The Effects of Ifrs on Financial Ratios

TheEffectsofIFRS onFinancialRatios: EarlyEvidenceinCanada By: ichelBlanchette,Francois-EricRacicot M andJean-YvesGirard Sponsor: ockLefebvre,MBA,CFE,FCIS,FCGA R ResearchandStandards,CGA-Canada ElenaSimonova,MA(Economics),MPA ResearchandStandards,CGA-Canada AbouttheAuthors Michel Blanchette, FCMA, CA is a professor of Accounting with Universite du Quebec en Outaouais. Francois-Eric Racicot is a Professor of Business with Universite du Quebec en Outaouais, and Jean-Yves Girard, CMA, is an Industrial Analysis and Development Officer at Industry Canada, Government of Canada.

The authors thank Diane Bigras, Denis Cormier and Therese Roy for their comments on an earlier version. AboutCGA-Canada Founded in 1908, the Certified General Accountants Association of Canada (CGA-Canada) is a selfregulating, professional association of 75,000 students and Certified General Accountants — CGAs. CGA-Canada develops the CGA Program of Professional Studies, sets certification requirements and professional standards, contributes to national and international accounting standard setting, and serves as an advocate for accounting professional excellence.

CGA-Canada has been actively involved in developing impartial and objective research on a range of topics related to major accounting, economic and social issues affecting Canadians and businesses. CGA-Canada is recognized for heightening public awareness, contributing to public policy dialogue, and advancing public interest. For more information, contact can be made through: 100 – 4200 North Fraser Way, Burnaby, BC, Canada, V5J 5K7 Telephone: 604-669-3555 Fax: 604-689-5845 1201 – 350 Sparks Street, Ottawa, ON, Canada, K1R 7S8 Telephone: 613-789-7771 Fax: 613-789-7772 Electronic access to this report can be obtained at www. ga. org/canada ISBN 978-1-55219-641-0 © By the Certified General Accountants Association of Canada, 2011. Reproduction in whole or in part without written permission is strictly prohibited. 2 Certified General Accountants Association of Canada TableofContents Abstract …………………………………………………………………………………………………………………. Executive Summary ………………………………………………………………………………………………….. 1. 2. 5 7

Introduction …………………………………………………………………………………………………….. 11 International Financial Reporting Standards (IFRS) ……………………………………………… 2. 1. Evolution of Canadian GAAP towards IFRS …………………………………………….. 2. 2. Main features of IFRS …………………………………………………………………………….. 2. 3. The unique context of the first application of IFRS……………………………………… 13 13 15 19 3.

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Financial Ratios ……………………………………………………………………………………………….. 21 3. 1. Selected ratios ………………………………………………………………………………………… 21 3. 2. Effects of IFRS on financial ratios…………………………………………………………….. 23 Methodology and Data ……………………………………………………………………………………… 31 4. 1. Research design ……………………………………………………………………………………… 1 4. 2. Data ……………………………………………………………………………………………………… 31 Results ……………………………………………………………………………………………………………. 5. 1. Comparison of means, medians and variances …………………………………………….. 5. 2. Analysis of distributions ………………………………………………………………………….. 5. 3. Industry and other effects ………………………………………………………………………… 1 41 43 46 4. 5. 6. 7. Concluding Remarks and Recommendations ……………………………………………………….. 51 References ……………………………………………………………………………………………………….. 55 The Effects of IFRS on Financial Ratios: Early Evidence in Canada 3 ListofTables Table 1 – Fair value accounting in IFRS ……………………………………………………………………… 16 Table 2 – Elements of IFRS 1 not representative of ongoing application of IFRSs ……………. 0 Table 3 – Selected financial ratios…………………………………………………………….. ………………… 22 Table 4 – IFRS transition disclosures in MD&A of Canadian companies, 2009 ……………….. 29 Table 5 – Expectations of Canadian senior financial executives on the adoption of IFRS …… 30 Table 6 – Selection of companies to form the data set …………………………………………………… 33 Table 7 – Breakdown of companies in the sample …………………………………………………………. 4 Table 8 – Descriptive statistics of financial statements included in the sample ………………….. 36 Table 9 – Descriptive statistics of financial ratios ………………………………………………………….. 38 Table 10 – Tests of equality ……………………………………………………………………………………….. 42 Table 11 – Regression of IFRS ratios with Canadian GAAP ratios ………………………………… 44 Table 12 – Regression of IFRS ratios with Canadian GAAP ratios and dummies …………….. 7 ListofFigures Figure A – Relationships between balance sheet, income statement and OCI …………………… 18 Figure B – Potential incremental effects on financial ratios of the adoption of IFRS in Canada ……………………………………………………………………………………. 26 4 Certified General Accountants Association of Canada ABSTRACT This paper provides preliminary evidence of the impact on financial ratios caused by the transition to International Financial Reporting Standards (IFRS) in Canada.

The main features of IFRS are explained in the context of a shift from Canadian Generally Accepted Accounting Principles (GAAP) while the main differences between the two sets of rules are underscored – heavier reliance of IFRS on fair value accounting and comprehensive income, and the use of the entity theory for consolidation. The effects of IFRS on financial ratios in the areas of liquidity, leverage, coverage and profitability are discussed and verified using a sample cohort of early adopters in Canada.

The preliminary evidence reveals significantly higher volatility to most of the ratios under IFRS when compared to those derived under pre-changeover Canadian GAAP. While the means and medians of IFRS ratios differ from the means and medians of the same ratios under pre-changeover Canadian GAAP, the differences are not statistically significant overall. However, important individual discrepancies are in some cases observed. Naturally, analysts using ratios for analytical purposes during the transition period need to be vigilant as ratios computed under IFRS are not directly comparable with those derived under pre-changeover Canadian GAAP.

It is recommended that heightened attention be directed to the new feature – comprehensive income – which incorporates unrealized gains and losses that bypass the income statement. The suggested analytical tools best suited to mitigate the contributing effect include reliance on comprehensive-Return on Assets (ROA) and comprehensive-Return on Equity (ROE). The Effects of IFRS on Financial Ratios: Early Evidence in Canada 5 6 EXECUTIVESUMMARY Financial reporting in Canada is undergoing remarkable change as publicly accountable enterprises transition from GAAP to IFRS.

