US embassy cable - 04FRANKFURT10393

UNCLAS SECTION 01 OF 04 FRANKFURT 010393 
 
SIPDIS 
 
SENSITIVE 
 
STATE FOR EUR PDAS, EB, EUR/AGS, AND EUR/ERA 
STATE PASS FEDERAL RESERVE BOARD 
STATE PASS NSC 
TREASURY ALSO FOR IMB, Monroe ICN COX, HULL 
 
E.O. 12958: N/A 
TAGS: ECON, EFIN, EUN 
SUBJECT:  Accounting - Bumpy Ride to The Big Deal 
 
 
This cable is sensitive but unclassified.  Not/not for 
Internet distribution. 
 
1.  (SBU) Summary:  Having all 7,000 EU firms listed on EU 
stock exchanges use the same accounting standards will be a 
very big deal for European financial markets.  Investors 
will be able to compare investment opportunities, capital 
will be allocated more efficiently, and supervisors will 
more clearly assess the pan-European spectrum of a firm's 
activities. The big deal is due to become a reality starting 
with financial year 2005 when EU listed firms are to prepare 
their accounts using International Financial Reporting 
Standards (IFRS) endorsed by the European Commission (EC). 
The transition, however, will be bumpy.  Firms and their 
auditors and regulators will need time to adjust to the new 
accounting rules, some of which are new or still being 
developed.  Starting at the end of the first quarter next 
year, look for an increase in corporate communications 
explaining to shareholders that the company is as solid as 
ever, despite the change in profit and loss accounts due to 
accounting changes. Once through this bumpy transitional 
stretch, the road to more efficient markets should be 
smoother. End Summary 
 
2005: The Big Deal 
------------------ 
 
2.  (SBU) Financial year 2005 will be the first in which all 
EU firms listed on EU stock exchanges will be required to 
use IFRS as endorsed by the EC.  This requirement emanates 
from a July 2002 EU regulation. (A regulation takes direct 
effect in Member States in contrast to a Directive that 
requires a lengthier process of transposition into national 
law via national legislation.)  7,000 firms will be affected 
by the measure.  This is a very big deal in creating a more 
integrated EU financial market.  Accounts of firms will be 
comparable across borders, permitting investors to make 
better-informed choices, promoting a more efficient 
allocation of capital, and giving supervisors a better sense 
of operations on a EU-wide basis.  The EC's economic experts 
have reckoned that of all the major discretionary policy 
measures that could help knit EU financial markets closer 
together and boost growth, a high quality, uniform 
accounting standard is the most powerful. 
 
3. (SBU) Given the breadth and depth of implications of this 
accounting regulation, it is a wonder that the measure was 
adopted without much fuss.  European financial experts had 
sought for years to agree on common accounting standards, 
then in 2001 settled on the International Accounting 
Standards, now being called IFRS.  The substantive 
implications of this decision did not attract much attention 
at the political level.  Council and Parliament moved the 
measure briskly along to demonstrate that Europe was moving 
quickly on this front against the background of major 
accounting scandals in the United States. 
 
Transition: More Than Bargained For 
----------------------------------- 
 
4.   (SBU) Moving from the political plane to the practical 
has presented challenges.  More are yet to come.  The 
Commission has to endorse the IAS with the advice of the 
Accounting Regulatory Committee (ARC), a committee composed 
of member state representatives.  This endorsement mechanism 
is legally necessary to make the standards binding.  The 
Commission had hoped to have all IAS endorsed quickly, by 
early 2003.  Translation requirements slowed the process 
considerably to late fall 2003.  Accounting standards are 
not literary works, often requiring new words to express 
their very exact concepts hitherto without expression in 
some national languages. 
 
5.  (SBU) The endorsement process is politically important. 
In essence, the EC and member states are relinquishing their 
rights to formulate the accounting standards to a private 
entity, the International Accounting Standards Board.  Thus, 
the Commission and member states in the ARC were to give 
political cover for the use of IAS.  Commission experts 
explained that they had no intention of changing any of the 
IAS, with the understanding that European accounting experts 
participated in their development either directly in the 
IASB or through hearings on IASB proposals. 
 
