Thought you were done with IFRS? Beware of the language trap
(As originally published in Lexpert Magazine, April 2012 issue)
By Kelly Khalilieh, Senior Manager, Professional Standards, EY
As Canadian businesses come to grips with last year’s transition to International Financial Reporting Standards (IFRS), lawyers involved in reviewing or preparing financial statements have discovered that a change initially meant to help bring more clarity within such documents can sometimes do anything but. When it comes to accounting or financial language in the statements and agreements you review, be wary: things may not always be what they seem.
IFRS has been the accounting standard for public companies in Canada since January 1, 2011. But private companies still have the option to comply with either IFRS or accounting standards for private enterprises (ASPE). Meanwhile, some companies are still reporting under previous Canadian generally accepted accounting principles (GAAP).
As economies become more global in scope and a growing number of companies are operating in international markets, the Accounting Standards Board implemented the new reporting standards in an effort to adopt a more globalized benchmark within audits and financial reports. The new standards are also meant to improve transparency and clarity in the face of escalating regulatory demands triggered by the recent financial crisis.
But with different accounting standards potentially in play depending on whether a company is private or public, the reality of operating with three active GAAP can be anything but simple and clear. In this environment, savvy lawyers should remain especially cautious about the use of accounting terminology, for it may have significant legal or financial implications.
Understanding that accounting terminology may have definitions in accounting standards that can vary depending on the GAAP that the company is subject to is important. For example, financial terminology in legal documents may not be defined, or may have no definition at all. Some terms may have different meanings under IFRS and ASPE than they did under Canadian GAAP, so what “used to be” may no longer apply. This lack of clarity has real implications for the agreements you review, as transactions may now have unintended financial consequences for the entities involved.
Let’s look at a couple of agreements as examples:
In purchase and sale agreements, such terms as “accrued” and “capitalized costs” are not defined in either IFRS or ASPE, but the accounting requirements set out relating to these terms differ meaningfully between the two reporting standards. Wait, it gets trickier. These requirements also differ from what was previously accepted under GAAP. Such variations can cause disputes and can even affect the selling price, particularly if the vendor and purchaser have a different understanding of which items should be accrued in the selling company’s financial statements. For example, if the selling company had a management employment agreement that establishes conditions for a termination settlement, the vendor and purchaser may disagree whether or not that termination settlement should have been accrued in the selling company’s financial statements.
Loan agreements also present hazardous territory. Differences between IFRS and ASPE, and between these standards and Canadian GAAP, may have important implications for key covenants.
For example, these standards set out different requirements relating to the recognition and measurement of revenue and related transactions, certain types of expenditures, and even assets and liabilities. Working capital and debt-to-equity ratio, key financial metrics in some agreements, may also be measured differently depending on GAAP, as is the way in which instruments are classified on the balance sheet between current and long-term and between debt and equity.
What’s the upshot? It could represent a significant financial impact for your client. The standard used to report figures can affect profit /loss evaluation, or report a more favourable debt-to-equity ratio under one reporting standard than the other.
What’s more, loan agreements typically require the borrower to prepare consolidated financial statements, and sometimes interim financial statements, too. IFRS and ASPE have different criteria for the former, while ASPE offers greater leeway for the latter with an absence of any guidance at all. These distinctions, along with variations in the definition of capitalized expenditures, have implications for both lender and borrower.
My advice? When it comes to accounting or financial language in the statements and agreements you review, be wary, and reach out to accounting professionals for clarification. And while I do not expect any major changes to ASPE at least for another three to five years, there are some ongoing initiatives that are likely to generate significant changes to the financial statements of those entities preparing under IFRS. To protect your clients, it’s important to stay informed of these changes, and to consider their possible effects within new agreements. With multiple accounting standards and definitions in effect, better safe than sorry is the best order of the day.
Kelly Khalilieh, Senior Manager, Professional Standards, at Ernst & Young LLP, can be reached at her Toronto office at email@example.com.