Although the conceptual basis and many of the general principles are shared, the application of IFRS may be significantly different. Consequently, the differences between IFRS and pre-changeover Canadian GAAP may impact figures presented in financial statements and lead to variances in financial ratios computed under the two regimes. The objectives of this paper are to analyze the early implementation of IFRS in Canada and to provide preliminary empirical evidence of the impact on financial ratios of Canadian companies caused by a migration to IFRS. The analysis is based on the examination of a et of financial ratios commonly utilized by investors and other users of financial statements. The 16 ratios examined are grouped into four broad categories: liquidity, leverage, coverage and profitability. The impact of IFRS is analyzed through the comparison of ratios computed under IFRS and pre-changeover Canadian GAAP for the same time/period. Specifically, the tests for equality of means, medians and variances between each series of ratios are used to understand whether the distributions of IFRS values differ from pre-changeover Canadian GAAP.

Further, least-square regressions are employed to analyze the relationships between ratios under the two regimes. The analysis is based on a sample of all Canadian companies authorized for early adoption of IFRS and for which audited financial statements are publicly available. The final sample consists of 9 companies and provides for 22 full sets of audited financial statements covering a 12-month period and 30 balance sheets at specific dates. As the following pages reveal, it can be reasonably contended that: IFRSpresentsanumberofspecificcharacteristicsthatdifferentiateitfromotheraccounting regimes.

Among the most important are (i) the principle-based approach that gives more importance to substance (over form) and allows management to use greater discretion in its application; (ii) the greater reliance on fair value accounting involving varying degrees of subjectivity; (iii) the concept of comprehensive income that reflects all revenues, expenses, gains and losses to be recognized during a specified time period; (iv) the entity theory that underlies consolidation requiring assets and liabilities of subsidiaries acquired and minority interests to be measured at fair value and the presentation of minority interests within equity; and, (v) the improved transparency and completeness that, on the downside, arguably leads to an overload of information as notes accompanying financial statements are numerous and complex. IFRS’simpactonfinancialratiosisdrivenbyfundamentaldifferencesinapplicationoffair valueaccountingandconsolidationunderIFRSandpre-changeoverCanadianGAAP,andbya numberofotherdifferences.

Fair value accounting causes adjustments in balance sheet figures, direct allocation of some unrealized gains and losses to the income statement, and allocation of some other unrealized gains and losses to other comprehensive income. As a result, liquidity and leverage ratios are affected due to balance sheet variations while profitability The Effects of IFRS on Financial Ratios: Early Evidence in Canada 7 and coverage ratios are affected due to balance sheet variations and recognition of unrealized gains/losses. The impact of consolidation on ratios is difficult to isolate as the differences are incorporated or combined in the consolidated figures. Incorporating minority interest in equity also significantly impacts the financial statements; directly affecting profitability and leverage ratios.

Other differences affect leverage and profitability ratios, particularly in impairment test procedures applied to long-lived assets. The standards on leases, pensions and contingencies may report higher levels of liabilities under IFRS while the standard on share-based payments may require higher expense and equity recognition. Moreover, IFRS requires more information to be disclosed in the corresponding notes to financial statements; providing additional information potentially useful but further jeopardizing the comparability of ratios. MostofthefinancialratiosunderIFRSpresentasignificantlyhighervolatilitythanthose computedunderpre-changeoverCanadianGAAP.

Although the effects of IFRS on means and medians of ratios related to the financial condition of companies are not statistically significant, maximum values of several ratios are higher and the minimum values are lower under IFRS. There is a significant difference in the distribution of values around medians for such ratios as current and quick ratios, debt, alternative-debt and equity ratios, interest coverage, fixed-charge and cash-flow coverage, return on assets (ROA), comprehensive-ROA and price-earnings related ratios. Results of regression analysis confirm the increased volatility of IFRS leverage and profitability ratios. TheimpactofIFRSissubjecttotheindustryeffectandthetimeofthetransition.

It appears that the companies in the mining sector have certain incentives to early adoption of IFRS as early adopters primarily consist of companies operating in this sector. Under IFRS, there is a significant industry effect for mining companies on six profitability and coverage ratios. The analysis also suggests that profitability of companies that transitioned to IFRS recently is affected more negatively than profitability of those applying IFRS on an ongoing basis. However, the composition of the sample imparts certain limitations to these conclusions. In turn, exceptions and exemptions stipulated by IFRS 1 do not affect significantly the differences in ratios computed under the two regimes.

DifferencesbetweenIFRSandpre-changeoverCanadianGAAPdonotaffectcashflows. In general, IFRS does not materially change the cash flow statement when compared to pre-changeover Canadian GAAP. However, there may be some differences in presentation particularly for interest and dividends, and in the scope of consolidation. TheexactsourceofincreasedvolatilityinfinancialratiosunderIFRSremainsunclearandmay representafutureareaofresearch. Volatility may be caused by incremental adjustments that are specific to IFRS, for instance, unrealized gains or losses on items measured at fair value under IFRS versus historical cost under pre-changeover Canadian GAAP.

It may also be driven by adjustments or methods applied under IFRS principle-based standards allowing 8 Certified General Accountants Association of Canada more discretion and judgment by management. Specific areas of accounting standards that explain the increased volatility in the Canadian context may include fair value accounting, impairment, revenue recognition, capitalization, pension and scope of consolidation. PreviousresearchalsoconfirmstheimpactofIFRSonfinancialratios. In Finland, the analysis of ratios calculated under IFRS and Finnish GAAP for the same time period found that liquidity ratios decrease under IFRS, while leverage and profitability ratios increase.

A review published by the Canadian Securities Administrators (CSA) showed that Canadian companies identify a number of differences between IFRS and Canadian GAAP in their Management Discussion and Analysis (MD&A) including those dealing with asset impairment, revenue recognition and property, plant and equipment. Another study revealed that senior financial executives across Canada most often expect IFRS to increase assets and pension liabilities on the balance sheet, and to decrease net income in the income statement. A number of recommendations are provided based on the results of the analysis. Analysts are advised to be cautious when examining financial ratios during the transition to IFRS in Canada.

