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International Financial Reporting Standards: why are they important?

Students must be able to grasp the implications of the move to IFRS if they are to progress. In the first in a new series, Clare Finch explains the basics

One of the best illustrations of the importance of a harmonised set of accounting standards are the Vodafone accounts for the year end 31 March 2004. These were the last accounts prepared to UK GAAP and showed a pre-tax loss of £5.3 billion. When the UK moved listed companies to IFRS in 2005, these accounts had to be restated. The restated accounts now showed a pre-tax profit of £9 billion!

So can a different book of accounting standards change red ink to black? Absolutely - but this situation is embarrassing for the accounting profession. Investors across the world need to be able understand companies' accounts on a clear and equivalent basis. With the Vodafone example we are not just marginally different - we can't even agree whether the company comes in above or below the line. Embarrassing, and why the UK is committed to harmonisation of UK GAAP with IFRS.

So it is now generally agreed that the accounting profession needs a single book on accounting standards on the shelf. Nearly 100 countries currently require or permit the use of, or have a policy of convergence with, IFRSs. Recent FRSs (FRS 20-29) produced by the UK Accounting Standards Board (ASB) are completely in line with the international equivalent.

So what caused the loss to turn into a profit?

The single biggest change for a UK company adopting IFRS is that it allows companies to drop the practice of amortising, or writing down, goodwill per FRS 10. For Vodafone this had huge significance because it carried £94.5 billion of goodwill - otherwise known as intangible assets - on its balance sheet. This was a legacy of its acquisition spree during the 1990s boom that included a £100 million bid for German operator Mannesmann.

'FRS 10 Goodwill and Intangible Assets' contains a presumption that goodwill has a useful economic life (UEL) of 20 years or less and should, therefore, be amortised over this life. Although this UEL presumption is rebuttable (ie you can argue about it if you like). Vodafone amortised it at a rate equivalent to £15.2 billion a year, plunging it into a pre-tax loss. But adding back the amortisation of goodwill, minus one or two small charges, has instead produced the pre-tax profit of £9 billion.

The international equivalent IFRS3 'Business Combinations' does not go down the amortisation route, but instead requires an annual impairment test. If the acquired goodwill is not impaired there will be a nil expense in the consolidated income statement and nothing gets written off the intangible asset account.

Will the impact be so startling for all UK companies? No, it will be variable. Not all companies have grown by acquisition and even those that have may have always rebutted the UEL presumption under FRS 10. The classic example of this is Rentokil, which did not amortise but instead adopted the impairment test. (I suppose rats are truly not subject to taste and trends and it is very unlikely that this year you may not want rats in your kitchen.! Next year when it becomes the height of fashion? Rats are rats after all!). By rebutting the UEL presumption the impact on the Rentokil accounts was not so drastic. For 2004, the financial impact of transition to IFRS was to reduce the profit before tax from £297.8 million to £273.9 million.

So can the profits go either way on transition? Absolutely - one of the main impacts was a difference between FRS 10 and IFRS3, although working the other way to the Vodafone impact. IFRS 3 requires the recognition of intangible assets on business combinations if certain criteria are met. For business combinations made by Rentokil, the value attributable to customer lists or portfolios acquired now needed to be treated as an intangible asset and was valued separately from goodwill. The value attributable to the customer lists or portfolios acquired (intangible asset) is then amortised over the expected life of that asset. It was just the goodwill itself that was subject to the annual impairment test.

Is there global harmonisation?

Unfortunately not, although for listed companies, 2005 was a major step forward. The next issue to watch for on exam papers is the steps to harmonise IFRS with US GAAP. It is not that the US disagrees with the principle of harmonisation, but more that they have always believed US GAAP to be the 'most robust set of accounting standards in the world'. So it was more a case of harmonisation - great idea - but why should we give up our system? Before 2002 many commentators felt that was the position, but following the corporate collapses of that year - Enron, Worldcom, plus 10 others (all preparing accounts to US GAAP) - the US accounting standards board (FASB) is now in talks with the International Accounting Standards Board (IASB). The topic of harmonisation is going to be important for students for some time to come.

Clare Finch is a top tutor at Kaplan Financial