The upcoming International Financial Reporting Standards conversion represents a phenomenal opportunity to rethink, retool, and re-engage the entire organization around the goal of breakthrough performance.
For decades, global financial reporting was dominated by the U.S. GAAP. But beginning in 2001, a London-based organization known as the International Accounting Standards Board (IASB) began developing a new set of standards.
These new rules, the International Financial Reporting Standards (IFRS), feature a number of enviable attributes. Rather than being built up in a patchwork fashion over time, as the U.S. GAAP standards were, the IFRS represent a fresh start. The IASB had the option to adopt the best elements of existing practice but also the freedom to design more effective rules.
Another attractive attribute is that IFRS rules are broader and more principles-based than their U.S. GAAP counterparts. Offering limited interpretive guidance, the IFRS rules instead require preparers and auditors to look at, and report on, the genuine substance of each transaction. One example of this is the depreciation of asset components. While component depreciation is allowed under GAAP, it is not frequently used. IFRS requires that component depreciation be used for all assets that have differing patterns of benefit. A company that depreciates an entire aircraft under GAAP will now be required to depreciate the engines differently from the fuselage, as one example. This change in requirement will lead to changes in cash flow reporting and changes in calculation of profitability. While it may take time for the reporting practices of each company and each industry to coalesce into familiar and consistent frameworks, the principles-based approach carries the long-term promise of greater transparency.
Finally, U.S. companies that convert to IFRS will find value in numbers. Today, the world has two principal accounting and reporting standards. The need to understand, and possibly apply, both IFRS and U.S. GAAP rules represents added cost and complexity for issuers and investors alike. Certainly, a single global standard that is applicable to every industry and company, no matter where it is domiciled, will reduce businesses' need for multiple reporting systems and will promote more efficient investment decisions. The global movement to IFRS is a giant step toward global harmonization.
These benefits are desirable, but they are specific to companies' external financial reporting processes. The companies that gain the most from IFRS conversion will be those that move IFRS concepts deeper into their business performance management (BPM) processes — those that take the conversion as an opportunity to revisit their entire approach to managing performance.
The Performance Opportunity
First instincts have led some executives to think of IFRS as a set of accounting policy regulations that will impact nothing outside of external financial reporting. Managers who deal primarily in strategic planning, budgeting, forecasting, and other areas of business performance management could easily view the conversion to IFRS as an activity that they will deal in only if, and when, they are dragged into the transition. But these people should think again.
Financial reporting is the window through which capital markets view a business's performance. And this is where the opportunity within IFRS is unveiled. The move to IFRS will affect not only the accounting and reporting functions, but also investor relations and all other areas of the business that rely on accounting information — including tax, IT, HR, and legal.
In certain areas, such as tax planning and management, the changes will be both numerous and complex. Here companies will need to comb through the regulations in great detail to determine their impact.
However, in other areas the changes will be simple to implement and in some cases allow for more straightforward accounting or presentation. One example is that under IFRS, companies may have more flexibility around financial statement presentation methods. Another example is that IFRS rules require significantly more detail on property, plant, and equipment (PP&E) in the chart of accounts. Though many such changes in isolation may be relatively simple to implement, interdependencies and the overall number of changes will lead companies into a project of significant complexity and potential strategic consequence.
Additionally, as IFRS offers significantly less specific guidance on the details of implementing the new accounting rules, they place the onus on companies and their advisers and auditors to create practices that sufficiently capture the substance of transactions, consistent with the principles embodied within IFRS. Some executives thinking about the massive undertaking that IFRS conversion represents are beginning to realize that they can use the conversion as an opportunity to rethink the way their company analyzes and rewards business performance, to re-evaluate their performance management framework from the ground up. After all, an IFRS conversion necessarily shifts the lens through which the company's performance is evaluated.
Adoption of IFRS will be a monumental exercise for a company, regardless of how it proceeds. However, in the process of revisiting its BPM framework, an organization must consider the fundamental assumptions behind what drives its value. Exhibit 1 illustrates the Ernst & Young approach to business performance management. BPM best practices exist in an environment that reconciles fundamental business strategy with essential drivers, stakeholders, and enablers. Our model incorporates not only the internal views about organizational performance, but also the attitudes and expectations of groups such as investors and customers. It is also keenly aware of both the regulatory and competitive environment. For BPM to be effective, the organization must determine its true drivers of performance, translate those into specific metrics, and then establish appropriate performance targets and goals. It must compare initial goals with actual results, then evaluate what went well and what was off the mark. Performance targets will have to change with the adoption of IFRS because the company's method of measuring its financial achievement will change. This makes the period leading up to conversion a good time to re-evaluate the organization's vision, value drivers, and performance metrics, and then to incorporate such re-evaluation into a loop of continuous refinement and improvement.
