Some of the major differences that the IFRS may bring about for Australian companies are set out below.

Generally, the changes will have significant effects on the value of some assets and how some financial instruments are accounted for. The changes are likely to result in increased volatility for the profits of a significant number of companies. There could be far-reaching effects on mining companies, banks, insurance companies, companies that issue hybrid securities and derivatives and engage in hedging, and companies that hold substantial intangible assets on their balance sheets.

The major changes include:

• a tougher impairment test for all assets [1] (that is, the evaluation of the carrying value of assets will be more formal and require evidence of a formal review) including a new impairment test for deferred exploration and evaluation expenditure;
• financial instruments and hedging [2] - requiring all derivatives and most financial instruments to be recognised at their fair value;
• intangible assets [3] - internally-generated brands, mastheads, customer lists and similar assets cannot be recognised as assets of value. No revaluation of other identifiable intangibles not traded in active markets. All research start up and advertising expenditure to be expensed;
• business combinations [4] - non-amortisation of purchased goodwill and a greater emphasis on identifying and properly valuing intangible assets;
• employee benefits [5] - recognition of defined benefit fund surpluses and deficits;
• expensing shares and options issued to directors and officers as share-based payments; and
• removing doubt that reset preference shares and other hybrid securities which have debt characteristics are liabilities.

In many circumstances the new standards will require an alteration to the current accounting system for a substantial number of companies. The amount that an accounting system needs to be altered will depend on each individual company's circumstances. For example, the effect of IAS 39/AASB 139 "Financial Instruments: Recognition and Measurement" is that companies with extensive hedging programmes, or contracts with embedded derivatives or hedges, holding a large number of derivatives, or with operations across a number of jurisdictions, will find that the sophistication of their system and the information produced will need to increase. For example, they will have to identify and value these financial instruments for each financial report.

Almost any company with foreign exchange transactions (ie, multinational operations) will need to consider its hedging strategy for foreign exchange risk. Some companies may also find their contracts with overseas suppliers or customers contain certain derivatives that need to be "broken out" and recognised separately at fair value. For example, companies will have purchase and supply contracts that have prices linked to such things as the price of oil or gold that is not the same as the commodity being bought or sold. Such contracts therefore have "embedded derivatives" that require separate accounting under IAS 39/AASB 139.

Based on these changes, companies with the following attributes may be significantly impacted:

• companies with high levels of internally-generated intangible assets on the balance sheet;
• companies which have been active in acquisitions and which have obtained subsidiaries (at a premium) that are currently underperforming;
• companies with high levels of research expenditure that is currently capitalised;
• companies with financial assets and liabilities;
• companies with a defined superannuation benefit fund;
• companies with share- and option-based equity payments; and
• companies with high levels of acquired intangible assets where impairment factors are triggered.

Asset impairment testing [6]

What has changed?

The general rule in IAS 36 is that no asset may be carried above its recoverable amount. When the recoverable amount is less than carrying value, an expense (impairment loss) is immediately recognised in the company's income statement. Companies must assess whether there is any impairment loss attributable to any of their assets at the date of transition to the new standards and at each reporting date in the future.

This is more rigorous than impairment testing under existing Australian GAAP. The "recoverable amount" is the higher of the net selling price (fair value less costs to sell) and its "value in use". Value in use is the net present value (NPV) of expected future cash flows discounted at a current market risk-free rate.

The impairment test applies to all non-financial assets other than investment properties, inventories deferred, tax assets, assets arising from construction contracts and assets arising from employee benefits. These assets have their own test. Assets potentially impacted include property, plant and equipment, intangibles (ie retail and distribution licences) and goodwill.

Under AASB 136 an asset is only assessed for impairment if an "impairment trigger" arises. This means some sort of indication that the asset may be impaired (ie. external sources of information, changes in market conditions and internal sources of information that have negatively impacted assets of the business). If an "impairment trigger" is found, the company must determine whether the asset's recoverable amount is less than the carrying account and if so, the asset needs to be written down.