Comparability of ratios based on IFRS figures with those based on pre-changeover Canadian GAAP may naturally be impaired and the trend analysis misleading. Financial statement users need to be aware of the main features of IFRS that differ from pre-changeover Canadian GAAP and are well served to distinguish between reported performance changes caused by the transition to IFRS from those caused by changes in the business. A possible solution may be to recalculate ratios using IFRS retroactive information presented in the year of the shift. Relying on cash flow analysis, particularly in cases when accounting practices are subject to uncertainty or discretion of management is recommended.

In addition, financial statement users are advised to verify the uniformity of the underlying figures when using gross profit and operating profit margins in profitability analysis. Finally, it is important to be mindful of the new feature through comprehensive income which incorporates unrealized gains and losses that bypass the profit of the income statement. The suggestion is to use two ratios when analyzing comprehensive income: the comprehensive-ROA (return on assets) and the comprehensive-ROE (return on equity). These are an adaptation of the regular ROA/ROE but with the comprehensive income as the numerator. Several areas for future research are identified.

Testing specific exceptions and exemptions of IFRS 1 with a larger sample may help to detect particular variations in financial ratios based on IFRS and pre-changeover Canadian GAAP. Identifying specific areas of accounting standards that explain the increased volatility of ratios under IFRS may identify more clearly the exact source of volatility in ratios. Moreover, future research could consider extending the analysis to interim statements to increase sample size; although the results may be less reliable. It will also be possible to increase the sample size with data of mandatory adopters following the IFRS changeover in 2011 in Canada. The Effects of IFRS on Financial Ratios: Early Evidence in Canada 9 10 1. INTRODUCTION

Financial reporting in Canada has been undergoing a remarkable change since International Financial Reporting Standards (IFRS) have been adopted as Canadian Generally Accepted Accounting Principles (GAAP) for publicly accountable enterprises and government business entities. In the past, Canadian standards for financial accounting and reporting by public companies were developed by the Accounting Standards Board (AcSB). 1 Since adoption of IFRS, the AcSB has been active in monitoring the technical content and timing of standards implementation to Canadian public companies which are required to report under IFRS no later than 2011. 2 The International Accounting Standards Board (IASB) is responsible to develop and publish IFRSs which have been increasingly adopted globally, with or without adaptation.

IFRS is becoming the dominant financial reporting regime on the international scene as it is either required or permitted in more than 100 countries, including the European Union, Africa, Asian, Oceanic and South American countries. The United States continues to use its own GAAP as promulgated by the Financial Accounting Standards Board (FASB) which has encouragingly become influenced by IFRS. The Securities and Exchange Commission (SEC) accepts financial statements prepared under IFRS by foreign issuers whereas the U. S. accounting standards-setter – the Financial Accounting Standards Board (FASB) – is committed to joint projects with the IASB in developing a single set of high-quality international accounting standards.

Although the conceptual basis and many of the general principles are very similar under IFRS and Canadian GAAP, the application of IFRS may be nevertheless significantly different. Consequently, the differences between the two regimes may impact figures presented in financial statements and lead to variances in financial ratios computed under IFRS and Canadian GAAP. The objectives of this paper are to analyze the early implementation of IFRS in Canada and to provide preliminary evidence of the impact caused by the shift in regimes onto financial ratios. Although Canadian listed companies are required to apply IFRS only in 2011, they have had the option of early adoption that is subject to authorisation by Canadian securities regulators.

The analysis presented in this paper is based on the sample of all Canadian companies that have been authorized to adopt IFRS early and for which financial statements are available through the System for Electronic Document Analysis and Retrieval (SEDAR)3 (CSA, 2010c). Results show preliminary evidence of the potential influence of IFRS on selected financial ratios in the areas 1 2 The AcSB is an independent body with the authority to develop and establish standards and guidance governing financial accounting and reporting in Canada. It is overseen by the Accounting Standards Oversight Council. Canadian GAAP requires that publicly accountable enterprises apply IFRS for interim and annual financial statements relating to annual periods beginning on, or after, January 1, 2011 (CICA Handbook, Part 1, Introduction, para. 1. 7).

This includes listed companies but also entities that are in the process of becoming listed, entities traded over-the-counter and entities that hold assets in a fiduciary capacity for a broad group of outsiders (e. g. banks). Private enterprises can also elect to apply IFRS on an optional basis. In this paper, the focus is on publicly-traded companies. SEDAR is a filing system developed for the CSA that provides access to public securities documents filed by public companies and investment funds (CSA, 2010c). 3 The Effects of IFRS on Financial Ratios: Early Evidence in Canada 11 of liquidity, leverage, coverage and profitability. It is found that the impact of IFRS is subject to industry and to some other related effects.

It should be noted though that the comparison of ratios was based on their quantitative values while evaluation of the structure and importance of the ratios themselves was not within the scope of this study. In the process of analysis, a number of ratios based on the new accounting feature – comprehensive income – were developed. This study responds to an urgent need of users of financial statements to know the impact on financial ratios as a result of the shift to IFRS. For instance, investors rely on ratio analysis to make decisions regarding stock transacting; bankers consider ratios in their credit analysis and some debt covenants; governments use ratios in monitoring grants and other support measures. Financial ratios can reveal avourable or unfavourable values, depending on their trend over time, and relative to those of other companies operating in the same industry. Making financial decisions based on ratios that are not fully comparable can simply lead to undesirable consequences. The balance of the paper is organized as follows. Section 2 reviews the evolution of Canadian GAAP towards IFRS and highlights its main features. It describes the introduction of IFRS in the Canadian context and considers several other sets of rules currently in application or in development. This section also explains the unique context of the first application of IFRS which, in turn, provides the opportunity to compare financial statements prepared under both Canadian GAAP and IFRS for the same period.

Section 3 describes the selected financial ratios and reviews literature that examines the impact of IFRS on financial ratios. Section 4 presents the methodology and data. Sections 5 and 6 discuss the results and provide concluding remarks and recommendations. 12 Certified General Accountants Association of Canada 2. NTERNATIONALFINANCIAL I REPORTINGSTANDARDS(IFRS) In 1973, the International Accounting Standards Committee (IASC) was created with the explicit intent to develop accounting standards for international use. The objective of the IASC was to develop and promote the use and application of International Accounting Standards or IASs (IASB, 2010, Preface).