As a business responds to the demands and opportunities of IFRS conversion, revisiting its fundamental BPM processes will likely prove worthwhile. The ultimate gauge of whether corporate performance is well-managed is the strength of its link between strategy and execution. If BPM is well-executed, the company realizes benefits as a result of having all its employees and managers on the same page.
Impacts of IFRS on the BPM Framework
Many elements of the BPM ecosystem illustrated in exhibit 1 will be impacted as a result of IFRS conversions. Successful organizations will need to consider several questions as they rethink BPM post-IFRS:
• How will the capital markets view our “new” IFRS-centered performance? Do we still compare as favorably to our competitors as we did prior to the conversion?
• How will our target-setting processes change? Will there be new value drivers and metrics that we will need to use as a result of the change?
• How extensive are the changes going to be regarding our reporting environment? Does master data need to change? Are existing management reports still acceptable? How extensive will the remapping from statutory or legal reporting to management reporting be?
How a company answers these questions will necessarily impact all four realms in which its external performance is monitored: its regulatory environment, competitive environment, customer sentiment, and capital markets and investor sentiment.
Where To Start
For many companies, the link between strategy and execution is elusive and difficult to pin down. But IFRS conversion provides a fairly easy-to-follow path toward effective BPM.
The first step on this path is to take a fresh look at the organization from the perspective of the capital markets. As investors begin viewing companies through the new IFRS lens, they will see new answers to many of their questions about a company's performance. In many cases, IFRS will provide different financial results than U.S. GAAP. For example, consider a pharmaceuticals company that will be able to capitalize a greater portion of its development costs once it adopts IFRS. Rather than running these costs — often billions of U.S. dollars — through its P&L statements, the company will be able to place the costs on its balance sheet and amortize them over the long term. This accounting change will instantly improve reported margins and return on invested capital (ROIC). Consequently, as this company prepares to report its financials in IFRS, it will need to reorient its communications with capital markets in a way that explains the differences between its historical performance as reported under U.S. GAAP and its current performance under IFRS.
Equally important, a company facing this type of change in its reported financial results will need to determine appropriate targets for the metrics it will report under IFRS. Reporting under IFRS will change the reported outcomes in all manner of financial performance ratios. From SG&A as a percentage of revenue to gross margins, R&D expenditures, or inventory turns, a wide range of metrics will require new expectations for performance as a company goes through its planning and reporting in IFRS for the first time. Translating existing targets for fundamental metrics into IFRS performance bases and objectives will prove challenging for many businesses. However, it will be a crucial exercise.
In setting new performance goals under IFRS, executives will have to evaluate ways in which the accounting change will affect how the organization appears relative to its industry sector. Executives need to think about several questions: When will each of our most critical competitors adopt IFRS? (This answer may be particularly relevant if any of those competitors are considering early adoption of IFRS.) What changes will likely take place in our competitors' reported financial position and results of operations? And how are analysts likely to perceive these changes? How will analysts' perceptions of our company change as a result?
As companies identify fundamental shifts in key ratios, they will need to be proactive in their communications with the capital markets. Investor relations executives will need to clearly and thoroughly explain what is changing and why. In addition to communicating with stakeholders outside the company, executives will have to immediately impress upon their management teams the need to recalibrate expectations about appropriate levels of market performance. Each company adopting IFRS will need to re-establish its expectations around internal budget plans and forecasts. Executives will also need to review the company's compensation packages. As the basis of measurement changes, target levels in compensation plans that include pay for performance will need to be reset. These changes will require participation and alignment at all levels of the organization; it's a complex, cascading, and iterative process. But with proper incentives and direction, the exercise can be used to help everyone from senior management to the shop floor rethink business processes and performance.
How To Proceed
As a company embarks on this self-evaluation, which will be necessary for survival of the IFRS transition, decision-makers should also consider whether they ought to be satisfied with their old ways of viewing the business's performance. Managers need to ask themselves: Are the old metrics adequately aligned with our current business objectives? Are we capturing the right data and using suitable performance targets? Are our metrics aligned with the right business objectives? Thinking about these issues can lead to new insights that guide the redefinition of business performance metrics — which, in turn, might lead to adjustments in IT systems or accounting practices. For example, a company might find that it needs to retool the way it captures, reports, and allocates costs.
The point is that while an organization is determining new targets for its metrics — something it can't avoid in conversion to IFRS — the management team might as well take that process as an opportunity to rethink; rejustify; and, where applicable, adjust its metrics. In addition, as IFRS conversion looms, companies should consider how the changes in financial reporting will affect their interactions with customers, capital markets, regulators, and competitors. How will perceptions of the company's financial performance change among these external parties? Companies that are smart will add to this analysis a careful consideration of whether their interactions with all of these third parties are effective. Was the company effectively managing perceptions of its performance prior to IFRS?
