Financial Reporting - Getting to grips with IAS - Preparing for the audit committee

David Tilston continues his cautionary story of fictional Distributors plc as it prepares for an audit committee meeting to sign off the full-year accounts.

James was in a foul mood.

Bob, chairman of the company's audit committee, had called a few hours earlier and had inconveniently invited himself around for a preparatory discussion. The audit committee was scheduled to meet in two weeks' time.

Bob had been a FTSE 250 FD, but had retired a few years ago and now held a portfolio of non-executive director roles. He had not been that interested in IAS when James had raised it at the board a few months previously and had not been helpful. Now there were accounts to approve he was taking a much more active interest in the issue whilst not being particularly constructive. Bob had now arrived and they were settling down to business.

James took Bob through the main numbers. The audit was well advanced and the auditors had already indicated they did not expect to require any significant changes.

Distributor plc's financial turnaround had been completed in the last six months and the second half had been reasonably profitable and slightly ahead of market expectations. The sales pipeline for the current year was strong and improving. Gearing was still too high and dividend cover too low, but these would improve over time given the strengthening trading outlook. Bob concluded with a few pessimistic remarks on sales expectations and then they moved on to talk about IAS matters.

Distributable reserves

'I think we should get approval for a scheme of arrangement at the AGM to help protect our distributable reserves,' said James. 'Much of our trading is currently conducted through the holding company, and distributable reserves could be affected by accounting for pensions costs, deferred tax provisions, foreign exchange contracts and share options. I think we can create a new holding company, dividend up distributable reserves and hold the necessary reserves there in case the new accounting standards potentially deplete our existing reserves in the current holding company. We could ensure we have several years' worth of dividends represented by distributable reserves in a new holding company. We could then manage our accounting exposures so any adverse impacts only affected the trading subsidiary's distributable reserves.'

'What advice have we got from the auditors and lawyers?' Bob asked. 'Nothing of any great use, as the Department of Trade and Industry has not yet released the relevant regulations,' replied James. 'However, I know some of the larger quoted companies have gone down this route to provide themselves with greater financial flexibility, and they have not attracted adverse comment,' James added. Bob was unconvinced, but finally agreed to go ahead with it provided James could get the company's brokers to support it and got a cost budget the board were prepared to accept.


'How about borrowings?' asked Bob. 'You mentioned that our operating leases could be partly re-categorised as finance leases which would blow through our borrowings limits under the articles of association. Apart from me being personally liable for an ultra vires debt, which I would rather like to avoid, are the banks not kicking up a fuss?'

'The banks are not worried at the moment,' replied James. 'We do not need to refinance our loan agreements for at least a couple of years, at which time we will be better placed to discuss the sorts of financial covenants we should apply under IAS. In the meantime when we finally publish numbers under IAS all we need to do is to convert them back to our current accounting policies to calculate the financial covenant ratios. We specifically addressed this concern under the terms of the last loan agreement,' he added. 'The borrowing powers point is a bit more difficult,' James continued.

'I do not believe that many companies have looked at this yet. I believe one company has managed to get deferred tax and pensions balances ignored when calculating its borrowing capacity under its articles of association. In addition, finance lease creditors may not be included in the definition of borrowings and may therefore be excluded. As no market norms have yet been established I do not really want to go out on a limb on this point at the moment, and I think it might be better to leave it until the AGM next year.'

Bob felt unhappy about addressing the dividend point without also fixing the borrowings concern. He did not have any better solution to suggest however, and after some debate he agreed to support James's proposal to the board.

Telling investors about the impact of IAS

Conversation then moved on to the drafting of the operating and financial review, and the presentation slides to be used at the results presentation.

Bob thought the company should keep its head down and not tackle the impact of IAS on Distributors plc's results.

'But Bob,' implored James, 'if we say nothing some analyst could get the impression we have something to hide and accordingly mark us down! We must say something, if only to highlight the fact that the proposed leasing and currency standards will hit us! After all, we currently do make significant disclosures around both topics. The analysts can hardly say they did not know we have 25-year operating leases on our 100 sites, as this has been central to our growth in recent years. Similarly we have explained on several occasions our currency hedging policy, covering planned imports 12 months forward for good commercial reasons, so that is hardly new!'