In the early years, IASs were not widely applied. A noticeable change however took place in 2001 subsequent to replacement of the IASC by the IASB along with the new name given to the standards – IFRS. 4 Another incremental step to the success of IFRS took place in 2005 when the European Union (EU) decided to adopt IFRS as the mandatory set of accounting standards in the EU member states. 2. 1. EvolutionofCanadianGAAPtowardsIFRS The CICA Handbook contains Canadian GAAP (AcSB, 2010). The Handbook was first adopted in 1968 and published by the Canadian Institute of Chartered Accountants (CICA). Since then, it has evolved from a limited number of ules to a wide range of standards applied to a diverse group of entities. It contains guidelines and recommendations on general accounting, and specific and specialized accounting. The current standards include specific rules for pension plans (first introduced in the 1960s: Milburn and Skinner, 2001, p. 257), governments (developed in the 1980’s: ibid, p. 653) and not-for-profit organisations (since 1989: ibid, p. 44). The standards also address industry issues such as banking and insurance (since the 1990’s: ibid. , p. 44) and mining (CICA Handbook: Accounting Guidelines AcG-5 and AcG-16 on full cost accounting in the oil and gas industry, initially published in 1986 and 2003 respectively).

Prior to 2005, the development of Canadian accounting and assurance standards was highly influenced by the United States (Milburn and Skinner, 2001, p. 614). In fact, many accounting standards published in past decades were heavily based on the U. S. rules. In some way, this level of influence may be expected as the United States is one of the leaders of the world capital markets, as well as an important business and trade partner to Canada. The number and complexity of accounting rules has increased domestically and internationally reflecting the rising complexity of business transactions and vibrant economic growth. This growth engenders a new problem for accounting standards-setters – standards overload.

It has become common for accounting standards to be hundreds of pages long and very complex for preparers and users of financial statements. To simplify accounting in certain situations, 4 In practice, IFRS comprises of original IASs issued until 2001 (numbered from IAS 1 to IAS 41) and new IFRSs issued thereafter (numbered from IFRS 1 to IFRS 9 as of October 2010). Materials accompanying new standards include a Preface, a Framework and additional guidance to help in interpreting IFRSs (SICs numbered from 1 to 32 and issued by the Standing Interpretations Committee until 2001; IFRICs numbered from 1 to 19 as of October 2010 and thereafter issued by the International Financial Reporting Interpretations Committee).

The Effects of IFRS on Financial Ratios: Early Evidence in Canada 13 exceptions or differential reporting rules were introduced in 2002, authorizing non-publicly accountable enterprises to apply simplified methods as long as owners unanimously consent (AcSB, 2010, Section 1300). More recently, simplified sets of rules were published by the AcSB and the IASB: Accounting Standards for Private Enterprises (AcSB, 2010, Part II) and IFRS for small and medium-sized entities (IASB, 2009) respectively. Following the example of the European Union, a large number of other countries decided to adopt IFRS, primarily for listed companies. This diminished the U. S. nfluence on international accounting and elevated the role of IFRS as the benchmark set of rules worldwide. In Canada, the intention to adopt IFRS for publicly accountable enterprises was announced by the AcSB in 2006 (CICA, 2009). Since then, intensive studies and analyses have been performed and several decisions have been made as Canadian GAAP was converging to IFRS (CICA, 2010). Accounting standards in Canada are presented in two handbooks – the CICA Handbook – Accounting which consists of five parts, and the CICA Public Sector Accounting Handbook. With the transition to IFRS, the CICA Handbook – Accounting has also required modification.

The paragraphs that follow describe the content of the Handbook in its restructured form: CICA Handbook – Accounting (AcSB, 2010): – Part I contains IFRSs that are mandatory for publicly accountable enterprises (PAEs) in periods beginning in 2011. Earlier application is possible but very rare in practice. PAEs refer to entities, other than not-for-profit and pension plans, that have securities traded on a public market or hold assets in a fiduciary capacity for a broad group of outsiders. This includes banks, insurance companies, securities brokers and mutual funds. – Part II contains a new set of standards dedicated to private enterprises that elect not to apply IFRSs. These standards are simplified, in comparison with IFRSs, but nevertheless consist of more than 800 pages. They replace the differential reporting provisions available in the former section 1300 of the Handbook.

It should be noted that the IASB published a separate set of standards for small and medium-sized entities (IASB, 2009); however these standards have not been adopted in Canada. – Part III is reserved to not-for-profit organizations. It is an updated version of the former section 4400 of the Handbook. Not-for-profit organizations can apply these standards or elect to apply IFRSs. – Part IV is directed at pension plans and represents an updated version of the former section 4100 of the Handbook. – Part V contains the pre-changeover standards which applied before 2011. The IFRS transition period in Canada is somewhat confusing with many sets of rules and choices available to entities.

It may take a number of years before users of financial statements become familiar with the new rules and understand the limitations of comparing financial statements over time and across industries. The focus of this study is on IFRS as it is presented in Part I of the CICA Handbook – Accounting. 14 Certified General Accountants Association of Canada 2. 2. MainfeaturesofIFRS IFRS is a principle-based set of accounting standards designed to improve the comparability of financial statements internationally. An important goal of the IASB is to develop a single set of high quality global accounting standards that are understandable and that improve transparency in financial reporting on the various capital markets of the world (IASB, 2010).

The main characteristics of IFRS include a principle-based approach, fair-value orientation, the concept of comprehensive income, the entity theory underlying consolidation, and improved transparency. Principle-based approach The principle-based approach of IFRS implies that the standards rely primarily on principles and specified desirable regulatory outcomes rather than detailed, prescriptive rules. This approach gives more importance to substance (over form) and allows management to exercise judgment/ discretion in application. In short, management has greater flexibility in selecting accounting methods and in estimating accounting figures when preparing financial statements.

In turn, a rulebased approach offers less flexibility in aligning business objectives and processes with regulatory outcomes and forces specific treatments when precise criteria are met. For example, a standard on consolidation that is based on a general definition of control, such as “the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities” (IAS 27. 4), is principle-based. Another standard that gives specific quantitative benchmarks, such as ownership of a majority voting interest of over fifty percent of the outstanding voting shares (SFAS No. 94 published by the FASB in 1987), is considered to be rule-based. The distinction is not always clear and some argue that many actual sets of standards are a mix of both models.

