International Accounting Standards - potential impact on lending practices

By Andrew Hay.

Key Points:
The implementation of international accounting standards by Australian companies could impact on local lending practices.

Under a strategy adopted by the Financial Reporting Council in July 2002, the Australian Accounting Standards Board (AASB) is obligated to work towards the full implementation of the International Accounting Standards (IAS) (now known as International Financial Reporting Standards (IFRS)) in Australia. This strategy was also set out in the CLERP 9 proposals.

Entities (including Government business enterprises) will be required to prepare financial statements under Chapter 2M Corporations Act in accordance with the IAS/IFRSs adopted by the AASB for financial reporting periods on or after 1 January 2005.

At last count there are 33 IASs/IFRSs. It is intended that three of these will remain unchanged prior to 1January 2005; 11 IFRSs were amended and reissued in 2003 and the remaining 19 IFRSs are scheduled to be amended and reissued in 2004.

This will result in significant changes to the financial reports of Australian companies. This will also be some potentially significant legal issues to be considered and worked through.

The AASB and Australian Securities & Investments Commission (ASIC) have strongly encouraged company boards and management to understand the implications of the significant changes from the company and shareholders viewpoint, take an active interest now and develop and implement a strategy to effectively manage a timely transition. Audit committees also need to take an active role now in dealing with the transition to the 2005 International Accounting Standards.

Objectives

The primary objective for the introduction of the new accounting standards is the expected efficiency of the capital markets that will arise from the existence of a set of globally acceptable accounting standards that result in high quality comparable and transparent financial reporting. Why is this important? One of the reasons is that the EU is driving towards the creation of a single capital market.

Entities will be able to make an unreserved statement that their financial reports are prepared in compliance with International Accounting Standards Board accounting standards (IASB Standards) and will enable audit reports to refer to an entity's compliance with the IASB Standards.

The second objective is the facilitation of cross border comparison of accounts by investors, leading to the reduced cost of capital for Australian companies and assisting them to raise capital or list overseas.

Thirdly, this represents the first stage in a convergence of the standards of the IASB and the US Financial Accounting Standards Board which uses US GAAP standards. This will take time but is considered by the AASB to be a move in the right direction. In order for this to occur the US SEC will seek to understand the differences between the two standards and also seek to become convinced of the quality of the IASB Stanards. This is expected to occur over the next few years.

Standards are being applied now

The new standards will apply for the reporting periods commencing on or after 1 January 2005.

Companies should start to inform and educate members and other stakeholders who use the financial reports on the impact and consequences of the new standards. The extent of any changes to the financial position and performance of the company needs to be explained and understood. Confirmation for the reason for such changes needs to be explained - that is, changes attributable to the new standards as opposed to changes in the company's underlying business.

The final IASs and IFRSs will not be completed until later this year. The AASB has been progressively approving the contents of the standards and has made them available on their website.

Adoption of the International Accounting Standards

Starting point - AASB 1 provides assistance to an entity when it adopts the new standards for the first time. To promote comparability among the financial reports of Australian entities, early adoption of the new standards including AASB 1 is not permitted. In particular, AASB 1 requires an entity to do the following in the opening balance sheet that it prepares as a starting point for its accounting under the new standards:

- AASB 1 provides assistance to an entity when it adopts the new standards for the first time. To promote comparability among the financial reports of Australian entities, early adoption of the new standards including AASB 1 is not permitted. In particular, AASB 1 requires an entity to do the following in the opening balance sheet that it prepares as a starting point for its accounting under the new standards:

• recognise all assets and liabilities whose recognition is required by the new standards;
• not recognise items as assets or liabilities if the new standards do not permit such recognition;
• reclassify items recognised under previous GAAP as assets, liabilities, or components of equity in accordance with the new standards;
• apply the new standards in measuring all recognised assets and liabilities;
• contain high quality information that is transparent for users and comparable over all periods presented; and
• can be generated at a cost that does not exceed the benefits to users.

Resulting adjustments - The accounting policies that an entity uses in its opening balance sheet under the IASB standards as adopted by the AASB may differ from those used previously. Resulting adjustments will arise. An entity shall recognise those adjustments directly in retained earnings (or, if appropriate, another category of equity) at the date of transition.