Typical impairment indicators include:

• Government actions (such as new environmental regulations or the imposition of price/tariff controls)
• declines in prices of products or market value of products, increases in production costs or changes in technology
• significant downward revisions of reserves estimates
• carrying amount of net assets exceeds market capitalisation
• increases in the anticipated period over which reserves will be produced
• loss or restriction of access to suitable markets (eg loss of pipeline access, imposition of export restrictions or marketing restrictions)
• increases in market interest rates
• evidence of obsolescence or damage or worsening economic performance of the asset
• an asset is idle or there are plans to sell or discontinue the asset
• reassessment of the useful life of an asset; and
• significant adverse changes in technology, markets, economy or legal factors.

Practical effect

Companies will now (for the first time in Australia) be required to discount their cash flows in assessing the recoverable amount for each asset. Also, companies must estimate annually the recoverable amount for goodwill and non-amortising intangible assets.

The introduction of this new standard has the potential to increase earnings volatility of Australian industrial companies quite significantly.

In the past, companies may have aggregated poorer performing assets with strong performing assets and thus (in aggregate) potentially satisfied recoverable amount tests. Now, to the extent that these poorer performing units have identifiable cash flows, AASB 136 requires these units to be tested as separate cash generating units - arguably causing more write-downs.

Companies will also be required to disclose key assumptions used in impairment models - this information is usually treated as sensitive by the company and may be considered a significant loss of intellectual property.

Financial instruments and hedging [7]

What has changed?

The proposed AASB 139 contains requirements for the recognition and measurement of financial instruments excluding leases, employee benefits, rights under insurance contracts and some other assets set out in AASB 139. The applicable financial instruments will be recognised as financial assets or financial liabilities and will be recorded on the balance sheet of a company with any change in that value to be recorded in the company's income statement. Generally the standard requires companies to calculate the fair value of their derivative positions and reflect any change in that value in the income statement. The current practice is for companies to set out their hedging strategies and their policies for use of derivatives but not to detail any unrealised gains or losses on their positions. Under the new standard, the change in value of such positions will have to be stated.

Companies have previously dealt with the fluctuations by adopting the principle of a "reasonable hedge" (ie. if the match created by the hedge is close enough it will not be reported). The new standards are stricter - companies must run scenarios on possible outcomes and report any mismatch. The standards will prohibit the common practice of netting several hedging positions, and each hedge contract must be linked to an underlying asset, income stream or liability.

Derivatives will no longer be ignored in financial statements - and companies will no longer be able to hold off on reporting them until the contract is settled. Companies are likely to have difficulties in calculating the fair value of derivatives and hedges, and no doubt shareholders will be wary of the new instability in the accounts.

In the case of a cash flow hedge, changes in the fair value of a derivative hedging instrument are recognised in equity, not the income statement. Companies will be required to maintain sufficient documentation to prove that a hedge is effective at inception and at each reporting date, as well as satisfying the 80-125 percent hedge effectiveness test. Current practice is that, if the overall cash flow hedge is effective, all gains/losses (including the ineffective portion) are deferred.

Further, for cash flow hedges, the forecast transaction must be highly probable, with all formal documentation of the hedge relationship being in place before entering into a transaction (to be done on a transaction-by-transaction basis). This is more onerous than the obligations that currently exist under Australian GAAP.

Practical effect

Companies that hedge foreign exchange, interest rate or commodity/supply exposures will be affected. Practically, this standard will introduce a new element of earnings volatility into the reported earnings of many companies. Companies may need to reassess their dividend policies, and grossing up balance sheets may impact debt covenant ratios. Also, the impact of any hedging or derivative product will need to be carefully considered before it is entered into.

Primary producers, energy companies, importers and exporters and property trusts that use a range of derivatives to hedge their exposure to currency movements, commodity spot market fluctuations and interest rate movements will be hardest hit.

Power and utility companies often enter into derivative transactions such as futures or forward contracts to hedge cash flows against volatile commodity prices or lock in a margin for sales commodities. Practically in such instances it may be difficult to determine "value in use" for the purposes of AASB 136. For example, consider the following scenarios:

• should a seller of oil, which has used a derivative instrument to place a "floor" on its future selling prices, consider the "floor" for determining the related assets' discounted estimated future cash flows for the impairment test purposes?
• AASB 139 requires derivative financial instruments to be recorded on the balance sheet at fair value. Therefore inclusion of their effect into estimated future discounted cash flows for impairment test calculations under AASB 136 would effectively result in recognising the derivative asset or liability twice in the financial statements.