The need to communicate about IFRS presents a similar opportunity for getting everyone in the company speaking the same language about the company's finances and performance. A conversion to IFRS reporting represents significant change across the whole of an enterprise. Executives across the organization must provide senior management with the information necessary to make informed decisions throughout the IFRS conversion. Therefore, relevant executives at all levels and within all departments must fully understand senior management's objectives for the conversion. Education and communication relating to IFRS not only improve alignment, but also help to establish a common business language within disparate divisions.
It's important to note that the shift to IFRS reporting involves significant tax consequences. As a result, a number of business performance management decisions and metrics will need to take taxation into account. As part of the recalibration, companies should make sure that tax expertise has a seat at the table, and should be ready to re-examine all aspects of the tax planning and compliance life cycle.
If a company decides to view IFRS conversion as an opportunity to overhaul its strategies, along with its overall BPM framework and various other processes, very few business processes will remain perfectly intact. Such an undertaking may seem daunting, but the benefits are likely to outweigh any complications or costs. Foremost among the basic benefits of moving to IFRS are the efficiencies achievable under a single, global standard for performance measurement. Global companies will likely reduce costs and increase efficiencies by eliminating duplicative reporting requirements. In addition, conversion should add to global liquidity, as the vast majority of issuers and markets will be using the same accounting and financial reporting rules.
For organizations that use the conversion process as a springboard to refine their business strategies and related performance measures, frameworks, dashboards, and scorecards, a substantial competitive advantage will likely accompany the generic benefits achieved by standardizing on one set of reporting standards. Achieving this competitive advantage will require all elements of the business to pull together. Therefore, it will be vital for executives to treat the IFRS conversion project as a change-management initiative that receives clear direction and highly visible, unwavering support from senior management. Only then will companies be able to muster the cross-functional and cross-regional cooperation necessary to use IFRS conversion as a catalyst for achieving breakthrough performance.
The Time Is Now
For a time, many executives believed that U.S. companies might never be required to adopt IFRS, but today most agree that adoption is a matter not of “if” but rather of “when” and “how.” And “when” is sooner than many corporate managers realize.
The U.S. SEC published its proposed road map for IFRS conversion last November. If rule-making is undertaken as anticipated in the proposed road map, U.S. public companies would begin reporting their financial statements under IFRS for 2014, 2015, or 2016, depending on company size. Some very large companies from certain industries would be eligible for early adoption beginning in 2009. And since issuers will need to develop comparative financial statements, they'll need to translate their financial results from the two years prior to their IFRS reporting date. This means, in effect, that companies need to be prepared for this new set of accounting standards as early as 2012 — three years from now.
IFRS is definitely on its way. For a company that feels its best option is to rapidly implement the new reporting requirements, such an approach can serve as a temporary shortcut. But European executives who took such a shortcut now say that conversion required more effort in the long run than it would have had they tackled it head-on in the first place. Now many wish they had taken a more comprehensive approach from the beginning (see Lessons Learned in Europe). Moreover, companies that take the shortcut approach miss out on the opportunities to energize and transform their business performance management across all levels of the business.
According to November's road map, the SEC will make a final decision in 2011 about whether to proceed with the mandatory adoption of IFRS. Whatever a company's initial approach, its transition to IFRS will carry profound implications for everything from its statutory reporting to its IT systems; HR function; tax, finance, and investor relations activities; and, yes, business performance planning, reporting, and execution. It's a change your organization will almost certainly have to make. Will it end up being a mere compliance-oriented exercise? Or will your company view IFRS adoption as an opportunity to revisit and revitalize its most fundamental strategies, as well as its tools for driving business performance? I believe — as do a growing number of leading executives — that there is enormous value in the latter approach.
The views expressed in this article are those of the author and do not necessarily reflect the views of Ernst & Young LLP.
Andy Rusnak is an advisory services principal with Ernst & Young LLP.
Lessons Learned in Europe
Executives can learn a great deal from the experiences of those who have gone before. For the most part, major European companies have already made the transition and are now fully compliant with the IFRS framework. But along the way, many experienced a number of snags.
Foremost among these is the mistake of viewing IFRS conversion as a simple process of exchanging one set of accounting practices for another. Some executives believed conversion could be achieved with minimal effort, by simply converting existing reporting into the new standards without performing any preimplementation analysis of the implications for the business. They believed that:
- The most important issues would become clear immediately,
- the impact of those issues would be minor,
- and any difficulties would be easy to correct.
But two problems surfaced. First, the types of problems that emerged were far from minor. In many cases they were significant enough to create major disruptions for the businesses. Additionally, correcting such errors after the fact wound up requiring far more effort in the long run on the part of these executives.
Overall the best way to approach IFRS conversion is to begin with proactive assessment of the most critical issues followed by prioritization of efforts. Though the wait-and-see strategy may seem alluring, in the end it can be costly.