- The accounting policies that an entity uses in its opening balance sheet under the IASB standards as adopted by the AASB may differ from those used previously. Resulting adjustments will arise. An entity shall recognise those adjustments directly in retained earnings (or, if appropriate, another category of equity) at the date of transition.

Comparatives - An entity's first financial report under the new standards are required to include at least one year of comparative information.

- An entity's first financial report under the new standards are required to include at least one year of comparative information.

Explanation of transition - An entity is to explain how the transition from previous GAAP to the new standards (via AIFRPs) affected its reporting financial position, financial performance and cash flows.

- An entity is to explain how the transition from previous GAAP to the new standards (via AIFRPs) affected its reporting financial position, financial performance and cash flows.

In order to comply with this disclosure requirement the first financial report under the new standards must include various reconciliations of the entity's equity reports, profit and loss statements and any impairment of losses or reversals.

Legal impact of introduction of new standards

Some of the legal impacts of the new standards on companies include, amongst others, those set out below:

Affect reported profit and therefore a company's ability to pay dividends: adjustments may be required and such adjustments will affect retained earnings (ie. profits) of an entity. Under the Corporations Act, dividends may only be paid out of the profits of the company.

Implications for compliance with an entity's loan covenants:

• Financial covenants are imposed often in lending/security documents.
• They may be absolute values or ratios.
• In either case, the changes to standards are likely to substantially change those figures and thus trigger an event of default giving the bank the opportunity to "call" on the loan/security, ie act on.
• Two consequences emerge: (a) the bank enforces it security and calls up the loan or puts the company into some form of insolvent administration; or (b) the bank uses the opportunity of the "potential default" to renegotiate the terms of the covenants or commercial deal generally.

In either case, the bank can take this as a useful opportunity to house clean/review its books. Of course, the bank may, having regard to the client relationship, do nothing and simply let the default sit with or without formally waiving it, holding it in the latter case as a trigger for some future occasion should it want to act.

The borrower may in any of these scenarios assert that the terms were agreed to on the basis of a totally different understanding of accounting treatment and for the bank to now rely on an external change such as this is unconscionable - ie, this may be the sort of defence/cross claim run if things got nasty.

In a similar vein, the banks might want to rely on what is often called a Material Adverse Change or Material Adverse Event clause to say that these changes trigger the operation of such clause allowing the bank to call a default.

Implications for management and other employee incentive schemes linked to the entity's performance: There may be a need to revise schemes where incentives or performance based formulas or ratios are based on profits. This may require shareholder approval.

Impact on future tax liabilities: Thin capitalisation rules - for example, derecognition of internally generated identifiable intangible assets may result in interest payments on borrowings from foreign parent companies not being deductible under the thin capitalisation requirements. The thin capitalisation provisions specify the maximum amount of interest bearing debt of a relevant entity that can give rise to interest deductions in a year of income. Under these provisions, interest on debt in excess of the maximum allowable debt for the entity will be denied as a deduction. The approach to determine the maximum allowable debt of an entity varies depending upon whether the entity is an inward or outward investing entity, and whether or not the entity is an authorised deposit taking institution (eg., bank) or other financial entity. However, maximum allowable debt is broadly the greatest of (a) a safe harbour of 75% of the average asset value of Australian operations (net of non-interest bearing liabilities and investments in associates); and (b) an arm's length debt or capital amount assuming an independent lender, subject to certain specified criteria. The safe harbour amount has as its broad starting point the average value of an entity's assets adjusted for various matters including non-debt liabilities. However, the entity must comply with accounting standards when identifying and valuing assets, liabilities and equity capital for the purpose of the thin capitalisation provisions. Changes in the recognition and valuation of assets under the new accounting standards may result in many entities that currently pass the thin capitalisation test failing post 1 January 2005.

The changes are likely to affect system development costs and require need for system changes. Many entities will require additional or improved reporting and information systems in order to comply with the new standards.

Disclosure: the change in accounting standards will have an impact on the financial information contained in disclosure documents (for example, prospectuses, takeover documents etc).

For further information, please contact Andrew Hay.