Letter number 30 of February 2008


News : Towards a worldwide accounting standard?

By Patrick Iweins; Partner of Advolis, the audit firm.

Since it was set up in 1973, the International Accounting Standards Committee (IASC), which went on to become the International Accounting Standards Board (IASB) in 2001, has, very clearly, undergone profound change. It has, however, succeeded in taking a firm hold, managing to avoid a number of pitfalls along the way. The initial course that was plotted was extremely long and problematic. The early good winds and initial enthusiasm began to taper off after a while, and the temptation to cling to a more familiar vessel on higher seas was great (1). The early 2000s, on which far-reaching structural modifications and the position taken by the European authorities had a major impact (2), boosted the idea of an international set of standards, the effective emergence of which has been confirmed by the recent position adopted by the Securities and Exchange Commission (SEC).

1. Setting up a convergence process…

This process was initiated in the Autumn of 2002, following a meeting of the Financial Accounting Standards Board (FASB) and the IASB, when these two bodies officially stated their joint willingness, in the Norwalk Agreement, to: 
• make the two standards fully compatible as soon as possible
• co-ordinate their working programmes with this aim of compatibility in mind.

On March 6, 2007, the SEC organised three round tables, bringing together the various stakeholders (issuers, institutional investors, financial institutions, analysts, etc.). Most of the participants supported an evolution of existing regulations in the USA, and the elimination of reconciliation notes that foreign private issuers were required to produce. A few weeks later, the SEC indicated that it would soon be presenting a proposal on the matter.

On June 21, 2007, the SEC rendered its decision official and proposed the amendment of certain provisions of the Exchange Act (relating to the drafting of document 20 F (3) and Regulation S-X (4)) (5).

On November 15th, after a period of public comments, the SEC approved rule amendments under which financial statements from foreign private issuers in the US, prepared using the English version of the IFRS as issued by the IASB, will be accepted without reconciliation to US Gaaps.
The rule amendment will apply to financial statements covering years ended after November 15, 2007.

2. …that is clearly intended to simplify matters for foreign issuers…

Regulations covering document 20 F were based on the provisions of the Securities Exchange Act of 1934, granting the SEC with its powers and setting out (section 13 and 15) the mandatory information required by any public issuer in the USA.
More specifically, foreign private issuers that filed financial statements prepared in accordance with a basis of accounting other than US Gaaps, were required to identify and quantify the material differences from the requirements of US regulations. From a practical point of view, this reconciliation could be presented pursuant :

• Either “Item 17”: narrative description of the main existing differences and a quantitative reconciliation of specific financial statement lines items from non US issuer’s Gaaps to US Gaaps (net income and shareholders’ equity);
• Or Item 18: reconciling information provided in compliance with provisions set by Item 17, as well as disclosures required under US standards and regulation S-X.

Additionally, an issuer should comply with Item 18 when filing financial statements for offerings of equity, convertible and other equities for any new issue of shares or other securities.  Moreover the foreign issuer was also required to complete its notes to the financial statements with all of the specific disclosures in force in the USA (in particular comprehensive income, detailed information on tax (6); segment information, etc.).

The elimination of these provisions, both in terms of annual information (20 F) and interim financial reporting (half-yearly accounts…), will substantially reduce the amount of financial information that foreign issuers listed in the USA were required to provide, and will also relax the time restrictions for completing operations. This should enable their finance departments to spend all of their time on their IFRS financial statements by avoiding a long and expensive process. The AXA representative who participated in the third round table on March 6, estimates expected savings resulting from this simplification of close to $25m.

