BUSINESS WEEK: Bringing Europe Inc. Into Sharper Focus: Red ink is turning black overnight -- and vice-versa -- as companies adopt one standard for financial reporting: “… Royal Dutch/Shell Group acknowledges that if IFRS rules had applied in 2004, it would have been forced to disclose the full extent of its pension deficit, which would have wiped nearly $5 billion off its balance sheet.” (ShellNews.net) Posted 21 April 05

By Kerry Capell in London with Jack Ewing in Frankfurt

Updated: 12:00 a.m. ET April 19, 2005

On Jan. 20, Vodafone Group PLC (VOD) achieved the impossible. It turned a $10 billion loss for 2004 into a $17 billion net profit overnight. Managerial magic? Monumental book-cooking? Not quite. The Newbury [England] mobile-phone operator turned red ink into black simply by applying International Financial Reporting Standards [IFRS] to its balance sheet. Those are the new accounting rules that will soon be mandatory for all companies listed in Europe. Around 120 have already made the switch, and Vodafone is one of the pioneers. Under IFRS, the cellular giant will no longer have to automatically amortize over time the hundreds of billions in goodwill it racked up after a five-year string of acquisitions. Instead, it will only write off goodwill if the value of the assets falls.

It's a similar story for Bertelsmann. The German media giant wrote off $813 million in 2003 for such items as its depreciation of TV rights. The write-off in 2004: zero. The change helped boost the company's net profit nearly fivefold, to $1.6 billion.

Mind you, IFRS doesn't mean Europe Inc. is getting a free ride. The new standard that requires companies to expense stock options, for instance, helped chop $743 million off British pharmaceutical giant GlaxoSmithKline PLC's (GSK) 2004 earnings. Similarly, Royal Dutch/Shell Group (RD) acknowledges that if IFRS rules had applied in 2004, it would have been forced to disclose the full extent of its pension deficit, which would have wiped nearly $5 billion off its balance sheet.

BREAKING DOWN BARRIERS

There will be more eye-popping adjustments, and some share price volatility, as IFRS replaces wildly differing accounting practices. In coming months, 7,000 listed European companies will switch their books to IFRS. [Those traded on London's Alternative Investment Market and those listed in the U.S. will have until 2007 to make the transfer.] Tax experts reckon that it will take up to two years before analysts and investors fully come to grips with what the changes mean. Yet most believe the long-term benefits of IFRS outweigh any short-term hassle. "Analysts and investors will have a much better understanding of a company's financials," says Ken Wild, head of IFRS for accounting firm Deloitte & Touche in London. "It will be like going from black and white to color."

That's because IFRS will force companies to disclose more information than ever before. The biggest change will be the switch from historical cost accounting, where all items on the financial statement are based on their original cost, to fair value accounting, which recognizes gains and losses in value on an ongoing basis. For investors, that means a real-time snapshot of a company's worth. The new rules also will unveil items that many European companies either buried as footnotes in their reports or simply didn't reveal at all, such as derivatives and pension liabilities.

The aim of the new standards is to simplify accounting and make it easier for investors to compare companies across borders. Developed by the London-based International Accounting Standards Board [IASB] in conjunction with its counterpart in the U.S., the Financial Accounting Standards Board, IFRS is seen as a giant first step toward global harmonization of accounting standards. A total of 90 countries around the world will either permit or require the use of the new standards. IASB Chairman Sir David Tweedie believes that companies will save money and time by having to keep fewer sets of books if they do business across borders. They will also be able to get their financial information across to international investors in more easily digestible form. This, Tweedie says, will "break down barriers to investment and trade, and stimulate growth."

Still, for Europe's bean counters IFRS means more work and less flexibility. For David Nish, the chief financial officer of Scottish Power PLC (SPI), determining the real value of the electric utility's derivative exposure was a slog. "We have thousands of contracts, all of which were set up at a different time and in a different way, so it meant going through each one with a fine-toothed comb," Nish says. Opportunities to smooth earnings will also grow scarce as companies can no longer choose when they may book a gain or a loss from the sale of an asset. Under IFRS, Dutch chemicals company Akzo Nobel saw its 2004 net income rise by $115 million, but CFO Rob Frohn reckons that under the new accounting rules he has less room to maneuver: "Say you need to take some charges on the [profit and loss statement] as a result of restructuring. IFRS defines exactly when you must take them, while Dutch accounting rules gave you a lot more freedom."

So far, the markets appear to be taking the switch in stride. Of the European companies that have so far restated their 2004 earnings under IFRS, none has seen a dramatic shift in its share price. "No doubt, some investors will see these new numbers and wonder: 'What the hell is this?"' says Bobby Rakhit, vice-president of FactSet JCF Estimates, a London financial data provider. "But once people look behind the headlines and evaluate companies based on cash flow, they'll see the valuation isn't likely to change."

European CFOs agree. "Company valuations are based on cash flow, and that remains the same," says Graham Chipchase, CFO of British consumer-packaging company Rexam, whose pretax profit for 2004 was 2% lower under IFRS. It's nice to know some values are forever.

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