Conversion kick-start.

The adoption deadline for international accounting standards is now looming large. Preparing or the change will be a major undertaking for financial managers in many EU-listed companies that have been slow to act so far. Simon Rydings raises some practical questions to help accountants identify the transition's likely impact on their organisations.

Unlike previous changes to UK accounting standards, the conversion to the international accounting standard (IAS) framework will cover a large number of standards from day one. Every listed company in the European Union will have to adopt around 30 IASs from 1 January next year, although not all published standards will be mandatory from that date because some of them are still being ratified.

Several of the earlier IASs will be revised over the next few months in order to remove inconsistencies with more recent standards. These disparities arose because the original standards were drafted at a time when the conventional wisdom on the worth of financial information focused mainly on the profit and loss account. Today, the usefulness of financial statements is driven far more by the balance sheet. Also, the development of more complex contracts and financial instruments has brought with it a need to change how assets and liabilities are reported.

All of this means that UK-listed companies--particularly groups with overseas operations and those with complex ownership structures--will certainly need to commit considerable time and effort to the task. They will need to set adequate controls to show how the required changes have been made to their reported figures--no finance director will be prepared to sign their first set of published IAS accounts unless these alterations can be explained. In essence, this entails reconciling all IAS changes back to the original UK Gaap accounts with a clear audit trail to explain each change.

In many organisations the conversion process has already started. Based on current indications from the International Accounting Standards Board, firms that have a yearend falling on or after 1 April 2005 will also have to prepare their previous annual results under IAS in order to present one year's comparative figures in their first published set of IAS accounts. In practice, this means that all listed companies must have IAS-compliant figures for any year ending in the 12 months up to and including 31 March 2005. So, in the case of companies with a calendar year-end, the group will need to have IAS figures for the year ending 31 December 2004.

Many accountants are probably asking themselves: "What does IAS really mean for me?" To some extent the answer depends on your position in an organisation, how involved you are in preparing financial accounting information and what use you make of reported figures. What is certain is that accountants in listed companies will be required to go through a process of "IAS conversion".

Although it will be mandatory only to publish group accounts under IAS, there is an option to prepare parent and EU-registered subsidiary accounts under it too. Although local laws--especially for non-EU companies-may make it necessary to prepare two sets of accounts, the option to use IAS alone wherever possible may be hard to ignore and would certainly ease the burden on local finance teams.

For some of us IAS has already become a reality at work. Several multinationals have adopted it in the past five years, so their worldwide operations have had to manage the conversion from previous reporting standards well ahead of the January 2005 deadline.

In the light of the increasing responsibilities of board members--non-executive directors in particular--CFOs will be under growing pressure to show that they are managing their conversions well. Although public awareness will remain low for at least another year, external auditors, bankers and major investors will all seek assurances that UK-listed firms are on track to deliver IAS-compliant accounts in 2005. For companies with onerous banking covenants, imminent rights issues or restructuring plans the need to change the performance measures embedded in these plans or agreements is another compelling reason to start converting sooner rather than later.

But why will IAS have such a major impact on financial reporting in listed companies? Although organisations that embrace good accounting practice should already have some of the tools required to prepare IAS-compliant accounts, specific rules will require them to adopt some new practices. These will create the need for both systems modifications and accounting policy amendments. Changes will also be needed in order to capture new information for disclosure purposes.

The following (non-exhaustive) checklist indicates some of the key requirements that firms will face and the questions that finance teams need to be asking themselves. Several standards are being amended early this year, so it will also be important to keep abreast of changes occurring right up to January 2005.

Treasury

Many firms will be affected by roles on the recognition of revenue or expense for financial instruments (IASs 32 and 39). These instruments include derivatives such as commodity, currency and interest-rate swaps/options; hedging instruments; "securitised" investments; and factoring. IAS39 may not be mandatory from January 2005, but many of the requirements in this draft standard will be relevant for companies converting to IAS.

* Are reporting systems able to recognise assets in accordance with the defined IAS classification and is there documentary evidence to support the chosen classification?

* Have models been developed to evaluate and record fair value and test impairment of financial assets?

* Are there systems in place to identify and control reclassifications of assets that may give rise to "asset-tainting" if they are moved from "Assets held to maturity"?

* Have appropriate methods for recording and measuring liabilities such as corporate bonds been adopted? Do they measure the amortised cost of non-trading liabilities using the "effective interest" method?

* Have appropriate methods been adopted to measure revenues and costs relating to financial assets and liabilities?

* Have suitable methods and contracts been adopted for the recognition of hedging relationships between assets and/or liabilities and the corresponding hedge instruments? Can these hedges be measured accurately in terms of effectiveness, and can gains/losses be recognised in accordance with IAS39?

