By Shaun Cochran
The first quarter of 2011 will prove challenging for the equity investment community for a different reason than usual. This reporting quarter marks the introduction of the formal requirement for listed Korean companies to report under IFRS.
This means that as the results are released analysts and investors will be frantically looking through the details and the infamous expanded footnotes to decipher how much of the inevitable changes in numbers are underlying changes in economics and how much are simply the reporting perspective?
An important lesson to remember from the experience of companies that have already transitioned, such as KT&G, is that this can and very likely will be a very confusing time.
One typical comparison made of the difference between Korean generally accepted accounting principles (K-GAAP) and International Financial Reporting Standards (IFRS) is that while the existing Korean system is rules based, the incoming and globally accepted IFRS is a principles based approach.
So what does that mean in practice? It means for example, that when a financial officer is working with management to discuss the implications of using a capital versus an operating lease they will face a different decision set.
While in the past the desire to classify a transaction as an operating lease rather than a capital lease might have impacted the contract structure to get around prescriptive rules, in the future IFRS will focus on conceptual issues such as the transfer of ownership and control.
This should mean that trivial changes to contracts do not impact the substance of reporting in the future. The question is of course; how will management respond?
In theory this is clearly a positive development.
If the spirit of the rules is applied in practice, reporting quality will indeed improve. The reality will only be apparent after several reporting periods have past.
This is because the quality of reporting in Korea is now more than ever, subject to the choices of management. On balance we are approaching this process with a simple assumption.
The higher quality companies with strong management and balance sheets, simple structures and a track record of decisions that make sense for shareholders are likely to be unaffected by this process and or will see any improvements in numbers taken at face value.
However, it would not surprise us to see companies pursue unusual accounting decisions or structural changes to businesses to avoid reporting obligations (such as consolidation), in the face of investor skepticism.
Where the quality of numbers declines, it is plausible if not probable that capitalization rates will follow.
At the end of the day it is the substance of the businesses that investors are buying. This is what they assess and re-assess every day.
And this brings us to a critical point. While the noise level about IFRS is likely to peak during this coming reporting season, we should not forget that the underlying cash flows of the companies, which should form the bedrock of any valuation, are unequivocally unaffected by changes in reporting standards.
As a case in point, Shinhan Financial will likely report higher earnings in part as a result of no longer needing to amortize goodwill on acquisitions.
However this is something that we believe investors already explicitly adjust for in their valuation approach.
That change on its own will certainly have no impact on our fundamental view of the group. It is only where investors believe that they are receiving materially more information that furthers both their understanding of and confidence in a business that a change in reporting might bring about a real change in the price the market is willing to pay for it.
The good news for all members of the investment industry value chain is that the opportunities to add value should prove abundant through this process.
Companies that choose to prioritize transparency and convey deeper more meaningful information should be rewarded by more confident investors who might ultimately prove willing to pay more for earnings they better understand.
There is also substantially greater scope for analysts, auditors and regulators to add value in seeking to identify where the reporting and the underlying economic reality diverge and keep the system honest.
It will be interesting to see how we collectively handle this opportunity.