The Move to IFRS: Understanding the Impact on M&A Deals |
What once seemed unthinkable now seems possible — International Financial Reporting Standards (IFRS) could become the prevailing set of accounting standards for the U.S. capital markets.
More than 100 countries, including those in the European Union and parts of Asia and Latin America, have already adopted IFRS. More than 7,000 companies are on board in Europe alone. By 2009, some public companies in the United States may have the option of IFRS reporting. Mandatory use of IFRS could begin as early as 2014 for large public companies.
For many U.S. companies, early conversion from U.S. Generally Accepted Accounting Principles (GAAP) to IFRS has appeal. Simplified reporting. Reduced operating costs. Greater transparency and comparability for investors. Improved access to capital. All are potential benefits. That’s why momentum toward IFRS adoption has been steadily building, even before it’s required.
If you’re considering an M&A deal, your short list may already include one or more companies that have adopted IFRS. And if not now, probably soon will. This article presents a big-picture view of the changes, opportunities and challenges you’ll want to keep in mind, along with some practical tips.
So what’s the difference?
IFRS does not have the industry-specific guidance, or many of the bright-line tests pervasive in U.S. GAAP; rather, IFRS places a greater emphasis on professional judgment in assessing the substance of a transaction. As a result, IFRS is often described as more principles-based, with less reliance on bright-line rules.
| Implementation tip | |
| Difference | Translation |
| IFRS does not currently have separate guidance for investment companies and therefore the general consolidation requirements apply. | PEIs, if required to adopt IFRS, would consolidate “controlled” portfolio companies, rather than reporting them at fair value as an investment. |
For example, the IFRS rules on revenue recognition, including those related to multiple-element arrangements are far less detailed than those that presently exist in U.S. GAAP. As a result, depending on a company’s application of the revenue recognition principles in IFRS, revenue recognition for many companies may or may not be similar under an IFRS model versus U.S. GAAP. That said, because of the absence of explicit IFRS guidance but similar principles between IFRS and U.S GAAP, many believe that compliance with the stricter U.S. GAAP rules-based revenue recognition guidance meant “de facto” compliance with IFRS. However, as the need for foreign private issuers to reconcile between the two sets of standards has disappeared, the incentive to minimize differences between U.S. GAAP and IFRS may diminish. Consequently, these companies may revisit their revenue recognition practices (or others) and select approaches allowable under IFRS that are no longer consistent with U.S. GAAP.
Deal impact of IFRS – The big picture
While convergence between IFRS and U.S. GAAP continues to occur (e.g. business combinations) and therefore the magnitude of differences will continue to decrease over time, the push for convergence is neither intended, nor expected to, result in full convergence. Accordingly, at least for the time being, buyers will need to become “bilingual.” Strategic buyers, and potential U.S. corporate partners for Private Equity Investors (PEIs), especially multinationals, may begin to consider the IFRS implications of deal structures now as they begin to contemplate their own migrations to IFRS. Meanwhile, PEIs may look for ways to leverage differences between the standards.
Two areas of difference of particular interest to dealmakers as they consider structures that include liability/equity classification and consolidation rules:
- With respect to liability/equity classification, puttable or contingently redeemable shares (features sometimes requested by PEIs) that might qualify for equity or temporary equity treatment under U.S. GAAP may result in liability classification under IFRS. Furthermore, more instruments are likely to qualify for derivative treatment under IFRS as no “net settlement” requirement exists in the IFRS definition.
- With respect to consolidation rules, many differences exist. For example, IFRS includes guidance that might allow consolidation in the instance of “de facto” control. Therefore, a company that owns less than 50 percent of another company may still consolidate if the other interests are widely dispersed. Additionally, the consolidation model under IFRS incorporates both governance and risks and rewards aspects into a single model. This single model is very different as compared to either the variable interest or voting interest models under U.S. GAAP. As a result, buyers need to be cognizant of the fact that a target company may not consolidate the same set of entities under IFRS that would be required under U.S. GAAP.
| Structuring tips | |
| Difference | Translation |
| IFRS retains the concept of having different reporting entities (parent and subsidiary) throughout the separate financial statement process. |
“Push-down” accounting, as required by the SEC for U.S. GAAP, is not required under IFRS. Accordingly, under certain structures, portfolio companies reporting under IFRS would not be saddled with the corresponding earnings drag associated with the amortization of intangibles arising from purchase accounting. |
| IFRS generally requires that traditional convertible debt be bifurcated between its liability and equity components. |
The lower interest charges (and primary accounting benefit from an earnings and EPS standpoint) typically associated with PIPE investments taking the form of traditional convertible debt are eliminated. |
Similarly, for due diligence on any target company reporting under IFRS, a U.S. buyer will need to understand the present differences in relation to U.S. GAAP, particularly if the target company will not continue to report under IFRS. The need to understand differences, however, might not stop there, as differing local country or company interpretations of IFRS may exist, resulting in challenges in benchmarking and valuation multiples at the outset, and increased disputes over purchase price adjustments and earn-out targets over time.