Revenue

A revised IAS18 will be made consistent with IASs 39, 40 and 41. Revenue recognition currently relies on the passing of risks, rewards and control. The control rule does create limitations on the application of these later standards. Revenue is defined as inflows resulting in "increases to equity", which is clearly not always the case when goods or services are transferred to customers. The interchangeable use of terms such as "income" and "revenue" can also create confusion. There are also specific rules on the recognition of revenue relating to interest, dividends and royalties.

Fixed assets, goodwill and brand value

The adoption of IASs 16, 36 and 38 will be mandatory from January 2005 and they may have significant consequences when it comes to valuing different asset classes.

* Are there any items of plant, equipment or goodwill with a useful life of more than 20 years? If there are, can this estimate of useful life be reliably proven? If there aren't, what is the impact of changing the accounting life to a maximum of 20 years?

* Has any property, plant or equipment been revalued to replacement value? This isn't permitted under IAS. Any revaluations must be conducted regularly and reliably to decide the fair value of tangible assets, will there be a dynamic fixed-asset register to record these values? Can the valuations be supported using active market benchmarks?

* For any tangible assets that are revalued will you be able to recognise the revaluation reserve attributed to these assets if they are disposed of or impaired?

* Have models been developed to show whether or not assets need to be impaired? Can these be run as frequently as your firm publishes its accounts? Do the projected cash flows comply with IAS rules?

* If tangible fixed assets include items that carry a material decommissioning cost at the end of their useful lives--for instance, nuclear power stations--has an allowance been made for the full decommissioning costs as part of "provisions", and has it been subject to annual review?

* Have impairment models been developed that avoid double-counting gross earning streams used to justify valuations shown for other asset classes (including goodwill and brand value)?

* Is a brand recognised where it can be measured using active market benchmarks or where it was purchased?

A revised IAS38 should limit internally generated brined value to very few cases--for example, franchise operations.

Inventory

IAS2 will be mandatory from 1 January 2005. Inventory value will need to be shown at the lower of cost and net realisable value (NRV).

* Is last-in-first-out used for inventory? This will not be permitted from January 2005.

* Have models been developed that can identify NRV allowing for the cost to complete unfinished inventory and the selling costs? Although IAS2 is imprecise about the nature of selling costs, it's reasonable to assume that all direct costs incurred by a sale--eg, packaging and transport-- are relevant.

Pensions

Organisations that provide or have provided a defined-benefit pension scheme will have to adopt IAS19. Actuarial gains or losses in the fair value of the fund compared with the defined-benefit obligations will have to be measured and recorded correctly.

* Have arrangements been made to evaluate actuarial gains and losses annually?

* Will it be possible to recognise whether gains/losses exceed [+ or -]10 per cent of the higher of the defined-benefit obligations and the fund value?

Lease obligations

IAS17 requires finance lease obligations to he shown at the lower of the asset's fair value and the discounted value of minimum future lease payments. The future intention seems to be to make all non-cancellable leases subject to the same treatment as finance leases. This has major implications for firms that rent assets.

* Are assets acquired under a finance lease being written down over their useful lives rather than over the lease term?

* Will estimates of useful life be reviewed regularly for all relevant asset classes?

* Have there been any sales and leasebacks that gave rise to a profit or loss on sale? If so, will it be possible to recognise and amortise the profit/loss correctly over the lease term?

Provisions

Rules for the recognition of provisions are similar in UK Gaap and IAS37. The most significant change arises in respect of decommissioning costs.

* Where the time value of money is material have the provisions been calculated using a pre-tax discount rate weighted for risks specific to the liability?

* Although contingent assets and liabilities cannot be recorded in the balance sheet,

they may be disclosed in the notes where the economic obligation can be measured reliably and the risk is credible.

Deferred taxation

IAS12 allows for a wider recognition than UK Gaap of deferred tax assets and liabilities, and there are key differences in the calculation and reporting of deferred tax.

* Has deferred tax been calculated using discounted cash flows? This will not be allowed after 1 January 2005.

* Is it possible to identify deferred tax assets and classify these as current assets?

* Are deferred taxes on unrealised intra-group profits calculated at the buyer's tax rate?

* Are deferred tax calculations adjusted for changes in future underlying tax rates as they become known?

* Will a deferred tax asset/liability be recognised on the revaluation of assets, including those held for sale?

IAS states that unremitted profits held in subsidiaries, joint ventures and associates must be taken into account by the parent when calculating the holding company's deferred taxes, except where the parent controls the timing difference and it's probable that this difference will not reverse in the foreseeable future.

