This year represents a major milestone for the International Financial Reporting Standards (IFRS), as many companies around the world have now begun to use this new financial language for their external reporting. In July 2002, the European Union (E.U.) passed a regulation that requires public European companies -- those listed on E.U. stock exchanges -- to comply with IFRS for their group financial statements in 2005. Since then, many countries outside of the European Union have begun working to converge their national accounting standards with IFRS or requiring the adoption of IFRS.
The impact of the international rules is not limited to businesses that have headquarters in Europe. A mandate from the European Commission's Prospectus Regulation and the Transparency Directive will require most non-E.U. issuers of securities that are traded on an E.U.-regulated exchange, or organizations that make a public offer of their securities in Europe, to prepare and present their financial statements on the basis of E.U.-endorsed international accounting standards (IAS) or IFRS as of Jan. 1, 2007.
Only issuers whose (non-E.U.) home country's accounting standards are determined by the European Commission to be equivalent to IFRS will be allowed to bypass a second round of external financial reporting that meets international standards. On April 27 of this year, the Committee of European Securities Regulators (CESR) published draft technical advice on the equivalence of U.S., Canadian, and Japanese GAAP to IFRS. The CESR determined that an organization preparing its external financial reports under any of these nations' rules would need to provide a combination of additional qualitative and quantitative disclosures in order to be equivalent to IFRS.
Just as the U.S. Financial Accounting Standards Board (FASB) defines the framework for U.S. GAAP, the International Accounting Standards Board (IASB) defines an equivalent platform for IFRS. Since 2002, convergence has been the goal of both standard-setting bodies, but today there are still differences between the two frameworks. The general principles are in harmony; the goal of both groups is to improve the quality of financial statements. But the devil is in the details of interpretation (see U.S. GAAP vs. E.U. IFRS, below). Companies that need to comply with both sets of accounting standards should understand their similarities and the differences between them.
Midsize and large organizations that are not now bound by IFRS should also be familiar with the rules because these companies will likely be affected by international standards in the future. They may merge with or acquire a business in the euro zone. Their home country's GAAP may converge with IFRS. And even if neither of these events happens soon, executives may need to discuss with investors and other stakeholders the potential impact on their business of reporting under IFRS as opposed to their GAAP.
In order to comply with IFRS or multi-GAAP reporting and ensure that their executives have the information they need to run the business, many companies are finding it necessary to transform their financial reporting processes.
Tactical Approach or Embedded IFRS?
Meeting the requirements of the International Financial Reporting Standards is much more than just a technical accounting issue. As with Sarbanes-Oxley Section 404 compliance, a company's issuance of its first IFRS report is a major achievement -- but one that should be the start of a journey toward obtaining business benefits from the shift.
In the first year, most companies' IFRS financial reporting was driven primarily by timing and resource constraints and secondarily by uncertainty about the impact of the change and the evolution of key standards. Organizations that chose to approach IFRS compliance from a short-term, tactical perspective generally produced their reports outside of their reporting systems, as a snapshot of the business. They reconciled IFRS numbers to their old GAAP, which remained the base language for internal management reporting. Many of them relied on manual intervention, spreadsheets, and ad hoc solutions to do so.
These changes had to be made quickly, and the overall robustness of the company's controls environment may have deteriorated as a result. In addition, the staff of companies that have taken a strictly tactical approach to IFRS compliance have most likely missed the opportunity to gain a deep understanding of the rules. This approach to reporting may be contributing to reduced efficiency within these organizations. Although publishing their first financial statements under IFRS is an important goal for all organizations affected by the new standards, once this initial stage is finished, they need to consider whether they have just changed the numbers or whether they have managed to embed sustainable reporting into their performance management processes.
Some companies are already experiencing extensive benefits from their move to IFRS. These are the organizations that approached the change as an opportunity to position themselves for future success, rather than simply an exercise in meeting externally imposed mandates. They are integrating IFRS language into the measurement and communication, both internally and externally, of the financial performance of each of their impacted business units and corporate departments.
When the IFRS guidelines are the basis of internal management reporting, complying with them becomes business as usual. Reporting processes become less time-consuming than they would be if different entities within the organization reported under their different national GAAPs, and the company gains the ability to reconcile among several reporting bases on an ongoing basis. The business also benefits in terms of financial transparency, trust, quality, speed, the efficiency of its processes and controls structure, and the comparability of its performance. In a context in which the expectations of stakeholders and regulators are rising, the quality of a company's financial communication may even turn into a competitive advantage.