6.  (SBU) Alas, politics did creep in when French President 
Chirac took up the cause of French banks who felt their 
operations would be unduly prejudiced by IASB proposals on 
the financial reporting standards (IAS 39).  As of the 
beginning of December, the Commission has endorsed all the 
IAS with the exception of two provisions of IAS 39 on 
financial accounting that are still being refined by the 
IASB.  The Commission expects the IASB to conclude work on 
these two provisions so they can be endorsed in 2005. 
 
Implementation:  Bumpy Road 
--------------------------- 
 
7.  (SBU) The more interesting transitional phase will be 
when firms begin reporting under IFRS at the end of the 
first quarter in 2005.  Analysts variously characterize the 
change as an "accounting reformation," "accounting 
confusion," a "shock wave" like Y2K, or "more significant 
than the introduction of the common currency."  Some of the 
hype might be attributed to salesmanship by accountants and 
auditors.  Yet there is more than a whiff of uncertainty in 
the air. 
 
8.  (SBU) Fitch Ratings points to several risks:  investors 
will be uncertain as to how to interpret the new 
information; accountants will make errors resulting in 
misstatements; difficulty in applying the new concepts will 
lead to restatements of accounts, particularly in the 
absence of a developed infrastructure on consistency and 
enforceability.  In technical guidelines prepared by the 
Institute of Chartered Accountants in England and Wales 
(ICAEW), the authors note that accountants are used to 
"incremental change," and that some may find "such major 
conceptual shifts are difficult to absorb and apply 
correctly to complex accounting issues." 
 
9.  (SBU) Fitch believes that no one can predict the 
magnitude of these problems, but it is fairly certain they 
will exist and could result in restatements of profit and 
loss accounts.  Fitch does not go so fair as to believe the 
new accounting results will lead to a change in credit 
ratings.  Such changes are possible if they reveal 
underlying problems that hitherto had been camouflaged by 
national accounting rules. 
 
What's In the Change? 
--------------------- 
 
10.  (SBU) What kinds of changes can be expected in the 
switch from national accounting standards to IFRS?  The 
answer differs from firm to firm.  The ICAEW's guideline 
notes that different definitions could result in items being 
placed in different accounting classifications, some items 
recognized as assets or liabilities under national 
accounting principles may not be so recognized under the 
international rules, and more extensive information 
requirements will require greater data capture needs. 
 
11.  (SBU) Experts cite some specific examples. 
Amortization of goodwill on acquisitions will be abolished, 
off balance sheet liabilities will have to be disclosed 
(such as pension plans or derivatives), the performance of 
separate lines of business will be disclosed, and stock 
options will be treated as an expense.  Such changes can 
affect different firms in different ways.  Until accountants 
provide the details, the outcome is not known.  Analysts, 
however, are tying to divine possible outcomes so as to be 
prepared for the day when a firm publishes its new accounts. 
 
12.  (SBU) Societe General equity analysts sought to review 
the potential affects of the accounting rule changes on 50 
European firms.  Generally, overall valuations would not be 
negatively affected, in their opinion, with some exceptions, 
and the quality of disclosure will remain the same or 
improve.  Firms in countries with local accounting rules 
closer to IFRS (e.g. the Netherlands and the UK) are less 
apt to see changes than those in countries with rules that 
are more different (France, Germany and Spain). 
 
13.  (SBU) Merrill Lynch reviewed potential results on UK 
banks and developed three broad conclusions.  Earnings could 
be generally lower at larger banks but higher at mid-sized 
banks as a result of bring additional costs on the profit 
and loss statements (pension charges and equity-based 
compensation).  Capital could be higher based on the 
assumption that general provisions will be added back to 
equity and the year-end dividend accrual is no longer 
accounted for as a liability.  Volatility could increase as 
a result of the new changes taking affect. 
 