For instance, Canadian GAAP relies predominantly on principles but evolved gradually towards more rules (Chlala and Fortin, 2005; Fortin and Labelle, 2005). U. S. standards are generally referred to as rule-based (Zarb, 2006), but some argue that they are also principle-based with more robust guidance (Rosen, 2008). Fair value accounting Fair value accounting represents a departure from the traditional historical cost principle. IFRS puts a much greater emphasis on fair value than that rendered under earlier Canadian GAAP. It primarily responds to the needs of investors which are given deliberate importance in IFRS compared to other users (IASB, 2001, par. 10; Chua and Taylor, 2008).

Since investors need market-based values to make decisions regarding buying or selling stocks, many items in financial statements are required or eligible for fair value accounting under IFRS. Estimating fair value involves various degrees of subjectivity depending on the availability of an active market for the assets and liabilities in question. Currently, the IASB and the FASB are jointly developing a new standard to improve guidance for calculating fair values and to enhance related disclosure (IASB Staff, 2010). The Effects of IFRS on Financial Ratios: Early Evidence in Canada 15 In general, fair value is mandatory in measuring transactions at initial recognition under IFRS.

In some instances, items such as financial instruments held-for-trading and derivatives are required to be remeasured at fair value subsequently. In addition, many assets and liabilities can also be remeasured at fair value on an optional basis although this practice is not widespread (Table 1 provides a list of items measured at fair value). According to a survey of 199 listed companies from 15 countries including the European Union, South Africa, and Hong Kong, only 2% of companies actually applied fair value accounting to property, plant and equipment in 2005 (KPMG and Keitz, 2006). The same survey showed that none of the companies applied fair value accounting to intangible assets and only 42% did so for investment property (ibid. ). Table1–FairValueAccountinginIFRS

FairValueRequirement Fairvaluemandatory Impaired assets (IAS 36) Financial instruments held-for-trading (IAS 39) Financial instruments available-for-sale (IAS 39) Derivatives other than used in designated cash flow hedges (IAS 39) Derivatives used in designated cash flow hedges (IAS 39) Biological assets (IAS 41) Agricultural produce at the point of harvest (IAS 41) Minority interest at initial recognition (IFRS 3) Fairvalueoptional Property, plant and equipment (IAS 16) Intangible assets (IAS 38) Investment property (IAS 40) Selected items on IFRS transition (IFRS 1) Note: “OCI” stands for other comprehensive income TypeofFairValueAccounting Through profit or loss Through profit or loss Through OCI Through profit or loss Through OCI Through profit or loss Through profit or loss One-time fair value Through OCI Through OCI Through profit or loss One-time fair value 16 Certified General Accountants Association of Canada Under IFRS, fair value accounting is seen as more relevant for the measurement of balance sheet items.

However, one of the consequences of such a measure is represented by the increased volatility of profits due to the recognition of unrealized gains and losses. To avoid volatility of profits in the income statement while allowing fair value measurement in the balance sheet, the concept of comprehensive income was developed. Comprehensive income Comprehensive income is a major development in the recent evolution of accounting standards and a central notion in the conceptual framework of IFRS. It is a new feature reflecting all revenues, expenses, gains and losses that are to be recognized according to accounting standards during a period, and is summarized in a separate financial statement named the Statement of Comprehensive Income. It is formed of two components.

The first corresponds to the bottom line (profit or loss) of the income statement as it is commonly measured, incorporating gains and losses on transactions with outside parties and a number of unrealized gains and losses on items measured at fair value through profit or loss. The second component of the statement of comprehensive income relates to unrealized gains and losses caused primarily by fair value adjustments. This component is designed to bypass the income statement. In order to do that, a new category of accounting adjustment has been introduced – other comprehensive income (OCI), which is presented directly in shareholders’ equity. OCI may be seen as a buffer that allows the use of fair value accounting without its direct impact on the income statement.

Figure A shows the relationship between the balance sheet, the income statement and the statement of comprehensive income. The profit accumulates in retained earnings; the annual variation of the OCI accumulates directly in shareholders’ equity, whereas the sum of annual profit and annual variation of OCI forms the comprehensive income. It should be noted that the separate reporting of comprehensive income was introduced in U. S. accounting standards in 1997 (SFAS No. 130 Reporting Comprehensive Income) and in Canadian accounting standards in 2005 (CICA Handbook: Section 1530 Comprehensive Income). Consolidation The entity theory underlies the application of the consolidation technique in IFRS.

It requires that assets and liabilities of subsidiaries be measured at their full fair value on the date of acquisition. Consequently, minority interest (called non-controlling interest) is measured at fair value at the same date. 5 This is a major difference compared with Canadian GAAP which does not recognize the fair value adjustments related to minority interest. 6 5 6 Although IFRS has adopted the concept of fair value for the measurement of minority interest initially, there is still an issue outstanding in the calculation, allowing alternative treatments. It relates to the inclusion (or not) of a control premium or discount in the initial value of minority interest (IFRS 3. 19, 20, B44 and B45).

It should be noted that the Canadian standards for consolidation and non-controlling interests changed in December 2008 to converge with IFRS, but are to be applied in 2011 only (CICA Handbook, Standards 1582, 1601 and 1602). In this study, we refer to standards applied before 2011. The Effects of IFRS on Financial Ratios: Early Evidence in Canada 17 Figure A – Relationships Between Balance Sheet, Income Statement and OCI BEGINNING ENDING (A) (B) +/– adjustments for unrealized G/L (C) Balance Sheet Assets Liabilties Balance Sheet Assets Liabilties +/– adjustments from I/S – Dividends paid/payable Shareholders’ equity Capital stock Retained earnings Accumulated OCI /– profit/loss from I/S +/– unrealized G/L – Dividends declared Shareholders’ equity Capital stock Retained earnings Accumulated OCI Comprehensive income Note: (A) Adjustments affecting the income statement (I/S) (B) Annual variation of other comprehensive income (OCI), mainly unrealized gains and losses (G/L) (C) Dividends Other adjustments could be applied In addition to the measurement issue, the entity theory has important implications on the presentation of minority interest. Under IFRS, minority interest is presented on the balance sheet within the shareholders’ equity as the minority shareholders are considered partial owners of the consolidated entity.