Steps to Sustainable Reporting
Organizations can use the shift to IFRS as a catalyst to improve the day-to-day management of their business. To do so, they must have the necessary organizational structure, strategy, processes, data capabilities, and people in place. These five key enablers of embedded IFRS reporting are the foundation of performance management. They do not all have to be addressed at the same time, and change can be phased in gradually through an incremental approach. The company's focus should be on immediate deliverables and priorities, but it should also consider each opportunity for greater effectiveness, efficiency, and control and should build in the capacity to accommodate future developments.
Processes and controls. Effective processes and efficient controls can ensure that reporting is timely and accurate, with a minimum of human intervention. For example, a company wanting to develop sustainable processes will regularly update its IFRS policies and procedure manuals and will optimize ongoing processes such as valuations or impairment testing, the period-end close process, and its reporting processes for reconciling between different reporting bases.
Data, software systems, and technology. The type and amount of data required for compliance with IFRS rules differs substantially from some countries' GAAP. It is not unusual to see the number of data points significantly increase in the move to IFRS, as new data may be required for financials and disclosures. In addition, a company may have some of the data required by IFRS but not have it saved in the right format or else may have only poor-quality information. At many companies data is scattered, derived from a range of sources, and distributed by e-mail or paper copies, which makes the information unreliable and difficult to use. Corporate management may need to tighten controls in some areas to obtain more accurate and timely outputs.
To achieve this goal, some companies establish a single enterprisewide planning and reporting system. They create a data warehouse for storing financial, performance, and industry data, then link that system to their intranet so that they can communicate essential information in real time. They may also establish common definitions for key business data and require all employees to use the same terminology. Such efforts to create integrated systems and verbiage ensure that employees and managers companywide have access to a single, reliable, and consistent source of information.
When such changes are implemented, management needs to keep in mind that reporting disciplines must be able to cope with the increased data collection that accompanies increased disclosure. Technologies such as extensible business reporting language (XBRL) may be useful in eliminating communication difficulties and in standardizing data. The data model on which these systems are built should be specifically designed to minimize rework and reconciliations. The amount of effort required to embed IFRS deep within an organization depends on the state and complexity of the company's current reporting systems. Fragmented systems -- those with a different subsystem for each part of the business, legacy systems inherited from recent acquisitions, or manual systems still operating in subsidiaries -- represent greater challenges than those that are modern and consolidated.
Embedding IFRS also means aligning internal management information systems with external reporting, using one common data flow. IFRS numbers differ from those produced under national GAAPs. Staff will need to prepare budgets and forecasts that make sense in the IFRS environment while simultaneously ensuring that management has a full understanding of the impact of its decisions on the business.
People. Properly educating the end users of IFRS-driven initiatives is critical to success. Many companies are already providing regular training and updates for their staff, but few have embedded IFRS so that it forms part of the organization's basic business language. IFRS needs to be used when and where business is done. All managers -- not just those in finance -- need to be aware of the requirements and implications of IFRS in order to understand what the rules will mean for the company's key data and ratios and what impact they will have on strategic business decisions. For example, all executives should be aware of the effects of international accounting standards on the organization's bonus and reward schemes, treasury operations, tax liabilities, and debt covenants.
Few companies will have sufficient internal expertise to manage a transition to IFRS without implementing a skills development program for employees. Simply outsourcing the necessary skills and knowledge is not a realistic option, as it does not address the long-term need to embed the accounting changes throughout the organizational structure. Companies should supplement their use of consultants with knowledgeable internal resources in order to enable a strong foundation of knowledge.
Involving in-house staff in developing new systems, and then training them once the changes are in place, helps embed IFRS by extending its influence beyond the activities of preparing the external financial statements. Employees who work in investor relations, IT, corporate treasury, HR, and tax must also understand how to apply the standards. These people must learn the new processes and systems the company is implementing to support the modified accounting regime and assess how they change the business's day-to-day way of operating.
Organizational structure. The structure of the finance function should allow highly qualified finance teams to focus on adding value to the business -- for example, supporting management decisions and analyzing the key ratios -- rather than on closing the books. Frequent transactions should be standardized, simplified, and automated as much as possible.
To engage employees effectively in performance management, the company should train them on how to use its new or enhanced software tools. Those feeding data into the system, as well as those analyzing the information, must learn about the framework and components of the performance management process.
Planning strategies and reporting. Strategic planning, resource planning, operational planning, and performance monitoring should enable businesses to optimize the current and future activities of their finance function. The finance team must be able to make timely, proactive decisions about how to influence and cope with future changes. In practice, this means moving beyond the rudimentary annual budgeting process to establish a strategic plan for the finance group.
The finance department's planning, budgeting, and forecasting reports should model the impact of IFRS rules on the company's externally reported financial performance. Reconciling these internal reports to meet external reporting requirements should be straightforward, as all reports should be based on a single data set. It is important to ensure that there is consistency and efficiency in the way the company sets about meeting the reporting requirements of its various constituencies.
