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Certain Commercial Transaction Implications Arising from the Adoption of IFRS by Canadian Enterprises

Published: 11/19/2009

By Bruce McNeely, Nicole Washington

For annual periods beginning on or after January 1, 2011, each Canadian publicly accountable enterprise (PAE) must (and any other enterprise who wishes to opt-in, may) use International Financial Reporting Standards (IFRS) instead of Canadian generally accepted accounting principles (Canadian GAAP) in preparing their financial statements. PAEs which are cross-listed on the Toronto Stock Exchange and the US Securities and Exchange Commission (SEC) for trading have the right to opt-out of conversion to IFRS, and may continue to prepare their financial statements in accordance with US GAAP. Other than PAEs and opting-in entities, any other Canadian business enterprise may continue to prepare its financial statements using Canadian generally accepted accounting principles for small and medium enterprises (SME GAAP) and all Canadian not-for profit entities may continue to use Canadian GAAP in preparing their financial statements. Early adoption of IFRS by PAEs is permitted, but we understand that few have applied to the Ontario Securities Commission (OSC) for permission to do so, probably because shareholders and analysts are not yet familiar with the form of IFRS-based financial statements.

The purpose of this note is to bring your attention to some of the big-picture transactional concerns arising out of the transition from Canadian GAAP to IFRS for those entities who are obligated to adopt IFRS or elect to do so.

Rationale and Timing

  • IFRS is not a new concept. Since 1973 most developed countries (other than Canada, the US, China, South Africa, Singapore, New Zealand and Brazil) have mandated the use of IFRS, or a version of it with minor variations, by all business and not-for-profit entities in their jurisdictions in preparing financial statements. IFRS is regulated by the International Accounting Standards Committee and its Board based in the UK. Implementation of IFRS for US publicly accountable enterprises may be slow-tracked by the newly appointed head of the SEC. However, Canadian regulatory authorities (Canadian Accounting Standards Board, the Ontario Securities Commission and the Office of the Superintendent of Financial Institutions) remain committed to implementation of IFRS for the reporting period beginning January 1, 2011. The rationale for implementing IFRS is to create a common world standard in order to increase transparency in financial reporting matters and, ultimately, to reduce the cost of raising capital. Since chartered banks in Canada have a fiscal year ending on October 31, they will lag behind other PAEs in making the accounting standards change to IFRS by 9 months.
  • To be in a position to provide prior-year comparative figures in 2011, PAEs will have to  have appropriate data beginning on January 1, 2010. There may be circumstances where an enterprise (e.g. one positioning itself for sale) may be required to provide comparable financial information for a period ending prior to that time. Many affected Canadian enterprises may still be behind the curve on this one.
  • Once implemented, PAEs will not have to reconcile their financial statements to conform to US GAAP for SEC filing purposes provided Canada adopts a pure (that is, an unamended) version of IFRS. Although the issue is not yet settled, it would appear that a pure IFRS approach will be adopted in Canada. 
  • To give effect to IFRS, systemic changes will have to be made throughout the reporting enterprise (e.g. for budgets, forecasts, key performance indicators (KPIs as compensation parameters), financial covenants found in credit agreements and debt instruments and for acquisition analyses). Implementation and planning will involve tax and treasury functions (fx and other hedging programs), the board of directors, investor relations (in dealing with stakeholders and performance analysis), human resources (employee evaluation and compensation programs), IT (new data collection and presentation) and general counsel, all to address the resulting disconnect between the enterprise’s new financial reporting standards and existing arrangements, including contractual obligations.
  • As at the end of the first fiscal quarter following January 1, 2011, each IFRS reporting entity will have to prepare and file unaudited quarterly financial statements with prior-year comparative figures for its fiscal quarter then ended. If an enterprise wishes to make itself an attractive acquisition prospect or securities issuer, or private enterprise borrower which competes with PAEs for funding, up to five years of historical IFRS financial statements may be required. It is a substantial project to generate the required data and restate five years of financial results where your staff has little or no experience with IFRS. In addition, there is a chance that information required to carry out the exercise may not have been collected, recorded or retained.
  • The Management Disclosure and Analysis (MD&A) filed in April, 2009 by PAEs with their December 31, 2008 annual report would have included discussion regarding the PAE’s IFRS conversion plan. Subsequent annual reports and MD&As must describe the PAE’s progress with its plan.

A Brief Comparison of Canadian GAAP and IFRS

The following chart is not intended as a comprehensive list of the differences between Canadian GAAP and IFRS – it is only intended to highlight some of the differences and the resulting business implications arising from the change in financial reporting.