Financial instruments: disclosure and presentation [8]

What has changed?

AASB 132 clarifies the liability and equity classifications of financial instruments and sets out the disclosure requirements for each class of financial assets and financial liabilities.

Entities that have issued hybrid financial instruments or convertible financial instruments currently classified as equity may be required to reclassify those instruments as debt/liabilities depending on the terms and conditions of the instruments.

Financial assets and liabilities are now to be classified into five categories and measured as follows:

• originated loans and receivables (amortised cost)
• held-to-maturity investments (amortised cost)
• available for sale securities (fair value, any movement in value is recorded against equity)
• financial assets held for trading and derivatives (fair value, any movement in value is recorded in the profit & loss); and
• non-trading liabilities (amortised cost).

Practical effect

The classification of some financial instruments as debt rather than equity is likely to affect many companies' debt-equity ratios and balance sheets. The new standards tend to provide for more liability/debt categories than equity categories. This may have an impact on how some companies raise capital. For example, reset convertible securities (reset preference shares), which have been a popular hybrid for raising capital in recent times, may well be reclassified as debt.

Companies will need to classify (and in some cases re-classify) and measure their financial assets and liabilities according to the above categories.

Intangible assets [9]

What has changed?

Entities that have recognised internally-generated identifiable intangible assets (brands, mastheads, publishing titles, customer lists and items similar in substance), excluding goodwill, will be required to derecognise those identifiable intangible assets which do not satisfy the recognition criteria in AASB 138. Internally-generated goodwill must not be recognised as an asset.

In addition, those entities that have revalued intangible assets, whether purchased or internally developed, will be required to derecognise those revaluations that have not been determined by reference to an active market.

Currently, Australian companies are able to recognise intangible assets such as goodwill, brand names, intellectual property or capitalised expenditure, including internally-generated intangibles. They are measured at cost or revalued by the directors based on fair value.

Under the new standards, companies cannot recognise internally-generated intangible assets where there is no active market for those assets because these assets are indistinguishable from internally-generated goodwill. Such assets can be recognised at cost if acquired, in the form of purchased goodwill. However, companies will be unable to revalue purchased intangibles. As a result of AASB 136 and 138, companies will have to review their intangible assets. Many internally generated assets will have to be written off and most assets that can remain will need to be written down to original cost.

By way of summary, AASB 138:

• defines an intangible asset as an identifiable non-monetary asset without physical substance
• requires an asset to be treated as meeting the identifiable criterion in the definition of an intangible asset when it:
  • is separable, that is, capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability; or
  • arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.
• requires an intangible asset to be recognised if, and only if, it is probable that the future economic benefits that are attributable to that asset will flow to the entity; and the cost of the asset can be measured reliably
• requires an intangible asset to be measured initially at cost
• requires expenditure on research to be recognised as an expense when it is incurred
• requires an intangible asset arising from development to be recognised if, and only if, the recognition criteria are met
• prohibits internally-generated brands, mastheads, publishing titles, customer lists and items similar in substance from being recognised as intangible assets
• requires an intangible asset with a useful life to be amortised over its useful life subject to he impairment test
• prohibits the amortisation of an intangible asset with an indefinite useful life - instead, such intangible assets are tested for impairment annually and whenever there is an indication that the intangible asset may be impaired; and
• requires disclosure of information about an entity's intangible assets.

Practical effect

The introduction of AASB 138 will require companies to do the following:

• determine the useful life of their intangible assets
• derecognise certain internally-generated intangible assets
• reverse any previously revalued intangible assets where there is no active market for that asset
• expense previously capitalised start-up costs; and
• expense previously capitalised research costs.

