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Banka: Impact of global accounting methods felt in stock prices
International Financial Reporting Standards is a principle-based set of accounting standards designed to improve the comparability of financial statements internationally.
The goal is to develop a single set of high quality global accounting standards that are understandable and that improve the transparency of financial reporting on the various capital markets of the world (stock exchanges).
These standards were adopted in Canada for any year ending in the 2011 calendar year for a publicly traded company meaning a company listed on a stock exchange.
Early adoption of these standards was encouraged and some companies did opt for the early adoption.
The European Union adopted these standards beginning in 2005 and the USA still uses their own FASB standards that are now heavily influenced by IFRS.
Due to this early adoption, we can now begin to see the differences between IFRS and Canadian GAAP standards on the comparison of financial ratios when evaluating whether to invest in a particular stock.
Some of the major differences between Canadian GAAP and IFRS are that IFRS uses a principal based approach to selecting accounting methods and estimates rather than a rule approach and fair value accounting is used rather than a historical cost approach.
There are more notes required to explain the computation of the fair values on the financial statements and an additional statement called Statement of Comprehensive Income is required.
This statement resembles an income statement generated using fair values and shows the effect of unrealized gains and losses caused by the fair value adjustments made in the statements. At the bottom of the report is listed the effect of the unrealized gains and losses that were not adjusted for in the statements.
There is another significant difference with the consolidation of an entity that has minority interest shareholders.
With IFRS the income allocated to minority shareholders are recognized as equity where previously it was recorded as an income statement expense or a liability in Canada.
Financial ratios are based on accounting information and are widely used by investors, bankers, brokers and anyone who needs to analyze the financial condition or performance of a company.
These ratios are usually categorized into four main types—liquidity, leverage, coverage and profitability.
Examples of the liquidity ratios are the Current or Quick ratio. A leverage ratio is the debt ratio, the equity ratio or the debt to tangible net worth ratio. Coverage ratios are interest coverage, fixed charge coverage and cash flow coverage.
Profitability ratio examples are return on asset, return on equity, gross profit margin, net profit margin, asset turnover and price earnings ratio.
The application of fair value accounting under IFRS may cause balance sheet figures to be adjusted, some gains and losses to be directly allocated to the income statement and other gains and losses will only show up under other comprehensive income and the effect of these gains and losses will not immediately be realized.
Fair value accounting will affect all categories of financial ratios. The application of IFRS to consolidations will change the way that profits are allocated to minority interest shareholders which will directly affect the profitability ratios.
Measurement of long lived assets are based on management’s judgment on the useful life of an asset and the asset is required to be tested for impairment. Depending on the change in professional judgment, leverage and profitability ratios could be affected.
Long lived liabilities such as leases or pensions may be required to be classified differently in IFRS where they may need to be classified as equity rather than long term liabilities.
This reclassification would also affect the leverage and profitability ratios.
In a document recently published by CGA Canada, senior executives were surveyed to determine what effect they thought the adoption of IFRS would have on the financial statements.
Most indicated that asset values would increase, pension liabilities would increase, net income would decrease, earnings per share would decrease and goodwill would decrease.
Investors are cautioned when comparing ratios from IFRS prepared statements with those prepared under Canadian GAAP as the results could be significantly different and be incomparable.
One solution may be to convert the Canadian GAAP results to IFRS before comparing ratios, but that may be an expensive solution.
With the adoption of comprehensive income the ROE and ROA ratios should be recalculated with the use of comprehensive income as the numerator to get the effect of the unrealized gains and losses not on the income statement.
Gabriele Banka is a Certified General Accountant and the owner of Banka & Company Inc.