IFRS Canadian GAAP Business Issues

Principles-based – records transactions based on a broad review of all possible resulting economic benefits and obligations. This approach results in an increase in the auditor’s discretion as to how a matter may be reflected on the books, and in the financial statements, of the enterprise. There is no general requirement that all assets be recorded at fair value. The reporting entity can, in many cases, chose to record the asset at cost.

First time adopters of IFRS-based financial reporting may chose to use fair value of property, plant and equipment on its opening balance sheet. This may be an important option.

 Rules-based – series of bright line tests which dictate how a matter must be reflected on enterprise books and financial statements
  • Increased shareholder and contract counterparty uncertainty because of the absence of bright line tests
     
  • Increase in financial statement and MD&A disclosure to rationalize the approach taken, and the judgment exercised by management and accepted by the auditors – some estimate that annual reports may initially double in length
     
  • Others believe that for exempt private enterprises, once IFRS based financial statements move past the first few years of use, their IFRS-based financial statements will be shorter, and contain less disclosure than presently required under Canadian GAAP
     
  • Increased volatility of asset valuations arising out of the ability of the entity to record investment property at fair value rather than cost and an obligation to record impairments in value. This will affect the enterprise’s debt to total asset ratio and return on asset ratio (Canadian GAAP would have used historical cost amounts as the basis for the calculation)
  • Contingent liabilities are given greater weight in IFRS-based financial statements. As a result, in acquisition transactions, the buyer may prefer to purchase assets and not shares
Componentization - those parts of a reporting entity’s plant property and equipment which have similar lives are to be grouped for reporting purposes  
  • New valuation approach
Disclosure and valuation of future obligations (e.g. recurring payment of bonuses, future year promises in labour negotiations) Disclosure may not be required
  • Valuation and analysis required
Off-balance sheet treatment of affiliated conduits – Under IFRS it is difficult to exclude affiliate transactions where the reporting entity retains benefits from the operations of the conduit and is subject to obligations. IFRS requires a risk/reward analysis to be applied to the reporting entity as it operated prior to the transaction with its affiliate and after completion of the related-party transaction Off-balance sheet treatment is given to transactions with affiliates
  • Assets and liabilities of conduits will be brought back onto the balance sheet of the reporting entity. As a result,financial ratios could be adversely affected by consolidation
  • "True sale" opinions will no longer be required in securitization arrangements – bright line test gone
The meaning of EBITDA (earnings before interest, taxes, depreciation and amortization) and financial ratios may be different from corresponding terms in Canadian GAAP  
  • Credit agreement financial covenants may not be in sync with IFRS-based financial reporting – threshold amounts may no longer properly test the financial covenants, resulting in apparent breaches (where there has been no material change in the performance of the business)
  • One approach to address the issue would be to prepare and provide financial covenant calculations using both Canadian GAAP and IFRS to give comfort to lenders (and other counterparties) that apparent covenant breaches are the result, in part, of the change to IFRS-based financial reporting, and not a change in the performance of the borrower
  • We strongly recommend that PAEs prepare an appropriate information package for its lenders and other counterparties by June 30, 2010 – if the relationship in question is in jeopardy you will need significant lead time to negotiate with lenders and to develop a strategy to deal with apparent breach of other significant relationships that cannot be terminated in the short term
  • If a PAE has issued debt in the public markets with financial covenants based on Canadian GAAP, there may be significant adverse implications arising out of the shift to IFRS
  • Financial covenants in commercial agreements may no longer fit the intent of the parties – again calculations using both approaches may be needed to evidence compliance – we strongly recommend that material contracts be reviewed as early as possible to identify issues to permit PAEs to develop strategies to address any concerns triggered by the transition to IFRS
  • Where there is a consensus, parties may have to amend existing agreements to introduce new terminology using IFRS concepts and to change threshold amounts
  • Existing agreements which reference Canadian GAAP should be reviewed and counterparty lenders, landlords and others briefed on reporting based issues
  • New agreements which reference Canadian GAAP should provide for a future conversion to IFRS-based financial reporting in the definition of Canadian GAAP
  • Contract counterparties and taxing authorities may challenge management’s application of broader IFRS reporting standards where the counterparty believes that the entity has used the IFRS standard to artificially reduced its financial obligations
Further to the note above regarding the opening balance sheet for IFRS purposes, an entity must record most of the adjustments made to its opening balance sheet assets and liabilities as an adjustment to retained earnings or another equity account.  
  • Certain ratios (debt to equity and return on equity) will be affected by this adjustment
IFRS requires that certain assets not recognized by Canadian GAAP be recorded for IFRS purposes  
  • If this occurs, it will affect current ratio calculations
IFRS is a work in process – one issue under consideration is the treatment of true and capital leases.  
  • If the change is made to account for capital leases like true leases, then both lease assets and liabilities would be reflected in the financial statements and have an effect on the enterprise’s debt-to-asset ratio and its debt-to-equity ratio