Why Privately Held Manufacturers Should Implement IFRS-ready ERP Solutions
In this article, we'll review the different reasons why even private companies should prepare to adopt International Financial Reporting Standards (IFRS). We'll also delve into the reasons why asset-intensive industries should be excited to make the switch, and we'll discuss the specific steps involved in IFRS adoption.
Currently, the United States (US) is slow to adopt IFRS to replace Generally Accepted Accounting Practices (GAAP). While the timeline for adopting IFRS in the US may be an uncertainty, it may be inevitable. In the meantime, the International Accounting Standards Board (IASB) recently released IFRS guidelines specifically for small to medium businesses (SMBs)—which should put privately held companies on notice that IFRS is of keen interest to them as well.
In the US, some companies like IFS North America have already adopted IFRS. Companies with overseas operations may also adopt IFRS for parts of their business while running the rest of their operations on US-based GAAP.
What is IFRS, and Why Do I Care?
It is perfectly logical to think of IFRS as a new set of accounting standards that some companies will be required to adopt, and one that companies in some countries have already adopted. By looking past the regulatory requirement to holistic business dynamics, we get a better picture of what IFRS really means.
IFRS is becoming the global language of business. In the future, companies will communicate with investors in public securities, bankers, customers, merger and acquisition consultants, and other influential parties. It will be a consistent standard that everyone will be measured against—whether you are in China, the US, Canada, Mexico or anywhere else. As the global economy begins to encompass more and more mid-market manufacturers, and as more of these companies have trading partners or even subsidiaries overseas, it will be important for companies to speak the same financial language as the rest of the globe.
The IASB developed IFRS. This new method of financial reporting has already been formally adopted by many countries who are members of the European Union (EU), and more countries are adopting this standard every day. Some of the key business drivers for IFRS include the need for consistent accounting standards and disclosure requirements. If you are using US-based GAAP, or some other accounting standard, conduct international business operations, and you are dealing with IFRS, you are really operating with two different sets of records. This can be time-consuming, costly, and challenging at the end of every month, quarter, and annum as the different sets of books are reconciled.
In the meantime, you might be using management basis of accounting to run your business because US-based GAAP does not provide the best real-time information when it comes to making decisions about your business. This means that some companies may find themselves running three sets of books: IFRS, US-based GAAP, and management basis of accounting. Enterprise solutions are agile enough to deliver this degree of flexibility with minimal rework and administrative overhead, which is critical for manufacturers.
Figure 1. Internal Ledgers (top) track IFRS, US-based GAAP, and management accounts in one transaction feed eliminating the complexity of tracking multiple reporting books. The screen that displays asset carrying cost (below) provides visibility in multiple currencies by transaction, account, and corporate entity. Illustration provided by IFS North America.
Apart from agile enterprise software, financial executives will need agile minds as IFRS places a greater emphasis on fair value as a measurement basis. This may require some additional legwork and exercise of sound business judgment. IFRS is a more principle-based approach. It gives the financial executive greater latitude to exercise judgment as they account for the economic realities of a transaction rather than following proscribed steps. However, this will create challenges in the absence of precedent or guidelines. Accountants, chief financial officers (CFOs), and chief executive officers (CEOs) will find themselves making more judgment calls than they might initially be comfortable with.
There are three basic reasons why manufacturers will want to be prepared for IFRS sooner than required by regulation—even if the private companies are not affected by the US Securities and Exchange Commission (SEC) mandates:
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IFRS is important in order to access capital markets. Publicly held companies should find this attractive as an alternative method of obtaining capital, but if you are a private company, you are often entirely dependent on commercial lenders for capital. Analysts for these lenders are always looking at your company's progress, often comparing your company against competitors. It is hard to do that without a uniform measure for comparing organizations.
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The increasingly global nature of business will make IFRS capabilities a business success factor. Some US manufacturers with subsidiaries in countries that have rolled out IFRS will already have to run at least part of their business on international standards. Other companies planning to expand globally will want to develop IFRS capabilities proactively. There are already enough organizational hurdles to hanging a shingle in a different country without adding a new financial reporting methodology at the same time. Moreover, potential customers, particularly those located in geographies where IFRS is already mandated, will use international standards rather than US-based GAAP to evaluate the financial stability of their vendors.
