List of Figures

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Presented to: University of Groningen, Faculty of Economics

in fulfillment of the thesis requirement for the Master Diploma in Accountancy

Author: Vinci, S.C. Ee

Student ID: S1519301

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Abstract

As we advanced to the year of 2005, the mandatory application of International Financial Reporting Standards has become a practical reality for domestic publicly listed companies in The Netherlands that are currently using the national accounting standards in consolidated financial statements.

Although recent changes in Dutch GAAP have been based on IFRS and various IFRS developments have been incorporated in the local standards, there are still differences between the two in a great numbers of areas. Therefore, it is of interest to study the impact that the companies would have from this forced changeover. The focus is on what are the key changes and the change magnitude most of these companies would have from applying IFRS in their accounts for the first time.

In this thesis, the establishment and regulatory context of IFRS and Dutch Guidelines for financial reporting are elaborated. The main financial areas that cause key changes to companies’ accounts are identified and discussed. The impact and implication of IFRS adoption for companies are analyzed and discussed.

In particular, a quantitative study of IFRS financial impact on 5 surveyed Dutch listed companies is conducted. Financial data was collected mainly from their 2004 and 2005 annual reports and also press releases in regards to IFRS impacts. The study focuses on the impact of IFRS First-time adoption for surveyed companies in practice. The quantified impact of IFRS main changes are elaborated and discus sed. Subsequently, the overall IFRS impact on consolidated equity and net income for sample companies would be analysed and discussed.

The study is motivated by the adoption of IFRS in the European Union (EU) and The Netherlands and of contribution to the international accounting literature. The issues and findings to be addressed in this thesis would be relevant and of interest to companies, financial reporting users, accounting professions and accounting regulatory bodies. In addition, this study should be important for unlisted companies in the Netherlands and companies in other countries worldwide that are going to adopt IFRS in the near future.

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Foreword

This thesis is part of my master course program in accountancy and written under the supervision of Drs. J. Westra-de Jong. I would like to give special thanks to Drs. J. Westra-de Jong for giving me her valuable opinions and advises.

I would also like to thank Prof. Dr. Van der Meer for believing in me and giving me the opportunity of doing the Dutch master course in accountancy, despite the fact I am a foreigner and was merely about a year period in the Netherlands.

Furthermore, many thanks to my husband, Bart Camp, for his encouragement to enrol in this course and great supports during my study period. Also, special thanks to Paul Camp, Marianne Camp and Oma Hennissen for lighting candles and wishing me good luck for the exams.

Vinci Ee, June 2006

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Abbreviation

ARC Accounting Regulatory Committee

EC European Commission

EFRAG European Financial Reporting Advisory Group

EU European Union

DASB Dutch Accounting Standards Board IAS International Accounting Standards IASB International Accounting Standards Board IASC International Accounting Standards Committee IFRS International Financial Reporting Standards

IOSCO International Organization of Securities Commission NIVRA Royal Dutch Institute of Register Accountants

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List of Figures

Figure 1.1: The due process for setting an IASB standard Figure 6.1: Main areas of IFRS Impact on Income Figure 6.2: Main areas of IFRS Impact on Equity

Figure 6.3:Quantified IFRS Impact on Consolidated net Income Figure 6.4: Quantified IFRS Impact on Consolidated Equity

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List of Tables

Table 5.1: The IFRS key areas within five industry sectors Table 5.2: Significant changes reported by sample companies

Table 5.3: The classification of financial assets and financial liabilities Table 5.4: The principal differences between IAS 39 and Dutch standards Table 5.5: The principal differences between IAS 32 and Dutch standards Table 5.6: The use of preference shares for sample companies in 1998 and 2004 Table 5.7: Percentage of preference capital to total group equity

Table 5.8:The main differences between IFRS and Dutch standards on business combination and goodwill

Table 5.9: The principal differences between IAS 19 and Guideline 271(2003 edition) Table 5.10: The differences between IFRS 2 and Guideline 271

Table 6.1: Principal differences between IFRS and Dutch Standards that have impact on IFRS conversion

Table 6.2: Quantified IFRS Impact on Income Statement and Equity

Table 6.3: IAS 39 and IAS 32 quantified impact on income statement and equity of ABN AMRO under IFRS restatement

Table 6.4: IAS 39 and IAS 32 quantified impact on NL consolidated net loss and equity for Ahold under IFRS restatement

Table 6.5: IFRS impact on the total assets, total liabilities, consolidated net income and equity Table 6.6: Statement of changes in equity format presented by surveyed companies

Table 6.7: Accounting options under IFRS 1 taken by surveyed companies

Table 6.8: Valuation model used by surveyed companies for share options and performance shares

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1 Introduction

In this section, the subject of this thesis is introduced. The purpose of this study and the problems to be addressed are described.

1.1 Background

In June 2000, the European Commission proposed that all listed EU companies prepare their consolidated financial statements in accordance with one single set of accounting standards, namely International Accounting Standards¹, by 2005 at the latest. The Commission acknowledged that financial reporting is a key part of achieving an efficient market within Europe. Applying a common framework for financial reporting would bring about transparency and greater comparability between financial statements of companies operating on the European capital market.

This would contribute to greater market efficiency, better diversification and lower capital costs. In turn, lower cost of capital for listed companies promotes investment, growth and employment.

The Commission introduced its legislative proposal in February 2001. In June 2002, The European Council of Ministers approved the IAS Regulation no. 1606/2002 and it was immediately passed into the national laws of Member States. Because the IAS regulation is primarily a capital market measure, it applies to all companies governed by the law of Member State whose securities are admitted to trading on a regulated market in the European Union (EU). The Netherlands has incorporated the law into Part 9, Book 2 of the Netherlands Civil Code. The consequence is all domestic publicly listed companies in the Netherlands and their subsidiaries and non-listed groups who issue negotiable letters of credit under the regulations of the EU market are affected under this new regulation. All listed companies are compulsory to apply IFRS in theirs 2005 consolidated financial statements and at least one year of comparatives for external reporting.

1.2 Problem Discussion

The decision of European Union to adopt IFRS is aimed to reinforce the efficiency of the internal European market, reduce companies costs of capital, serve to increase the trust of investors, and ultimately improve the competitiveness and growth potential of companies adopting IFRS.

