The Effects of IFRS on Financial Ratios: Early Evidence in Canada Backgrounder
This timely CGA-Canada publication examines the impact of
International Financial Reporting Standards (IFRS) on key financial
ratios of public Canadian companies as they transition to the new
financial reporting regime this year. IFRS replaces Canadian Generally
Accepted Accounting Principles (GAAP) for publicly accountable
enterprises and affects figures presented in financial statements. The
differences between IFRS and pre-changeover Canadian GAAP regimes may
lead to variances in financial ratios – the key indicators on which
investors rely to gauge a company’s financial performance. The
variances in ratios can impair the comparability and analysis of
historic trends. The report does point to opportunities to mitigate
these challenges. Companies are initially required to produce
statements using both sets of accounting standards.
Report highlights
Most of the ratios under IFRS are more volatile than those under
pre-changeover Canadian GAAP
Maximum values of several ratios are higher and minimum values are
lower under IFRS, although the effects of IFRS on means and medians of
ratios related to the financial condition of companies are not
statistically significant.
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.
The exact source of the increased volatility of ratios under IFRS
remains unclear. The causes may include the incremental adjustments
that are specific to IFRS, and those associated with the
principle-based approach that allows for more discretion and judgment
by management.
Differences between IFRS and pre-changeover Canadian GAAP do not
affect cash flows
The cash-flow statement is less influenced by accounting methods and
estimates, and serves as a sound basis of comparison.
The impact of IFRS is subject to the industry effect and how recently
the company transitioned to IFRS
Companies in the mining sector seem to have certain incentives to
early adoption of IFRS as early adopters primarily consist of
companies in this sector.
Under IFRS, profitability and coverage ratios of mining companies are
affected to a greater extent than the ratios of companies in other
sectors.
Companies that implemented IFRS more recently had lower profitability
than those that had been applying it for some time.
IFRS’ impact on financial ratios is driven by differences in
application of fair value accounting and consolidation, and several
other differences
Fair value accounting leads to adjustments in balance sheet figures,
direct allocation of some unrealized gains and losses to the income
statement, as well as allocation of other unrealized gains and losses
to other comprehensive income.
Liquidity and leverage ratios are affected by fair value accounting
practices due to balance sheet variations while profitability 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.
Incorporation of minority interest in equity also has a significant
impact on financial statements, directly affecting profitability and
leverage ratios.
A number of other differences between IFRS and pre-changeover Canadian
GAAP impact financial ratios. Leverage and profitability ratios are
sensitive to the differences in impairment test procedures applied to
long-lived assets, as well as to the impact on liabilities, expenses
and equity caused by the differences in application of standards on
leases, pensions and contingencies, and share-based payments.
Specific characteristics differentiate IFRS from other accounting regimes
IFRS is principle-based; it gives more importance to substance (over
form) and allows management to use greater discretion and flexibility
in choosing accounting methods and estimates when preparing financial
statements.
Fair value accounting responds to investors’ needs for information
that reflects market-based values, but involves varying degrees of
subjectivity. 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.
Comprehensive income reflects revenues, expenses, gains and losses
recognized during a specified time period. It is summarized in a
separate financial statement made up of two parts; one corresponding
to the bottom line (profit or loss) of the income statement and the
other – called other comprehensive income (OCI) – relating to fair
value adjustments.
The entity theory underlies consolidation requiring assets and
liabilities of acquired subsidiaries and minority interests to be
measured at fair value. Under IFRS, the share of profit allocated to
minority interest is recognized directly in equity rather than income.
IFRS improves transparency and completeness of financial statements,
yet can lead to information overload as accompanying notes are
abundant and complex.
Recommendations
Analysts should continue to be cautious when examining financial
ratios during the transition to IFRS in Canada.
Financial statement users need to be aware of the main features of
IFRS that differ from pre-changeover Canadian GAAP and distinguish
between reported performance changes caused by the transition to IFRS
from those caused by changes in the business.
Relying on cash-flow analysis is recommended, particularly in cases
when accounting practices are subject to uncertainty or discretion of
management. Another possible solution may lie in recalculating ratios
using IFRS retroactive information presented in the year of
transition.
Financial statement users are advised to verify the uniformity of
underlying figures when using gross profit and operating profit
margins in profitability analysis.