Inflated values of licences and other assets for which there is no active market[10] must also be written down. This potentially affects mining and broadcast licences held by resources and media companies. These losses could affect the share prices of such companies because they may change key measures of return on equity and gearing which may affect bank debt covenants and the ability to pay dividends.[11]

In the balance sheets of many major Australian companies, this will require some assets to be de-recognised and others written back to original cost, reversing past revaluations. That may mean gearing and other liability ratios would increase and may mean that asset ratios decrease and are breached.

Practically it may also be necessary to explain to shareholders and other stakeholders why a company's assets are being reduced, when core operating performance and intrinsic brand value remain unaffected.

Business combinations [12]

What has changed?

Entities that purchase goodwill and are amortising that goodwill over its useful life will have to cease such accounting practice and apply an annual impairment test for goodwill and if impaired, write down its value. Such impairment write downs or losses cannot be reversed at a later date. Also, the new standard requires the identification of an acquirer in a business combination including a merger. The identified acquirer is required to account for the acquisition at fair value. Such fair value is to include unbooked contingent liabilities, intangible assets and restructuring provisions in the transferee's books.

There is currently a rebuttable presumption that the useful life of goodwill does not exceed 20 years. It is proposed to remove this rebuttable presumption such that the cost of acquired and internally generated intangible assets will be amortised over their useful economic life and assets with an indefinite life will be tested for impairment each year in accordance with AASB 136.

Further, IFRS 1 requires retrospective application of the IFRS. However, IFRS 1 provides an exemption for past business combinations. By virtue of the exemption which is set out in AASB 3, an entity may choose from one of three courses of actions:

• retrospectively apply the business combination standard to all past business combinations; or
• apply the exemption to all past business combinations; or
• retrospectively apply the business combination standard to one business combination and all subsequent business combinations and therefore apply the exemption to earlier business combinations.

Where a company retrospectively applies a business combination standard to a past business combination, it must identify and recognise, separately from goodwill, intangible assets acquired as part of a business combination. Companies must value intangible assets at their fair value, at the acquisition date.

Practical effect

This means there is likely to be greater recognition of properly identifying intangible assets in future acquisitions and a greater emphasis on their proper valuation - most of them amortised. A list of intangible assets that should satisfy the new recognition criteria include trade marks, trade names, service and certification marks, internet domain names, customer lists, customer contracts, use rights (such as drilling, water, mineral, etc.), patent and under patentable technology.

A more extensive assessment of intangible assets will be necessary during a merger and/or acquisition.

Employee defined benefits [13]

The new IFRS require entities that sponsor defined benefit superannuation plans to recognise actuarial gains and losses relating to such plans in income as they arise and to recognise an asset or a liability in respect of the plans.

Companies that have defined benefit superannuation funds for employees will be significantly affected. Currently, movements in the fair value of assets or liabilities of such superannuation plans do not need to be recognised in a company's accounts and remain off the balance sheet unless the company has a legal obligation to make good any fund deficits.

Under the new standards, if the fair value of the fund compared to the future obligations of the fund is in surplus, it would be recognised as an asset and if in deficit, it would be recognised as a liability. Annual changes in the fund's position will need to go through the income statement - as revenue if the value of the fund compared to future obligations increases and as an expense if it decreases.

Practical effect

The changes will significantly alter the way companies currently deal with such benefits. Currently, fund surpluses or deficits remain "off balance sheet" unless the company has a legal or constructive obligation to make good fund deficits.

The changes are likely to increase earnings volatility where a company has a defined benefit superannuation plan.

Affected companies will need to put in place the necessary systems to ensure annual actuarial reviews in order to accurately reflect movements in fund surpluses/deficits each reporting period.

In relation to the defined benefit schemes, companies may decide to progressively wind down or terminate/wind up existing schemes, if possible, because the variations in the value of these obligations are dealt with in the income statement of the company. Such schemes are mostly found in the mining industry, and therefore some oil/gas and utility companies may want to reduce the scale of their commitments and pass more risk to employees by replacing the "defined benefit" scheme with the now more common "defined contribution" schemes. These changes might affect employees' job satisfaction and create possible employee unrest in the mining industry. They might also create tensions between the company and other interested parties such as external stakeholders, unions, institutional investors and financial analysts.