However, this progress of adopting IFRS will not come without some unintended impacts on affected companies.

According to NIVRA (2002-2003), the mandatory use of IFRS as from 2005 will place a huge burden on the accounting systems and departments of those companies converting to IFRS. Martin Hoogendoorn, chairman of DASB, criticizes that many affected companies may have difficulties of meeting the IFRS deadline due to the frequent changes to the international standards and the complexity of these changes. In a period of 11 months (from Jun 2003 till April 2004), there are a

1 International Accounting Standards (IASs) were adopted by the International Accounting Standards Board in April 2001. IASs were issued by its predessor, the International Accounting Standards Committee (IASC).

Accounting standards developed by the IASB are called International Financial Reporting standards (IFRSs)

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total of 2065 pages of new standards being published and most of the published standards are applicable from 1 Jan 2004. ²

Large accounting firms around the world, such as Ernst and Young and PricewaterhouseCoopers, considered that the transition to IFRS is more than changing from one set of accounting principles to another. There are a number of different financial accounting and disclosure requirements in IFRS that will result in material financial reporting differences. Those companies, which prove to be the most transparent and which help their investors to understand the impact of the change will be the ones who gain the most.

The much detailed and stricter formulated IFRS would have significant impacts on companies’

reported numbers, Dr. Vergoossen, R.G.A. (2003). Particularly, the IFRS concept of fair value accounting, that passes non-cash asset and liability revaluations through the income statement. This would lead to increased volatility in the reported earning. Wilson (2001) said that the IFRS adoption problem would be huge for many European companies. This is because Europe is embracing a vision for financial reporting that is not necessarily widely known or understood. It is a vision that considers fair value measurement to be paramount, rejecting historical costs, accruals and the realization principle.

Cheney (2002) state that companies in many countries within the EU, especially those countries with a local GAAP that is not particularly developed or where it quickly adjusts to international standards, will have no difficulties to prepare consolidated statements in accordance with IAS. On the other hand, Andre Tukker (2003) warns Dutch companies that there are significant differences between IFRS and the local reporting standards despite the fact that recent changes in Dutch Guidelines have been based on IFRS and various developments have been incorporated in the Dutch law. The impact will be different for different companies. He anticipates the impact would be more significant for banks and insurance companies than for multinational trade and production corporations.

Some argue that the change to IFRS involve only ‘paper’ effects and will not directly affect future cash flows of companies and consequently future dividends and share values. It would not matter to companies as long as the affected companies fully disclose and explain the changes. However, others argue provide that firms are affected from the change of accounting standards, if such changes adversely affect reported net income, key performance measures would be adversely affected, even though there is no impact on cash flow. Key performance measures such as debt-to- equity ratio and earning per share. For example, a borrowing firm may covenant to maintain a specified level of debt-to-equity during the debt contract term. If IFRS leads to quite different profit and balance sheet results to those under the previous reporting regime, there is a significant risk that the financial covenants will be breached in some loan agreements. This could result in a bank being permitted to demand repayment of its loan and cross defaults being triggered in other finance agreements.

As has been discussed above, the forced changeover to IFRS is expected to bring significant impacts and implications to the affected companies in the Netherlands. Despite in recent years the Dutch Guidelines and company legislation are strongly influenced by IFRS and EU Directives, there are still differences existed as no two systems are exactly the same. Differences between IFRS

2 Koopmans and Vergoossen (2004), Europa moet IFRS goedkeuren, De Accountant , issue July/August

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and Dutch standards are found in all areas according to Ernst & Young (2005). Hence, we could hypothesize that the use of IFRS is highly likely to lead to significant differences on affected companies’ financial results.

1.3 Problem

The problem statement of this thesis is:

What are the major impacts that affected companies in The Netherlands would have from applying IFRS in theirs consolidated financial statements?

Comprising the above big question are these sub questions, which are the main areas of the thesis focus:

(1) Which are the main financial areas cause changes to the financial statements for most of affected companies?

(2) To what extent the companies’ financial results are affected in real practice?

(3) What are the impact and implication for companies from this changeover?

To address the questions, the following issues will be addressed in this study:

• The establishment and endorsement of International Financial Reporting Standards

• The development and regulatory context of Dutch accounting standards

• The principal differences between IFRS and Dutch Guidelines for the main financial areas, which cause the key changes to the financial statement for most of affected companies.

1.4 Purpose

The main purpose of this thesis is to study the impact of IFRS adoption for companies and to provide evidence the application of IFRS leads to quite different profit and balance sheet results to those under the Dutch accounting standards.

In particular, a quantitative survey of IFRS First time adoption is conducted. The aim of conducting the survey is to study the financial impact of IFRS for affected companies that have restated their 2004 financial statements in accordance to IFRS in real practice. It focuses on the impact of IFRS adoption on key areas and subsequently consolidated equity and net income. The survey approach, data collection and sample selection will be discussed in section 2: Research methodology.

1.5 Scope and Limitations

The study mainly concerns the impact of IFRS for domestic publicly listed companies in the Netherlands. This is done because presently unlisted companies are still allowed to report in accordance to Dutch legislation and guidelines. Under the IAS regulation, companies that report

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under US GAAP may continue to do so until 2007. However, the Dutch government did not grant the extension. Nevertheless, The financial impact of IFRS for those companies that are currently using US GAAP for reporting will not be investigated in this study.³ This study is limited to explore the key differences between IFRS and Dutch Guidelines for financial reporting and the financial impacts due to the differences between the two.

In addition, this paper is not attempting to a comprehensive description of IFRS, but to flag the main accounting issues that most of affected companies may come across in converting their consolidated accounts from Dutch standards to IFRS.

Both IASB standards and Dutch Guidelines for financial reporting are in a process of continuous development and change. As a result, a number of the differences highlighted in this document may disappear, and new differences may arise. The cut off date for this study is on 31 December 2005.

1.6 Structure

This thesis is organised as follows:

Section 2 describes the method used, data collection and sample selection for this thesis.

Section 3 elaborates the establishment and regulatory context of International Financial Reporting Standards. The EU endorsement of IASB standards would also be discussed.

