New IFRS standards have an impact on processes and revenue recognition
IFRS 15 and 16 are about finance collaborating with controllers, HR, Procurement and Legal.
Integration of non-financial KPIs in IFRS will become important
Mario Matthys: 'Finance departments underestimated the timing and planning that were necessary to adopt these IFRS standards.'
Mario Matthijs, could you do a little recap on recent IFRS implementations? Where are companies in the process? What are the most common issues they encounter?
Mario Matthijs: “Two years ago, we witnessed a new wave of IFRS standards, which were threefold: you had IFRS 9, containing the financial instruments that were mainly issued to ‘help’ the banking industry. We also saw IFRS 15, which is a new standard on revenue recognition that became applicable as of 2018. Then there was IFRS 16, the new standard on leasing, initially also applicable for 2018, but postponed to 2019 because of the workload.
The International Accounting Standards Board (IASB) presented the reasoning behind the newly issued IFRS Standards already in 2006. At this stage (July 2019, editor’s note), all companies reporting under IFRS/US GAAP have adopted or are in the latest stage of adopting these three new standards. For companies in corporate industries, the implementation of leasing and revenue recognition has been quite a struggle.
There’s definitely value in the new standards. The adoption phase was difficult, but we see things smoothen out in the years to come.”
What about the process? Is it running well in most companies?
Mario Matthijs: “Some companies have already installed really efficient processes. Adoption is going well there. There’s a nice follow-up process. Other companies are struggling. About 60 percent of the companies I know are still struggling to establish an efficient process, whereas 40 percent have put a lot of effort already into establishing strong processes, only to see their efforts paying off.”
What were the most common stumbling blocks?
Mario Matthijs: “There are a few ‘post-mortem’ remarks to be made. As expected, finance departments underestimated the timing and planning that were necessary to adopt these IFRS standards. They underestimated the impact the standards have on the company itself. As opposed to past IFRS standards, the new IFRS contains standards that are broader than finance only. The new standards have an impact on processes and revenue recognition. It forced companies to look at their sales conditions and sales contracts.
IFRS 16 on lease even had a stronger impact, because sales contracts are often easily available, whereas lease and rent contracts were a lot harder to find for many companies.”
In the recent past you warned that IFRS on lease had all the makings of becoming a major headache.
Mario Matthijs: “It turned out to be the case. Even companies that bought and installed very expensive contract management systems and management databases struggled, because these systems often included only 20 percent of the contracts.”
Proving again that technology is not the solution if the process is not running smoothly.
Mario Matthijs: “It’s essential that your process is coupled with the right technology, but if your process is not functioning properly, you can buy a Rolls Royce and it will not get you anywhere. So, another learning was that organizations should make sure their processes are well-defined, efficient and working. That was not really the case, not even in big, well-renowned companies. A lot of time and effort was put into the adoption of IFRS standards, with IFRS 16 turning out the most difficult one.
In well organized companies that have already put a lot of effort into creating policies, a policy often exists to create new policies and processes. These organizations have a procedure to fall back on when they want to establish a new process. It gives them the chance to swiftly follow that process by distributing the right responsibilities to the right people. Companies that don’t have a procedure to adapt their process to a new reality, clearly suffered most.”
It’s 2019, the year that all three new standards should have been adopted. At the end of the year, when all financial statements are really audited, we could see some surprises. It will be the first year that the auditor will have reviewed and made his remarks on the adoption of IFRS 16.”
Was that a general problem?
Mario Matthijs: “Yes. The changes are pretty straightforward. Putting all leases and rents on balance sheet instead of an off-balance sheet treatment is quite easy to understand. But it had a big impact on companies. New processes had to be introduced. Who is going to do what? Who is going to take care of modifications in lease contracts? Who is going to take care when an asset is not used anymore? How is information getting to the right person who is responsible for IFRS 16, when we are for instance confronted with an early termination of a contract?
Those were things organizations were not really prepared for. A lot of companies created new functions, like ‘Right-of-Use accountants’, who are dealing with the standard, similar to the ‘Fixed Assets accountants’.
Another learning was that awareness did not always reach the highest levels of the organization. I still encountered a lot of Cs who were not fully aware of what these new standards meant for them. They were inclined to say that the new IFRS implementations in their companies were not a big deal. Soon, they had to acknowledge that the new standards led lto important changes. Certain companies saw their key figures and KPIs totally changed.
The new role of Procurement, for instance, is an extended role. Coming back to the process: the procurement organization definitely gains in importance with IFRS 16. They actually drive the IFRS 16 process. It’s them who are the contract negotiators. So, they have to make sure the contracts are correctly processed through the IFRS rules.
But awareness was not there. Certain people in the Finance department were aware, some controllers, but there certainly was no awareness in Procurement, Legal or HR. That really posed a problem. Legal is now confronted with the fact it needs all contracts. Granting someone a lease car did not require a lot of effort or attention from HR. Now, you have to take care of the contract and make sure the right information is passed on to the finance department.”
If the process touches so many points in the organization, how do companies organize it? Who is in the lead, or should be?
Mario Matthijs: “That’s a very good question. It varies from company to company. In some companies, it’s still the Finance department, in others it shifts towards Procurement and HR. Or they split up: lease cars is an HR responsibility, equipment and buildings have to be taken care of by Procurement. That’s the front end, the people who negotiate and sign the contracts. They are mostly backed up by a Shared Service Center or a Competence Center where they typically organize the function of the Right-of-Use accountant who is gathering the information on a monthly basis and makes sure it is correctly processed in the financial records of the company. So, we are actually talking about a front office and back office.
