By Kirit S. Sanghvi, Chartered Accountant
Article
We are heading towards full convergence of the Indian GAAP
with the International Financial Reporting Standards (IFRSs) subject to certain
small exceptions. Otherwise also, the recently issued accounting standards are
based on either the corresponding IFRSs or the International Accounting
Standards (IASs). Thus, the process of convergence has already begun. The chief
reason given for such convergence is that in a globalised economy and with
investors in all countries looking for outbound investments, it is desirable
that corporations the world over follow the same set of principles in preparing
their accounts. Another area of concern is that the present accounts fail in
disclosing strength or weakness of a corporation, as the figures in financial
statements, in most cases, represent ‘cost,’ which has hardly any relevance in
times of changing values.
The conceptual difference between the accounts under IFRSs
and under the Indian GAAPs is that in many instances (except in the case of
inventory, where the age-old principle of ‘lower of cost or net realisable
value’ will continue to apply) the figures in accounts under the IFRSs will be
reported on the basis of ‘fair value’ of the items, whereas such items by
and large are reported at present at ‘cost’, unless the fair value happens to be
lower than the cost — for example — investments. The fair value concept demands
that if an item has appreciated in value over its cost, the appreciation will be
recognised and if it has declined in value, the decline will also be recognised.
Thus, basically, the fair value-based accounting amounts to abandoning the
concept of prudence — that is — unrealised gains are not to be accounted.
The question is : should India fully converge with IFRSs and
adopt fair value as the basis of accounting in place of ‘cost’ ? The answer
depends on the following discussion.
First, let us see reasons that are in favour of ‘cost’
forming the basis of accounting. ‘Cost’ of an item can be computed with
reasonable certainty. Cost of an item may comprise elements like cost of labour,
material, finance charges, etc. It is possible that different corporations may
define ‘cost’ differently for the purpose of accounting an item. However, once
‘cost’ is defined by a corporation for a particular purpose, it is uniformly
adopted for all purposes. All elements of cost would be such as have resulted in
an outgo of resources or in creation of an obligation if there is no immediate
outgo of resources. In short, cost of an item is by and large a figure arrived
at objectively. Such cost yields itself to verification and to its reliability.
Thus, the accounts presented under the cost-based accounting are
reliable.
Let us also see the reasons that represent weakness of the
cost basis of accounting. The most significant weakness of such accounting is
that it fails to reflect ‘changing values’ and fails to account for inflation
(or deflation) in the value of currency. Because of such weakness, it is argued,
accounts fail to reflect strength or weakness of a corporation and fail to yield
to comparison with the accounts of another corporation. This weakness is real.
Let us examine the technical soundness of the conceptual
aspect of the IFRSs. As seen above, the IFRSs are fair value-driven unlike our
present conservative approach to accounting displayed in the principle of ‘lower
of cost or net realisable value’. IFRSs require write-up of financial assets of
trading nature if their fair value exceeds the cost just the same way as they
require such assets to be scaled down if the fair value drops below the cost.
This is quite in contrast to the principle of ‘prudence’, which so far formed
the basis of accounting policies and standards.
Thus, fair value-based accounting does remove the above
weakness of cost-based accounting. Hence, accounts under the ‘fair value’ basis
will show the present value of a corporation representing the changing values of
assets, and may therefore, be more useful to users. It is argued that accounts
prepared on ‘fair value’ will be more realistic as they reflect the correct
value of a corporation.
However, the major weakness of the fair value-based
accounting is that such accounts will depend a lot on valuation of assets. Value
of an asset is determined by an open market if the asset is freely traded there,
or arrived at on the basis of such valuation models as accountants and valuers
use, or a combination of both. Fair value accounting implicitly assumes that
such value is the correct value of the asset. It is questionable whether this
implicit assumption is correct. Valuation of an asset involves a good amount of
individual skill, the making of a number of assumptions, forecasting future,
using several valuation models and accepting value arrived at under one method
or accepting an average of values arrived at under different models. Only the
naïve can be convinced that such valuation is objective as there will be a
good deal of subjectivity involved in the process of valuation.
