Some legal implications of the new standards

By Andrew Hay.

Key Points:
Changing the accounting treatment of items and events will have flow-on effects, under both Corporations Act requirements and pre-existing commercial arrangements.

Some of the legal and other impacts of the implementation of the new international accounting standards on companies include the following.

Reported profits and dividends

The new standards will have an impact, in one way or another, on the reported profits of a substantial number of companies and as such, will have an impact on those companies' ability to pay dividends.[1] Any adjustments that are required as a result of application of the new standards will require an adjustment to be made to the retained earnings of the entity (or, if appropriate, another category of equity). Legally, this in turn may have an effect on the ability of the company to declare dividends in the initial financial year after transition to the new standards and subsequent years. This fundamental issue will have a flow-on effect into other areas of corporate existence such as loans, capital raisings and many other areas.

Loans and borrowings

There are implications for compliance with an entity's loan and other debt covenants.

Financial covenants are often imposed in lending/security documents. They may be absolute values or ratios. In either case, the changes to standards may substantially affect compliance with those ratios and potentially trigger an event of default.

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

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. This situation will, of course, raise disclosure issues for a listed company.

Market perception and continuous disclosure

It will be necessary for the directors and senior management of materially affected companies to make adequate and timely disclosures to the market to inform all stakeholders of the implications for amended results and balances to assets, liabilities, income, expenses, profits and losses.

Incentive schemes linked to the entity's performance

There may be a need to revise internal performance evaluations and share-based incentive schemes where such evaluations and incentive hurdles rely on performance-based formulae or ratios linked to profits or some other accounting yardstick that may be more volatile under the new accounting standards.

In the case of share-based incentive schemes, such amendments may require shareholder approval.

Corporate governance

For a large number of companies, directors or senior management will be required to seek regular valuations of the company's assets, liabilities, share option-based payments to employees, etc from independent valuers who are suitably qualified and experienced to perform the task.

This may be necessary in order to mitigate the risk of asset or other values being materially misstated in financial statements. The result will be more work for such independent valuers. For example, if values are understated, in many cases under the new standards there is no opportunity to later increase values recorded in the accounts - impairment testing and revaluing will allow a revalue of assets downwards but not allow an increase.

Compliance and accounting systems

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

• the type and amount of data a company must produce to comply with the IFRS is likely to be different to that collected to satisfy the Australian GAAP. Therefore data collection and reporting systems will need to be reviewed;
• companies with extensive hedging operations or operations across a number of jurisdictions may be particularly hard hit. Almost all oil and gas companies rely heavily on derivatives and operate on a global basis - as do a growing number of electricity and water companies - and these entities' information requirements will increase quite dramatically under the new accounting standards; and
• the amount of work required to convert to the IFRS will depend on a company's existing reporting systems. If companies have fragmented systems with different systems for each office or part of the business, more work may be required.

Review of business agreements

The implementation of the IFRS will change some companies' reported profits, losses and capital assets to the point where companies may decide it is no longer sensible to engage in certain transactions or business lines.

For example, some companies may find they have "embedded derivatives" of which they were previously unaware. Having to record these at fair value may significantly impact on the company's income volatility. As such, they may wish to conduct business in a different manner or amend some business agreements.

Future acquisitions

Due to the treatment of assets, and in particular intangible assets and goodwill when acquired, there will be a greater emphasis in future acquisitions on more accurate identification and valuation of assets and in particular, intangible assets and goodwill.

Capital raisings

The adoption of the IFRS may have a substantial effect on the ability of companies to pay dividends.

This is because the IFRS will lead to the profits and retained earnings of many companies being written down - such profits and retained earnings being affected, for example, due to write-downs (eg. goodwill, asset impairment) or adjustments being booked to retained earnings or profit due to reclassifications, recognitions or de-recognitions under the new standards (eg. derivative and hedging positions, defined superannuation fund positions, expensing of capitalised research expenditure, de-recognition of internally-generated intangible assets, expensing of share-based remuneration) on transition and in subsequent years.

