The Effects of IFRS on Financial Ratios: Early Evidence in Canada 

Backgrounder

This timely CGA-Canada publication examines the impact of International Financial Reporting Standards (IFRS) on key financial ratios of public Canadian companies as they transition to the new financial reporting regime this year. IFRS replaces Canadian Generally Accepted Accounting Principles (GAAP) for publicly accountable enterprises and affects figures presented in financial statements. The differences between IFRS and pre-changeover Canadian GAAP regimes may lead to variances in financial ratios – the key indicators on which investors rely to gauge a company’s financial performance. The variances in ratios can impair the comparability and analysis of historic trends. The report does point to opportunities to mitigate these challenges. Companies are initially required to produce statements using both sets of accounting standards.

Report highlights

Most of the ratios under IFRS are more volatile than those under pre-changeover Canadian GAAP

• Maximum values of several ratios are higher and minimum values are lower under IFRS, although the effects of IFRS on means and medians of ratios related to the financial condition of companies are not statistically significant.
• There is a significant difference in the distribution of values around medians for such ratios as current and quick ratios, debt, alternative-debt and equity ratios, interest coverage, fixed-charge and cash-flow coverage, return on assets (ROA), comprehensive-ROA and price-earnings related ratios.
• The exact source of the increased volatility of ratios under IFRS remains unclear. The causes may include the incremental adjustments that are specific to IFRS, and those associated with the principle-based approach that allows for more discretion and judgment by management.

Differences between IFRS and pre-changeover Canadian GAAP do not affect cash flows

• The cash-flow statement is less influenced by accounting methods and estimates, and serves as a sound basis of comparison.

The impact of IFRS is subject to the industry effect and how recently the company transitioned to IFRS

• Companies in the mining sector seem to have certain incentives to early adoption of IFRS as early adopters primarily consist of companies in this sector.
• Under IFRS, profitability and coverage ratios of mining companies are affected to a greater extent than the ratios of companies in other sectors.
• Companies that implemented IFRS more recently had lower profitability than those that had been applying it for some time.

IFRS’ impact on financial ratios is driven by differences in application of fair value accounting and consolidation, and several other differences

• Fair value accounting leads to adjustments in balance sheet figures, direct allocation of some unrealized gains and losses to the income statement, as well as allocation of other unrealized gains and losses to other comprehensive income.
• Liquidity and leverage ratios are affected by fair value accounting practices due to balance sheet variations while profitability and coverage ratios are affected due to balance sheet variations and recognition of unrealized gains/losses.
• The impact of consolidation on ratios is difficult to isolate as the differences are incorporated or combined in the consolidated figures. Incorporation of minority interest in equity also has a significant impact on financial statements, directly affecting profitability and leverage ratios.
• A number of other differences between IFRS and pre-changeover Canadian GAAP impact financial ratios. Leverage and profitability ratios are sensitive to the differences in impairment test procedures applied to long-lived assets, as well as to the impact on liabilities, expenses and equity caused by the differences in application of standards on leases, pensions and contingencies, and share-based payments.

Specific characteristics differentiate IFRS from other accounting regimes

• IFRS is principle-based; it gives more importance to substance (over form) and allows management to use greater discretion and flexibility in choosing accounting methods and estimates when preparing financial statements.
• Fair value accounting responds to investors’ needs for information that reflects market-based values, but involves varying degrees of subjectivity. Since investors need market-based values to make decisions regarding buying or selling stocks, many items in financial statements are required or eligible for fair value accounting under IFRS.
• Comprehensive income reflects revenues, expenses, gains and losses recognized during a specified time period. It is summarized in a separate financial statement made up of two parts; one corresponding to the bottom line (profit or loss) of the income statement and the other – called other comprehensive income (OCI) – relating to fair value adjustments.
• The entity theory underlies consolidation requiring assets and liabilities of acquired subsidiaries and minority interests to be measured at fair value. Under IFRS, the share of profit allocated to minority interest is recognized directly in equity rather than income.
• IFRS improves transparency and completeness of financial statements, yet can lead to information overload as accompanying notes are abundant and complex.

Recommendations

• Analysts should continue to be cautious when examining financial ratios during the transition to IFRS in Canada.
• Financial statement users need to be aware of the main features of IFRS that differ from pre-changeover Canadian GAAP and distinguish between reported performance changes caused by the transition to IFRS from those caused by changes in the business.
• Relying on cash-flow analysis is recommended, particularly in cases when accounting practices are subject to uncertainty or discretion of management. Another possible solution may lie in recalculating ratios using IFRS retroactive information presented in the year of transition.
• Financial statement users are advised to verify the uniformity of underlying figures when using gross profit and operating profit margins in profitability analysis.
• The use of comprehensive-ROA (return on assets) and comprehensive ROE (return on equity) is recommended to enhance comparability when analyzing comprehensive income. These represent an adaptation of the standard ROA/ROE calculations which substitute comprehensive income as the numerator.

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