3. … although still within very strict limitations…

The SEC’s amendments to the existing requirements do permit the filing of  financial statements prepared in accordance with the English version of the international standards as issued by the IASB.
This last requirement is based on the desire that has been expressed for the use of a high-quality internationally accepted accounting standard as opposed to diverse local versions. It appears in line with IAS 1, which explicitly provides in §14 “that financial statements cannot be presented as complying with IFRS unless they comply with all of the requirements of IFRS”. The IASB has in the past declined to require issuers to provide figures showing the impact, if any, of existing differences compared with a strict compliance with all of the IFRS.
The different analyses that have been carried out by the SEC, with all necessary professional diligence (7), on the basis of financial statements submitted to it, justify this position.
On April 12, 2007, at the annual IOSCO conference (8), Roel C. Campos, a member of the SEC and Vice Chairman of the IOSCO technical committee, expressed his surprise that only 40 foreign issuers out of a total of almost 300 had produced their 2005 financial statements in strict compliance with the IFRS, as issued by the IASB. He condidered that one of the reasons behind this small number was the distortions made in the different jurisdictions.

For example, issuers in the EU are required to comply with IASB standards as published in the Official Journal of the European Union.  Note 1 to their financial statements refers explicitly to IASB standards, “as endorsed by the EU”. 

For 2006 financial statements the only real difference concerned the application of IAS 39 and more specifically, certain provisions concerning the accounting of hedging instruments within the bank industry.

This situation could, however, evolve in the future, and may become more restrictive for EU issuers.

The process for adopting the standards in force within the EU (“endorsement”) does encompass several stages. All standards or interpretations issued by the IASB must receive the approval of the European Commission (following a technical assessment by the EFRAG and the approval of the ARC) and then be put to the vote in Parliament, after which they must be published in the Official Journal of the European Union. This endorsement process by the European authorities requires full compliance with a mandatory process that is likely to lead to a delay in application, and possibly even amendments to IASB standards.  It can thus not be ruled out that this situation will result in the creation of distortions of the IASB standard endorsed in the EU and those issued by the IASB and required by the US regulator.

Accordingly, it is obvious, that while we are currently seeing a hiatus in the amendment of the stable platform of 2005 (9), four standards and interpretations issued by the IASB have not been ratified by Parliament (IAS 3 amended – capitalisation of financial expenses; IFRIC 12 – interpretation relating to concessions; IFRIC 13 and 14) (10).

The case of IFRS 8 – operating segments, is a case in point. This is a standard that was issued by the IASB on November 30, 2006, applicable for financial years commencing as of January 1, 2009, and replacing the existing IAS 14 (early adoption is however encouraged). Very similar to the US FAS 131, it profoundly alters the concepts underlying IAS 14 by making provision for the following:

• segment financial information based on the issuer's internal reporting (IAS 14 provides a definition of segment upon which issuers are required to format their information) 
• detailed disclosures (issued from the internal reporting) not necessarily in compliance with IFRS, even if this information has globally to be reconciled to the  financial statements.

While the approval on IFRS 8 provisions was obtained from the EFRAG and the ARC , the proposal made by the Commission resulted, on April 18, 2007, in a decision of rejection by the Economic and Monetary Affairs Committee of the European Parliament. Attached to this decision was an injunction to the Commission to continue with its examination and to carry out a public consultation (which took the form of a questionnaire, responses to which were expected at the latest by June 29). In the end, the European Parliament approved on 14 November 2007 this new standard, but expressed reservation as to the lack of comparative information and requested the Commission to report back to the Parliament no later than 2011.
It should be mentionned that, in a press release on June 24, 2007, the Chairman of the Economic and Monetary Affairs Committee (11) issued a warning that the convergence movement and the recent decision of the SEC are working against the prerogatives of the European Parliament.

Without doubt, the IFRS 8 case has become a precedent which could be reproduced subsequently for all major rules to be published by 2009 and may create uncertainty for EU issuers.
4. …towards the spread of IFRS to the USA?

The possibility that all foreign issuers that comply with IFRS will no longer have to reconcile their financial statements with US Gaap is no less than a small revolution.

Furthermore, the SEC issued a Concept Release on allowing US issuers to prepare financial statements in accordance with IFRS.  At the March round table referred to above, the Chairman of the SEC himself raised this issue (12). This idea will be worked through although it is not at all certain that it will lead to the widespread adoption of IFRS in the USA. Several obstacles have to be circumvented.

