Lost in translation, apples and oranges, or tomahto to tomayto?: The need for companies on the Nigerian Stock Exchange to carry the investment community along in the transition to International Financial Reporting Standards (IFRS).
With less than seventeen months to go to the Central Bank of Nigeria mandated deadline for the adoption of the International Financial Reporting Standards (IFRS) by Nigerian banks, and twenty-seven months to its obligatory adoption by all companies listed on the Nigerian Stock Exchange, it is curious that no institution has made an effort to sensitize investors and analysts on the significance of the new accounting standards. Instead, those institutions that have adopted IFRS have presented the move as one of adherence to global best practices without seeding awareness about what the change means for the way they prepare financial statements. In fact, there seems to be a tendency to communicate the act of adoption as a commitment to the enhancement of shareholder value and corporate governance. While improved transparency, relevance, reliability and comprehensibility are among the anticipated goods of IFRS, it is a misnomer, or worse, misleading, to imply that an accounting standard change can, by itself, create value. Value is created when firms increase their cash-generating ability, not when they change methods of reporting business performance. In this post, we discuss the importance of communicating the effects of IFRS adoption by companies on the Nigerian Stock Exchange. We use illustrative cases of companies in the EU which placed a priority on preparing the market for the new order.
On April Fool’s Day, First Bank, a foremost Nigerian bank, issued a press release stating that it had adopted the International Financial Reporting Standards (IFRS). Without prior notice, the bank stated that the change to IFRS would take immediate effect and will apply to the bank’s financial report for the year ended March 31, 2009.
In the release, which acknowledged that the shift was voluntary, the bank said it would continue to report financial results in the local Statement of Accounting Standards (SAS) until full convergence is required by regulators. Knowing the planning, training and costs of transitioning to IFRS for financial institutions, it is unlikely that First Bank made a hasty transition to IFRS. But such preparation as there was was a strictly internal process. The bank failed to prepare the investment community for the shift. Only scant, even vague, reference is made to the beneficial payoffs for the institution and its stakeholders.
In today’s global market where investors seek opportunities in markets outside their home economies, the need for financial statements to be comparable on the same basis across territories is an imperative. The adoption of IFRS by First Bank will enhance shareholder value and bring added benefits to its business relationships with numerous overseas correspondent banks, multilateral organizations and international investors that require financial statements to make informed decisions about the bank.
Presently, at least, six companies on the Nigerian Stock Exchange (NSE) have adopted IFRS: Access Bank, First Bank, Guaranty Trust Bank, Oando, UBA and Zenith Bank. Recently, Oceanic Bank also announced that it has begun the transition to IFRS. Oando, the only non-bank in this class and the first Nigerian company to adopt the standard, has a dual listing on the Johannesburg Securities Exchange (JSE). The energy company has been reporting its results according to IFRS since 2004.
Commendable as the trend toward adoption ahead of the deadline is, it is vital for companies, as preparers of financial statements, to remember that investors, analysts and business partners as end-users or clients of these documents need to understand the implications of the shift.
Accounting methods are the cornerstone of contractual agreements between investors and corporations, creditors and borrowers. In a provocative paper that examines both sides of the argument for convergence in accounting standards, Ray Ball, a leading thinker in the field, explains that:
The fundamental economic function of accounting standards is to provide agreement about how important commercial transactions are to be implemented. For example, if lenders agree to lend to a company under the condition that its debt financing will not exceed 60% of tangible assets, it helps to have agreement on how to count the company’s tangible assets as well as its debts. Are non-cancelable leases debt? Unfunded health care commitments to employees? Expected future tax payments due to transactions that generate book income now? Similarly, if a company agrees to provide audited profit figures to its shareholders, it is helpful to be in agreement as to what constitutes a profit. Specifying the accounting methods to be followed constitutes an agreement as to how to implement important financial and legal concepts such as leverage (gearing) and earnings (profit). Accounting methods thus are an integral component of the contracting between firms and other parties, including lenders, shareholders, managers, suppliers and customers.