Section 4 elaborates the development and regulatory context of Dutch accounting standards.

Section 5 identify the main financial areas that cause key changes to the accounts for most of affected companies, analyses and discuss the key differences between IFRS and Dutch Guidelines on these main financial areas and subsequently the corresponding impacts due the key differences between the two standards.

Section 6 presents the empirical results and empirical finding analysis Section 7 concludes the paper

3 Dutch Companies that are listed in both the domestic and foreign exchange market are permitted to use US GAAP for reporting. For example, Royal Philips Electronics decided to change from Dutch GAAP to US GAAP as primary basis for reporting in 2002.

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2 Research Methodology

This section describes the research method used, data collection and sample selection method for this thesis.

2.1 Research Method

This study applies a mixed methodology, combining a qualitative method and quantitative method, to address the questions of this thesis. A mixed methodology enables us to obtain both quantitative and qualitative data as to corroborate and complement findings.

In this study, the changes from the forced IFRS changeover for affected companies are analysed based on the collected qualitative data. The differences between IFRS and Dutch accounting rules and major financial impacts of applying those IFRS are explored. The purpose of using qualitative approach is to gain much information and a deeper understanding of the researched problems. This enables us to describe the problems thoroughly.

In addition to qualitative approach, a quantitative study, i.e. quantitative data derived from sample companies’ annual reports are analysed and quantified, is used. This is to measure the magnitude of the effect for sample companies from applying IFRS. The quantified results are analysed as to provide a deeper and more detailed view of the studied area.

2.2 Data collection and sample selection

For this study merely the secondary data are used. The existing literatures concerning international accounting and Dutch accounting, the available publications and articles from the website of large accounting firms, the European Union, the IASB, Dutch Accounting Standards Board (DASB)⁴ and Royal Dutch Institute of Register Accountants (NIVRA). Some data collected by large accounting firms and NIVRA are utilized for this study.

For the quantitative survey, a small sample of 5 Dutch firms that are listed at the Euronext Amsterdam exchange is selected. The selected sample companies apply theirs consolidated financial statement for the financial year of 2005 for the first time and comparative information for at least one year. The transition date to IFRS is on 1 January 2004. Their annual reports for the year of 2004 and 2005 and any other disclosures released by the sample companies in regards to IFRS transition are downloaded from their websites. The survey focuses in particular on the impact of IFRS restatement on key areas in financial instruments, goodwill, pensions and share-based payment and subsequently the reported consolidated equity and net income in year 2004 of sample companies. Quantitative data derived from the downloaded annual reports and documents are processed and analysed as to produce empirical results and findings.

4 The name in English changed from The Council for Annual Reporting to Dutch Accounting Standards Board since July 2005.

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3 International Financial Reporting Standards

The establishment and the EU endorsement of IASB standards is elaborated and discussed. The significance of IAS 39 carve-outs is discussed in this section.

3.1 The need for a single set of international accounting standards

The accounting and financial reporting practices of companies vary vastly between different countries. For example, in respect of the assets valuation, some countries require strict historical cost, others allow revaluations of selected assets at selected times. In several countries, governments have required controlled revaluation of fixed assets from time to time. Prior research typically attributes the differences among the domestic accounting standards to variations in the development of accounting and financial reporting practices, legal system, financing, tax laws and the strength of the accountancy profession etc.⁵ This leads to great complications for those preparing, consolidating, auditing and interpreting published financial statements and being seen as one of big obstacles to the efficiency of global capital market. Therefore many organizations such as the EU and world bank, accounting profession bodies and capital market participants across the world sees the need and strongly support for a single set of accounting standards used throughout the world to produce comparable financial information.

3.2 Standard Setting

3.2.1 IASC and standards setting developme nt

International standard setting began in 1973 through an agreement reached by professional accountancy bodies in Australia, Canada, France, Germany, Japan, Mexico, the Netherlands, the United Kingdom, Ireland and the United States of America. They established a standard setting body named International Accounting Standards Committee (IASC). The IASC is an independent body, not controlled by any particular government or professional organization. Its main objective is to achieve uniformity in the accounting principles that businesses and other organizations around the world use for financial reporting.

In 1975, the first accounting standards of IAS 1: Disclosure of Accounting policies and IAS 2:

Valuation and Presentation of inventories in the Context of the Historical Cost system were issued.

Various phases have been identified in the standard setting process operated by the IASC:

Stage 1 Issue of general standards 1973-9

Stage 2 Development of more detailed standards 1980-9 Stage 3 Reduction of flexibility –comparability project 1990-5 Stage 4 IOSCO core standards project 1995-8

Source: cited in Robert, C.; International Financial Accounting (1998) p129

5 See Nobes and Robert (2004) for detailed discussions of the factors influencing domestic accounting standards across countries.

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The first standards issued by the IASC in the 1970s were basic, straightforward and largely not controversial. They had a high level of generality and concentrated primarily on matters of presentation and disclosure rather than more controversial issues of measurement (Nair and Frank, 1981). In the period of 1980-1990, the issued standards allowed substantial flexibility to accommodate different national interest. It had been noted that most standards had two acceptable alternative treatments because of the necessity of ensuring that the required 75% of the 14 voting members of the board voted in favour (Fleming, 1991). These early standards were criticized for being too broad and allowing too many alternative accounting treatments and thus comparability was lacking in financial statement that claimed to be in compliance with IASs (Saudagaran, 2003) In 1995, IASC made a significant agreement with the International Organization of Securities Commission (IOSCO) with the goal that IASs can be used in cross-border listings as an alternative to national accounting standards. IOSCO made it clear that a reduction of options in IASs is essential. Thus, standards issued or revised from 1995 onwards contained fewer options than previous standards. A core standards program to promote the development of more uniform and high-quality standards was completed in 1998.

In 2000, the European Commission (EC) committed itself to making international accounting standards mandatory for listed companies within the EU from 2005. The following year, with constitutional reform, the IASC was restructured as International Accounting Standards Board (IASB) to reflect this new focus. At the end of its life, IASC issued a total number of 41 International Accounting Standards (IASs).