The first obstacle is a legal one, stemming from the founding rules of the SEC. These texts explicitly state that the Commission has the authority in terms of accounting standards for issuers operating on US markets (13). Accordingly, in its consultation at the end of July, the Commission reiterated the fact that supervision by the FASB is one of its prerogatives conferred by law (§ 1-D) and reaffirmed in the Sarbanes-Oxley Act (section 108 (c)). Such supervision cannot, obviously, be reproduced for IASB, the independence of which, the guarantee of its success, is so far organised through its Foundation.
The second is cultural. US Gaap has formed an integral part of the US accounting landscape for more than a century. Its supremacy can not be called into question.  Moreover, the introduction of any new accounting system would require a major effort on the part of all of the stakeholders involved (issuers, directors, analysts, auditors). The generalisation of IFRS in Europe, even though massive efforts have been made in terms of communication, still needs to be fully assimilated in areas other than financial services involving issuers, their expert advisors and auditors.

The last obstacle should be seen in perspective, given the tough legal aspects of economic life on the other side of the Atlantic. Even though the “P” in US Gaap stands for principles, changes in this area are one of the underlying reasons why the US authorities have developed a set of detailed rules, which can be applied today, with the advent of IFRS which are founded on the respect of principles, and are thus less detailed. The debate on whether to choose a Principles based or Rules based system is not yet closed, even though this issue was apparently not raised at the Roundtable in March.  Different studies (14) warn against moving towards a system offering greater flexibility in the interpretation of rules, which would be likely to steer us away from the goal sought, which is the comparability of financial statements.

Moving beyond this debate, we should not underestimate the obstacle posed by the fear of abandoning a body of historical standards which are familiar, even if they have become increasingly complex over recent years, in order to shift to a new standard (IFRS) which is unknown and which appears to be a lot less specific. Only a few large groups, which have a very wide international base may be tempted to do so, in order to benefit from the international status of IFRS.


The convergence process underway does not aim to achieve a perfect symmetry of the two standards, but rather to make them compatible. Observations made by SEC staff following the completion of the review of IFRS financial statements (15) and going beyond the requirement for strict compliance with IFRS, highlight the lack of information on the part of the FPI. Nonetheless, the decision of the SEC is a still major event which will legitimise the IFRS.
This decision has clearly been taken in a more general context of our US partners becoming aware of the excesses of US regulations and the need to relax their regulations if US financial markets are to remain attractive. For the first time, in the first quarter of 2007, the equity capitalisation of all of the European stock markets reached a higher level that that of US stock markets, with a growing number of European companies planning to delist from US markets.  The PCAOB (16) has just published a new standard, AS 5 (17) on internal control that comes with guidance for compliance issued by the SEC (18) aimed at introducing greater simplicity.

The way towards a single high-quality international accounting standard is still a long road ahead, but the IASB is clearly present. Achieving a new step does require to foster the sustainability of the IASB and secure it as an independent setter providing investors and users with neutral, decision useful information. The balance that has thus far been achieved has not to be sacrificed on the altar of convergence. That is the new challenge that is underway! Measures have to be quickly taken.
(1) The US standard on financial instruments was in fact introduced into IAS, in the early 2000s, without any real debate.
(2) Declaration of the European Commission on June 13, 2000, followed by the European Regulation of December 13, 2001.
(3) Equivalent to the annual financial report in the meaning of the European Transparency Directive.
(4) Regulation S-X sets the framework for accounting rules, and for the form and content of financial statements to be published in application of the provisions of the US regulations (Securities Act 1933, Securities Exchange Act 1934,…).
(5) Securities and Exchange Commission  17 CFR Parts 210, 230, 239and 249 “Acceptance from foreign private issuers of financial statements prepared in accordance with international financial reporting standards without reconciliation to US GAAP”.
(6) This information has been further developed since the implementation of the provisions of FIN 48 Accounting for Uncertainty Tax Positions.
(7) The SEC’s staff has received feedback from different issuers (in the form of responses to specific questions on the treatment chosen and the justification for their compliance with IFRS). These exchanges can be consulted on the la SEC’s website ( www.sec.gov/divisions/corpfin/ifrs_reviews.htm).
(8) International Organization Securities Commissions (Organisation of national stock market regulators).
(9) Decision, made official by the IASB on June 25, 2006 not to plan any major amendments of the stable platform before the 2009 financial year
(10) EFRAG Endorsement report of July 9, 2007.
(11) Press Release of June 24, 2007 by Pervenche Beres and Alexandre Radwan.
(12) He noted that it would be logical to offer this possibility to US issuers while foreign issuers listed on the same markets complied with IFRS
(13) Especially the Securities Act of 1933 section 19 [77s].
(14) Georgia Tech Financial Analysis Lab:Financial Statement Comparability in a Principles-Based reporting environment: a look at the statement of cash flows (May 2007).
(15) Press release dated July 2, 2007.
(16) Public Company Auditing Oversight Board.
(17) PCAOB auditing Standard N°5 “an audit of internal control over financial reporting that is integrated with an audit of financial statements”.
(18) SEC 23 May 2007 “New guidance for compliance with Section 404 of Sarbanes-Oxley.

