IFRS transition - The analyst's story

We return to our fictional company as it presents its IFRS changes to the market. This time David Tilston's diary looks at Distributors plc through the eyes of an analyst.

It was all getting rather tedious. This was the eighth International Financial Reporting Standards (IFRS) presentation Alice had been to in the last three weeks, and she was getting thoroughly bored of it. You had to turn up just in case the finance director said something new, but they never did!

Alice studied the material she had just collected from the Distributors plc meeting. Its share price had fallen on IFRS concerns when the preliminary results had been announced, but had drifted back up since. Actually the group's return to profitability over the last 18 months from a loss-making position had been good, although debt was still too high. The IFRS papers were thankfully short, with only 15 slides and an announcement running to 20 pages. All the familiar themes were there as she started to draft out her note to go to institutional investors the following day. She jotted down the key points:

•    IFRS would not have any impact on the risk profile, performance or earnings growth of Distributors plc.

•    There would be no impact on cash generation of the group.

•    There would be no impact on Distributors' financing arrangements.

•    The overall impact on the P&L was not significant.

•    Segmental reporting would change.

•    Future profitability could be more volatile due to fair valuing the various currency contracts used to manage import risk.

•    The pension fund deficit would be put on the balance sheet and create negative net assets.

•    There would be an increase in finance leases on the balance sheet due to property treatment.

•    All the other adjustments netted out to minimal effect.

•    Resolutions would be passed at the forthcoming egm to ensure Distributors plc could continue to pay dividends and would not breach the borrowing limits in its Articles of Association.

It all seemed to be under control, and Alice had written an almost identical list on two other clients during the past week.

Fundamentally cashflow was unaffected. She had discussed this in some depth with a business school professor previously. They had concluded that valuation ultimately came back to the net present value of future cashflows, and as reporting under IFRS did not alter these then there should be no change to the company's value. The only reason why cashflows might be affected was due to the increased accountants' fees which many of the FDs had been grumbling about.

Alice ran the new IFRS numbers through her spreadsheet model and cashflow was unchanged as she had expected. This meant that she could continue to use the same cashflow multiples as she had used previously for valuation purposes. So far, little to report.

A closer look

Could she have missed something? Distributors had said that it was using the corridor method to smooth actuarial gains and losses. This appeared to be a different approach to what some of the other companies had said.

However, this only appeared to change accounting numbers and not cashflow, so Alice thought it was not an issue.

The segmental analysis was interesting. Distributors had not previously given any analysis on how its portfolio of branches were actually performing.

It was quite apparent that the level of profitability achieved in the northern region was significantly higher than the other geographic regions.

This could suggest that either there was a different business mix in the northern region, or the other regions were under greater competitive pressure.

In the preliminary results announcement Distributors had alluded to some slight worsening of the competitive environment, but this new analysis suggested this new factor could be potentially damaging the group's prospects. She would have to check this out with the FD.

Pension problems

How about the overall risk profile of the group? Although the cashflow projections in Alice's model did not change, the balance sheet gearing would shoot up to around 900%. The change to the borrowing powers in the Articles of Association did therefore look important, but it seemed to be just a legal technicality. What if Distributors decided to pay off its pension deficit more rapidly? Cashflow projections would be reduced and less cash would be available to invest in and grow the business. Gearing would also increase.

Back to the pension fund deficit then, she thought. Could this get worse?

If it did, could it have a bigger cash impact on the group than anticipated?

The pension fund deficit was certainly around 10% larger than previously indicated due to some technical differences between

FRS 17, Retirement Benefits, and IAS 19, Employee Benefits.

In addition, the preliminary results had suggested that the size of the deficit had been increased recently due to longer life expectancy assumptions.

The defined benefit scheme was now closed to new entrants but it did still appear to be a source of risk to the group. If it increased in the future due to changes in assumptions it must inevitably lead to a reduction in cashflow at some point.

She understood that Distributors had reduced a significant amount of risk in the pension scheme by shifting a high proportion of the assets into gilts. This presumably meant that if the equity markets continued to recover, Distributors' pension fund deficit would not reduce. There was a simple argument to say that the pension fund deficit effectively represented a loan from scheme members to the company, in which case Distributors' gearing was effectively much higher than 900%! In addition, the pensions regulatory environment was getting much tougher and the pension fund trustees' position for directly negotiating with companies on how pension fund deficits would be rectified had been strengthened.

So how was Alice going to conclude her note, as the investors needed a few simple themes? She drafted the final paragraph of her note.

'The IFRS announcement does not affect our underlying forecast for the year. Additional segmental analysis suggests that some of the regions are suffering more tangibly from competition than we previously understood.

The general debt and gearing levels, when combined with the pension fund deficit, suggest the group has more limited financial flexibility than we believed, and is less able to withstand external shocks. Move from hold to sell.'

Back in the July 2003 (p90) issue we learned how James, FD of Distributors plc, was beginning to identify the impact of IFRS on his financial statements.

His concerns included the increase in reported gearing levels and the impact of the pension fund deficit. In the February 2004 issue (p70) he and his colleagues debate what information should be released when, and in the January 2005 (p68) issue, Distributors announced its preliminary results. Distributors plc has now done a separate briefing to City analysts on the impact of IFRS and we now get their perspective on this issue.

David Tilston has been FD of two listed companies and is the former chairman of the Education Committee at the Association of Corporate Treasurers. The first article in this series, 'A bad day at the office' (July 2003) received a citation from the International Federation of Accountants in recognition of contribution made to Professional Accountants in Business in the 2004 PAIB article award competition.

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