UK plc faces the demanding process of conversion to international financial
reporting standards at a time of increasing regulatory and shareholder scrutiny.
Earlier this year, the Financial Services Authority wrote to the CEOs of
listed companies, making it clear that it will be taking a close interest in the
transition to IFRS and that price-sensitive information on conversion needs to
be released without delay.
Analysts too are understandably concerned about the impact on share
valuations. Over half of the companies that have made separate IFRS
announcements experienced an immediate price movement of 1% or more (relative to
the index), ranging from a 4% share price increase to a 5% share price fall.
Given that large share price falls for companies with US listings can attract
both US class action litigation and regulator curiosity, managing the impact of
your IFRS conversion must be a priority for all FDs. Even companies with robust
IFRS conversion process are not immune to problems.
It is essential that the financial reporting teams, both at the centre and at
a business unit level, should not only understand the main differences between
IFRS and UK GAAP, but also have an in-depth knowledge of IFRS.
The general principles of IFRS are not that different – but the devil is in
the detail. An ongoing IFRS training plan is necessary as new international
standards are continuing to be issued. Effective decisions on applying the
standards depend on the understanding of those identifying issues at the
Problems arise when the substance of contracts at a business unit level,
which can turn on the detailed terms or on side letters, are not adequately
understood or reported to the centre, and as a result are not adequately
reflected in the accounting underlying the financial statements.
This is even more of an issue under IFRS, as a company will need to
understand its contractual arrangements to comply with IFRS in areas such as
revenue recognition, identifying and accounting for embedded derivatives and
determining the correct treatment of leases including separately evaluating the
accounting treatments for leasehold land and buildings.
Companies must ensure that the various stages of their conversion process are
appropriately documented, as this can be used as key evidence in the event of
any investigation or litigation. Just as the lack of appropriate documentation
can hinder a client in presenting its case, material suggesting that problems
were identified, without recording how they were resolved, is not helpful.
This applies to both the overall process and the identification of individual
issues around subjective areas, such as asset impairment reviews. Recording the
basis for judgements is particularly relevant because, compared to UK GAAP, IFRS
involves more subjectivity from the greater use of fair values and hence
increased profit and loss account variability
But what do we mean by appropriate documentation? This would typically
include the relevant facts and how they have been identified; the options
management considered; the views of any appropriate experts, auditors or
counsel; and how management arrived at its final decision.
The internal controls surrounding the process are a key aspect of conversion.
When the FSA wrote to CEOs in April, it emphasised the importance of embedding
IFRS into the business, rather than relying on short-term fixes, such as
spreadsheets, at group level. The importance of internal controls has been
further underlined in Sarbanes-Oxley, which introduces the certification
requirement of internal controls for foreign registrants listed on US exchanges.
Effective internal controls should be designed to detect and prevent material
financial misstatements. The controls around financial reporting are no
exception and should be at least as supportable as those used for UK GAAP.
Audit committees should challenge each component of the conversion process,
understand why the numbers may look different under IFRS and know what the
impact of new disclosures might be.
Regular meetings with management and external auditors should be held and
focus on how the IFRS statements were produced, including what IT systems were
employed and what controls were in place. The audit committee should also ask
how standards have been applied, what views were expressed by the auditors and
how the IFRS conversion process has been reviewed.
Ultimately, the audit committee needs to demonstrate it has been active and
effective in challenging the IFRS conversion process, and this should continue
through to the communication of the financial statements.
At the same time, management and audit committees should consider whether the
company has a ‘fire drill’ in place if it is faced with a challenge to its
financial reporting. The effectiveness of the initial communications plan in
response to such a challenge is vital.
A company that can quickly show it is on top of the issues by providing clear
and informed responses will benefit hugely. There should be clear lines of
responsibility and accountability for the IFRS conversion process, starting at
the top and extending throughout the organisation.
As UK companies look forward to the completion of the IFRS conversion
process, following these steps will protect them from regulatory investigation.
And should the worst happen, robust preparation, strict controls and thorough
documentation will go some way to minimising collateral damage.
Andrew Gordon is a partner and David Morell a director in the forensic
services group of PricewaterhouseCoopers LLP
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