Accounting standards. So far, so good

But the real test for Europe's new accounting regime lies ahead

MANY things set the various countries of the European Union apart - language, culture and laws, to name a few. But since the start of this year the list has been one item shorter. From January 1st, Europe's 7,000 listed companies adopted international financial reporting standards (IFRS), replacing the mishmash of 25 local accounting regimes with one set of rules.

So far there have been no big blow-ups. The stockmarket, despite its skittishness when companies miss earnings targets by mere pennies, has taken revisions calmly. One reason is that many of the changes, long in the works, were expected. Many also believe that the revisions are mainly cosmetic, reflecting little about companies that was not already known.

Still, there have been some surprises. Lloyds TSB, a British bank, caused a ripple or two when it said late last month that the change to IFRS would cut this year's pre-tax profit by 8%, more than expected. A report in April by UBS, a Swiss bank, put the average absolute change in profits (before goodwill) of companies that had then announced results under IFRS at 12%. That hides a wide range. Deutsche Telekom's profit in 2004 was two-thirds lower under the new rules than under the old one, while Alcatel's and Telecom Italia's were more than twice as high.

Bigger revisions may lie ahead. The early reporters under the new rules have tended to be big, healthy companies. Smaller firms, with fewer resources to prepare for the change, may spring more surprises. More important, the real test is not the “one-time, two-dimensional restating of last year's information under IFRS” seen thus far, but the new system's “ongoing effect”, according to David Lindsell of Ernst & Young, an auditing firm. Under IFRS, the focus of accounts shifts from historic costs to “fair-value accounting”: the fluctuations in the value of everything from pension promises to property portfolios will be reflected regularly in profit statements. This seems sure to make profits much more volatile than in the past.

Most inconvenienced by this will be banks, insurers and other heavy users of financial instruments (derivatives, insurance contracts and the like) whose values change frequently, often by a lot. Worse, companies have had little time to apply the complex valuation rules, because these were not finalised until late last year, owing to a protracted tussle between standard-setters and European financial-industry regulators, the affected companies and politicians. Because controversy lingers, the rules may well change again.

Profits are not the only item affected. A study by Dresdner Kleinwort Wasserstein, an investment bank, found that under IFRS net debt is on average 16% higher than under local rules, with some companies hit much harder. Fiat, Italy's beleaguered carmaker, saw its debt double to about €16 billion ($19 billion). So far, no company has been downgraded for revising its debts. But Sue Harding of Standard & Poor's, a rating agency, notes that “it is still early days” and new disclosures could come to light that could impair a company's creditworthiness.

As with any rule, companies are likely to adapt their behaviour to get the best accounting treatment. This might be no bad thing: for example, IFRS rules requiring clearer disclosure of the state of company pension plans could lead to more scrutiny of how such plans are managed. Other possible changes in behaviour - such as reductions in foreign-exchange hedging - are more debatable.

One of the biggest complaints is that the new standards have led to insufficient consistency and comparability - contrary, you might think, to the whole point of IFRS. Now values must be found for things that often have no market price (such as employee stock options or most loans), so that estimates matter far more than before. Moreover, companies have great flexibility in deciding how to apply IFRS. In aerospace, the leeway given to companies in accounting for financial instruments “seriously limit[s] the comparability” of BAE Systems and Rolls Royce, according to a UBS note this week. Dennis Jullens of the bank thinks that in some cases it would have been better to limit firms' choices.

To a degree, says Guy Weyns of Morgan Stanley, this flexibility is inevitable because IFRS aims to be “principles-based” rather than highly detailed and prescriptive, like American accounting rules. He adds that companies are much easier to compare than under the old hotch-potch. For all its flaws, the new rules - which 90 countries have adopted or will adopt - are a big step towards global accounting standards. American and international standard-setters have made steady progress over many years to close the gap between America's rules and the rest.

Article says that the big test for Europe's new accounting regime lies ahead.

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