No accounting for the effects of new accounting standards

Benj Gallander and Ben Stadelmann
Friday, June 24, 2011

For value investors, the impact of the implementation of International Financial Reporting Standards (IFRS) in Canada is difficult to discern. That’s due in part to the very gradual eclipse of the Generally Accepted Accounting Principles (GAAP) methodology. The rating agencies have played ball; there has been no wave of debt downgrades due to the transition to IFRS.

“A change in the medium of communicating financial results does not normally have a significant impact on the economic position of an entity,” soothed Moody’s. Then, too, we are talking about the minutiae of bean counters, just slightly more penetrable than the legalese on a typical Internet terms-of-service agreement.

On the flip side of the coin, we have forensic accounting crusader Al Rosen, who darkly opined, “Under IFRS, corporate managers will have even more freedom to distort and manipulate their financial reports to make themselves look better than they really are.” So it would seem that it would be useful to have at least a passing understanding of IFRS. A search of the Amazon bookstore shows that an IFRS for Dummies does exist, but is only available in German. Scheiss!!

One thing is for sure: the adoption of the new standard has increased the girth of the financial reports of many publicly traded companies, with the addition of copious notes and appendices. When past results are restated to incorporate IFRS retroactively, shareholders can review the reconciliation between the old and new to illuminate the bottom-line impact of the change.

Take, for example, Bellatrix Exploration, an oil-and-gas play from the Vice President’s Portfolio. The 2011 Q1 report released last month was the first in accordance with IFRS. In order to initiate an apples-to-apples comparison, the balance sheet as of the end of 2009 was restated through the filter of IFRS.

The impact is significant. Under GAAP, Bellatrix reported total assets of $441 million and liabilities of $159.6 million, for a net shareholder equity of $281.4 million. With IFRS, $30.6 million worth of stuff apparently dissolved into thin air, reducing total assets to $410.4 million. On the other side of the equation, an extra $12.3 million in liabilities popped into existence. Together, that resulted in a $42.9 million reduction in shareholder equity, to $238.5 million, enough to knock the book value from $3.57 to $3.03 per share.

Notably, Bellatrix’s stock price opened 2010 at $3, so what appeared to be a bargain compared to book value under GAAP saw the discount nearly wiped out under IFRS.

Rolling forward to March 31, 2010, the spread between GAAP and IFRS has narrowed a little. Under GAAP, Bellatrix would have shown shareholder equity of $324.8 million; instead, the new IFRS figure is $285.9 million.

Out of the reams of detail from the report, there are a couple of key components to the divergence that stand out. Due to the changes in how exploration, evaluation and development expenditures are capitalized, less of the company’s efforts to find petroleum are now considered future assets. For the calculation of decommissioning liabilities, a discount rate is applied, as it represents money that will be spent far into the future. Under IFRS, a lower discount rate is used than under GAAP, so the current liability is much higher.

The thing for investors to remember in all this is that accounting must cover two very different types of data. There are items that are known with certainty — how much was paid for such and such, what category it belongs in, how much money is in the bank, the total owed, etc. But in other areas, accounting must make a reasonable, conservative estimate that, in reality, might prove to be more conjecture than reality.

Sure, one can assume that decommissioning a well with future dollars will cost less than in today’s dollars, but the ambiguity isn’t restricted to what discount rate to apply. What will the environmental standards for decommissioning be 30 years from now? What new technologies for doing so will exist? What innovative methods of extraction will be developed to prolong the well’s life? Will the future price of oil make those techniques economic? The answers to these questions will have a lot more to do with the eventual cost than tweaking an interest rate model.

So what’s better, GAAP or IFRS? This is a debate that will keep the blue jackets going for years. The view from here is that either accounting methodology, applied correctly, is good for telling you what has happened in the past. Too often though, neither will formulate an adequate crystal ball.