3.2.2 International Accounting Standard Board (IASB)

The IASB consists of 14 board members (12 full-time and 2 part-time members) and has sole responsibility for setting accounting standards. The foremost qualification for the IASB membership is technical expertise and to ensure that any particular constituency or regional interest does not dominate the IASB (IFRS 2004). The move to full time professionally remunerated membership with merely two part time members is to further ensure the independence of the Board.

This enables the IASB to draw upon accounting standard setting expertise from a range of countries while facilitating the individual standard setters’ independence from their national standard setter or professional accounting body. The argument of ensuring the ‘independence’ of the Board is that good accounting standards are those designed in the public interest following a published IASC conceptual framework⁶. Thus, many believe that the IASB standards are of high quality because of the ‘independence’ of the Board.

The IASB's objectives were set out in a revised constitution. The ultimate goal is the development and rigorous application of a single set of global accounting standards, which will produce high- quality financial information to help participants in the world's capital markets to make economic decisions.

6 The IASC’s framework is designed for use by the Board when setting accounting standards and for preparers, auditors and users of financial statements as they interpret accounting standards.

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The IASB assumed accounting standard setting from responsibility from IASC. The main areas of the works are:

1. Improvement to IASs; the purposes are to reduce or eliminate alternatives, redundancies and conflicts within the Standards, to deal with some convergence issues and to make other improvements. 18 standards were revised and IAS 15 Information Reflecting the effects of Changing Prices was removed from the period of 2003-2005.⁷

2. The continuing projects include accounting for insurance companies and for extractive industries.

3. Major reforms include the abolition of the pooling method of business combinations, the proposed extension of capitalization to all leases and the extension of the income statement to include all aspects of comprehensive income.

From 2003 till 2005, a total number of 7 new Standards in the “IFRS” series are issued by IASB⁸. As at 31 December 2005, there are a total of 40 IASs and 7 IFRSs. They comprise both the international accounting standards (IASs) issued by the IASC and amended where necessary by the IASB and the IFRSs issued by the IASB. See Appendix 1: The list of IASs and IFRSs as at 2005.

3.2.3 IASB Due Process

IASC and IASB standards are developed through a formal system of due process and broad international consultation that involves accountants, financial analysts and other users of financial statements, the business community, stock exchanges, regulatory and legal authorities, academics and other interested individuals and organizations from around the world. ⁹ The IASC and IASB due process would not be further discussed. The emphasis is on the due process of IASB standard endorsement in EU.

Figure 1.1: The due process for setting an IASB standard

Source: IFRS Today (Dec, 2005), KPMG

7 Source from http://www.iasplus.com/standard/effect.htm

8 Source from http://www.iasplus.com/standard/effect.htm

9 See International Financial Reporting Standards 2004 for the due process steps

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3.3 The Endorsement of IASB standards in The EU

The due process for endorsing IFRS in the EU is emphasized in this study because affected companies are only required to use those IFRS adopted by the EU under Article 3 of The IAS regulation. Thus, it is important to understand how IASB standard being endorsed by the EU.

Schaub.A (2005), although most people supported the choice of IASB standards as the appropriate international standard, there was nevertheless considerable opposition to handing over accounting standard setting for listed companies to a private body that was largely self-controlled. This did not conform to the democratic traditions of Member States, which required that laws be made directly by Parliament or through delegation by the Parliament. Therefore, efforts were taken to ensure that the standards adopted by the IASB are fully acceptable to the European Union. The real safeguard is to provide the process for adopting or rejecting the standards under the IAS Regulation.

Steps in due process as provided under IAS regulation:

1. The European Financial Reporting Advisory Group (EFRAG)¹⁰, the accounting technical committee, assess each new IFRS and submit that assessment to the EC. In order to approve or disapprove an accounting standard, two-thirds of the members of EFRAG’s Technical Expect Group must agree.

2.The EC then submits a proposed standard to the European Parliament and the Accounting Regulatory Committee (ARC). The ARC is chaired by the EC and is composed of representatives of the EU member states. To be agreed by the ARC, a majority of Member states in favor of the proposed standard is required.

3.The EC formally decides on the use of new IFRS within the EU after approval by the ARC and the European Parliament.

4.Once the EC has adopted a standard, it is then published in full in each of the official languages in the Official Journal of the European Union.

3.4 Carved-out IAS 39

The EU had endorsed all the proposed IASB standards. However, IAS 39, the standard on the measurement of financial instruments, has generated considerable controversy. Under IAS39, derivatives are stated at fair value on balance sheets. European banks and companies complained that this would introduce excessive volatility into balance sheets and income statements. The continued concerns voiced by the European Central Bank and supported by the European Parliament, a carved-out version of IAS39 was adopted. The carved-out IAS39 leads to ‘IASB approved IFRS’ and ‘EU endorsed IFRS’ and creates differences between the two.

The EC sees this only as a very exceptional and temporary measure. The Commission hopes that the IASB will be able to come forward very quickly with a revised standard that is acceptable to all

10 (EFRAG) is created by the main parties interested in financial reporting namely the users, the preparers, and the accountancy profession, (supported by the national standard setters). It is an independent private body whose task is to provide the EC advice on the technical soundness of new standards.

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parties concerned (Schaub, A., 2005). However, some believes that this damaged the goal of accounting convergence. IASB Chairman Sir David Tweedie warned that if political pressures in a national or regional context are able to overrule standards that have been developed in a deliberate and open manner, then it may lead to a system of ‘beggar thy neighbor,’ which will not provide the consistency and quality of accounting standards that the world ‘s market demand.¹¹ McCreevy, current European Commissioner for Internal Market and Services, argues that ‘international standard setters must be independent but in touch with business reality and with the users of the standards they elaborate.’ ¹²

The carved-out IAS39 has also created confusion to the companies and the users. The two carve- outs are relating to the full fair value option and hedge accounting. (EC, 2004) For the carved-out on full fair value option, The EC provides that the Fourth EU Directive (Directive 78/660/EEC) does not allow full fair valuation of all liabilities; the main category of liabilities excluded from fair valuation is companies fair valuing their own debt. Companies are therefore not allowed to use the full fair value option. Neither can Member States require mandatory use of the carved out fair value provisions. (EC, 2005) In June 2005, a revised IAS 39 fair value option has been adopted in June 2005. The adoption is retroactive to 1 January 2005 so that companies will be able to apply the amended standard for their 2005 financial statements.