Some other notable changes

Changes in foreign exchange rates [14]

Entities are currently required to present financial reports in Australian currency. AASB 121 will change this position. A company will have to determine its functional currency and measure its results and financial position in that currency. The company does not have a free choice in relation to its functional currency. The functional currency is the currency of the primary economic environment in which the company operates. The company may also freely select a presentation currency for their financial reports other than Australian currency. The presentation currency may be different from the functional currency. This may be useful if companies have business operations in a number of jurisdictions.

Companies providing their financial reports in a currency other than $AUD will need to disclose the reason and justification for the choice of presentation currency and spend time coming to grips with changes to their accounting systems - in terms of both compliance and training of its staff. Also, where the functional and presentation currency are different, the company must translate its financial reports to the presentation currency.

Provisions, contingent liabilities and contingent assets [15]

Entities will be required to recognise provisions relating to retirement or disposal of long-lived assets and will need to change the timing of recognition of proposed dividends.

Share- and option-based remuneration: [16] In relation to remuneration, the changes to be implemented by the new standards can be summarised as follows:

• the treatment of share and option schemes under the IFRS is different to that under Australian GAAP;
• many companies reward managers and employees with performance-related share and option schemes. Under the IFRS most companies will have to produce a fair valuation of the shares or options they issue, the date they are granted, and they will have to charge the value of those shares or options as an expense against net income during the same period as that in which the shares or options vest;
• for many cash-poor companies, net profit may be dramatically reduced where they rely heavily on paying their senior executives and employees with options and/or shares;
• data collection will increase - most share-based compensation plans include performance conditions that may include revenue targets etc. and therefore it can often be difficult to determine the fair value of share-based compensation. Charging the value of shares or options to expenses reduces a company's net income and basic earnings per share. In the case of awards to large numbers of employees, the effect could be significant; and
• the IFRS may force companies to reassess their remuneration schemes and perhaps grant fixed awards that vest immediately in order to obtain a stable charge, or change the balance of their remuneration schemes with more emphasis on cash and other benefits and less emphasis on shares or options.

Investment property [17]

Entities with investment properties will be required to measure these properties at fair market value or at cost less accumulated depreciation (without revaluation). If the fair market valued model is used changes in such fair market value are to be recognised in the income statement. No depreciation can be claimed under the fair value method. The valuation model chosen must be used for all investment properties. Currently entities can treat investment properties at their cost or revalued amount under AASB 1041 Revaluation of Non-Current Assets.

Many Australian industrial companies have retained the fair value basis of measuring property (as well as plant and equipment) rather than at cost. Currently revaluation increments and decrements can be offset within a class of assets, reducing the chance of any revaluation's having a current or future profit and loss impact.

Under AASB 140 these assets can be carried at fair value or cost (consistent with current practices) but revaluation increments and decrements will need to be offset against the asset revaluation reserve balance relating to the individual asset. This means that no class of asset aggregation is allowed.

Detailed records of asset-by-asset revaluation movements will need to be maintained by companies. This may require changes to the internal reporting systems and training procedures of the company.

[1] see AASB 136 and IAS 36

[2] see AASB 139 and IAS 32 and 39 - IAS 32 and 39 are not yet fully adopted by IASB

[3] see AASB 138 and IAS 38

[4] see AASB 3, 136 and 138 and IFRS 3, IAS 36 and 38

[5] see AASB 119 and IAS 19

[6] see AASB 136 and IAS 36

[7] see IAS 32 and 39 and AASB 132 and 139

[8] see AASB 132 and IAS 32

[9] see AASB 138 and IAS 38

[10] see paragraph 7 of IAS 38 - an active market is a market where all the following conditions exist: (a) items traded within the market are homogeneous, (b) willing buyers and sellers can normally be found at any time, and (c) prices are available to the public.

[11] section 254T of the Corporations Act requires dividends to be paid out of profits or retained earnings of the company.

[12] see IFRS 3, IAS 36 and IAS 38; AASB 3, 136 and 138

[13] see IAS 19 and AASB 119

[14] see IAS 21 and AASB 121

[15] see IAS 37 and AASB 137

[16] see IFRS 2 and AASB 2

[17] see IAS 40 and AASB 140