Point of Departure 
------------------ 
 
14.  (SBU) The roughness of the ride for some firms will 
depend on the point of departure.  Firms that have been slow 
to prepare might find themselves rushing to meet deadlines. 
A survey of UK, French, German and Dutch firms by ATOS 
Consulting suggested that in the beginning of 2004 only 16% 
judged themselves ready, most (40%) being German, the least 
being UK (2%).  This figure could be misleading.  ICAEW 
notes that some firms that thought they were ready earlier 
in the year now believe they are behind because they 
misjudged the extent of changes necessary to make the 
transition to the new accounting standards.  A more recent 
study by PriceWaterHouse Coopers indicates that two-thirds 
of the smaller, mid-sized European firms do not yet have 
IFRS projects established on only 15% of these firms were 
confident to make the changes on time. 
 
 
15.  (SBU) There is also the question of whether a firm 
thinks the transition is worth the effort - not that they 
can do much about it - but it may color their attitude 
toward preparations.  40% of the firms in the ATOS survey 
indicated that they believe the new accounts will increase 
shareholder value, potentially a built-in incentive to move 
more quickly.  However, 22% thought the effect would be 
negative.  Overall, this meant a net of 18% of the firms 
judged the change to be positive for shareholder value. 
Honing in on the detail reveals a varied picture.  More 
German firms judged the change as positive for shareholder 
value (a net 29%), while the UK firms surveyed were, on 
balance negative (2%). 
 
Consistency is Key: Enter CESR 
------------------------------ 
 
16.  (SBU) The transition will take several years, in 
Fitch's opinion.  Interpretations and enforcement will begin 
to answer questions and smooth out differences in accounting 
creativity.  Some accounting experts believe the U.S. 
Securities and Exchange Commission will also play a role as 
firms with listings on US markets will seek SEC accounting 
experts' council in preparing their new accounts. 
Consistent interpretations at the national level would be 
one challenge; consistent interpretations among all EU 25 
member states is a daunting challenge.  The Committee of 
European Securities Regulators (CESR) has taken it up. 
 
17.  (SBU) CESR has published two standards on financial 
information and coordination of financial activity.  CESR 
will convene European Enforcer Coordination Sessions (EECS) 
to exchange views and discuss enforcement issues including 
decisions on interpretation of a standard by national 
enforcement authorities.  CESR will maintain a database of 
enforcement decisions that national enforcers can consult 
prior to making their own decisions.  Decisions taken by 
national authorities that are in apparent contradiction to 
those taken previously would be discussed by the EECS. 
 
Get the News Out 
---------------- 
 
18.  (SBU) Consulting firms are advising clients that, 
whatever the new accounts look like, firms should be quick 
to explain the results to investors.  CESR has advised firms 
to begin early to explain its transition plans to 
shareholders and to have comparable IFRS accounts for 2004 
as well as a "bridge" explaining differences between the 
2003 and 2004 accounts. Different accounting outcomes do not 
mean that a firm has changed in its overall performance, but 
investor's perception of that performance can change. 
 
19.  (SBU) Whether the change is for the better or for worse 
will depend, as noted above, upon the firm's previous 
accounts.  Analysts at Societe General believe that firms 
may use discretion afforded under IFRS to reduce the affect 
on their profit and loss statements and balance sheets. 
Getting through the transition period for some firms may not 
be easy.  A German accounting professor pointed out that 
uncertainties surrounding such a transition could lead to 
higher costs of capital in the near term.  Rewards at the 
other end, however, could be considerable for some firms. 
For EU financial markets as a whole, firms and investors, 
the gains will be significant. 
 
20.  (U) This report coordinated with USEU, Embassy Berlin, 
London and Paris. 
 
21.  (U) POC: James Wallar, Treasury Representative, e-mail 
wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 
7535-2238 
 
Bodde