Generally, there are three publicized advantages of a single global accounting standard:
The costs of development and adoption are optimized since they only need to be developed once and then scale afterward
They eliminate the incentive for opinion shopping or jurisdictional arbitrage and
They vastly improve the comparability of statements across jurisdictions.
Ball goes ahead to list the direct and indirect benefits of IFRS for investors.
The direct benefits of IFRS include:
The improved comparability of statements will reduce the cost of processing information
Ceteris paribus this would increase the flow of capital and make the price determination process of shares more efficient
More accurate, comprehensive and timely financial statement information with the likelihood that this will lead to improved models for the estimation of future cash flows
Enhanced informational content of financial statements for all investors will lead to a more level playing field, one which does not discriminate between retail and institutional investors. Traditionally, the former group has been handicapped by their inability or limited access to other complementary sources of information, such as high quality analyst reports and management, in reaching investment decisions
The elimination or significant reduction of the discretionary adjustments that analysts have to make to firms’ financials to render them comparable across accounting standard jurisdictions. This practice penalizes some companies and jurisdictions and misprices risks in others. In particular, frontier markets are vulnerable to the extreme case of basing adjustments.
The removal of a major barrier to cross-accounting jurisdiction acquisitions with the potential to unlock reward opportunities for shareholders of acquired or merging firms.
The indirect benefits of IFRS include:
Transparency will increase the alignment of manager actions with shareholder expectations
Higher information quality reduces the perceived risks of share ownership and, as such, should reduce the cost of capital for firms
Timelier loss recognition will ‘force’ managers to abandon projects with negative net present value (NPV), or at least, induce them to reduce the number of such uneconomic projects.
The informativeness of fair value accounting will lead to the speedier incorporation of new facts based on economic reality, allowing investors to make more responsive judgments on current asset allocation decisions for their portfolios.
On this last point, on which there is a contentious debate, there are strong views that while the mark-to-market model may be a more useful value than historical values, it is also open to abuse because of the discretionary leeway it allows managers.
Fair value accounting rules aim to incorporate more-timely information about economic gains and losses on securities, derivatives and other transactions into the financial statements, and to incorporate more-timely information about contemporary economic losses (impairments) on long term tangible and intangible assets.
Specifically, IFRS provides a fair value option for the following:
Property, plant and equipment (IAS 16)
Asset impairments (and impairment reversals) to fair value (IAS 36)
Intangible asset impairments to fair value (IAS 38)
Intangibles to be revalued to market price, if available (IAS 38)
Fair value for financial instruments other than loans and receivables that are not held for trading, securities held to maturity; and qualifying hedges (IAS 39)
Fair value option for investment property (IAS 40)
Share-based payments (IFRS 2)
Minority interest (IFRS 3)
It would seem that while the best-practices appeal and item (1) in the direct benefits of transition to IFRS have been emphasized by Nigerian companies, the other direct benefits, indirect benefits and material implications of fair value accounting on their financial statements have either been ignored, overlooked or forgotten. We feel strongly that all the benefits as well as both the classification differences and material adjustments needed to calculate earnings under IFRS must be clearly communicated to the investment community.
In fact, one may ask, do Nigerian investors and analysts even understand IFRS or its significance? The reality is that very few do. This is not common to Nigeria. Even in Europe which had ample lead time between the legislation of the standard by Brussels and its adoption by companies as well as a sophisticated investor and analyst base, many companies still ensured that they organized teach-ins to appraise them on the implications of the transition.
In spite of this, there is some evidence to show that even knowledgeable analysts with long experience covering companies and making accurate earnings forecasts under the old accounting standards made non-insignificant errors when the transition to GAAP was made.
Furthermore, there is early evidence that as the investment community becomes familiar with the new accounting standard, the synchronicity of stock prices with economic reality increases.
To buttress this, research on UK companies which have adopted IFRS shows that there is a statistically significant abnormal negative return for firms reporting negative reconciliation adjustment. In other words, the transition to IFRS and the necessary reconciliation required has a non-trivial effect on market perceptions about the future cash generating ability of the firm.