“The question we heard most often once the adoption was over, was: ‘Who is going to take the process in hands?’ This is much more a combined effort of different departments than it was before. IFRS 15 and 16 are about finance collaborating with controllers, HR, Procurement and Legal. It’s a shared responsibility. In the past, an accounting standard was something for Finance. IFRS 15 and 16 have proven that a lot of other departments are involved in setting up a good process.”
Mario Matthijs: “In the past, differences between IFRS and local GAAP were not that huge. People used that as an excuse not to apply IFRS. That has become much more difficult now. IFRS on Financial Instruments, Revenue recognition and Leases has created an additional gap with local GAAPs. Companies are more and more forced to choose a direction in which they want to report figures to the market. Big companies are obliged to do IFRS or US GAAP, but what about all the small and medium-sized companies just below that are private-equity owned. For private-equity owned companies, it’s the international reporting that counts.
Banks and credit institutions that give big credit facilities are also pushing towards IFRS. We saw an increase in importance of IFRS for companies who are not obliged to report under IFRS, because there are other stakeholders like credit institutions, shareholders and still other partners who demand it. In the past, small and medium-sized entities could stick to local GAAP. That has become a lot more difficult. A lot of SMEs ask for IFRS advice and IFRS conversion.”
What is the risk of not being compliant?
Mario Matthijs: “You could lose attractiveness in the market if you don’t use IFRS. Will an investor still be interested in your company if you cannot provide IFRS-compliant information? Can he rely on local GAAP figures? Will that investor be interested in Belgian GAAP, that basically consists of tax-driven accounting principles that do not give enough valuable information to make an investment decision? That does not give enough valuable information to make an investment decision. So, investors might turn towards companies that can deliver international KPIs for them to invest in. That could be a factor.”
Did you see different attitudes on the side of companies that are looking for international investors? Are they the most eager to comply?
Mario Matthijs: “Absolutely. There’s definitely a trend in private-equity owned companies. I have noticed a strong wish to adopt IFRS in that segment. Reasons to adopt could be twofold. First of all, markets are becoming even more international, with a lot of foreign investors looking for opportunities to invest all over the globe. That definitely drives companies to deliver international, IFRS-compliant information that everywhere in the world can be recognized. Secondly, IFRS adoption could also be an indirect consequence of IFRS 16 that makes the valuation of companies more appealing. Adoption of IFRS 16 actually increases the valuation of a company if you are using valuation techniques such as multiple EBITDAs or discounted cash flows. In both cases, an IFRS 16 adoption increases that value. That’s of course a ‘nice’ consequence, and as investor you need to be aware of this effect.”
Any other developments coming up?
Mario Matthijs: "Now this wave is over, the IASB has freed up some time to consider other projects. I see two or three important changes coming up. One is the digital submission of annual financial statements in an iXBRL format. That’s called ESEF or the European Single Electronic Format. As from January 1, 2020, the European Commission is requiring an XBRL type of reporting. All EU listed companies reporting under IFRS will have to use that digital format. The financial statements 2020 will be the first financial statements that will be reported under this single electronic format for European companies. (XBRL stands for eXtensible Business Reporting Language (XBRL), a freely available global framework of accounting standards used for exchanging business information. XBRLis based on XML coding and is a standardized way of transmitting financial records around the world. Editor’s note)
There certainly are a few advantages. Key financial information will be made more user-friendly and accessible. Previously, you could take a blank piece of paper and start to write your IFRS financial statements. Just like Belgian GAAP, the Belgian statutory accounts, the EU will now provide formats in which you must import certain financial figures. ‘Revenue’ will have to be entered in the exact same field that represents ‘Revenue’. That should make it easier for investors who want to check and compare revenue.
“I must say, market awareness about ESEF is still low. It’s only a formatting issue of course. It doesn’t change any reporting principles, but only the format in which the statements will be presented. ESEF will bring some workload, definitely, but there will be a smaller impact than from IFRS."
Mario Matthijs: “Two other developments that we will see some impact of are management commentary and non-financial reporting. Next to the mandatory IFRS financial statements, there’s also the commentary produced by the board of directors or the management, illuminated by nice tables and graphics. They tell you whatever you want to hear and how well they did.
IASB is now considering to integrate the management commentary into the financial statements. A clear advantage for investors is that the management report will be audited, as part of the financial statements. Companies won’t be able anymore to write whatever they want, because it will be regulated up to a certain degree.
In a management report today, you find nothing else than recurring EBITs, recurring EBITDA and EBIT before non-recurring items. Everybody interprets ‘non-recurring’ differently. Can you call a yearly restructuring a non-recurring item? Some companies do, and they take it out of the performance measurements. But should it be taken out? Probably not. Certainly if you do a restructuring program each year. Because the savings you do on salaries are not taken out. Integrating the management report into the financial statements will force companies to think about their non-IFRS terminologies that will become IFRS terminology.”
You also talked about non-financial reporting. Where does that lead us?
Mario Matthijs: “A lot of companies already report on non-financial performance such as the environmental and social impact of their activities. They disclose information on environmental parameters like recycling, water and energy consumption. That is becoming more important for investors as well. Knowing if a company is climate-neutral could become a differentiator for investors. Which company an investor is going to invest in: a climate-neutral manufacturing company, or a heavy-polluting manufacturing company?
The same is true for social parameters like equality: equal pay for men and women, equal representation in boards and on management level. Companies will be required to publish this non-financial reporting, which already a lot of them do, but in separate reports totally different from financial reports. Think of corporate governance reports, global citizenship reports, global environmental reports, a mix of all kinds of reports.
That’s why integration of non-financial KPIs will become important. If they are integrated in IFRS, the audit will also be better, and their importance will increase. It’s a trend that cannot be stopped. It’s not a question of IF it will be there, but WHEN it will be there."