matters about the new IFRS. These include:
- the title of the IFRS
- the nature of the change in accounting policy
- a description of the transitional provisions
- the amount of the adjustment for each financial statement line item that is affected.
Additionally, IAS 1, Presentation of financial statements, requires a third statement of financial position to be presented if the entity retrospectively applies an accounting policy, restates items or reclassifies items, and those adjustments had a material effect on the information in the statement of financial position at the beginning of the comparative period.
IAS 33, Earnings per share, requires basic and diluted earnings per share (EPS) to be adjusted for the impacts of adjustments resulting from changes in accounting policies accounted for retrospectively, and IAS 8 requires the disclosure of the amount of such adjustments. Where there are new accounting policies, the impact on the interim financial statements will not be as great as on the year-end accounts. However, IAS 34, Interim financial reporting, requires disclosure of the nature and effect of any change in accounting policies and methods of computation.
The entity itself should prepare an impact assessment relating to the introduction of any new IFRS. There may be significant changes to processes, systems and controls, and management should communicate the impact to investors and other stakeholders. This would include plans for disclosing the effects of new accounting standards that are issued but not yet effective, as required by IAS 8. Audit committees have an important role in overseeing implementation of any new standard in their organisations.
For example, under IFRS 15, an entity may need to evaluate its relationships with contract counterparties to determine whether a vendor-customer relationship exists. Existing revenue recognition policies will also need to be evaluated to determine whether any contracts within the scope of IFRS 15 will be affected by the new requirements.
Where a new standard requires significantly more disclosures than current IFRS, the entity may want to understand whether it has sufficient information to satisfy the new disclosure requirements or whether new systems, processes and controls must be implemented to gather such information and ensure its accuracy. The entity should choose a path to implementation and establish responsibilities and deadlines. This may help to determine the accountability of the implementation team and allow management to identify gaps in resources.
For example, IFRS 15 requires entities that select the full retrospective approach to apply the standard to each year presented in the financial statements. This will require entities to begin tracking revenue using the new standard from the current period to the effective date of 1 January 2017.
A key thing about recent standards is that the IASB has given entities a reasonable amount of time to plan implementation. For example IFRS 9, Financial instruments, has an effective date of 1 January 2018. However, insurance companies will need this time to plan their implementation.
The new IFRS 9 standard includes revised guidance about the classification and measurement of financial assets, including a new expected credit loss model for calculating impairment. It also supplements the new general hedge accounting requirements that were published in 2013.
Insurance companies will be greatly affected as they plan to adopt new standards on financial instruments and insurance contracts. However, before insurers reach conclusions about how they apply IFRS 9, they will want to consider its interaction with the forthcoming standard on insurance contracts.
Accounting standards have economic effects, which can be beneficial for some entities and detrimental to others. The IASB’s evaluation of costs and benefits are by nature qualitative. The quantitative effects should be anticipated by entities as they are the ones that will feel them.
Graham Holt is director of professional studies at the accounting, finance and economics department at Manchester Metropolitan University Business School.