IFRS: turning confusion to competitive advantage.

A change in accounting standards sounds like the bread and butter of finance directors, the kind of thing they can fit in around their day jobs. But the move to International Financial Reporting Standards (IFRS)--which is to become mandatory across the European Union (EU) countries, as well as in Australia, Russia, parts of the Middle East and Africa--is no small tweak of the numbers.

This is a conversion that will shake the whole basis of reporting for many corporations, affecting not just their external communication of performance, but also their internal management reporting and data collection systems.

If this sounds rather alarmist, take the example of a European company that recently prepared its first financial statement according to IFRS. Management was shocked to see that its return on investment under the new requirements fell from 16 percent to 3 percent. Add to this the potential for the new "fair value" provisions, which would increase substantially the volatility of reported financial numbers in certain situations, and it is clear that IFRS conversion will challenge preparers and readers alike.

This is more than the stuff of nightmares for investor relations managers. Apply these principles within the organization, and the perceived contribution of any given product or team to total corporate profitability could be transformed overnight. The potential financial, structural and cultural implications of this transition are pervasive.

Amidst the many changes that conversion to IFRS might entail, one challenge dominates the agenda of investors and directors alike: how to evaluate corporate performance. This begs the question: How, in a world of greater earnings volatility, can I differentiate good management from bad, luck from skill?

In all fairness, this problem is not unique to reporting under IFRS. Indeed, many would argue that the ability to evaluate the financial performance of a company is far easier when fair value, rather than historic cost principles, are applied. However, the additional volatility that might creep into the financial performance of a company will make far more visible the danger of relying on purely financial numbers to communicate company performance.

As long as the primary tools of managerial assessment are financial in nature, boards and investors alike will struggle to assess both the quality and sustainability of corporate performance. And the impact of that uncertainty is tangible; empirical evidence (see, for example, "Winning the Competition for Capital," by Thomas, A., Gietzmann, M. and Shyla, A., European Business Forum, Spring 2002) shows that as confidence in forecasts falls, the costs of equity and debt for any company rise.

To reduce these costs and find appropriate metrics for reporting corporate performance, PricewaterhouseCoopers has conducted extensive industry-based research, asking CFOs and the investment community to identify the information they regard as critical for understanding corporate performance in a given industry. Codified into PricewaterhouseCoopers' ValueReporting framework, this research suggests that there are four common building blocks of information that all users require when assessing the quality and sustainability of corporate performance. The four are: Market Overview, Strategy, Value Creating Activities and Financial Performance.

How can such a framework reduce the uncertainty that a transition to IFRS might generate? At the simplest level, by linking financial performance to other key indicators of performance, the company would allow readers to set in context any earnings "blip."

If a financial disappointment is balanced by strong operational numbers, such as rising market share and increased customer satisfaction, investors and other users of this information are much more likely to "look across the valley" and see the big picture.

Of course, in practice, piecing together the performance puzzle is not as straightforward as it sounds. The first challenge is to understand the specific information needed to evaluate activity in each company and industry. The second is to present these measures in credible fashion--and it is the quality of the information provided, not the quantity, that counts. The final and, for many companies, biggest barrier to implementation is the lack of robust non-financial information at the level of top management and the board.

Too often, I have attended meetings where senior executives fervently claim that people are the company's life-blood--but then confess that they have no routinized metrics that allow them to assess their ability to retain and attract the kind of staff they need.

Will the transition to IFRS be the incentive that management needs to take that long, hard look at the quality and availability of information within the company? For the sake of their company's value, and for the sake of good business management, let's hope so.

Contributed by: Alison Thomas, Director, Global Research, ValueReporting, PricewaterhouseCoopers LLP, in London