Preparations at the entity level are affected by whether IFRS is acceptable for subsidiaries' statutory and tax returns in different territories. Domestic subsidiaries in France, for example, must still produce national GAAP accounts for 2005 statutory reports, while corporate subsidiaries in the United Kingdom have a choice between IFRS and U.K. GAAP. In countries where IFRS accounts can be used for tax purposes in 2005, government tax departments have clarified their position on some IFRS interpretations, but other issues are still outstanding.
The reconciliation between multiple reporting bases is a key area in which a company should define up front its strategy for addressing both its internal business needs and its external regulatory requirements in a sustainable manner. This reconciliation includes the people, processes, and systems necessary to reconcile from the entity's primary GAAP to secondary reporting bases. It requires an organization to understand the differences between its different reporting standards (e.g., between IFRS, U.K. GAAP, and U.S. GAAP) and then to assess the changes it will need to make to its reporting processes to accomplish this reconciliation. For example, a company may be required to change its financial goals and reporting timetables, add reconciliations for interim reporting, design new reconciliation reports, and communicate these changes to the market and regulators.
The reconciliation among the different reporting standards used within the organization is such an important control that the head office of a multinational company may consider embedding it within its reporting systems, including those of its subsidiaries -- which, in addition, should minimize the risk that IFRS may increase the length of the overall reporting process.
Making the Change
Embedding IFRS throughout an organization by introducing sustainable and flexible solutions generates long-term benefits. In my experience, it is easy to underestimate the volume and complexity of the work involved in implementing IFRS. The move to new reporting standards is a significant journey, and one of such a strategic nature that it requires a rigorous change management program.
Because the journey has implications for stakeholders across the entire organization -- including the board of directors, treasury, human resources, investor relations, and the company's subsidiaries and employees -- it makes sense to include people from all of these groups in the change process, and to do so as early as possible. For example, changing to IFRS is likely to affect the treatment of pension plans. Many companies moving to IFRS will find that pension exposures must appear on their balance sheets for the first time, and the impact of pension obligations can be substantial. As a result, some companies may want to reduce the scale of their commitments by replacing defined-benefit with defined-contribution schemes. Stock-option plans are also treated differently under IFRS. Decisions about how to change share-based compensation or pension plans may affect a substantial proportion of a company's staff and may therefore call for sensitive handling.
Companies that tackle the challenge of moving to IFRS by employing best practices in change management have the best chance of success. This is also true for companies that first took a tactical approach to IFRS and are now working on fully embedding the rules. Setting a clear and sustainable vision at the outset, with the business units included in the design, will give the change program a clear direction and will help ensure that the key players are engaged from the start. It is essential that people understand the change management plan as incremental and achievable and see a strong sponsorship from the executive level of management.
Establishing clear managerial accountability from the start will help make the program more efficient. The effective handling of cultural and behavioral issues can also improve the success rate of embedding programs. For example, the change should fit the company's way of working and should not be seen as something imposed by corporate headquarters.
Another factor in every effective change program is particularly key in the context of IFRS: a clear communication plan. In addition to communicating the aims and outcomes of the initiative internally, external communications must identify and explain the significance of the changes in reports to external stakeholders such as governments, institutional investors, and financial analysts. Companies that engage key stakeholders in a dialogue about IFRS early in the transition have the most success in preparing the markets for the changes that will result in their reported profits or asset values. Failure to communicate well may lead to confusion or misunderstanding that can damage an organization's market value. Transitioning to IFRS is an opportunity to improve the quality of external communication in general -- and not just because a company is suddenly required to disclose more information.
An Opportunity To Face the Future
The only certainty for financial reporting in the coming years is that it will face continuous change. To thrive and succeed in such an environment, a company will require a sustainable reporting infrastructure, both in its finance function and throughout the rest of the organization. Companies that see the change to IFRS or to other requirements as an opportunity to streamline their reporting infrastructure -- whether by fully embedding the standards into their company culture or just by initiating the first incremental steps -- will be in a better position to face the future and to react to upcoming changes.
U.S. GAAP vs. E.U. IFRS
The United States' GAAP and the International Financial Reporting Standards (IFRS), now the mandatory rules for companies that trade on European Union stock exchanges, still have today some significant differences in the following areas:
Businesses with securities listed in both the United States and the European Union may need to remedy these differences through reconciliations, additional disclosures (narrative and/or quantitative), or supplementary statements.
For more information about the specifics of IFRS rules, visit www.cesr-eu.org
Dominique Bichut is a director with PricewaterhouseCoopers' global capital markets group in Belgium.