The use of comprehensive-ROA (return on assets) and comprehensive ROE
(return on equity) is recommended to enhance comparability when
analyzing comprehensive income. These represent an adaptation of the
standard ROA/ROE calculations which substitute comprehensive income as
the numerator
This timely CGA-Canada publication examines the impact of
International Financial Reporting Standards (IFRS) on key financial
ratios of public Canadian companies as they transition to the new
financial reporting regime this year. IFRS replaces Canadian Generally
Accepted Accounting Principles (GAAP) for publicly accountable
enterprises and affects figures presented in financial statements. The
differences between IFRS and pre-changeover Canadian GAAP regimes may
lead to variances in financial ratios – the key indicators on which
investors rely to gauge a company’s financial performance. The
variances in ratios can impair the comparability and analysis of
historic trends. The report does point to opportunities to mitigate
these challenges. Companies are initially required to produce
statements using both sets of accounting standards.
Report highlights
Most of the ratios under IFRS are more volatile than those under
pre-changeover Canadian GAAP
Maximum values of several ratios are higher and minimum values are
lower under IFRS, although the effects of IFRS on means and medians of
ratios related to the financial condition of companies are not
statistically significant.
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.
The exact source of the increased volatility of ratios under IFRS
remains unclear. The causes may include the incremental adjustments
that are specific to IFRS, and those associated with the
principle-based approach that allows for more discretion and judgment
by management.
Differences between IFRS and pre-changeover Canadian GAAP do not
affect cash flows
The cash-flow statement is less influenced by accounting methods and
estimates, and serves as a sound basis of comparison.
The impact of IFRS is subject to the industry effect and how recently
the company transitioned to IFRS
Companies in the mining sector seem to have certain incentives to
early adoption of IFRS as early adopters primarily consist of
companies in this sector.
Under IFRS, profitability and coverage ratios of mining companies are
affected to a greater extent than the ratios of companies in other
sectors.
Companies that implemented IFRS more recently had lower profitability
than those that had been applying it for some time.
IFRS’ impact on financial ratios is driven by differences in
application of fair value accounting and consolidation, and several
other differences
Fair value accounting leads to adjustments in balance sheet figures,
direct allocation of some unrealized gains and losses to the income
statement, as well as allocation of other unrealized gains and losses
to other comprehensive income.
Liquidity and leverage ratios are affected by fair value accounting
practices due to balance sheet variations while profitability 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.
Incorporation of minority interest in equity also has a significant
impact on financial statements, directly affecting profitability and
leverage ratios.
A number of other differences between IFRS and pre-changeover Canadian
GAAP impact financial ratios. Leverage and profitability ratios are
sensitive to the differences in impairment test procedures applied to
long-lived assets, as well as to the impact on liabilities, expenses
and equity caused by the differences in application of standards on
leases, pensions and contingencies, and share-based payments.
Specific characteristics differentiate IFRS from other accounting regimes
IFRS is principle-based; it gives more importance to substance (over
form) and allows management to use greater discretion and flexibility
in choosing accounting methods and estimates when preparing financial
statements.
Fair value accounting responds to investors’ needs for information
that reflects market-based values, but involves varying degrees of
subjectivity. 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.
Comprehensive income reflects revenues, expenses, gains and losses
recognized during a specified time period. It is summarized in a
separate financial statement made up of two parts; one corresponding
to the bottom line (profit or loss) of the income statement and the
other – called other comprehensive income (OCI) – relating to fair
value adjustments.
The entity theory underlies consolidation requiring assets and
liabilities of acquired subsidiaries and minority interests to be
measured at fair value. Under IFRS, the share of profit allocated to
minority interest is recognized directly in equity rather than income.
IFRS improves transparency and completeness of financial statements,
yet can lead to information overload as accompanying notes are
abundant and complex.
Recommendations
Analysts should continue to be cautious when examining financial
ratios during the transition to IFRS in Canada.
Financial statement users need to be aware of the main features of
IFRS that differ from pre-changeover Canadian GAAP and distinguish
between reported performance changes caused by the transition to IFRS
from those caused by changes in the business.
Relying on cash-flow analysis is recommended, particularly in cases
when accounting practices are subject to uncertainty or discretion of
management. Another possible solution may lie in recalculating ratios
using IFRS retroactive information presented in the year of
transition.
Financial statement users are advised to verify the uniformity of
underlying figures when using gross profit and operating profit
margins in profitability analysis.
The use of comprehensive-ROA (return on assets) and comprehensive ROE
(return on equity) is recommended to enhance comparability when
analyzing comprehensive income. These represent an adaptation of the
standard ROA/ROE calculations which substitute comprehensive income as
the numerator
No comments:
Post a Comment