IFRS
The use of International Financial Reporting Standards (IFRS)
as a universal financial reporting language is gaining momentum across the globe
especially from the position only seven years ago where numerous different
national standards existed.
In line with the global trend, the Ministry of Corporate
Affairs (MCA) has notified a plan for convergence with IFRS in a phased manner.
Convergence with IFRS will also need careful analysis of the
present auditing standards. Auditing standard-setters may also need to assess
the requirement of auditor obtaining requisite IFRS knowledge which can be
evidenced through a certification process.
Auditing standard-setters will need to address the impact on
auditing procedures for the changes proposed in the accounting principles due to
convergence with IFRS.
Under IFRS, management is required to make several estimates
in the below-mentioned areas in applying accounting policies that have a
significant effect on the amounts recognised in the financial statements.
Audit of non-current assets :
Property, plant and equipment :
IFRS requires an asset to be depreciated over its own useful
life instead of rates suggested under regulations (like Schedule XIV to the
Companies Act). Further, significant components of an asset are depreciated
separately. The estimate of useful life of assets needs to be reassessed at
least once every balance sheet date.
The audit procedures relating to fixed assets would need to
be designed to obtain sufficient appropriate audit evidence whether the
management’s assessment of useful life is appropriate. The auditor may require
performance of inquiry procedures with the plant engineers to assess the
reasonableness of the process for estimating the useful lives and identification
of components within individual assets that have a different useful life and
needs to be separately depreciated. Companies would also need to maintain
suitable audit trail for the basis for estimation of useful life and
identification of components.
Intangible assets :
The depreciation/amortisation of an intangible asset depends
on whether its useful life is finite or indefinite (indefinite does not mean
infinite). An intangible asset has an indefinite useful life when, based on an
analysis of all relevant factors, there is no foreseeable limit to the period
over which the asset is expected to generate net cash inflows for the entity.
An intangible asset with indefinite useful life is not
depreciated; instead it is tested for impairment every balance-sheet date.
Classification of intangible assets acquired in business
combination (like brands, trademarks, customer relationships) needs to be
assessed closely by the auditor. For instance, in assessing whether the useful
life of a brand is indefinite or finite, the auditor may need to assess the
following factors :
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How well and for how long has the brand been established in the market ?
If the brand is mature and contributes significant value to the business and
therefore its abandonment would represent an unrealistic decision, then this
might be an indicator of an indefinite useful life.
-
How stable is the industry in which the brand is used ? In rapidly
changing industries it is less likely that a brand will be identified as
having an indefinite useful life.
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Is the brand expected to become obsolete at some point in the future ?
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Is the brand used in a market that is subject to significant, enduring
entry barriers ?
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Is the useful life of the brand dependent
on the useful lives of other assets of the entity ? If so, what are the
useful lives of those assets ?
Embedded leases under IFRIC 4 :
The purpose of IFRIC 4 — ‘Determining whether an arrangement
contains a lease’, is to identify an arrangement which, in substance, is or
contains a lease (even if the contract does not use the term lease). For
instance, A Company has a contract with its supplier (job worker) whereby the
Company is contractually bound to get 10,000 units of goods manufactured by the
supplier. The supplier has installed a machinery to manufacture and supply the
goods for the contract.
Price terms are as under :
-
For first 10,000 units — Rs.22 per unit
-
10,001 onwards — Rs.10 per unit
-
In case of any shortfall as compared to 10,000 units, a penalty of Rs.12
per unit of shortfall shall be levied.
An analysis of the arrangement would indicate that up to
initial 10,000 units, the Company is bound to pay Rs.120,000 (10,000 x 12) to
the contract manufacturer (as there is a penalty of Rs.12 per unit for any
shortfall in offtake by the Company up to 10,000 units) and this would be
nothing other than lease rent for the asset being used. The balance amount of
Rs.10 (22 – 12) per unit would be job work charges for the manufacture of goods.
