“The transition from previous GAAP to IFRS had no material effect on the reported cash flows generated by the Company.”

Baytex Energy Corp., 2011 Q3 Unaudited Financial Statements, page 36.

“The transition from Canadian GAAP to IFRS has not affected the Corporation’s cash flows.”

Bonavista Energy Corporation, 2011 Q3 Unaudited Financial Statements, page 37.

These statements, in our view, are half-truths.  More accurately, companies choosing the IFRS option to move interest expense out of operating cash flows into cash flows from financing activities should state that IFRS has not affected the corporation’s overall cash flows, as this maneuver clearly affects the most watched figure, operating cash flows. 

True, the combined effect of this change in treatment, summing operating and financing cash flows, is zero overall, but this is not made clear by Baytex and Bonavista’s descriptions.  Unlike their peers, the two companies do not provide a 2010 reconciliation between Canadian GAAP and IFRS cash flows that illustrates their treatment.

The bigger problem is that peer results are no longer comparable under IFRS. Of the energy companies covered by Veritas, only Baytex, Bonavista, Pengrowth, NAL and Talisman have chosen to move interest expense out of operating cash flows, resulting in higher operating figures.  In Figure 1, below, we highlight the resulting impact on reported operating cash flows under IFRS.

Figure 1

Effect of Moving Interest Expense from Operating to Financing Cash Flows Under IFRS

(Amounts in millions of Canadian dollars, except as noted)

*2010 Q3 year-to-date data used as no reconciliation is provided between 2010 Canadian GAAP and IFRS cash flows.

Source:  Segmented company disclosures and cash flow statements, Veritas.

As illustrated, the change in the treatment of interest materially inflates reported operating cash flows, anywhere from 4% to 15%. 

In our original report on the subject (see our June 20^th Accounting Alert:  IFRS in the Oil & Gas Sector), we argued that, if the market truly sees through the shift in interest expenses, multiples for these companies should contract relative to peers that continue to deduct interest expenses when calculating operating cash flow. 

We test this possibility in Figure 2 by looking at multiples to forward consensus operating cash flows, pre-IFRS at October 31, 2010, and post-IFRS today.

Figure 2

Have Multiples Adjusted for the Treatment of Interest Expenses under IFRS?

(Forward multiples based on consensus operating cash flows)

* Former trust peers include:  ARC, Crescent Point, Enerplus, Penn West, Peyto and Vermilion.  Talisman’s large cap peers include:  Canadian Natural, Canadian Oil Sands, Cenovus, Encana, Husky, Imperial Oil, Nexen and Suncor.

Source:  Bloomberg data, Veritas.

The evidence is mixed on whether markets are making the necessary adjustments for the IFRS treatment of interest expenses.  Figure 2 illustrates that, for NAL, Pengrowth and Talisman, multiples have contracted significantly since October 2010 relative to peers.  Two companies, Baytex and Bonavista, have seen their multiples expand. 

NAL, Pengrowth and Talisman have each disappointed on volume guidance in 2011, which explains at least some of their multiple contraction relative to peers since last year.  An argument can be made that part of the reduction in multiples is an adjustment for their IFRS choices.