The new transparency

From Times Online, UK

September 05, 2004

The new transparency

Greater accountability means hard work in the boardroom, says Peter Wyman

Life has probably never been harder for board directors. Recent US business scandals have prompted a wave of new legislation and regulation on both sides of the Atlantic. The plethora of governance codes and corporate social responsibility surveys challenge boards to explain their actions. And the 2005 introduction of international financial reporting standards (IFRS) will fundamentally alter the way that a company's numbers will be reported. What are the real risks and what can board members still do to mitigate them?

Perhaps the most basic risk is that IFRS will affect the instinctive look and feel that a board has for its company's numbers. How can directors tell whether profit figures are even in the right ballpark when they are generated using new principles? How can they be confident in the reported balance sheet, when the means by which it is calculated has changed so significantly? I suspect for most directors the answers will not lie alone in the weighty tomes of accounting standards and guidance notes issued by the International Accounting Standards Board (indeed, at more than 3,000 pages they make War and Peace look like a slim holiday paperback).

Senior directors in some of the UK's leading companies are telling us they are struggling to find the same level of instinctive understanding that they have always had using UK accounting standards. This is particularly difficult when group accounts are being produced using IFRS, while management accounts remain on the UK accounting basis. Managers are finding it hard to come to grips with how the old and new figures reconcile, and what they say about the business and its operating performance.

The instinctive understanding of the IFRS-based accounts will take time to develop. Even the standard-setters themselves have recognised it may take a few years for IFRS- based reporting to settle down. In the meantime, companies are at far greater risk of having to restate their accounts. It isn't just the action of switching to new standards that increases the restatement risk. While UK generally accepted accounting principles (UK GAAP) only require accounts to be restated when fundamentally wrong, under IFRS restatements are required whenever there is a "material error" — a much tougher test. Moreover, the first set of financial statements prepared under IFRS has to contain a reconciliation back to the last set prepared under UK GAAP, and may itself have to identify "errors made under previous GAAP", thus highlighting an issue which may not otherwise have been publicly reported.

As a result, we will almost certainly see many more companies having to own up to mistakes in their published figures. This is neither something UK analysts and shareholders are used to, nor something they like to see.

Think of the negative publicity — and impact on share price — that any company suffers when corrections have to be made. These are matters the whole board needs to understand, since the whole board may find itself subject to criticism if the markets do not understand and accept the restatement.

This is unlikely to change, particularly given the emphasis now placed by investors and other stakeholders on corporate accountability. The shadow of Enron, WorldCom and other corporate failures around the world still falls, heightening investor sensitivity to any weakness in controls or corporate reporting. The prevailing assumption is that any problem, however small, associated with the financial statements is symptomatic of a much worse problem in the business as a whole. The increasingly litigious world in which we live is also raising the stakes. In America, for example, it is already the case that if a company issues a restatement of its accounts, whatever the reason, a class action is unlikely to be far behind.At the least, directors having to restate their accounts will find themselves vulnerable. It won't just be the reputation of the business that suffers, but confidence in management will also be shaken. Where mistakes are particularly serious and the financial impact significant, senior executives will be held accountable and could find their services no longer required.

The importance of good governance around IFRS adoption must therefore be a high priority for all listed company directors. The board needs to be assured that appropriate action will ensure any risk of financial misstatement is minimised. You cannot simply delegate the task to the finance function. Board members share collective responsibility for signing off on IFRS financial statements and, in firms that also have US registration or listings, on the processes, systems and controls that underpin them.

Similarly, while delegating some work to audit committees may be a pragmatic response, it is not a sufficient one. The impact of IFRS touches many areas of the business that are beyond the audit committee's responsibility. And while committees are likely to consider process issues related to IFRS adoption, few consider all the risk aspects. This risk focus lies with the board and cannot be delegated.

IFRS conversion impacts on many areas of the company and its operations — a message that partners responsible for IFRS at PricewaterhouseCoopers have been emphasising to clients for some time now. Board members must ensure that steps are being taken to address all the resulting risks. For example, competitors could gain commercial information as a result of the new, often greater disclosures required by IFRS. Are boards confident they know what the new segmental analysis will give, and that they have a commercial strategy to counter any damage? Remuneration and pension schemes could need redesigning because of the IFRS accounting treatment for stock-based compensation and pension schemes. Have directors considered the risk that they may not have sufficient resources to complete IFRS adoption successfully? Incentive schemes may be required to ensure firms can recruit and retain enough staff with appropriate expertise.

The board must also decide whether the whole group can and should adopt IFRS. It isn't just practical factors that need to be considered, such as the number of subsidiaries and accounts involved; switching to IFRS could have an impact on distributable profits (potentially causing a dividend block) and tax planning. There is also the "all-or-nothing" IFRS compliance
requirement of the Inland Revenue when filing tax accounts, although groups with overseas subsidiaries have the added complication that, for local tax purposes, they may still require accounts in local GAAP.

As already mentioned, investors will judge companies on their ability to handle IFRS conversion. Managing investor relations is therefore an important issue for the board. Directors must decide what to communicate to the market and when. Analysts are already asking companies for information on how IFRS will affect areas such as off-balance-sheet vehicles. Being slower than competitors to respond could create speculation that the business is not on top of the IFRS conversion process; however, rushing out figures and then having to restate them could have an even worse impact on the firm's and the board's reputation.

There are already suggestions that some investors are preparing to take advantage of the opportunities that IFRS adoption will create. Speculators may seek out the companies that show themselves to be poorest at IFRS conversion, exploiting the share price volatility that results from accounts having to be restated.

Boards need to resist the temptation to see IFRS conversion as just another technical matter, and consider all the risks involved and reassure themselves that adequate controls are in place. Inevitably some companies will not have laid the ground for the transition. It is the board directors who will be held publicly responsible for failings, and their reputations that will be irreparably damaged. The message is clear. There is still time to prepare. Use it wisely or be prepared to face the consequences.

Peter Wyman is head of professional affairs at PricewaterhouseCoopers