A lease arrangement conveys rights to use an asset for agreed
period of time in return for a payment or series of payments.
The assessment whether an arrangement is or contains a lease
is based on whether :
A challenge to audit-embedded lease arrangements is to derive sufficient appropriate audit evidence that a specific asset(s) would be used throughout the arrangement. Further, audit procedures need to include determining fair values of embedded lease component and other components of the arrangement. This would involve judgment on the part of the company and a process to be set for determining appropriate audit trail for the basis of determination of fair value.
Appropriate representation may also be needed from the Company for identification of all embedded lease arrangements.
Investment property :
Investment properties include properties that are either held to earn rental income or capital appreciation, or are held with undetermined use. Investment properties are measured at cost or at fair value every balance-sheet date. If the client measures investment properties at cost, it still needs to disclose its fair value.
Audit procedures must include procedures to assess the classification of property as ‘Investment Property’. Further, the audit procedures may be performed on the appropriateness of assumptions/ factors considered in deriving the fair value of the Investment Properties.
Audit of Business Combinations and Consolidation :
Consolidation :
Unlike Indian GAAP, the definition of a subsidiary focusses on the concept of control and has two parts, both of which need to be met in order to conclude that one entity controls another :
- the power to govern the financial and operating policies of an entity;
- to obtain benefits from its activities.
Thus, if a Company A holds 80% of the issued share capital of Company B and another investor C holds balance 20% of the share capital and participates in the management (through shareholders agreement) of the Company, then Company A cannot treat Company B as a subsidiary, as it cannot unilat-erally control that Company.
Thus, the auditor needs to verify the shareholder’s rights for classification of an investee as subsidiary.
Appropriate representation may also need to be sought from the company for non-existence of participative rights with minority shareholders.
Consolidation of special purpose entities :
A special purpose entity (SPE) is an entity created to accomplish a narrow and well-defined objective, e.g., a vehicle into which trade receivables are securitised. The principles discussed above for identifying control apply equally to an SPE. The control concept in SIC-12 is based on the substance of the relationship between an entity and an SPE, and considers a number of indicators.
Audit procedures that auditor may need to apply to identify whether the SPE needs to be consolidated need to be established.
Appropriate representation may also need to be sought from the company for identification of all SPEs.
Accounting policies across the Group :
The separate financial statements of subsidiaries, joint ventures and associates are prepared based on their accounting policies. However for the purpose of consolidation with parent company, all the sub-sidiaries, associates, joint ventures and SPEs need to prepare IFRS financial statements with the same accounting policies as that of the parent company.
Auditors need to verify consistency in application of IFRS accounting policies throughout the group. Thus auditors of the parent company may need to engage actively with the management and auditors of the subsidiary, joint ventures and associates to assess application of consistent accounting policies within the group.
Business combinations :
A business combination is defined as ‘a transaction or other event in which an acquirer obtains control of one or more businesses’.
In relation to business combination, the following audit procedures may need to be performed :
- Verify the date of actual transfer of control to the acquirer i.e., the date of acquisition. An appointed date as per agreement or court scheme cannot be termed as date of acquisition.
- Verify valuation reports as at acquisition date relating to assets transferred, liabilities incurred and equity interests issued by the acquirer. Verify the reasonableness of the assumptions used for valuation purposes.
- Verify intangibles assets that qualify for recognition. Verify the reasonableness of the assumptions used in the valuation of assets acquired, liabilities and contingent liabilities assumed.
Audit of income statement items :
Revenue : linked transactions :
In some cases, two or more transactions may be linked so that the individual transactions have no commercial effect on their own. For instance, a Company may enter into a contract to buy 100,000 units of goods from a vendor for Rs.1.5 per unit when market price for the goods is Rs.4 per unit (thus a cost savings of Rs.250,000). At the same time, the Company shall subscribe to the debentures of the vendor for Rs.400,000, whereby the vendor has a call option over the debentures to settle the liability at Rs.150,000 in all. Such transactions are linked transactions as the individual contracts have no commercial effect of their own.