Statistics : ROCE versus WACC in Europe

The top 50 European listed companies are in a very good shape. Only 2 of them earnt significantly less than their cost of capital in 2007 (UBS and Deutsche Telekom); the median group earnt 6% more than its cost of capital; the star was Nokia with a ROCE (after tax) 80% above its cost of capital!

Some groups were penalized by recent acquisition which diluted their ROCE at least in the short term: Rio Tinto (Alcan), Iberdrola (Scottich Power), Enel (Endesa) to mention only a few.

Source : Exane BNP Paribas and other brokers.

For banks and insurance groups ROE and cost of equity is respectively subsituted to ROCE and cost of capital (WACC).

Research : Why do firms issue equity?

This may seem to be a rather basic question, but no-one has yet been able to come up with a fully satisfactory answer.

According to the most traditional theory, there are both advantages and drawbacks to taking out debt. The drawbacks include the costs linked to the risk of bankruptcy and possible conflicts between shareholders and creditors. One obvious advantage of incurring debt is that interest on debt is deductible from taxable profits. Technically a firm’s decision to choose debt or an equity issue should be based on whichever results in the optimal debt level. If this statement were true, firms would opt to contract debt when share prices rise, in order to maintain an optimal debt to equity ratio. However, as can be seen from all empirical studies on the subject, the exact opposite is true.

Since the 1984 publication of an article by Myers and Majluf (1), an alternative theory, the pecking order theory, has developed (2). This theory focuses on the information asymmetries that exist between management and investors. It holds that debt is always preferable to an equity issue, which should remain the exception rather than the rule, and limited to periods of tension on the markets. This theory has also been contradicted by recent empirical studies (3).

There is now a third theory that is proving to be very popular, the timing hypothesis. Firms will decide to issue equity when shares are over valued, in order to procure financing at a lower cost (4). This theory is based on the assumption that investors are irrational and won’t notice that the shares are over valued.

Two US researchers, Ditmar and Thakor have come up with another theory (5), that is based on this assumption of investor irrationality. The underlying assumption of the article is that management will act in the interests of shareholders.  Issuing debt is expensive as creditors may believe that their interests are in conflict with management's investment plans, and may insist on restrictions, such as covenants (6), pledges, etc.

Dittmar and Thakor believe that firms issue equity when share prices are high and that investor expectations of projects to be financed are in lines with management’s expectations. Their empirical study covered close to 8,000 equity issues when the firm’s earnings per share were higher than forecast (which encourages investors to accept management’s new projects). Accordingly, firms that are highly valued and at which management and investor expectations are aligned, are four times more likely to issue equity than debt, while firms in the opposite position are twice as likely to take out debt.

