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However, their impairment risk will also be the highest, and the greater the concentration of the goodwill position, the higher the impairment risk. Financial instruments: Switch from cost to fair value Most national GAAPs in Europe do not employ a fair-value-based approach to accounting. Hence, most assets tend to be valued at historical cost. Under IFRS 39/32, the majority of assets, including hedge positions, are valued at fair value. Since this normally equates to market values, the new standard provides more up-todate information, which we view as a positive development. In addition, the move of derivative instruments from off to on balance sheet gives investors more insight into a company’s risk profile. On the other hand, earnings and equity will become more volatile due to the higher fluctuation of fair values. Financial sector firms such as insurance companies, banks and financial services providers are most affected by the switch to fair value because these businesses have large and volatile balance sheets. The adoption of hedge accounting affects financial services companies as well and might also impact sectors such as automobiles, aerospace and utilities. Recognition of pension costs as a balance-sheet item The net position of assets (invested plan assets) and liabilities (present value of future benefit obligations) position of pension plans must now be recognized on the balance sheet. In addition, all current pension plan costs must now be treated as an expense. As a result, the financial condition of pension plans will now be accurately reflected on the balance sheet, whereas previously, the net asset/liability positions of pension plans were reported inconsistently and were sometimes disclosed only in footnotes to financial statements. IAS 19 also now requires companies to disclose additional pension plan information. The introduction of IAS 19 is particularly troublesome for companies with massively underfunded pension plans because they must now record pension shortfalls as a liability. Although this problem must be individually evaluated for each company, it can generally be said that the pension accounting rule change is likely to have the biggest impact on British companies, which previously carried pension plans only as off-balance-sheet items (FAS 17) and will now have to systematically recognize them on the balance sheet. Figure 2 Ratio of goodwill to equity Source: Worldscope, Credit Suisse x Other minor changes will enhance the transparency and uniformity of corporate financial statements Companies previously had considerable discretionary latitude in capitalizing research and development costs. The introduction of IAS 38, on the one hand, now places narrow limitations on the capitalization of research costs. On the other hand, it also requires companies to capitalize development costs that satisfy the stringent criteria specified in IAS 38. This is likely to put some pressure on operating margins in industries that had heretofore liberally capitalized R&D costs, while industries that have always booked all of their development costs as an expense, as has been the practice at many companies in the automotive and industrial goods & services sectors, should now start exhibiting slightly higher operating margins. Since the start of this year, employee stock options must now be expensed at fair value over their vesting period. We think this will probably tend to diminish the use of stock options as a component of employee compensation. In addition, numerous 0.8 0.6 0.4 0.2 0 Automobile Banking Basic resources Chemicals Construction Cyclical goods & services Energy Financial Services Food & beverage Healthcare Industrial goods & services Insurance Media Non-cyclical goods & services Retail Technology Telecommunications Utilities
minor improvements in the accounting treatment of provisions, leases and revenue recognition enhance the uniformity of financial reporting. GLOBAL INVESTOR 1.05 IFRS— 15 The impact on valuations and credit profiles Oftentimes, the first reaction to accounting alterations is to argue that they are of limited relevance to company valuations since cash flows for the DCF models do not change. We do not fully agree with this view for four reasons. First, valuation metrics such as P/E , P/B and EV/EBITDA multiples, which will look more attractive thanks to the switch to IFRS, are still commonly used. Second, the underlying assumptions for DCF models could be affected as new and more reliable segmental information becomes available. Third, credit ratios such as EBITDA interest coverage, interest-bearing debt to EBITDA, and leverage will change and thus shift company credit profiles. It is still uncertain how the rating agencies will handle this issue, but some companies presenting higher operating performance in addition to beneficial alterations on their balance sheets are likely to receive rating and outlook upgrades in due course. And fourth, moving off-balance-sheet information to the balance sheet will change investors’ perceptions of companies’ leverage and risk. The introduction of IFRS is a welcome development The volatility of net earnings and shareholders’ equity is likely to increase, particularly due to the switch from goodwill amortization to impairment testing (IFRS 3) and the valuation of financial instruments at fair value (IAS 39/32) . Some market participants may initially have difficulty absorbing the new, complex financial information and appropriately assessing the aforementioned heightened volatility. Hence, the information policy (guidance) of individual companies is likely to be of essential importance here. We welcome the implementation of IFRS because, in the longer term, it will substantially enhance the transparency and comparability of corporate financial statements and will move European accounting practices closer to US GAAP norms. As for company valuations, we believe that the transition to IFRS will lead to improved earnings quality in the longer term and will thus give rise to more accurate, more reliable and more consistent valuations for European companies. Figure1 shows the impact that the introduction of IFRS will have on individual sectors. Banks (Société Générale, Italian banks), insurers (Allianz, Italian insurers), media companies and retailers are likely to experience the biggest changes. In all cases, the effects of IFRS must be individually examined for each firm, and company guidance must be taken into account. | Figure 3 Impact of the key changes on individual sectors Source: Credit Suisse Business combinations Goodwill, IFRS 3 Share-based payments Stock Options, IFRS 2 Financial instruments IAS 39/32 Employee benefits Pension Accounting, IAS 19 Automobiles Banks Basic resources Chemicals Construction Financial services Food & beverage Healthcare Industrial goods & services Insurance Media Oil & gas Personal & household goods Retail Technology Telecom Travel & leisure Intangibles R&D, IAS 38 Utilities very important important not important
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