Such changes may also have an effect on a company's ability to raise capital or the instruments it uses to raise capital. Some observations to consider include:

• as the rules relating to recognition of liabilities (eg debt) and equity differ under the IFRS, some companies may have to reclassify equity-type instruments as debts (eg. reset preference shares). If a hybrid security is classified as a liability, this may dictate that the hybrid security is not as attractive for the company to use in its next capital raising
• the use of hybrid securities has seen much growth in recent years as part of the capital structure of companies. Such hybrid securities have often used preference shares with an element of convertibility to ordinary shares. Companies using such securities to raise capital often secure their capacity to pay preference dividends on shares against high retained earnings which insulates the company against any short term fluctuations in profitability. For companies experiencing significant write-offs and adjustments due to the IFRS, their retained earnings may be wiped out in the transition to adoption of the IFRS
• the new standards may introduce adverse impacts to the legal capacity of a company to pay dividends. In such cases, companies that struggle to pay dividends out of profits may find that their ability to access equity capital markets is reduced due to lessened availability of equity capital and the cost of equity to it.

Impact of IFRS on disclosure documents

The change in accounting standards will also have an impact on the financial information contained in disclosure documents (prospectuses, takeover documents etc). Those involved in preparing public disclosure documents for a company, should be aware that ASIC expectsdisclosure of the anticipated impact of the IFRS in the document.

The documents covered are:

• prospectuses
• product disclosure statements,
• bidders statements
• target statements,
• "other relevant takeover documents",
• scheme of arrangement documents,
• offer information statements
• related party transaction documents that contain financial information about the past and/or prospective financial position and performance of the entity.

The ASIC Guide does not replace the law, though it does set out ASIC's view of what good disclosure is.

Level of disclosure

The level and type of disclosure depends upon a number of factors, including the amount of information available about the IFRS and the particular circumstances in which the document is issued. For example, in a hostile bid, details of the target's finances might not be very detailed, so that a detailed assessment of the impact of the IFRS on those finances would be difficult.

Materiality

The impact of adopting the IFRS will vary from entity to entity. However, when the impact is material, the Corporations Act imposes a duty on the entity to disclose it in a public disclosure document containing financial information.

ASIC believes that, even where the impact of IFRS is not material, it would be good practice to disclose the impact. Many of the old standards have been harmonised in the IFRS but there may be some material changes including:

• reported or forecast assets;
• liabilities;
• revenues;
• expenses; and
• cash flows of an entity.

Factors to consider

Factors to consider when preparing a public disclosure document on the basis of the old standards and the IFRS include:

• how close the date of the public disclosure document is to the date of the entity's first financial report under IFRS
• whether forecast information will cover periods for which reports must be prepared in accordance with IFRS
• the significance of uncertainties about the final requirements of the proposed accounting standards in the lead-up to the issue of the final standards by the AASB
• the size and extent of differences between the two sets of resulting figures; and
• when the public disclosure document will expire, relative to adopting IFRS in an entity's financial reports.

Accordingly, ASIC suggests three different types of disclosure, ranging from a full set of accounts to a general discussion:

• A line-by-line reconciliation of financial statements using both the old standards and the new standards. Significant reconciling items would be shown in a separate column between the two columns of financial statements and described through footnotes. This approach would be preferable, for example:
  • closer to adopting the new standards for financial reporting purposes and where forecasts run into the entity’s years starting on or after 1 January 2005; or
  • where the information under each basis is given similar prominence, or where a significant number of line items in the financial statements will be materially affected by adopting the new standards.
• Reconciliation of key items such as profit after tax and net assets (or perhaps also other items such as current assets, non-current assets, current liabilities, non-current liabilities, revenue, expenses and operating profit before tax). Generally, each significant reconciling item would be separately described. This approach would be preferable, for example:
  • in the year immediately before the year in which an entity will first apply the new standards;
  • where more prominence is given to information under one basis than the other; or
  • where few individual line items in the financial statements will be affected by adopting the new standards; and
• General discussion about the impact of the new standards, which may include how reported assets, profits, losses, financial performance, cash flows and prospects are affected. Where possible, try to quantify the main differences This approach would be preferable, for example:
  • in the first half of 2004, if there is significant uncertainty as to the final requirements of standards that impact materially on an entity, and where forecasts do not run into the entity’s years starting on or after 1 January 2005; or
  • where prominence is given to information on one basis of accounting and adopting the new standards won’t have a material impact on the entity’s financial information.