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Manufacturers who are not publicly held often act as suppliers to companies that are public. These corporations in turn may see IFRS as a way to gain greater visibility into the financial health of their supply chain partners, which means the ability to communicate through IFRS could make a vendor more attractive as a trading partner.
IFRS Insights for Manufacturers
While some elements of IFRS will be of particular interest to manufacturers, one key concept that every executive needs to understand is that these new global standards are much more open to interpretation than US-based GAAP. This is in part because of wording from IASB. Without precedence, track records, or history that accountants and executives can look to for guidance, it is difficult, for instance, to determine exactly how to value capital assets.
Now that we have established what IFRS is and why it is important for privately held manufacturers, let's delve into some key points about IFRS. One change that will affect many manufacturers is in the area of inventory valuation. IFRS does not allow for last-in, first-out (LIFO).
Figure 2. IFRS will require companies to have enterprise applications with a degree of flexibility in the area of inventory costing. Illustration provided by IFS North America.
Similar changes are afoot in asset accounting—especially in the area of fixed assets—which manufacturers will likely see some of the most significant changes. For instance, under US-based GAAP, when an asset's carrying value exceeds its fair value, it is recognized as an impairment loss, with fair value being determined by future undiscounted cash flow from the asset. But under IFRS, that impairment loss is realized once the asset's carrying value exceeds its fair value minus liquidation costs, or its value in use—whichever is higher. Unlike US-based GAAP, IFRS permits reversal of an impairment loss, except for goodwill losses, up to the new recoverable amount but not to exceed the original carrying amount.
IFRS also requires industries that own fixed assets to break down those assets into classes that have a significant value. If there is a different useful life to some components of those assets (e.g., if a turbine in an electric generation facility has a separate life cycle from the plant as a whole), they need to be accounted for separately as well. This differs from US-based GAAP which requires accounting at a much more granular level as opposed to accounting by classes of assets. Another consideration is that initial recognition is going to be a cost with US-based GAAP. In a regulated market like oil and gas, you also need to begin capitalizing any potential cost of dismantling and bringing that asset back into workable order as it nears the end of its life cycle.
Once the asset is capitalized, IFRS allows for two options for valuation after that date of recognition. It is possible to use the cost basis, which those accustomed to US-based GAAP are very familiar with; in this case, the asset would be depreciated over its useful life using whatever method reflects the way the asset was used over the period.
Alternately, accountants can use a new concept within IFRS—the revaluation method. Revaluation is an approximation of what the fair value of that asset is at any point in time. IFRS requires that a fair value assessment be carried out regularly, and that the carrying value of the asset does not differ materially from its fair value at any point in time. In theory, though, we could have an asset that on a US-based GAAP basis would be carried at historical cost at whatever you bought it for depreciated for each year that you have owned it. But this asset could now, under IFRS, be carried on a fair value every year for what it would cost you to go out and replace that asset. That will certainly move that asset component of your balance sheet closer to a more relevant, fair value concept.
IFRS compliance is easier if an enterprise application allows for user-defined base values for assets (top) and multiple depreciation methods. The ability to review asset data by account/project and life of cost and cash flow (below) is also helpful. Illustration provided by IFS North America.
The revaluation method will require ongoing due diligence in the market to determine fair market value. It is important to determine what your enterprise system can do to help you track what that fair value is at any given point in time.
If you have an increase in your revaluation level at any point, it will be necessary to track the increase separately as a component of equity. If the revaluation reflects a decrease, the revaluation surplus will have to be eliminated out of the component of equity. If you decrease the revaluation surplus out of equity to zero, the asset must be written down through the income statement.
Life cycle extensions for existing assets will also be treated differently under IFRS. Under IAS 16, the fixed asset is recognized when it becomes likely a future economic benefit from the asset that will flow to the enterprise, and the cost of the asset can be measured reliably. If organizations are reinvesting in existing fixed assets (e.g., rebuilding the process equipment within an oil refinery), they apply the principle-based concept in international accounting. This also gives the owners of complex assets the flexibility to capitalize things (e.g., spare parts that an oil and gas drilling contractor might have in their yard). If these parts still have value, an organization has the ability to keep them in the books as long as there is a future economic benefit within that part.
