article for Deloitte
April 16, 2010
Beware of apples to oranges comparisons with the transition to IFRS accounting rules
By January 1, 2011, all public companies and those with public reporting requirements must adopt international financial reporting standards (IFRS). In addition to representing a considerable change from generally accepted accounting principles (GAAP), IFRS could potentially wreak accounting havoc for private equity firms that fail to deal with the challenges it presents.
Since IFRS is fair value focused, it creates volatility in income statements, as well as spillover consequences on the key metrics used for M&A transactions and business combination accounting. With comparisons, trends, income analysis and exit strategies all affected, private equity firms need to understand the difficulties of analyzing businesses in this new environment and prepare a plan to address these issues.
Comparing apples to oranges
One of the first issues private equity investors—and other market analysts—must consider is the financial statement inconsistency introduced by the transition to IFRS. Because IFRS is optional for private companies, and is barely an inkling in the eye of regulators south of the border, you are likely to find yourself comparing one private company that uses GAAP to another using IFRS. Year-over-year comparisons of even one company that has used different accounting principles over a period of time become
It can get even more complicated. Compare a private company to its public peers, or Canadian companies and US companies (the U.S. is still several years away from even considering IFRS), and you could be staring at a veritable soufflé of different accounting principles.
If you think things will be a easier by using IFRS for all companies, think again. IFRS allows for more judgment versus Canadian or U.S. GAAP. So two companies could both be using the same accounting rules yet still recognize revenue differently, or they could have different interpretations of fair value. Similar challenges arise with trend analysis. It is difficult to accurately analyze a historical trend when a company uses different accounting standards over a period of time.
The sticky issue of income volatility
Private equity firms need to understand how the different accounting principles affect the analysis of their transactions. Changing accounting principles will likely lead to income volatility which becomes a sticky issue when you look at the Big Kahuna of M&A valuation metrics: EBITDA. For example, with IFRS you can no longer capitalize transaction costs. When you now have to expense transaction costs related to an acquisition it reduces EBITDA, which can affect a company's valuation. Income volatility creates perception problems on all sides of an M&A transaction which could potentially sabotage a deal.
GAAP vs. IFRS – which is right for a private equity company today?
Given the consequences of different accounting rules, the question arises−what makes sense for a private equity firm evaluating potential investments? A general rule of thumb is: If you're planning to take a company public or sell to a Canadian or European public company, it's appropriate to use IFRS.
While accounting policy should not determine how you run your business, it should be taken into consideration right now as the deadline for IFRS approaches. Having a savvy team of financial professionals in place to guard against misleading comparisons and faulty benchmarking will be key to successfully navigating the twists and turns that lie ahead for business combination accounting.
The likely impact of IFRS on income and earnings will affect a number of areas important to private equity firms, including:
· Revenue recognition
· Business combination
· Working capital and net debt