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Snoopy
07-10-2006, 10:32 AM
IFRS stands for 'International Financial Reporting Standards'. IFRS is like a disease that is sweeping through all of our company annual reports at the moment. Unlike a disease, I believe this is mostly a good thing. But there is one area where I do have my doubts, and that is in the treatment of foreign currency reserves and associated derivative issues.

The following is an extract from p64 of the FY2006 Sky City annual report, although for the purposes of this discussion it might have come from any number of companies. The italics are mine.

"Transactions and Balances

Foreign currency transactions are translated into the functional currency using exchange rates prevailing at the dates of transactions. Foreign exchange gains and losses resulting from the settlement of such transactions and from the translation at year end exchange rates of monetary assets and liabilities denominated in foreign currencies are recognised in the Income Statement, except where deferred in equity as qualifying cash flow hedges and qualifying net investment hedges."

The first question I would like to pose is, what on earth does all that mean? Many bonus points will be available to anyone who can translate it into plain English. Just to give you more of a clue here is the same paragraph from the Sky City FY2005 annual report, written in accordance with the old NZ accounting standards:

"Foreign Operations

Revenues and expenses of independent foreign operations are translated to New Zealand dollars at the exchange rates in effect at the date of the transaction, or at rates approximating them. Assets and liabilities are converted to New Zealand dollars at the rates of exchange ruling at balance date.

Exchange differences arising from the translation of independent foreign operations are recognised in the foreign currency translation reserve, together with unrealised gains and losses on foreign currency monetary liabilities that are identified as hedges against these operations."

The key to the importance of these two quotes is, I feel, not in the detail but in the differences. For the first time from FY2006, it seems these foreign currency effects have been pushed into the income statement. From a strict accounting standpoint this is more accurate. But from an investment standpoint this change IMO is not helpful. With a volatile currency like the New Zealand dollar these currency effects assume more importance than should be given to them. IME they tend to even out over several years and do not truly reflect the development plan of the underlying business one is analyzing. From an investment perspective these currency changes need to be removed to get a representative underlying result. Am I right?

SNOOPY

Snow Leopard
12-10-2006, 02:20 PM
It would appear that one of the aims/side-effects of IFRS is to drag every change to the balance sheet through the profit/loss statement.
It means that a companies headline profit is open to greater volatility and reading and understanding the accounts is as important as ever.

shasta
17-10-2006, 02:33 PM
You got it PT, more "one - offs" to distort the true picture & the company's true value!

Haven't read into it in great depth as yet, but i know Snoopys mate Warren has a dislike for companies that don't expense the cost of share options etc.

Snoopy - any changes on this front from what you have read?

Snoopy
27-10-2006, 01:21 PM
quote:Originally posted by shasta



Haven't read into it in great depth as yet, but i know Snoopys mate Warren has a dislike for companies that don't expense the cost of share options etc.

Snoopy - any changes on this front from what you have read?


If we take what Telecom are doing as correct accounting policy, share options now have to be expensed over the remaining vesting period. This even applies to share options that were granted prior to 1 July 2004 (the start of FY2005, which is the immediate previous comparative period for FY2006 - the first year under IFRS rules).

IOW all good news on the share option front - expensing of options now becomes the rule. Warren would be pleased!

In general I regard the adoption of IFRS as a good thing.

SNOOPY

Snoopy
27-10-2006, 02:23 PM
quote:Originally posted by Paper Tiger

It would appear that one of the aims/side-effects of IFRS is to drag every change to the balance sheet through the profit/loss statement.


Goodwill would be an exception to that. Under the old system it was amortised every year on a straight line basis, no matter what the real value of the goodwill. Under IFRS goodwill must be left out of the equation entirely. OK, there is a sop requirement, having an annual impairment test on any goodwill remaining. But after the initial phase in period of 'bedding in' the new rules, I am not expecting goodwill reporting to be an issue for most companies. That IMO is a good thing as it means reported profits more closely approximate real cashflows.

Another IFRS change example is revenue recognition. Revenue received in advance must now not be recognised fully until the expiry of any obligation to provide the concomitant service. That IMO is much more realistic of the true situation than booking revenue immediately it is received, as allowed under the the old rules.

Likewise government grants with a specific purpose. These cannot be recognised as 'income revenue' until the money has been spent on whatever 'specific purpose' listed in any grant agreement.

Likewise taxation. If there is any temporary difference between the accounting base of assets and the (real) tax base of assets, then a deferred tax amount is required on the balance sheet.

All of these changes listed so far should make profits less volatile than before. IMO that is a good thing.

That is why I have highlighted the foreign currency adjustment requirements. This IFRS change, combined with any associated IFRS change in financial instrument valuation, seems to be requiring unnecessary volatility in annual earnings that will ultimately come out in the wash as the years go by anyway. That is why, IMO, this change, and only this change, is a bad thing when trying to understand a company from an *investment* perspective.

OTOH from an accounting perspective, producing a snapsot of the true financial position of the company is the goal. That means revaluing foreign exchange balances and any associted derivatives does provide a more accurate view of the immediate state of the company. I guess that is why internatioanl financial standards were drafted like this.


quote:
It means that a companies headline profit is open to greater volatility and reading and understanding the accounts is as important as ever.


Does anyone agree that the currency volatility, and that alone, should be removed from the results before making investment decisions?