The Role of Enterprise Software
When preparing to adopt IFRS, it would make sense for executives involved in selecting new enterprise software to ensure that the application can manage the requirements for IFRS. Enterprise software can include various standard features (e.g., functionality to automate IFRS requirements for inventory valuation). More importantly, an enterprise application should be agile enough to allow a company to run multiple bases of accounting with minimal additional work.
Adopting IFRS will be one of the most significant changes most companies will have to deal with in coming years. Executives can look at this as a burden or an opportunity to increase the agility and flexibility in their systems. Early adopters of IFRS in Europe have found that it does not make sense to operate separate, parallel systems to achieve IFRS compliance. This creates reconciliation challenges as well as sustainability challenges. An enterprise software environment is flexible enough to handle multiple sets of books and records, and can report in multiple basis of accounting.
It is also important to understand the different data elements within your enterprise system required within IFRS that you do not have to account for currently. The different requirement to count for components in the capitalization of fixed assets is another example. You will need to collect different data, and access that information on a timelier basis. It is a good opportunity to examine your enterprise resource planning (ERP) system to determine if it has the flexibility. Privately held companies in North America will likely be able to adopt IFRS gradually over a period of time, which magnifies the biggest challenges for CFOs—keeping each of these bases of accounting in line and reconciled while serving the needs of their business constituents.
Those in regulated industries will have an even more complex task in adopting IFRS because they will have even more existing reporting bases to keep current during and after the transition. That is one of the lessons learned from companies in the EU that have already adopted IFRS. It does not make sense to try to comply with IFRS in a system that is running parallel with an existing ERP system because, if it is always going to be handled through some type of add-on or patch, it will never be integrated into your systems or reporting and internal control structure. Examples of additional reporting requirements that result from regulations might be Section 404 of the Sarbanes-Oxley Act (SOX). Utilities often have other financial reporting requirements, as do companies in other industries.
Once your company commits to adopting IFRS, don't panic! The task can seem daunting, but breaking it up into several discrete, manageable steps will help ensure success. When IFS converted to IFRS in January of 2005, these steps were followed, and the transition was smooth and orderly.
Compare existing accounting practices to IFRS. At the time IFS converted to IFRS, there were 41 international accounting standards, but it was determined that only 16 of those actually applied to IFS. The lesson to take from this is that the sheer number of accounting standards contained within IFRS may seem daunting, but the number that will actually affect your business will likely be smaller.
A business modeling tool within an ERP application can help standardize and automate IFRS compliance activities. Illustration provided by IFS North America.
Complete a gap analysis. Your chief accountant should walk through and look at your local accounting principles, create a list of the IFRS accounting principles that apply to your business, and highlight any major areas of change. In some cases, even when the international standard represented a change, it wasn't significant. For instance, IFS historically had to review financial instruments for embedded derivatives and typically reviewed our accounts payable (AP) contracts. But we found that under IFRS, IFS also needed to review all rental and lease contracts. In some cases like this one, the new IFRS standard might simply have a broader explanation than the US-based GAAP standard currently in place.
Revise the financial accounting manual. Update your financial accounting manual and summarize the new elements that local managers or division heads need to review. It is then necessary to work with each controller or others who maintain and audit your company's accounts to make sure they review the new elements of the financial accounting manual in detail and are ready to begin following these new processes.
It is also important to involve external auditors and other interested outside parties as early as possible because they will be the ones coming in to review your changes and assumptions. After all, if there is any difference in the way you and your auditor interpret the standard or how it applies, it is better to figure that out beforehand instead of after a new process has already been rolled out company-wide.
If you are reliant on your bank for loans and ongoing working capital, it might be a good idea to educate your bank on some of the specific changes it can expect to see in your balance sheet. In some cases, the move to IFRS has made it appear that companies were breaking covenants with their lending institutions; misunderstandings like that are easier to avert than to resolve. Bankers might be somewhat aware of IFRS, but may not have a very deep familiarity with how adopting international standards will be reflected in your company's balance sheet. For instance, valuing your intangible assets could affect your profit and loss report and balance sheet over the next three years, and some of the changes involved in IFRS may impact your forecasted earnings before interest and taxes (EBIT). It is important to communicate these changes in advance to help some real headaches down the road.
SOURCE:http://www.technologyevaluation.com/research/articles/why-privately-held-manufacturers-should-implement-ifrs-ready-erp-solutions-20471/
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