(EC, 2004) As for hedge accounting, because there is no existing EU law on this issue, individual companies may apply the ‘carved out’ hedge accounting provisions. A Member State may also make these provisions mandatory under its national rules. This implies that Dutch companies may choose to apply the carved-out on hedge accounting or not. This would consequently leads to differences between companies’ accounts. The endorsement of IASB standards is supposed to provide the ‘stable platform’ of IFRS for use within European Union. But, it seems that the ‘stable platform’ is not fully stable. Ian Wright, PWC global IFRS leader said the carved-out is significant for companies. Those companies that choose for carved-out version may find it difficult or even impossible to bridge back the differences at a later date. They risk a permanent difference, not just a short term one. ¹³

IASB sets the standards and has no endorsement authority but The EU. More complicating is the standards must also be acceptable to other constituencies. Hence, it is not surprising that companies would have to deal with many more cases like IAS39 carve-outs in the future. The impact of applying IAS39 for companies would be further discussed in later section.

See Appendix 2: IASB Standards applying in the European Union from 1 January 2005.

11 Rankin,K. (2004) IASB Chairman: Convergence must be two-way process. Accounting Today, Vol. 18 Issue 18, p3-45

12 Speech of McCREEVY, C. (April 2005), EU priorities: The Single Financial Market today and

tomorrowhttp://europa.eu.int/rapid/pressReleasesAction.do?reference=SPEECH/05/200&format=HTML&ag ed=0& language=EN

13 Endorsement: Clarity and complexity, World Watch, PWC, Issue 1, 2005

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4 Dutch Accounting Standards

The development of Dutch accounting standards and the regulatory context are briefly elaborated and discussed in this section.

4.1 Introduction to Dutch Accounting

The development of accounting in the Netherlands started somewhat independently from other countries, with ideas from Limperg on using replacement value accounting. Researches have found it hard to classify the Netherlands in relation to other countries and have tended to put it in a special category (Haller et al., 1998).

In recent accounting literature, Dutch accounting is cited as an example of Anglo-Saxon model but with the codified accounting rules of the Continental European model. It is famous for its business economics. It is characterized by its general and considerable flexibility of accounting regulations, formulated separate ly from the tax rules and more of shareholder oriented (Nobes and Parker, 2004;

Saudagaran, 2003 and Roosenboom et al., 2003).

There was practically no legislation at all on the form and contents of published financial statements before 1970. The company accounts had to be drawn up according to ‘sound business practice’¹⁴. Since 1970, the Dutch accounting practice is principally influenced by Part 9, Book 2 of the Netherlands Civil Code and the Guidelines, which issued by DASB.

4.2 Standard Setter and Standard Setting Process

Schoonderbeek (1994), the standard-setting process in the Netherlands can be described in a series of three steps. The first step is formed by statue law. The second step is constituted by the verdicts of the Enterprise Chamber¹⁵. The third step is the formation of Dutch Accounting Standard Board.

4.2.1 Dutch Law – Part 9, Book 2 of the Netherlands Civil Code

The first legislation was The Act on the Annual Accounts 1970¹⁶ and being incorporated in Book 2 of the Netherlands Civil Code in 1976. All public companies and private companies¹⁷ are subject to the provisions of the Act, in regardless whether they are obliged to publish financial accounts or not. The Act contained only a basic and minimum framework for the objectives and contents of financial statements.

14 Translated from Dutch words: Goed Koopmansgebruik

15 Translated fromDutch: De Ondernemingskamer

16 Translated from Dutch: Wet op de Jaarrekening van Ondernemingen

17 Public companies = Naamloze Vennootschappen; Private companies = Besloten Vennootschappen

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The EU’s move of achieving accounting harmonisation through the EU’s Directives has substantially influenced the Dutch Civil Code. It is amended several times to incorporate the EU accounting Directives in particular Fourth Directive¹⁸ in 1983 and Seventh Directive¹⁹ in 1988.

The relevant legislation for accounting is now contained in Part 9, Book 2 of the Netherlands Civil Code and in two decrees on disclosure, asset valuation and annual account formats. The provisions are broadly formulated and no strict valuation rules are provided in the legislation. The law leaves room for choice and interpretation of accounting principles. Reporting entities are required to provide the financial position and financial results fairly, consistently and cle arly. This is the Dutch equivalent of ‘true and fair view’. If the provisions in Book 2 are insufficient for a reporting entity to give a ‘true and fair view’, the reporting entity has the option to depart from the provisions, if necessary to do so (Article 362).

From 2005 onwards, the use of IFRS is mandatory for listed companies and allowable for unlisted companies. In other words, most of provisions in Part 9, Book 2 of the Netherlands Civil Code are no longer applicable for these companies. If Dutch government extends the mandatory use of IFRS to unlisted companies, this implies that the Book may no longer play an important role in the preparation of annual accounts in the Netherlands.

4.2.2 The Accounting Court -Enterprise Chamber

The Enterprise Chamber is a special section of the Court of Justice at Amsterdam. The Chamber is created in 1970 to settle the dispute between companies and parties interested in their financial statement. Any company that fail to comply with the legal requirements of financial accounts can be put before this Chamber by all parties who can prove that they have an direct interest in the company. The Public Prosecutor can also bring the reporting entity before the Chamber if he considers it to be in the public interests.

The accounting court is not a standard setting body. However, the Court can indicate grounds for its decisions, which may influence reporting practices of other companies (Klaassen, J. 1980). Court proceedings are time-consuming and costly and thus only small number of cases took place in the Court. As a result, this limits the influence of the Court on the accounting setting process in the Netherlands. In most cases, the discussion points that the plaintiffs bring up are specific to the case, and the verdict of the court does not give rise to rules that would be of significance to other companies reporting practices. Klaassen (1980) concluded that these cases demonstrate that a company court is not a proper institution to produce accounting standards.

4.2.3 Dutch Accounting Standards Board (DASB)

In 1970, The Tripartite Consultative Body was formed in 1970 at the request of the Government after the enactment of the Act on Annual Accounts 1970. In 1981 DASB replaced the Committee.