SNOOPY

Snow Leopard
27-10-2006, 03:49 PM
quote:Originally posted by Snoopy


quote:Originally posted by Paper Tiger

It would appear that one of the aims/side-effects of IFRS is to drag every change to the balance sheet through the profit/loss statement.


Goodwill would be an exception to that. Under the old system it was amortised every year on a straight line basis, no matter what the real value of the goodwill. Under IFRS goodwill must be left out of the equation entirely. OK, there is a sop requirement, having an annual impairment test on any goodwill remaining. But after the initial phase in period of 'bedding in' the new rules, I am not expecting goodwill reporting to be an issue for most companies. That IMO is a good thing as it means reported profits more closely approximate real cashflows.


You are wrong and missing the point my friend.

Under GAAP goodwill was amortised each and every year in a nice predictable manner and deducted from the headline profit figure. Under IFRS, with the annual impairment test it can vary drastically from year to year. When times are good then the impairment will in most cases be zero and NPATA and NPAT will be much the same. However when things go wrong/a bit off then that impairment test will result in a expense that still affects the headline profit/loss.

Snow Leopard
27-10-2006, 03:55 PM
quote:Originally posted by Snoopy

Another IFRS change example is revenue recognition. Revenue received in advance must now not be recognised fully until the expiry of any obligation to provide the concomitant service. That IMO is much more realistic of the true situation than booking revenue immediately it is received, as allowed under the the old rules.

Likewise government grants with a specific purpose. These cannot be recognised as 'income revenue' until the money has been spent on whatever 'specific purpose' listed in any grant agreement.

Likewise taxation. If there is any temporary difference between the accounting base of assets and the (real) tax base of assets, then a deferred tax amount is required on the balance sheet.

All of these changes listed so far should make profits less volatile than before. IMO that is a good thing.


I can not comment on the accuracy of the first two/three but I did highlight the IFRS accounting treatment of losses and post -loss profits on the Feltex thread sometime ago.

I would have a chat with a few accountant/CFO types about their opinion of IFRS on the accounts.

Snow Leopard
27-10-2006, 03:58 PM
quote:Originally posted by Snoopy


quote:
It means that a companies headline profit is open to greater volatility and reading and understanding the accounts is as important as ever.


Does anyone agree that the currency volatility, and that alone, should be removed from the results before making investment decisions?

SNOOPY



Well obviously I don't.

IFRS does not remove the need to read every line of the financials, follow every footnote and try and understand it, and worry over anything you can not understand. Assuming that is the way you worked before.

regards
Paper Tiger

Snoopy
27-10-2006, 07:21 PM
quote:Originally posted by Paper Tiger



You are wrong and missing the point my friend.

Under GAAP goodwill was amortised each and every year in a nice predictable manner and deducted from the headline profit figure. Under IFRS, with the annual impairment test it can vary drastically from year to year. When times are good then the impairment will in most cases be zero and NPATA and NPAT will be much the same. However when things go wrong/a bit off then that impairment test will result in a expense that still affects the headline profit/loss.


I agree with what you say PT, except the bit about me being wrong :-).

PT you said (with my emphasis):

"Under IFRS, with the annual impairment test it can vary drastically from year to year."

I think where we disagree is the likelihood of the 'can' bit. For specific examples, I can only comment in detail on the shares I own. But look what has happened with the shadow of IFRS hanging over the market so far in FY2006, in preparation for this new regime.

The Warehouse fully wrote down the value of the goodwill associated with their Australian investment. Telecom fully wrote down the last of the goodwill associated with AAPT. All fair enough as anyone who has followed both companies for the last few years knew all that Australian goodwill was valueless. Perhaps saying 'valueless' is a little unfair. But the fact that management wrote all Australian goodwill fully down to zero is conservative behaviour. I expect this new found conservatism to be encouraged by the new IFRS regime.

Under the old regime, both WHS and TEL have managed to disguise how bad their Aussie purchases turned out to be by first partially writing down the goodwill, and then taking thin slices of the remaining goodwill to only slightly reduce reported profits. This avenue of escape is no longer availble to our financial engineers. From here on in, a company cannot hide a bad purchase by fiddling around with the goodwill on the books like they did before. Like you say PT, the goodwill will need to be adjusted in one hit, possibly within a year of making the dud purchase! No chief executive would survive such an audacious write down. So, IMO, chief executives are going to become more risk averse and not make such 'bold' investment decisions.

Yes IFRS can increase earnings volatility via the treatment of goodwill. But the mere fact that it 'can' do so will see management take all steps to make sure it doesn't! The IFRS goodwill rules will have a similar deterrent effect to reckless acquisitions that that the atomic bomb holds over nuclear war - to use the battleground analogy!

SNOOPY

Snoopy
27-10-2006, 07:31 PM
quote:Originally posted by Paper Tiger

Originally posted by Snoopy

"Does anyone agree that the currency volatility, and that alone, should be removed from the results before making investment decisions?"

Well obviously I don't.

IFRS does not remove the need to read every line of the financials, follow every footnote and try and understand it, and worry over anything you can not understand. Assuming that is the way you worked before.


That's the whole point though Paper Tiger. The 'way I worked before', I never bothered about annual foreign currency revaluations and the net value of hedging and derivatives taken out in the course of covering normal business cashflows. Why should I worry about all that now? (back to the original question).

SNOOPY