Jamil Khatri's IFRS Diary: Part 3

As India begins the IFRS countdown to April 1, 2011, 'The Firm' launches a series of articles highlighting the milestones of this journey. Each month, Jamil Khatri of KPMG will write in with news and views on the latest developments on the IFRS front. Below is the third of this monthly series.

Convergence with IFRS: What should investors be looking for?

Will convergence with IFRS impact valuation of companies?  How should investors identify companies that may be most impacted by IFRS? Are there any specific sectors, which will be more impacted than others?  These and other similar questions are increasingly being asked by institutional investors and equity research analysts.  I am not an expert on equity valuations; but based on the experience in Europe and my own interactions with several stakeholders, I have attempted to summarize my thoughts on matters that may be relevant for investors.

Let us first start with international experience.  The European Union commissioned a report in 2007 to try and evaluate how IFRS implementation in Europe affected investors.  While 63% of investors agreed that IFRS implementation improved the overall quality of the financial statements, 49% of investors concluded that IFRS financial statements were more difficult to understand than previous local GAAP financial statements.  This demonstrates that while IFRS financial statements may provide more information and lead to consistency in presentation, the new standards will be more complex to apply and understand than previous standards.  Investors were concerned about the volatility in the reported earnings due to extensive use of fair values.  Similarly, several investors believe that the IFRS financial statements provided disclosures and additional information that was not previously available under local GAAP - and hence assisted the investment decision making process.  Several institutional investors indicated that the additional information had some impact on their investment decisions.  Most equity research analysts were unable to correctly predict the impact of IFRS implementation on individual companies.  Lastly, there was no consensus on whether IFRS implementation had any impact on the cost of capital for a company.

With that background, what should investors in India be looking for? 

First, investors need to think through the issue of comparability between peer companies, as some companies will report under IFRS from April 1, 2011, while several other companies will not follow these standards till April 1, 2014.  For companies that are not required to follow IFRS from April 1, 2011, institutional investors should consider asking company management to disclosure likely impact of IFRS.

Second, the transition to IFRS will also move investor focus away from standalone financial statements to consolidated financial statements.  It is surprising on how several large companies still manage to meet investor expectations by merely publishing quarterly standalone financial results.  Investors should closely look at consolidated financial statements, which reflect the true position and financial performance of the entity.  This is particularly important as several special purpose entities, which are currently not consolidated, would require consolidation under IFRS.  In such cases, several off-balance sheet arrangements may now be reflected in the consolidated financial statements (based on their substance).

Third, investors should realize that IFRS will impact revenues, earnings, book values and debt: equity ratios of several companies.  The degree of impact may vary.  Wherever companies are valued on multiples based on earnings (for example, PE ratios) or book values, investors would need to determine the impact of likely earnings adjustment and earnings volatility on valuations.  Several scenarios are possible.  For example, investors may decide that the reduction in earnings should be compensated by PE multiple expansion.  Alternatively, investors may conclude that the IFRS earnings better reflect the 'true earnings' of the company and hence valuations require an adjustment.  Many investors may have applied global benchmark PE multiples to previous earnings computed per Indian GAAP.  In such cases, it may be logical to apply the global benchmark multiples to comparable earnings computed under IFRS.

Fourth, investors may need to estimate which sectors or companies will be more impacted than others.  An analysis will reveal that the real estate sector, financial services sector and companies that operate through Build-Operate-Transfer (BOT) models may be more impacted than other sectors.  Similarly, certain companies would be more impacted than others.  For example, there are significant differences between Indian GAAP and IFRS in areas such as recognition of revenues for barter transactions, recognition of customer incentive schemes, depreciation accounting, acquisition accounting, exchange difference accounting, convertible instruments accounting, classification of preference shares, derivatives accounting, employee stock option accounting and accounting for redemption premium on debt.  Accordingly, companies that have significant transactions impacted by such accounting differences are likely to be more impacted than other companies.  Investors may need to analyze available information to estimate the degree of impact.

Fifth, transition to IFRS will provide significant additional information in the financial statements.  For example, the number of segments disclosed and the level of segment information disclosed may increase.  Investors would need to determine how to use such additional information in their investment decisions.  For example, new information disclosed, which was previously not disclosed under Indian GAAP may have value relevance.

Sixth, investors would need to determine whether the new accounting standards affect 'real' transactions.  For example, certain companies may not be able to pay dividends in certain periods due to volatility in earnings/distributable profits.  On the other hand, certain companies may be able to pay dividends earlier than previously anticipated (for example, due to revenue/earnings recognition by BOT companies during the construction period).  Similarly, new rules on classification between debt and equity may result in increase in debt: equity ratios and/or breach of debt covenants.  This may pose refinancing risks or increase the cost of debt.  There are several other situations where the change in accounting may have a consequential impact on 'real' transactions.

Lastly, investors would need to learn new financial reporting terminology and also learn how to read the IFRS financial statements correctly (as the format and terminology used may be significantly different than what has been historically used).

The above list is not meant to be exhaustive, but merely demonstrates that investors have a lot to think about in anticipation of the convergence with IFRS.

I look forward to your feedback and comments.  You may communicate with me at thefirm@in.com