DASB comprises of representatives of Dutch employers organizations (preparers), the Dutch trade

18 The directive covers public and private companies in all EU companies. Its articles include those referring to valuation rules, format of published financial statements and disclosure requirement.

19 The directive concerns consolidated accounting.

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unions (users), NIVRA (auditors) and the Association of Investment Analysts (financial analysts)²⁰. Its task is to review existing accounting principles, which are applied in practice and give its opinion on the acceptability of those principles within the framework laid down in the law. Its opinions are published as Guidelines for Annual Reporting. These guidelines also incorporated statements from IASC as well as the opinions from the Enterprise Chamber, as far as they were considered acceptable to Dutch accounting. The role of DASB is influential due to the lack of detailed rules in legislation. Therefore a lot of judgment is required from this accounting profession body. The Guidelines that the Board has issued are a fairly complete overview of financial reporting requirements in the Netherlands. See Appendix 3: A list of guidelines 2005 for large and medium companies.

The Guidelines are not legally binding. This means that companies are not mandatory to apply the Guidelines and auditors are unable to qualify their reports if the guidelines are not followed.

Nevertheless, the Guidelines are broadly accepted and applied. The majority of Dutch companies follow the Guidelines for their accounts. Klaassen (1980) describes the Guidelines as authoritative opinions of an influential private group. They are not intended to achieve uniformity between companies, but to allow for the circumstances and distinctive characteristics of individual companies. He further provides that a majority of the larger companies follow most of the Guidelines but in important cases, some of them did not.

Since 1991, the central focus of standard setting has irreversibly shifted from the national to the international level. An almost literal Dutch translation of the IASC framework for the preparation and presentation of financial accounts was incorporated in the Guidelines in 1995. Zeff et al. (2002) argues that the DASB has devoted most of its time to adapting the IASB standards to the Netherlands Guidelines rather than engaging in the more consequential work of developing original standards. It did, however, develop its own ‘industry standards’ in such fields as insurance, health care and housing cooperative.

From 2005 onwards, it is expected the Board to focus more on non-listed companies and presumably continue to be important for non-listed companies in particular small to medium size companies.

4.3 The Convergence of Dutch Guidelines towards IFRS

Since the EU decided to adopt IFRS in year 2000, new Dutch guidelines are issued and existing Dutch guidelines are revised heavily based on IASB standards with only minor changes to reflect Dutch law and business environment. For example, Guideline 213(Investment Property) is now almost completely based on IAS 40; Guideline 330 (Related Parties) is fully in line with IAS 24 (Related Party Disclosures) and the new Guideline 271 (Employee benefit) is based on IAS 19. This is understandable that a greater convergence of the Dutch Guidelines with IASB standards would ease the burden of Dutch companies when adopting IFRS from 2005 onwards.

The flexibility of Dutch accounting, its disconnection from tax accounting and the recent efforts of harmonizing Dutch Guidelines and IFRSs, many believes that it is less difficult for Dutch companies to adopt IFRS as compare to companies in other EU countries. However, in particular IASB has made a large number of changes in the period of 2004-2005 and not all of these changes

20 http://www.rjnet.nl/International_visitors/index.asp#News

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have been incorporated in the Dutch law and Guidelines. From previous discussion about the setting of IASB standards and Dutch standards, IASB standards are more stricter formulated and offer less options than Dutch standards. It is not unthinkable that the IFRS changeover would not be easy and can be fairly challenging for Dutch companies in practice. In the next section, the key changes for adopting IFRS due to the differences between IFRS and Dutch standards are explored and identified. The likely impact due to the key changes would also be analysed and discussed.

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5 Main Financial Impact for Companies

In this section, the changes in the key areas for most of affected companies due to IFRS changeover would be explored and identified. The principal differences between IFRS and Dutch accounting standards for these key areas would be elaborated and analysed. The impact and implication due to the changes are discussed.

5.1 Relevant standards

The main changes to the companies’ accounts due to the forced IFRS changeover would be explored and discussed by comparing IFRS with Dutch accounting standards. The affected companies would have to apply IFRSs with effective from 1 January 2005. Thus, in exploring the differences between the two standards, the focus is on the set of IFRSs that applicable from January 2005 (see appendix 2) and Dutch accounting standards that applicable for accounting year 2004.

5.2 Key Financial Areas

For many companies, the adoption of IFRS will have a fundamental impact on a number of important areas of financial reporting. This is mainly due the differences between IFRS and Dutch standards that are currently used for reporting. The differences arise between the two standards are mainly due to the absence of specific Dutch rules on recognition and measurement for certain accounting issues and the different treatment required under Dutch standards for accounting a particular issue from that required under IFRS. By comparing the two reporting standards, it appears that there are still many significant differences between the two. The areas are such as those in financial instrument (IAS 39 & IAS 32), business combinations& purchased goodwill amortisation (IFRS 3), employee benefits such as pension funds (IAS 19) and share-based payment (IFRS 2) and non-assets held for sale and discontinued operations (IFRS 5).

KPMG (2003) assesses potential differences for companies by analysing the financial statements of 17 Dutch companies from various industry sectors. The research shows that most Dutch companies could experience significant effects of IFRS accounting changes in financial instrument, business combination & goodwill and pensions. The research also identified specific areas that will likely be significant for Dutch companies within five industry sectors. See table 5.1: The IFRS key areas within five industry sectors.

Vergoossen and Helleman (NIVRA, 2005) researches the significant changes due to the IFRS reported by 24 companies listed in AEX and 23 companies listed in AMX in their 2004 annual reports and IFRS press releases. More than 50% companies identified that the significant changes are in financial instruments, pensions, goodwill and share options. See table 5.2: The significant changes reported by sample companies.

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Table 5.1: The IFRS key areas within five industry sectors.