4.The features of the loan itself statistically provide less explanation for the existence of collateral than the factors mentioned above. Efforts made by the bank to select loan candidates (which Voodeckers and Steijvers measure by their response time) do not reduce the probability of collateral being required. This contradicts the notion that banks use collateral as a substitute for credit analysis.
The results arrived at should be taken with caution, given the specificity of the sample (a single bank, on a very specific market and over a relatively short period). The study does, however, have the merit of validating certain theoretical observations and invalidating others, on an issue for which empirical analyses are still infrequent.
Another argument put forward by Dittmar and Thakor in support of their theory is that firms’ investment expenses increase much more frequently after a capital increase than after they take on new debt.  This ties in with the idea of issuing equity to finance projects, which could not be predicted under the timing hypothesis.

In conclusion, Dittmar and Thakor have come up with a new explanation for the motivations behind equity issues. The theoretical model put forward, given its many very strong assumptions (absolutely no conflict of interest between management and shareholders, investors are fully informed and rational), may not necessarily convince everyone, but the empirical study opens up new paths and demonstrates that this topic could still be the subject of a number of studies that, hopefully, will lead to new discoveries. 
(1) S. Myers and N. Majluf (1984), Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have, Journal of Financial Economics, n°13.
(2) For more information see chapter 34 of the Vernimmen.
(3) See article by Fama and French (2005), Financing Decisions: Who Issues Stock?, Journal of Financial Economics n°76.
(4) For more information see chapter 36 of the Vernimmen.
(5) A. Dittmar and A. Thakor (2007), Why Do Firms Issue Equity?, Journal of Finance, n°62.
(6) For more on covenants, see chapter 27 of the Vernimmen. 

Q&A : Solvency opinion

A solvency opinion, sometimes called capital adequacy opinion in the USA, has a much wider scope than merely measuring the solvency of a firm.  A solvent company is one that will be able to meet its commitments if it is liquidated, ie, if it ceases operating and its assets are sold off.  Accordingly, a firm can be considered to be insolvent when its equity capital is negative – it effectively owes more than its owns.

A solvency opinion provides a dynamic overview of the company and doesn’t just tot up and compare its debts and assets.

An issue of a solvency opinion is generally requested by a board of directors seeking an independent professional opinion on the financial viability of a firm, before approving a major operation that will result in its decapitalisation, for example following the payment of a large extraordinary dividend, implementation of a massive capital reduction by way of a share buy-back offer (1), merger with a company that is in a precarious financial situation.

In most cases, a viability opinion is issued when plans for a debt push down(2) are being made, such as the debt push down operation in which Pages Jaunes paid its shareholders an extraordinary dividend totalling €2.5bn, dramatically reducing its equity capital to –€2bn.

For this transaction, the Commercial Court of Paris appointed two experts “to assess (i) whether the financial structure of the company could withstand (…) an exceptional payout of financial reserves through debt (…) (ii) the consequences of the contemplated payout in terms of the company’s equity capital (…); to issue an opinion on whether the debt structure after payment of the extraordinary dividend will be adequately covered by the company’s growth prospects (…) and reflected in its business plan”.

In the USA, where there are often a lot more formalities involved, three tests are carried out:

• The Balance Sheet Test: does the value of the firm’s capital employed exceed that of its debts?
• The Cash Flow Test: is the firm able to honour its debts on their contractual due dates?
• The Reasonable Capital Test: is the firm’s equity capital sufficient in view of its activity?

The first test would appear to be a simple formality, as it’s hard to imagine that there are lenders who are prepared to lend a firm more the value of its capital employed. Such lenders would be described either as totally incompetent or completely crazy.  Unfortunately, the recent subprime episode is a sobering reminder that there are (or were) lenders about who fit this rather unflattering bill! 

There is a greater sense of logic underlying the second and third tests.  They are carried out using the business plan as a basis.  The solidity of the business plan is tested by sensitivity studies and the firm’s credit lines, and also any assets that could be sold, without too much disruption of business, are analysed.

(1) For further detailes see chapter 38 of the Vernimmen
(2) See Vernimmen.com Newsletter of December 2007.