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

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