Industry Significant areas

Banking Financial instrument – fair value and derivatives Debt equity

Business Combination and goodwill Pensions

Share options Chemical and Pharmaceuticals Development costs

Environmental provisions and major repairs Financial instrument

Business combination and goodwill Pensions

Share options

Consumer markets Properties

Financial instruments

Share options Electronics/Engineering Development costs

Revenue recognition Financial instruments

Share options Information/Media and Telecom Revenue recognition

Intangibles

Financial instruments

Share options

Source: KPMG 2003, EU companies, IFRS and The Capital Market

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Table5.2 Significant changes reported by sample companies

AEX (n=24) AMX (n=23)

Total (n=47) Changes

N % n % n %

Financial instruments (IAS32 &39) 19 79 20 87 39 83

Pensions (IAS19) 16 67 17 74 33 70

Goodwill (IFRS 3) 17 71 13 57 30 67

Share options (IFRS 2) 14 58 10 43 24 51

Provisions (IAS37) 7 29 16 70 23 49

Income taxes (IAS 12) 9 38 11 48 20 43

Property, plant &equipment (IAS 16) 9 38 10 43 19 40

Intangibles (IAS 38) 8 33 8 35 16 34

Leasing (IAS 17) 4 17 5 22 9 19

Inventory (IAS 2) 4 17 4 17 8 17

Investment in associates (IAS 28) 3 13 5 22 8 17

Work in progress (IAS 11) 0 0 6 26 6 14

Joint ventures (IAS 31) 4 17 1 4 5 11

Investment property (IAS 40) 1 4 4 17 5 11

Revenue recognition (IAS 18) 4 17 0 0 4 9

Insurance contracts (IFRS 4) 2 8 0 0 2 4

Source: NIVRA (2004), Het Jaar 2004 Verslagen, p22

In a survey to explore how European companies respond to IFRS adoption, Mazars (2005) sampled the opinions of chief financial officer, chief accountant and IFRS application manager of a total of 39 companies in The Netherlands. Financial instruments (40% of sample companies), employee benefits (24% of sample companies) and pensions (40% of sample companies) are cited as the most challenging areas to the business. For one quarter of companies who changed their management of financial operations, over 50% did so in these areas.

Given the above mentioned, it appears that the changeover to IFRS would cause various changes in Dutch companies’ accounts. Further, the changes would be varying across companies depending on its industry sector, structure and business circumstances. However, it is obvious that the most significant changes are found generally in financial instruments, business combination and goodwill, employee benefits in particular pensions accounting and share options. We could hypothesize that the IFRS accounting for these areas are likely to lead to significant impact on most of Dutch companies’ balance sheets and reported earnings. As a result, the IFRS accounting issues and the principal differences between IFRS and Dutch standards for these specific areas would be further elaborated and discussed in this study. The possible impacts and implication for companies would also be discussed and analysed.

5.2.1 Financial instruments

This area is covered by the much controversial IASB standards: IAS 39 and IAS 32. IAS 39 prescribes the principles for recognising and measuring all financial instruments, except for certain

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specifically excluded items²¹. IAS 32 sets out the requirements for the classification of financial instruments and the disclosure of information about them. IAS 39 and IAS 32 are lengthy and extremely complex standards. This study would not attempt to prescribe these standards in details.

The focus is on some important accounting issues of these standards when companies first convert from Dutch accounting to IFRS. The financial impacts from applying them would also be discussed.

5.2.1.1 IAS 39

Under IAS 39, financial instrument is any contract that gives rise to a financial asset of one company and a financial liability or equity equipment instrument of another company (IAS 32.11).

Examples of financial assets are cash, deposits in other companies, trade receivables, loans to other companies, investments in debt instruments, share investments and other equity instruments.

Examples of financial liabilities are trade payables, loans from other companies and debt instruments issued by the company.

IAS 39 also applies to more complex derivative financial instruments. Derivative is a financial instrument (IAS 39.9):

• Whose value changes in response to the change in an underlying variable (e.g. specified interest rate, financial instrument price, commodity price, foreign exchange rate or credit index);

• It requires no initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors and

• It is settled at a future date

The categorisation of financial assets and financial liabilities

Companies are required to classify financial assets at acquisition into 4 categories (IAS39.9):

• Held at fair value through profit or loss; financial assets that held for trading always in this category

• Held –to-maturity investments

• Loan and receivables

• Available for sale

Financial liabilities are classified into: Held at fair value through profit or loss and other financial liabilities. Derivatives are always treated as financial assets or financial liabilities held for trading unless they are effective hedging instruments.

The classification determines how the financial asset or financial liabilities is measured and where the unrealised gain or loss is charged. See table 5.3: The classification of financial assets and financial liabilities.

21 The excluded items such as investment in subsidiaries, obligations under insurance contracts etc are stated in IAS 39.2a -i.

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Table 5.3: The classification of financial assets and financial liabilities

Category Description Valuation Changes in

value charged to Financial assets

Held at fair value through profit or loss

All derivatives without effective hedging;

Financial assets acquired for trading.

Any item designated as such at origination

Fair value; if not reliably measurable, at cost

Income statement

Held-to-maturity Investment

Those that have fixed or determinable payments and fixed maturity.

Amortised cost -

Loan and receivables Non-derivative financial assets with fixed or determinable payments

Cost/amortised cost Income statement

Available for sale All financial assets not in other categories

Fair value; if not reliably measurable, at cost

Balance sheet (reserves)/

income statement when realised

Financial Liabilities Held at fair value through profit or loss

All derivatives without effective hedging Other items intended to be actively traded

Fair value Income statement

Other financial liabilities All the non-trading financial liabilities

Amortised cost -

Source: Ernst& Young (2005), Comparison IFRS with Dutch Law and Regulations Edition 2005

In order to restrict companies from managing earnings, IAS 39 restricts the ability to reclassify financial assets and financial liabilities to another category. Subsequent reclassification for financial assets or financial liabilities held for trading is not permitted. Reclassification of loan and receivables carried at cost to available for sale is not allowed. Reclassification between the available for sale and held to maturity is possible. If a company sells a significant of amount held -to- maturity investment, however, all remaining of such investments must be reclassified to available for sale.

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Derivatives and Embedded derivatives

Derivatives are contracts such as call options, put options, forwards, futures and swaps. They are often entered into at no cost. Under IAS 39, derivatives must be accounted in the balance sheets even though companies may have paid or received nothing on entering into the derivatives.

Companies are required to measure derivatives without effective hedging at fair value. Subsequent changes in fair value are directly charged to income statement on a periodic basis.