'All this is going to do is to flag up the fact that IAS will make our reported profits much more volatile,' said Bob. 'I do not think we should be highlighting this negative now, and perhaps we should also be considering our currency hedging policy. If we have to mark our contracts to market at the end of every year and take the results through the profit and loss account I really do not know how we can give anyone guidance on what our profits for the year are likely to be. I do not think we want to be issuing profits warnings and trading updates every time currency rates bounce up and down!'

'And that is the very reason why we need to address it now,' replied James. 'We have been through all of this before. It is cashflow which drives shareholder value, not what profit the accountancy profession wishes us to report. IAS should have no impact on our cash generation projections, and I think that is the point we need to make. The whole reason we enter into our currency contracts is to minimise the volatility of our cashflows, and we just need to remind the investment community of that.'

'You do make a good point on managing earnings expectations, however,' James continued. If we do get a blip on exchange rates on 31 December we could find the unrealised profit or loss on forward currency contracts moving our projected earnings well away from consensus estimates. I think the way around that is to give analysts a rough idea of the currency cover in place and the impact of exchange movements. We can then give all our trading updates on the basis of current currency levels and leave them to flex their estimates as appropriate.'

'Maybe the best way to handle all this is to ensure we give the analysts a clear reconciliation back to EBITDA, regardless of whether we are looking at current GAAP or IAS numbers,' James said. 'We can include something both in the annual report and the presentation to illustrate this. After all, we currently disclose the mark-to-market calculations on our currency exposures in the annual report, and I have never seen an analyst make any adjustment for these in their forecasts.'

'The problem with all this,' complained Bob, 'is that you are going to divert attention away from what has actually been a good year. The analysts are not going to absorb both the results and the IAS implications in one go. They are just going to go away with the impression that the results were satisfactory but they have some reservations around the impact of IAS. Can we somehow split the announcements?'

'Well, we could announce the results one week, and then have a teach-in for analysts a couple of weeks later,' suggested James. 'The only problem is that we would probably need to make a Stock Exchange announcement at that later date advising investors of any new information we put out. If any of this were price sensitive we ought to be announcing it with our results. Quite frankly, I do not know which elements of our IAS implementation are likely to be price sensitive or not in the current environment. I wonder if our brokers will know?'


Both parties were now keen to draw the conversation to a close and reflect ahead of the forthcoming audit committee meeting. Bob wanted to know whether the budget for the current year would look good or bad if it was reported under IAS. James wearily agreed to look at it and wondered how he was going to draft the audit committee papers now.

Back in the July 2003 issue (p90) we learned how James, the FD of Distributors plc, was beginning to identify the potential impact of International Accounting Standards on his financial statements and the problems that could arise (see table). Distributors had taken a large deferred tax charge under

FRS 19, Deferred Tax, had an underfunded pensions exposure and its forward currency contracts were unlikely to be counted as hedging transactions under IAS 39, Financial Instruments: Recognition and Measurement. We join him again as he prepares for the forthcoming audit committee meeting to sign off the full year accounts.

•   David Tilston is finance director of OverNet Data plc and the former chairman of the Education Committee at The Association of Corporate Treasurers

EFFECTS OF IAS ON DISTRIBUTORS PLC'S BALANCE SHEET Revised Consolidated Finance Foreign Additional balance balance lease exchange pensions sheet sheet adjustment adjustment provision m m m m m Fixed assets 20 38 58 Net working capital 26 26 Net debt -16 -16 Finance leases -38 -38 Pension provision -5 -5 -10 Deferred tax provisions -7 -7 Other provisions -7 -7 Net assets 18 6 Share capital 4 4 Share premium 4 4 P&L reserves 10 -7 -5 -2 Net assets 18 6 Net debt/finance lease gearing 89% 900%
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