This only underscores the need for companies to bring the investment community up to speed on what the transition means as failure to do so can and does have adverse material effects on the valuation of the company and in consequence, shareholder wealth.
In addition, the ’sudden’ transition to IFRS by Nigerian companies raises some questions about whether they have built the capacity to deal with the added complexities of the new reporting standard.
In this discussion, Peter Elwin, head of accounting at JP Morgan Cazenove, the investment bank, explains the vital importance of communications for corporate issuers making the transition to IFRS.
The ’sudden’ transition to IFRS by Nigerian companies raises a number questions about whether they had even built the adequate capacity to deal with the added complexities of the new reporting standard. Capacity issues need to be dealt with before communication concerns are addressed.
On its website, ANZ, the Australian-New Zealand bank, provides investors with a helpful time-line of its transition to IFRS. This helped to prepare the investment community ahead of the shift, and allowed them sufficient time to seek clarifications.
Thyssen Krupp AG, the German industrial group, is a glowing example of how companies should educate their investor and analyst constituencies about the implications of the transition. In February 2006, the company organized a virtual classroom to walk its investors and analysts through the effects of the transition.
In the following video, Dr. A. Stefan Kirsten, who was the company CFO at the time patiently explains the effects of IFRS adoption on Thyssen Krupp’s financial statements well as divergences between US GAAP, its former reporting standard, and the new one. The accompanying presentation and factbook are also provided below.
Other companies which have also held presentations on the adoption and transition to IFRS include:
We are unaware of any among those Nigerian public companies that have adopted or are planning to adopt IFRS which has organized a teach-in for the investment community on the financial statement effects of the transition.
So what should Nigerian companies cover in these sessions? In our view, the five most important areas to communicate to investors are:
The impact on key reporting areas: Companies need to shed more light on the differences between revenue recognition under Nigerian National Accounting Standards Board (NASB) Statements of Accounting Standards (SAS) and IFRS
The reporting methodologies, systems and data: Financial statements are information systems: garbage-in-garbage-out. Since IFRS is, to a large extent, principles- rather than rules-based, the accuracy of information used for the judgments made and the methodologies, policies and procedures need to be carefully reviewed and assured in the new environment. The greater scope for discretion necessitates the quality assurance.
The effects of IFRS reconciliation on a line- by- line, statement-by-statement basis
The implications of IFRS adoption for past projections based on historical accounting as well as performance measurement for those plans
Impact on contractual agreements, loan covenants and other legal documents tied to financial performance.
It is clear that Nigerian companies need to grasp that to inform is not enough. They have to ensure that the audience understands. They should borrow a leaf from the European companies cited above.
So before issuing the next press release on the adoption of IFRS, companies on the Nigerian Stock Exchange need to tell the market what the heck IFRS is all about and why it matters. If they fail to, the benefits they expect to flow, both to them and to investors, will simply drain away. In the end, it would not have been worth it at all.
NB: While those financial institutions which have made the transition to IFRS (Access Bank, First Bank, Guaranty Trust Bank, UBA and Zenith Bank) have not suffered any adverse consequences for not educating investors on the transition, this, in our view, due to two reasons: first, it is as a result of the unique economic circumstances where these banks are perceived to have minimal exposures to vexing margin loans and petroleum marketers. Therefore, on an investor’s prevailing scale of preferences, a decline in revenues from IFRS restatement is better than the excess risk of non-performing loans carried by their peers; second, the transition releases have been phrased as a governance and risk management issue, reinfocing perceptions of these banks as well run institutions, a misidentification as that is. As such these banks have not been penalized. Still, that is a negative benefit. The institutions and their shareholders are still missing the positive benefits of a proper understanding of the gains and implications of the transition to IFRS.
One cannot help noticing how Niyi Meka Olowola, Oando's Head of Corp Comms, is nodding in approval. Maybe Goldman Sachs can learn lessons.04:47:49 PM January 25, 2012from HootSuite
Twitter: CustomsStreet