Further, contracts that don’t appear to be financial instruments may have financial instruments embedded in them. If an embedded derivative is identified, IAS39.11 requires the derivatives to be separated from its host contract and presented at fair value. If it’s not separated, the entire contract can be designated as at fair value through profit or loss if certain conditions are met. Examples of an embedded derivative that must be separated:

• Equity conversion feature embedded in a debt instrument, e.g. investment in convertible bonds

• Equity-indexed interest embedded in a debt instrument Derivatives with effective hedging

IAS 39 permits companies designate a derivative financial instrument as an offset of net profit or loss associated with changes in the fair value or cash flows of a hedged item. However, companies would have to meet requirements prescribed under IAS 39 in order to apply hedge accounting.

(Abhayawansa& Abeysekera, 2005), the standard permits hedge accounting as an exception to the rule of accounting for derivatives. In other words, it assumes that derivatives are held for trading.

The standard recognises 3 types of hedge (IAS39.86):

• Fair value hedge

Derivatives are used to reduce the exposure to reported gains or losses associated with changes in the fair value of a reported asset or liability or a firm commitment to buy an asset at fixed price.

Changes in the fair value of the hedge are recognised in income along with changes in the fair value of the hedged item. The use of fair value hedge would reduce firm’s earning volatility.

• Cash flow hedge

Derivatives are used to reduce the exposure associated with the variability posed by the cash flows of a recognised asset or liability or a highly probable purchase or sale transaction. Changes in fair value of the derivative are deferred to an equity hedging reserve called other comprehensive income and flow to the income statement at the time the underlying cash transaction is executed.

• Net investment in a foreign investment hedge

Derivatives are used to hedge for net investment in a foreign affiliate. IAS 39 requires this type of hedge to be account for as a cash flow hedge.

The requirements to be met in order to apply hedge accounting (IAS 39.88):

• Designation of hedge relationship

Companies need to formally identify the hedged item or transaction and the nature of risk being hedged at the inception of the hedge.

• Hedge effectiveness Test

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Companies need to assess the hedge effectiveness both prospectively and retrospectively. This is because only derivatives with effective hedging can be accounted under hedging accounting. An effective hedge is the hedge that changes in cash flows or fair values of the hedging instrument to almost fully offset those of the hedged item, that is, within the range 80% to 125%. The maturity dates of a hedge instrument need to match those of the hedged item’s corresponding risk. Hedge ineffectiveness and gains and losses on components of a derivative that are excluded from the assessment of hedge effectiveness are recorded directly in income.

The hedge is assessed on an ongoing basis and determined to have been highly effective throughout the financial reporting periods for which the hedge was designated.

• Externalisation

Companies are required to provide clear demonstration of external hedge relationship. That is, every internal hedged risk has to be laid off through an external transaction.

• Documentation

To qualify as a hedge, the relation between a hedge and a hedged item has to be documented thoroughly. Companies need to document how ‘effectiveness’ is measured up front.

5.2.1.2 Comparison between IAS39 and Dutch Standards

Dutch legislation has just recently (Bill no 29737 passed by Upper House in Mei 2005) incorporated a number of provisions on the valuation and determination of the result of financial instrument. Companies are allowed to use fair value to account for financial instrument, investment property and agricultural assets (art 2:384 lid 1 BW). Changes in fair value are directly taken to income statement (art 2:384 lid 7 BW), otherwise to revaluation reserve (art 2:390 lid 1 BW). For financial instruments that used for hedging, art 2:384 lid 8 provides that changes in fair value are accounted direct to the revaluation reserve, to the extent necessary to ensure that these fair value adjustments are taken to the income statement in the same period as the value adjustment, which these instruments intend to hedge.

A draft Guideline 290a ‘financial instruments; recognition and measurement is included in Dutch Guidelines since the 2001 edition. The draft guideline is virtually the same as IAS 39 revised in 2000. However, DASB has not yet changed the draft Guideline in line with the revised standards and therefore the drafted Guideline has not yet being converted to a definitive Guideline.

As refer to the table 5.4, one of the most significant differences is no Dutch standards have comprehensively addressed when an entity should recognize a financial instrument in particular derivatives on its balance sheet, or how it should measure this financial instrument once recognized.

There are also no specific rules for the application of hedge accounting. Another significant difference is the use of fair value as a basis to measure most of primary financial instruments and derivatives and changes of fair value to be taken to profit and loss statement. The principal differences between IAS 39 and Dutch standards are summarised in the table 5.4.

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Table 5.4: The principal differences between IAS 39 and Dutch standards

Subject Dutch Standards

(Effective in FY2004)

IAS 39

Financial assets

Recognition in the balance sheet No specific rules When a company becomes party to a contract

Valuation of shares investment Lower of cost and market value or at current value

Fair value; if not reliably measurable, at cost Valuation of fixed interest

investment (e.g. debenture)

Commonly at redemption value; if not, amortised cost

Amortised cost for held to maturity investment; otherwise at fair value

Changes in value of other securities carried at current cost

Revaluation reserve and to income statement when realised

Income statement (held for trading); first to reserve and then to income statement when realised (available for sale)

Valuation of receivables held for trading

Lower of face value and fair value Fair value; changes taken to the income statement

Financial liabilities

Recognition in the balance sheet No specific rules When a company becomes party to a contract

Valuation of liabilities held for trading

Face value or amortised cost

* Fair value option is not allowed

Fair value, changes in value are taken to the income statement

Derivatives without effective hedging

Recognition No specific rules When a company becomes party

to a contract Valuation & Treatment of changes No specific rules except for

forward exchange contract

Fair value, taken directly to income statement

Hedge Accounting Valuation for financial instruments that are used for hedging

No specific rules except for foreign currency hedges

Specific rules are provided.

Source: Data mainly from Ernst& Young (2005), Comparison IFRS with Dutch Law and Regulations Edition 2005

List of Figures

Abstract

Foreword

Table of Contents

Abbreviation

List of Figures

List of Tables

1 Introduction

2 Research Methodology

3 International Financial Reporting Standards

4 Dutch Accounting Standards

5 Main Financial Impact for Companies