Modeling tips
| Difference | Translation |
| IFRS distinguishes between research costs and development costs and allows for the capitalization of development costs provided certain criteria are met. Under U.S. GAAP, development costs can be capitalized only in much narrower circumstances (such as internal use software). |
While there is no impact on free cash flow, the requirement to capitalize the costs of developing certain intangibles under IFRS will result in higher EBITDA. |
| IFRS uses a single-step impairment model focused on recoverable amount. |
The inability to look towards undiscounted cash flows as a means of recovering investments could increase the specter of an impairment charge and, hence, the volatility of future earnings under IFRS. |
| IFRS does not have the same “restrictive” fair value requirements for undelivered elements in multiple element revenue arrangements. |
Companies forced to utilize the residual method and/or defer revenue because of the lack of fair value may, in fact, be able to use other proxies (e.g. cost plus a margin) as fair value under IFRS standards and, hence, could recognize revenue earlier than would be allowable under U.S. GAAP. |
| IFRS recognition threshold for contingent liabilities is set at “more likely than not” as opposed to “probable.” |
The lower recognition threshold could increase the volatility of future earnings under IFRS. |
| IFRS requires “discounting” of certain provisions and the “write-up” of assets previously impaired. | Both practices, which are either infrequently used (in the case of discounting) or disallowed (in the case of “write-ups”) under U.S. GAAP, will increase EBITDA under IFRS. |
Adoption considerations
The worldwide adoption of IFRS may significantly lower the costs of financial reporting for multi-national issuers that currently report under two or more sets of accounting rules. The initial investment required to convert financial reporting systems of a target company, however, may be too daunting for a PEI buyer with a 3- to 5-year exit horizon, particularly when the timeframe of IFRS adoption by domestic issuers still remains uncertain. Once that timeline is established, PEIs may find that the benefits of a global exit strategy that could be executed via any foreign market using a single accounting standard like IFRS outweigh the costs of adopting.
In the meantime, both PEIs and strategic buyers may find foreign corporations already reporting under IFRS, or those multi-national corporations whose subsidiaries are already reporting under IFRS, increasingly attractive. And, for PEIs with portfolio companies in, for example, the financial services, pharmaceuticals, telecom, health services, and consumer and industrial products industries, there may be an added incentive to remain competitive in the global financial markets given the high percentage of global competitors in those industries.
Irrespective of the motivation, the challenges facing a buyer will relate mainly to the initial cost and effort required to transition to IFRS. In addition to working through the accounting mechanics of an IFRS adoption, issuers may need to train staff, adjust forecasts, restructure debt agreements and covenants, change information systems, and consider the impact on tax structures.
Tax planning tips
| Difference | Translation |
| IFRS prohibits the use of LIFO as an inventory accounting method. |
Because the IRS requires entities reporting inventory under LIFO for tax purposes to also use LIFO for financial reporting purposes, adoption of IFRS for a LIFO company could be accompanied by a significant tax cost unless the IRS changes its regulations. |
| IFRS could lead to changes in the earnings and profits calculations and/or distributable reserves of subsidiaries reporting under IFRS for statutory purposes. |
The lower interest charges (and primary accounting benefit from an earnings and EPS standpoint) typically associated with PIPE investments taking the form of traditional convertible debt are eliminated. |
Prepare for IFRS
While domestic acceptance of IFRS is gaining ground, IFRS has clearly established a solid footing in the worldwide financial community. If you are an M&A buyer, you will soon encounter IFRS, if you have not already. Further, PEIs may even begin considering selecting IFRS as the basis of accounting for newly acquired entities—allowing for avenues of both domestic and international offerings as part of an exit strategy. The quicker that M&A professionals learn and appreciate this new “language,” the better.
Related content
Series: Making the deal work
Book: M&A lies
Resources: M&A library
Overview: Four faces of the CFO
Contact
Nick Difazio
Partner
Deloitte & Touche LLP
+1 313 396 3208
ndifazio@deloitte.com
Mike Dziczkowski
Partner
Deloitte & Touche LLP
+1 212 436 2813
mdziczkowski@deloitte.com
Matthew Himmelman
Partner
Deloitte & Touche LLP
+1 714 436 7277
mhimmelman@deloitte.com
Paul Josenhans
Manager
Deloitte & Touche LLP
+1 714 436 7187
pjosenhans@deloitte.com
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The move to IFRS: Understanding the impact on M&A deals
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