This is substantially different from the Canadian practice of presenting minority interest outside of equity. As a result, under IFRS, the share of profit allocated to minority interest is recognized directly in equity, whereas it is currently an expense in the income statement under Canadian GAAP. Transparency Transparency represents another major characteristic of IFRS. It relates to the assumption that markets are efficient and that all of the information communicated to users of financial statements is accurately and reliably incorporated in stock prices. This represents the qualitative characteristic of completeness (IASB, 2001) which allows users, particularly investors, to make decisions based on all the relevant information.

One of the consequences of completeness, though, is an overload of information as notes accompanying financial statements are numerous, complex and sometimes hard to analyse in their entirety. This study primarily relies on figures taken directly from the financial statements, except in a few situations where notes are necessarily relied upon. 18 Certified General Accountants Association of Canada 2. 3. TheuniquecontextofthefirstapplicationofIFRS When a company applies IFRS for the first time, it must follow the rules and principles outlined in IFRS 1 First-time Adoption of International Financial Reporting Standards. This standard requires IFRSs to be applied not only for the year of the shift, but also retrospectively from an opening balance heet prepared at a transition date (IFRS 1. 6-7). The opening balance sheet is based on a full retrospective application of IFRS, as if these standards had always been in application, except for a number of exceptions and exemptions (Wiecek and Young, 2009. p. 364). The transition date is determined by management and must be at least one year prior to the year of the shift (IFRS 1. 21). The first year a company applies IFRS provides for a unique occurrence when it comes to financial reporting. Due to the transitional requirements of IFRS 1, the financial statements for at least one year prior to the shift are available under two sets of accounting standards: local GAAP and IFRS.

For example, if a Canadian company shifted to IFRS in 2009, it was required to present comparative financial statements retrospectively adjusted to IFRS for at least one year prior to 2009, i. e. for 2008. In that case, the full financial statements of 2008 are available under both Canadian GAAP and IFRS, including the opening balance sheet. This allows for comparison and identification of the differences between them. However, the comparison is not fully appropriate as IFRS 1 imputes certain exceptions and exemptions. In the retrospective application, IFRSs effective at the reporting date are fully applied, excluding the mandatory exceptions and optional exemptions. The exceptions and exemptions of IFRS 1 are one-time treatments that may not be representative of the ongoing application of IFRSs.

The exceptions refer to accounting policies that are not applied retrospectively as they would normally need to. 7 Exemptions, in turn, provide several alternative accounting treatments that are available on an optional basis. All adjustments, when applicable, should be recognized through retained earnings, or other equity items, at the transition date (Wiecek and Young, 2009). Table 2 provides an overview of the elements of IFRS 1 that may not be representative of the ongoing application of IFRSs. The primary purpose of this study is to analyse the significance of the impact on financial ratios by the differences between IFRS and Canadian GAAP.

In the sections that follow, we first present the financial ratios selected for analysis and then follow with a discussion of the effect of IFRS on financial statements and ratios. 7 Under IFRS, changes in accounting policies normally are required to be fully applied retrospectively (IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors). However, according to IFRS 1, exceptions are possible in the first year of IFRS application. The Effects of IFRS on Financial Ratios: Early Evidence in Canada 19 Table2–ElementsofIFRS1NotRepresentativeofOngoingApplicationofIFRSs MandatoryExceptionstoRetrospectiveApplication Estimates (IFRS 1. 14-17) – Estimates should not be adjusted retrospectively in accordance with IAS 10 Events after the Reporting Period.

Therefore estimates at transition date should be consistent with estimates made under GAAP applied before the shift to IFRS (previous GAAP) Derecognition of financial assets and financial liabilities (IFRS 1. B2-B3) – Some recognized and derecognized financial assets and financial liabilities at transition date may depend on previous GAAP Hedge accounting (IFRS 1. B4-B6) – Hedge accounting should respect IAS 39 Financial Instruments: Recognition and Measurement and should not be changed retrospectively except that some documentation on designated net positions may be updated if necessary, e. g. designate an individual item instead of a net position. Non-controlling interests (IFRS 1.

B7) – Some requirements of IAS 27 Consolidated and Separate Financial Statements relating to non-controlling interests may not be applied retrospectively OptionalExemptions The exemptions relate to the following topics (PriceWaterhouseCoopers, 2009): – Business combinations – Share-based payment transactions – Insurance contracts – Fair value or revaluation as deemed cost for property, plant and equipment and other assets – Leases – Employee benefits – Cumulative translation differences – Investments in subsidiaries, jointly controlled entities and associates – Assets and liabilities of subsidiaries, associates and joint ventures – Compound financial instruments – Designation of previously recognized financial instruments – Fair value measurement of financial assets or financial liabilities at initial recognition – Decommissioning liabilities included in the cost of property, plant and equipment – Service concession arrangements – Borrowing costs 20 Certified General Accountants Association of Canada 3. FINANCIALRATIOS Financial ratios that are based on accounting information are widely used in practice.

Investors, bankers, brokers and other stakeholders use them to analyze the financial condition and performance of a company, establish covenants in lending agreements or for other commercial arrangements. In this study, we calculate ratios based on figures obtained from financial statements prepared under two sets of accounting standards: IFRS and pre-existing Canadian GAAP. 3. 1. Selectedratios Although the general approach to computing ratios may be fairly similar, a number of discrepancies may exist when it comes to particular calculations. One reason for that lies in the absence of standards or rules regulating the computation of ratios, except for some legal or regulatory contexts such as debt covenants and capital adequacy for banks. Naturally, a range of approaches have emerged across regions and industries.

However, the focus of our analysis is directed at the impact of IFRS on key financial ratios in the Canadian context. As such, the discrepancies in the underlying formulas and classifications of ratios are not considered. Our approach involved selecting a number of ratios commonly used in practice and referring to the general formulas in four main categories: liquidity, leverage, coverage and profitability. Table 3 provides the list of ratios selected along with formulas. All of the components of the liquidity and leverage ratios are based on accounting figures taken from the balance sheet. The liquidity ratios are based on current assets and current liabilities while the leverage ratios show the importance of liabilities relative to assets or equity.

The coverage and profitability ratios are composed of items from the income statement, comprehensive income, the cash flow statement, the balance sheet; and stock price – one component which is obtained from outside of the financial statements. The coverage ratios weight some expenses or charges, such as interest expense, fixed charges, and current liabilities, against profit or cash available to cover them. The profitability ratios measure the return on investment and other efficiency or productivity indicators. Market-based ratios, such as price-earnings related ratios and two other ratios that involve comprehensive income, are also included in the profitability category.

