Starting next year, City investment analysts will face a complex new toolkit for scrutinising company accounts. With the introduction of International Accounting Standards (IAS), the tried and trusted accounting framework that sell-side and buy-side analysts have been used to will be a thing of the past.
Many analysts are reluctant to discuss the new accounting standards, suggesting that their degree of preparedness may not be up to scratch.
The large accountancy firms that are doing most of the work in training the investment analysts and company FDs are more forthcoming about what IAS is going to mean for interpreting company accounts.
“There is currently a communication issue between companies and analysts,” says Tony Clifford, a partner at Ernst & Young. “The more complicated aspects of IAS 39 (Financial instruments: Recognition and Measurement) are understood by some but not all analysts, and this poses a major challenge. In any event, there is a gradually increasing realisation that there is more to the accounts than the headline profit figure. The analysts will have to be up to speed on IAS before the first quarter of next year.”
PricewaterhouseCoopers recently completed an initial benchmarking survey of about 300 UK companies on their readiness for IAS. The report concludes that companies were not as advanced as PwC believes they need to be with regard to identifying and managing the changes and interpretation of management information under IAS, as well as internal and external financial reporting and communication with the markets. PwC says there needs to be far greater activity between the investor community, analysts and corporates in order for both sides to manage the inevitable confusion and uncertainty. In addition, there is too little time before 2005 for strategic systems specification changes and upgrade. More corporates and banks are having to consider tactical IT solutions, including wider use of spreadsheets, putting huge strain on existing systems and raising concerns about the quality we can expect of the financial reporting and the auditors’ level of comfort with the numbers produced.
Foster says that many of the companies he has been talking to are concerned about how they’re going to communicate these accounting changes to the market. He points out that having a complete change of numbers that are potentially going to be very volatile needs to be explained in layman’s terms to a nervous market. “One possible solution to that is getting something out in the next round of interim reporting in 2004, and making sure there’s significant communication between analysts, investor relations people and corporates during the coming months,” he says.
Jim Pettigrew, FD of FTSE-250 inter-dealer broker ICAP, says that we’re still only at the very start of the process of analysts finding out about how IAS will work. “I don’t think people have really, really focused on it yet.” It seems that, for many, reporting under IAS is still next year’s problem. And because the IAS standards have just settled down, analysts and FDs have not put in a big effort in coming to terms with the new system.
“I don’t expect analysts to be up to speed with IAS quite yet,” says Isobel Sharp, a partner at Deloitte & Touche. “The 2004 annual statements will be the ones to start tracking, and there will be much more information in early 2005. At that point, I think the analysts, who will have to expect interims on IAS standards for 2005, will have to invest more time in understanding the new standards.
“People are very aware of what’s going to happen, but in terms of getting to grips with detail in individual businesses and things that need to be done by analysts, my expectation is that this has not yet happened. FDs must communicate with the analysts and their investment community, and they’re gearing up for that. They haven’t been investing a lot of time in this as yet, which I think is natural.”
As one of the leading firms in the business, Morgan Stanley is one of the few to have established a Global Valuation and Accounting Team, which has recently produced a number of research circulars on the topic of IAS.
One paper issued in January specifically informs client investors of what they can expect companies to say about their preparation for IAS as they reveal their 2003 results. The Morgan Stanley team points out that CESR, the Committee of European Securities Regulators, says companies ought to be reporting this spring in qualitative terms about the major differences between their local GAAP results and their results under IAS, as well as commenting on progress on their IAS implementation. The Morgan Stanley team says that any boilerplate statements made by companies might be masking the fact that companies are behind in their IAS implementation, increasing the likelihood of transition “accidents”.
Ken Lever, FD of FTSE-100 engineering group Tomkins, agrees that there may be share price volatility arising out of confusion about IAS, though he adds: “If you’re transparent and have a good dialogue with your shareholders, you ought be able to alleviate some of the volatility.”
Apart from the twin difficulties of having to understand and trust the new sets of numbers, there’s another problem for analysts, as Foster points out: “Even with enhanced communication and detailed disclosures and reconciliation of old data to new, it will be almost impossible in the short term to replicate the historic trend analysis and the benefit of the historic earnings stream. So there is a big concern in the analyst community that the database of information they’ve built up under UK GAAP is virtually worthless.”
ICAP’s Pettigrew is a supporter of the concept of international accounting standards, but finds himself both worried and fascinated. With the virtually wholesale move away from historic cost accounting to market values, “the earnings and the profits are really going to be a deduced number – the closing market value balance sheet less the opening market value balance sheet,” Pettigrew says. “Ergo, you’re going to have an immense amount of volatility.
“If there’s a rumour on 31 March that Alan Greenspan has suddenly dropped dead, and you suddenly have bond and stock markets crashing, we’ve got to mark-to-market that.”
But Pettigrew thinks this sort of volatility is intriguing because of what it means for how analysts will go about the business of valuing companies.
“How will the efficient market work?” he asks. Under the existing metrics, you take a historic or forecast earnings number, multiply it by an appropriate p/e ratio, then throw in a premium or discount to get a market valuation.
“In the old world, it was easy to issue guidance about where your profits would be. Now I’m not so sure it’s so easy,” he says.
Guy Weyns of Morgan Stanley says that this doesn’t spell the end of the forward-looking p/e ratio as a valuation metric. He says that people will be “trying to make sure the ‘e’ is indicative of the future. They will try to purify the ‘e’ so it’s still meaningful.”
As Pettigrew sees it, there are two possible options. First, pro forma earnings statements might help provide more clarity in revealing what’s happening in the underlying business, though he recognises that such practices were discredited in the dotcom boom, “which I think is a bit of a shame”, he says. He himself prefers to use adjusted earnings per share, stripping out goodwill amortisation and exceptional items to get something that approximates underlying cash earnings, “but the accounting standard says you can’t just use adjusted EPS, you have to use basic as well”.
Hence, Pettigrew thinks there will be more focus on the cash statements in future, as do a number of FDs we’ve spoken to in recent months. Trevor Dighton, FD of Securicor, says that analysts have started asking questions about how IAS will affect his reported numbers. “We have completed several questionnaires for them,” he says. “Analysts are, however, primarily concerned with understanding underlying business performance and related cash flows, whereas the bulk of the changes resulting from IAS introduction will relate to more detailed disclosure issues.”
Interestingly, the Morgan Stanley team doesn’t seem to share FDs’ enthusiasm for the cash statements and a focus on free cash flows. It points out that free cash flows are almost always determined indirectly by making adjustments to accrual accounting numbers, and that current cash flows are not necessarily the best figures to use to predict future cash flows.
The team’s circular says: “The road to sound investment decision-making has no shortcuts: it requires a thorough understanding and examination of all the financial reporting information provided by a company.”
So analysts and FDs will, after all, have to struggle on with IAS.
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