When it comes to controversy in accounting standards the headlines may have been stolen by share-based payments, but that’s not to say the rather more obscure issues surrounding accounting for associates should be ignored.
Under the new international accounting standards, associated profits will be presented as post-tax profits, while under present UK GAAP they are presented in the accounts as pre-tax profits.
This seemingly innocuous presentational change will not affect bottom-line profits, but it will typically reduce the figure for profit before tax – a key performance indicator for many UK companies.
Peter Holgate, senior technical partner at PricewaterhouseCoopers, says it is ‘surprising’ that more has not been made of this implication. ‘This is quite an important change but it has not received much publicity,’ Holgate says. ‘It is going to affect a large number of companies.’
Holgate says it’s imperative for investors and analysts to be aware of the new accounting for associates, as the change may have a material effect on companies that have large interests in associates and joint ventures.
‘There needs to be an understanding of the nature of this,’ Holgate says. ‘Profit before tax is the main measure of performance for several companies. This accounting change could create a different impression of a business. Investors need to understand it so that they can react to reported figures appropriately.’
The outcome of the new presentation will have further implications for executive bonus schemes and even borrowing covenants. It is common for bonuses and covenants to be linked to pre-tax profit figures. If these targets are missed as a result of IFRS, hard earned bonuses could be missed and covenants breached.
Holgate says this is a ‘technicality’, but adds that the pre-tax profit target figures would ultimately have to be renegotiated. ‘There shouldn’t be too much of a problem, as many of these types of agreements will be maintained under frozen GAAP, but eventually the numbers will have to be reworked,’ he says.
Joint ventures and boosting your profits
The new treatment of associates in company accounts is not the only accounting change for subsidiaries and joint ventures that businesses will need to keep their eye on when reporting under IFRS.
In some cases companies will be faced with reclassifying some of their profitable subsidiaries as joint ventures – a move that could have an impact on profits and cash.
It is the little-talked about IAS27 that triggers the redefinition to joint ventures. The upshot is that instead of consolidating the full sales and profits of these interests in their financial statements, companies will only be able to reflect their share of these profits.
Peter Holgate, senior technical partner at PwC, however, says the change is unlikely to affect many businesses.
‘I don’t think we are going to see too many companies reclassifying subsidiaries as joint ventures,’ he says. ‘The new definitions might see the odd company have to reclassify because of the new criteria.’
Companies, however, will still need to be vigilant on the matter as some listed businesses have been affected.
Earlier this year telecommunications company Cable & Wireless disclosed that it would be reclassifying a subsidiary based in the Maldives, a business called Dhiraagu, as a joint venture.
The change cost Cable & Wireless £13m of its pre-tax profit and reduced revenues by £44m. More importantly, the company says that its gross cash balance at the end of March 2004 would be £35m down as a result of the reclassification.
One analyst at a leading credit rating agency says that similar reclassifications would have an affect on cash if they arose. ‘This situation could crop up for companies and influence their cash position, especially if the reclassified subsidiary generates cash.’
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