The price-earnings related ratios are used in two forms: one relies on basic earnings per share (EPS) whereas another one uses the diluted EPS. This allows observation of the impact of dilutive instruments on the profitability of shareholders. The ratios based on comprehensive income are adapted from the traditional return on assets (ROA) and return on equity (ROE) computations. They have the same denominator (total assets and equity), but the profit is replaced by comprehensive income in the numerator. We call these ratios comprehensive-ROA and comprehensive-ROE. The Effects of IFRS on Financial Ratios: Early Evidence in Canada 21 Table3–SelectedFinancialRatios Ratio

LIQUIDITY Current ratio Quick ratio LEVERAGE Debt ratio Alternative debt ratio Debt to worth Equity ratio Debt to tangible net worth COVERAGE Interest coverage Fixed-charge coverage Cash flow coverage Operating cash flow ratio PROFITABILITY Return on asset (ROA) Return on equity (ROE) Comprehensive-ROA Comprehensive-ROE Return on invested capital Gross profit margin Operating profit margin EBITDA margin Net profit margin Asset turnover Fixed asset turnover Price-earnings (PE) ratio Price-to-diluted earnings ratio Reverse PE ratio Reverse diluted PE ratio = = Formula Current assets / Current liabilities (Current assets – Inventory) / Current liabilities 3 3 = = = = = Total liabilities / Total assets (Total liabilities + Minority interest under Canadian GAAP) / Total assets Total liabilities / Shareholders’ equity Shareholders’ equity / Total assets Total liabilities / Tangible net worth 3 3 7 3 7 = = = = EBIT / Interest expense EBIT / (Interest expense + CMLTD) (Net income + Depreciation and amortization) / CMLTD Operating cash flow / Current liabilities 3 3 3 3 = = = = = = = = = = = = = = =

Net profit / Total assets Net profit / Equity Comprehensive income / Total assets Comprehensive income / Shareholders’ equity Operating profit / (Total liabilities + Shareholders’ equity) Gross profit / Net sales Operating profit / Net sales EBITDA / Net sales Net profit / Net sales Net sales / Total assets Net sales / Fixed assets Stock price / Basic earnings per share Stock price / Diluted earnings per share Basic earnings per share / Stock price Diluted earnings per share / Stock price 3 7 3 7 7 7 7 3 3 3 7 7 7 3 3 Note: CMLTD stands for current maturity of long-term debt or debt to be repaid within one year. EBIT stands for earnings before interest and tax. EBITDA stands for earnings before interest, tax, depreciation and amortization. Operating cash flow is from the cash flow statement, that is, net cash flow of the operating section. Depreciation and amortization is from the cash flow statement – in the operating section when the direct method is used.

All balance sheet items and stock prices are at the fiscal year-end. 8 “7 indicates ratios not tested. The rationale for which is presented in Section 4. 2. ” “3” indicates ratios tested. The results of testing are presented in Section 5. 8 It should be noted that all balance sheet items and stock prices used for computing the ratios are at the fiscal year-end. For ratios covering a period (such as the ROA), a weighted average of those items would better reflect variations throughout the year. However, since the purpose of the study is to compare Canadian GAAP and IFRS-based ratios, the use of year-end figures was deemed appropriate when applied consistently. 22

Certified General Accountants Association of Canada 3. 2. EffectsofIFRSonfinancialratios The differences in the measurement of accounting figures under IFRS and Canadian GAAP may directly affect the numerator of ratio calculations, their denominator, or both. In cases where the difference in measurement affects only the numerator or only the denominator, the effect of changes is straightforward, easy to identify and to interpret. For example, the current ratio is higher under IFRS (everything else being equal) if current assets are higher but current liabilities remain unchanged. Identification and interpretation is less obvious in cases of numerous diverging effects on ratios.

For example, a lower profit under IFRS will pull down the ROA by reducing the numerator but, at the same time, will pull it up by reducing the denominator. Moreover, there might be distinct accounting differences between IFRS and Canadian GAAP that have opposite effects on a particular ratio. An example is the impact on the current ratio of higher current assets under IFRS due to an earlier recognition of revenues and receivables concurrent with higher liabilities due to the recognition of a finance lease liability. The paragraphs that follow present the main differences between IFRS and Canadian GAAP. Understanding them is important for assessing the impact of IFRS on ratios. Fundamental differences between IFRS and Canadian GAAP

There are two main areas of fundamental difference between IFRS and Canadian GAAP – fair value accounting and consolidation. A higher reliance on fair value accounting in IFRS represents a substantial difference compared with Canadian GAAP. Fair value adjustments introduce volatility in accounting figures as unrealized gains and losses are recognized before the realization of a transaction with external parties. However, as discussed in Section 2. 2, the application of fair value under IFRS is limited when it is optional. Fair value accounting may cause three possible effects on financial statements. First, balance sheet figures are adjusted.

Second, some unrealized gains and losses are directly allocated to the income statement. Third, other unrealized gains and losses bypass the income statement until realization through a transaction with external parties or until impairment adjustment, and are allocated to OCI. Therefore, there are several ratios that are affected by fair value accounting: liquidity and leverage ratios, as a result of balance sheet variations; profitability and coverage ratios, as a result of balance sheet variations and recognition of unrealized gains/losses. The consolidation differences between IFRS and Canadian GAAP discussed in Section 2. 2 also have important implications on ratios.

The measurement of assets, liabilities and minority interest at their full fair value on the date of acquisition in IFRS changes every ratio involving balance sheet items. In practice, however, it is difficult to identify those changes because the differences are incorporated or combined in the consolidated figures. Major effects on financial statements also exist when it comes to the presentation of minority interest. Under IFRS, the annual share of profit attributed to minority interest is allocated directly to equity. This changes the profit figure relative to Canadian GAAP where profit attributed to minority interest is treated as an expense in the income statement. As such, the profitability ratios are directly affected. In addition, The Effects of IFRS on Financial Ratios: Early Evidence in Canada 23 he presentation of the accumulated value of minority interest on the balance sheet has a major impact on leverage ratios. Under IFRS, the treatment of minority interest is unambiguous as it is incorporated in equity. Under Canadian GAAP, though, minority interest is excluded from equity (CICA Handbook: Standard 1600. 69). As a result, two kinds of presentation are observed in Canadian practice. Most often, minority interest is presented between liabilities and equity (for example, in the 2008 financial statements of Eastern Platinum Ltd). In other instances, minority interest is incorporated within liabilities (for example, in the 2008 financial statements of Northern Dynasty Minerals Ltd).