Business combinations

Changes to lAS22 will be made so that merger accounting (uniting of interests) will be prohibited from 1 January 2005. Similarly, the provision under IAS27 for the exclusion of businesses from a group where the control is temporary will cease. Changes to IAS31 will require joint ventures to be consolidated using the equity method only.

* Are there differences in reporting year-ends for any entities that exceed three months?

* Are plans in place to eliminate unrealised intra-group profits? Do they include proportional eliminations on transactions with joint ventures and associates?

* Can the consolidated reporting systems track translation differences by asset and liability category for all changes recorded after 31 December 2004?

Future changes proposed under ED3 will require that the minority's share of net assets be fair-valued. This will force groups to fair-value non-wholly owned subsidiaries recognised in the group accounts. ED3 proposes that negative goodwill be recognised immediately as income rather than deferred and unwound against future losses made by the acquired firm.

Cashflow

IAS7 allows for the preparation of a cash flow using direct or indirect methods and either actual or average exchange rates. The statement is to be divided into operating, investing and financing cash flows. Some ambiguity exists in the classification of certain transactions, such as dividends paid and received.

Internal audit

Many companies rely on their internal audit departments to conduct effective reviews of their internal controls and data integrity. Internal auditors may also maintain group accounting policy documents.

* Has internal audit revised the benchmarks that are used to perform high-level testing in your organisation?

* Are there group-wide controls in place to ensure consistency in asset/liability valuations and classifications, revenue and cost recognition, asset impairment testing, provisioning and so on?

* Are IAS-compliant accounting policies and procedures well documented, and have they been widely circulated?

* Has adequate training on IAS been provided around the group? Will refresher courses be provided?

Financial systems

A significant number of organisations will have to make changes to their financial reporting systems. Late adopters will also need to manage the conversion and mapping of historicdata.

* Have all accounting systems been modified to cater for IAS reporting requirements?

* Are there plans for the conversion and migration of comparative historic data?

* Will systems upgrades compromise your ability to capture and record IAS-compliant financial information for any fiscal year ending in or after 2004?

Director and employee performance-related pay and share incentive plans

IAS19 requires bonus plans to be accounted for when a liability (obligation) comes into being--ie, once the conditions for earning the bonus have been met. Share-based payments are the subject of ED2, which could become mandatory in January 2005. This will require the measurement at fair value of all shares and options at the grant date. In many cases the conditions that determine whether or not bonuses, shares or options have been earned could be affected by the adoption of IAS.

* Have the benchmarks used to measure performance for performance-related pay schemes been converted to IAS?

* Have the reporting systems been amended to allow for the consistent measurement of performance over time?

* If your firm is operating in financial services, will the adoption of IAS affect traders' earnlugs and bonus entitlements. If so, have their contracts been changed to reflect this?

* Will changes to "financial measures" stipulated in executive incentive schemes need to be approved by the board or shareholders?

While IAS19 has no specific requirements for the measurement of share-based rewards, it's fair to assume that any financial obligations that can be measured with reasonable certainty must be recognised on an accruals basis.

Your firm's first published IAS accounts need to have the opening "retained earnings" balance restated for the earliest period presented. This will require the retrospective adoption of some accounting methods described in the standards. In addition, there are specific transitional rules where some standards are not to be applied retrospectively--eg, hedging (IAS39) or defined-benefit pension schemes (IAS19).

IAS1 covers the presentation of statements yet it doesn't stipulate any formats. Since the Companies Act 1985 does define the required formats for UK-published accounts, it's reasonable to assume that this still applies for now. But it's likely that a format will eventually be prescribed--perhaps once the US Securities and Exchange Commission has accepted the adoption of IAS for all US-listed entities.

A successful IAS conversion programme will require careful planning and effective change management. It will be crucial to bring all your functional specialists together to implement changes to reporting systems, internal controls, accounting policies, reporting processes, budgets, performance measures and various financial agreements. IAS will also affect merger and acquisition activity, rights issues, investor relations, deferred tax calculations, business planning and several other activities. The task of co-ordinating the work across these teams may call for a dedicated project manager, who will need the backing of the board and the respect and confidence of functional heads.

The disruption for some listed companies is likely to be substantial and costly. To put the scale of the task into some perspective, the basic IAS accounting checklists developed by the major audit firms number about 100 pages. These cover high-level issues that will need to be reviewed by every finance function. Managers must be able to show that all IAS changes have been made and that these can be reconciled back to source. Preparing for this will be the major challenge facing many accountants this year.

Simon Rydings ACMA ([e-mail]) is managing consultant at Des Voeux Consulting