In these cases it is the combined effect of the two transactions together that is accounted for. Audit procedures for linked transactions may include :
- Verify whether two or more transactions are linked based on the substance of the transaction.
- Verify identification of components in the overall arrangement.
- Verify allocation of consideration to the different components of the arrangement either on relative fair value method or on residual fair value method.
- Verify the basis for recognition of revenue for every delivered component of the arrangement.
Share-based payments :
Share-based payments under IFRS are measured at fair value, unlike Indian GAAP that allows use of intrinsic value method. The auditors need to verify the underlying assumptions relating to the fair value of the instruments. If the client has subsidiaries, the audit procedures are required to verify the extent of grants given to employees of the subsidiary company.
The auditor needs to verify the classification of the share-based payment into equity-settled and cash-settled share-based payment for the parent and subsidiary. Under certain circumstances, the classification of share-based payment could differ in the books of parent and subsidiary. For instance, subsidiary issues options to its employees that it settles by issuing its own shares. Upon termination of employment, the parent entity is required to purchase the shares of the subsidiary from the former employee. In such cases, as the subsidiary has an obligation to deliver its own equity instruments, the arrangement should be classified as equity-settled in its financial statements. However, the arrangement should be classified as cash-settled in the consolidated financial statements of the parent.
Audit of presentation of financial statements :
Current and non-current classification :
IFRS requires the assets and liability to be segregated into current and non-current assets/liabilities. Thus the audit procedures are required to determine the entity’s business cycle and thereby classification into current/non-current.
Disclosure of segment information :
IFRS requires segment disclosure based on the components of the entity that management monitors in making decisions about operating matters (the ‘management approach’). Such components (operating segments) are identified on the basis of internal reports that the entity’s ‘Chief operating decision maker’ (CODM) reviews regularly in allocating resources to segments and in assessing their performance.
Audit of segment information under IFRS would also lead to additional audit procedures like :
- Identification of the entity’s CODM;
- Audit of information reviewed by the CODM in the decision-making process; and
- Use of accounting policy for internal review.
The auditor might face challenges in performing audit procedures relating to information used by the management for decision-making process, as this information is always considered as strictly confidential and for internal use. Further, the information reviewed by the CODM (for instance, contribution margin analysis) may not be in strict compliance with GAAP. Hence test of completeness and accuracy of such financial information may be difficult.
Others :
Audit of IT system controls :
Entities where the use of Information systems is dominant (ERPs like SAP or Oracle) may require modifications in the IT configuration to track the information as required under IFRS. In such a scenario, the auditor would also require to test the new IT controls.
Audit of opening IFRS balance sheet :
To audit the opening balance sheet of the client, the auditor may prepare an audit programme to assist engagement team in issuing an audit opinion on the opening IFRS balance sheet prepared prior to the first complete set of IFRS financial statements. The audit programme may include the following audit steps :
- Understand the client’s transition process
- Update the understanding of the client’s business environment for transition matters
- Review compliance of the selected IFRS accounting policies with IFRS
- Assess the completeness and accuracy of the client’s gap analysis
- Identify IFRS balances with significant and/or high-risk gaps
- Identify appropriate audit objectives relating to gaps
- Evaluate the design and test the effectiveness of relevant internal controls
- Evaluate audit evidence and conclude.
Conclusion :
An entity may expect significant changes to its balance sheet and income statement due to transition to IFRS. It is essential for an auditor to carefully evaluate the IFRS impact areas both at the time of first-time adoption of IFRS and on a go-forward basis.
The auditor would need to suitably modify the design of its audit procedures to obtain sufficient appropriate audit evidence that the financial statements are not materially misstated.
Given the enhanced use of fair value in the presentation/preparation of IFRS financial statements and use of management judgment, the auditor will have to constantly be abreast of the client’s products/services, business and the related industry developments.