For the purpose of empirical analysis, two versions of the debt ratio were computed: one that excludes the minority interest figure in the numerator under Canadian GAAP (debt-ratio); and another that includes it (alternative-debt-ratio). Other differences between IFRS and Canadian GAAP The conceptual framework of IFRS is similar to the one of Canadian GAAP (CICA, 2009, p. 16). Both are principle-based and require professional judgment in application. While the main areas of fundamental difference can be attributable to fair value accounting and consolidation, there are several other areas of potentially significant differences in the detailed application (Blanchette, 2007). 9 In the area of long-lived assets, IFRS, like Canadian GAAP, requires impairment tests.

However, the method implies considerably different procedures. Although the conceptual justification for impairment – conservatism – is the same under the two regimes, the final result can differ significantly. For example, Eastern Platinum Ltd reported an impairment loss of $297 million U. S. dollars under IFRS in 2008 while it had no such loss under Canadian GAAP for the same period (total assets were $593 million and $872 million U. S. dollars respectively). Leverage and profitability ratios are particularly sensitive to the measurement of long-lived assets. On the liability side, a number of IFRSs differ from the corresponding standards under Canadian GAAP.

The standards on leases, pensions and contingencies may require different levels of liabilities under IFRS. Also, the standard on share-based payments may change expenses and equity. Leverage and profitability ratios are particularly sensitive to these standards. Differences between IFRS and Canadian GAAP do not affect cash flows. In general, IFRS does not change the cash flow statement compared with Canadian GAAP, although there may be some differences in presentation (Canadian Performance Reporting Board, 2010, p. 8). This is particularly evident for interest and dividends and in the scope of consolidation wherein consolidated cash flows depend on which entities are controlled or jointly controlled. 0 9 There are differences between IFRS and Canadian GAAP regarding the details of application in the following areas: revenues and construction contracts; long-lived assets; investments in associates and joint ventures; government assistance; exploration and evaluation of mineral resources; leases; employee future benefits; stock-based compensation and payments; income taxes; contingencies; related party transactions; hedging; foreign currency translation; earnings per share; accounting changes; interim reporting; and various presentation issues. See the website Canadian Standards in Transition for information and resources on the impact of IFRS on Canadian accounting practice (CICA, 2010), including a guide for users of financial reports (Canadian Performance Reporting Board, 2010). The criteria for control involve judgment and are not identical under IFRS and Canadian GAAP.

Proportionate consolidation is applied for joint ventures under Canadian GAAP while there is a choice between the proportionate consolidation and equity methods in IFRS. 10 24 Certified General Accountants Association of Canada IFRS generally requires more information to be disclosed in the notes accompanying financial statements; particularly regarding assumptions, estimates, reconciliations of balance sheet items from one year to the next and other supplementary disclosures such as the remuneration of key management personnel (Canadian Performance Reporting Board, 2010, pp. 6, 17). Users of financial statements may obtain useful information from the notes to improve financial analysis and ratios, but this may be a time consuming undertaking. In addition, the comparability of ratios is certainly eopardized when information is available in notes but not on the face of the financial statements. Overall, the differences between IFRS and Canadian GAAP affect all financial statements. The differences in balance sheet figures, caused by fair value accounting, consolidation procedures and others, impact directly the numerator and denominator of liquidity and leverage ratios, and some components of profitability and coverage ratios. The differences on the income statement and comprehensive income affect profitability and coverage ratios. Figure B highlights the potential incremental effects on financial ratios of the IFRS adoption in Canada. The Effects of IFRS on Financial Ratios: Early Evidence in Canada 25

Figure B – Potential Incremental Effects on Financial Ratios of the Adoption of IFRS in Canada Panel A: Optimistic Scenario Fair Value Accounting Liabilities Financial Statement Presentation Fixed assets Intangibles Investment property Agriculture } Financial instruments Leases Pension New OCI section for unrealized gains/losses Minority interest in equity Impact on balance sheet Assets + Equity + Assets + Liabilities – Equity + Liabilities – Equity + Equity (OCI) + Liabilities – Equity + Liquidity (current/quick ratio) (agriculture) + + (numerator +) (denominator +) (CMLTD –) + ± – n/a Comprehensive income Profit n/a + Profitability (ROA,ROE, etc. ) (numerator +) (denominator +) ± – ± – (numerator +) (denominator +) n/a (numerator +) (denominator +) ± –

Leverage (debt-to-worth, etc. ) – Note: Optimistic scenario assumes positive effects on assets (increasing), liabilities (decreasing) and/or equity items (increasing) CMLTD stands for current maturity of long-term debt 26 Certified General Accountants Association of Canada Panel B: Pessimistic Scenario Fair Value Accounting Liabilities Financial Statement Presentation Fixed assets Intangibles Investment property Agriculture } Financial instruments Leases Pension New OCI section for unrealized gains/losses Minority interest in equity Impact on balance sheet Assets – Equity – Assets – Liabilities + Equity – Liabilities + Equity – Equity (OCI) –

Liabilities – Equity ± Liquidity (current/quick ratio) (agriculture) – – (numerator –) (denominator –) (CMLTD +) – n/a Comprehensive income Profit n/a – Profitability (ROA,ROE, etc. ) (numerator –) (denominator –) ± + ± + (numerator –) (denominator –) ± + n/a (numerator –) (denominator ±) ± ± Leverage (debt-to-worth, etc. ) + (numerator –) (denominator ±) Note: Pessimistic scenario assumes negative effects on assets (decreasing), liabilities (increasing) and/or equity items (decreasing) CMLTD stands for current maturity of long-term debt The Effects of IFRS on Financial Ratios: Early Evidence in Canada 27 Financial ratios and IFRS in practice

In 2005, IFRS became mandatory for listed companies in the European Union. In the first year of IFRS adoption, companies were required to provide comparative financial statements adjusted retroactively to IFRS for 2004. Lantto and Sahlstrom (2009) investigated the impact of IFRS on financial ratios in Finland, by comparing ratios c

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