Any valuation necessarily involves looking into the future, making assumptions,
and the terms ‘future’ and ‘uncertainty’ are synonymous. No two individuals,
astrologers included, foresee the future in the same manner. When we contemplate
the large numbers that the accounts of modern corporations contain, we can
understand the significance of a small error, intentional or otherwise,
committed in arriving at fair value of items and its impact on the truthfulness
of accounts.
If accounts adopt values discovered by an open market wherever that is possible, for the purpose of preparation of accounts, the scenario may look better than the one under which value is determined by one or more valuers. However, it is also a myth that the value discovered by the free market is always ‘true value’. In fact, the way the markets behave one may wonder whether there is at all any thing like ‘true value’, especially in the context of financial instruments whose accounting will be greatly impacted under the ‘fair value’ accounting. Stock exchanges are the epitome of free markets and continually strive to discover value of securities. But high degree of volatility in the market makes the whole exercise speculative. Falls in the share market witnessed recently the world over exploded into smithereens the myth of reliability of market valuation. If one studies the recent market trends world over, one might think that the present times are ripe to abandon ‘fair value’ accounting and revert to prudence and cost-based accounting. I repeat recent market volatility should serve to establish the weakness of the ‘fair value’ accounting.
I believe ‘fair value’ accounting makes accounting subjective and financial statements prepared on the basis of subjective criteria hardly inspire confidence. Such accounts offer a great scope for manipulation at times with mala fide intentions. The hope that auditors willdetect such manipulations willalso prove to be a myth, not because auditors do not do their job but because auditing has its own limitations which the society and the users must recognise. We must admit that with the introduction of accrual basis of accounting we had introduced some degree of subjectivity in accounting especially whilst making provisions. Still, by retaining ‘cost’ as the basis of accounting coupled with prudence we have succeeded in eliminating much of subjectivity in the accrual system of accounting. We have been able to produce by and large reliable accounts. Fair value-based accounts will raise doubt about the reliability. As fair value-based accounts are deemed to be more relevant than cost-based accounts, it appears reliability is taking a ‘back-seat’ to relevance. The issue is : should this happen, is it good for business?
Let us also see whether the fair value-based ac-counting completely serves the purpose which it avowedly professes to serve. It is said that such accounting will help determine the true value of a business, which, in accounts prepared under the cost-based accounting is not possible. However, this argument in favour misses one vital point : that the value of a business is not only a function of the value of its assets, but is also a function of intangible assets including human resources, which are mostly off-balance sheet items. Hence, these two vital elements, namely, intangible assets and human resources, which influence the value of a business, still remain outside the books of account. Let us not forget that value of business is a perception. It is at times the price paid to enter the market to eliminate competition or acquire market share.
Though the fair value-based accounting has its advantages, like any other method of accounting may have, it is a question whether the fair value should form the basis of accounting replacing the cost as a concept. Fair value-based accounting may satisfy one group of readers of accounts, but it may throw up several issues of far greater significance. For example, balance sheets and income statements prepared under the fair value-based accounting will still have to be certified as being true and fair. May be such accounts are relevant for a purpose, yet it will be difficult to say that they are reliable. We need to decide what we want: relevant accounts or reliable accounts; I am of the opinion that reliability should not be sacrificed. However, to make financial statements more relevant all that is necessary is to require managements to provide on the value of assets including intangibles. The managements should also be required to disclose all off-balance sheet liabilities. The analysts and the investors I am sure would know how to make use ‘of this information. I don’t think we should play with the reliability of financial statements. In any case, no big investments in corporations are made without undertaking what is known as ‘due diligence’ exercise. Therefore, at the time of such exercise, all required information can be elicited from the management.
To sum up, fair value-based financial statements being highly subjective, are a myth open to manipulation for ulterior purposes. The age-old concept of ‘true and fair’ is in jeopardy. I don’t think, business and the profession should take or accept the ‘risk’ – risk of manipulation. Let us stick to prudence and reliability.
