FINANCIAL REPORTING DOSSIER

This article provides: (a) key recent updates in the financial reporting space globally; (b) insights into an accounting topic, viz., the functional currency approach; (c) compliance aspects related to Impairment of Trade Receivables under Ind AS; (d) a peek at an international reporting practice – Viability Reporting, and (e) an extract from a regulator’s speech from the past.

1. KEY RECENT UPDATES

PCAOB: Audits involving crypto assets

On 26^th May, 2020, the Public Company Accounting Oversight Board (PCAOB) issued a document, Audits Involving Crypto Assets – Information for Auditors and Audit Committees, based on its observation that crypto assets have recently begun to be recorded and disclosed in issuers’ financial statements and were material in certain instances. The document highlights considerations (at the firm level and at the engagement level) for addressing certain responsibilities under PCAOB standards for auditors of issuers transacting in, or holding, crypto assets. It also suggests related questions that Audit Committees may consider asking their auditors.

IAASB: Auditing Simple and Complex Accounting Estimates

On 29^th May, 2020, the International Auditing and Assurance Standards Board (IAASB) released ISA 540 (R) Implementation: Illustrative Examples for Auditing Simple and Complex Accounting Estimates, a non-authoritative pronouncement that provides examples of (i) provision on inventory impairment, and (ii) provision on PPE impairment designed to illustrate how an auditor could address certain requirements of the ISA for auditing simple and complex accounting estimates.

FRC: Covid-19 – Going Concern, Risk and Viability

On 12^th June, 2020, the UK Financial Reporting Council (FRC) released a report titled Covid-19 – Going Concern, Risk and Viability acknowledging that many parts of the annual report may be impacted by the pandemic. The report highlights the impact on three key areas of disclosure, viz., (i) going concern, (ii) risk reporting, and (iii) the viability statement. It considers each of these areas and highlights some of the key considerations for reporting entities and also provides examples of current disclosure practices.

IASB: Business Combinations under Common Control

On 29^th June, 2020, the International Accounting Standards Board (IASB) issued an update – Combinations of Businesses Under Common Control – One Size Does Not Fit All, that is part of its research project to fill a gap in IFRS by improving the reporting on combinations of businesses under common control (companies / businesses that are ultimately controlled by the same party before and after the combination). The update discusses the preliminary views reached by the Board that include: the acquisition method of accounting should be used for some combinations of businesses under common control and a book-value method should be used for all other such combinations. A discussion paper is expected later this year.

IAASB: Covid-19 and Interim Financial Information Review Engagements

And on 2^ndJuly, 2020, the IAASB released a Staff Audit Practice Alert – Review Engagements on Interim Financial Information in the Current Evolving Environment Due to Covid-19. It highlights key areas of focus in the current environment when undertaking a review of interim financial information in accordance with ISRE 2410, Review of Interim Financial Information Performed by the Independent Auditor of the Entity.

2. RESEARCH: FUNCTIONAL CURRENCY APPROACH

Setting the Context

The functional currency approach to accounting for foreign currency transactions and preparation of consolidated financial statements is relatively new in the Indian context. Functional currency is ‘the currency of the primary economic environment in which an entity operates’ which is normally the one in which it primarily generates and expends cash.

An entity (under Ind AS) is required to determine its functional currency and for each of its foreign operations. Such assessment, a process involving judgement, is required at first-time adoption and on the occurrence of certain events / transactions (e.g. acquisition of a subsidiary). Changes to the underlying operating environment could trigger the process of evaluating if there is any change to the functional currency.

The accounting approach requires foreign currency transactions to be measured in an entity’s functional currency. The financial statements of foreign operations are required to be translated into the functional currency of the parent as a precursor to on-boarding them to the consolidated financial statements.

In the following sections, an attempt is made to address the following questions: Is the functional currency approach new in the global financial reporting arena? What have been the related historical developments and the approaches adopted by global standard setters? What are the principles that underpin them? What is the current position under prominent GAAPs?

The Position under Prominent GAAPs

USGAAP

The Financial Accounting Standards Board (FASB) issued SFAS 52, Foreign Currency Translation, in 1981. This standard replaced SFAS 8¹ and introduced the concept of ‘functional currency’ providing guidance for its determination with certain underlying principles that included:

(a) when an entity’s operations are relatively self-contained and integrated within a particular country, the functional currency generally would be the currency of that country, and

(b) the entity-specific functional currency is a matter of fact although in certain instances the identification may not be clear and management judgement is required to determine the functional currency based on an assessment of economic facts and circumstances.

SFAS 52 was designed to provide information generally compatible with the expected economic effects of exchange rate changes on an entity’s cash flows and equity, and to reflect in consolidated financial statements the financial results and relationships of the individual consolidated entities as measured in their functional currencies. The FASB opined that the process of translating the functional currency to the reporting currency, if the two are different, for the purposes of preparing consolidated financial statements should retain the financial results and relationships that were created in the economic environment of the foreign operations.

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1    SFAS 8, Accounting for the Translation of Foreign Currency Transactions and Foreign Currency Financial Statements (issued 1975) introduced the concept of a reporting currency. Prior USGAAP pronouncements had dealt only with the accounting topic of ‘translation of foreign currency statements’ and not with ‘foreign currency’

The existing USGAAP ASC 830, Foreign Currency Matters (SFAS 52 codified) requires the following economic factors to be considered individually and collectively in determining the functional currency: cash flow indicators, sales price indicators, sales market indicators, expense indicators, financing indicators and intra-entity transactions and arrangements indicators.

IFRS

IAS 21, The Effects of Changes in Foreign Exchange Rates, issued in 1993 was based on a ‘reporting currency’ concept (the currency used in presenting financial statements). A related interpretation, SIC-19² elaborated two related notions, viz., the ‘measurement currency’ (the currency in which items in financial statements are measured), and the ‘presentation currency’ (the currency in which financial statements are presented).

The SIC-19 guidance was perceived to lay emphasis on the currency in which transactions were denominated rather than on the underlying economy determining the pricing of transactions. Some stakeholders were of the view that it permitted entities to choose one of several currencies or an inappropriate currency as its functional currency.

IAS 21 was revised in 2003 (effective 1^st January, 2005) and replaced the notion of ‘reporting currency’ with ‘functional currency’ and ‘presentation currency’. It defined ‘functional currency’ as the currency of the primary economic environment in which an entity operates, and the ‘presentation currency’ as the currency in which financial statements are presented.

In the determination of the functional currency, the primary indicators to be considered are: (a) the currency that mainly influences its sales pricing, (b) the currency of the country whose competitive forces and regulations mainly determine its selling prices, and (c) the currency that mainly influences its cost structure. Secondary indicators (not linked to the primary economic environment but that provide additional supporting evidence) to consider are: (i) the currency in which funds from financing activities are generated, and (ii) the currency in which operating receipts are usually retained.

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2    SIC-19, Reporting Currency – Measurement and Presentation of Financial Statements under IAS 21 and IAS 29 (issued in 2000)

When the above indicators provide mixed results with no functional currency being obvious, then the management is required to apply its judgement. The guiding principle in such determination is that such judgement should faithfully represent the economic effects of the underlying transactions, events and conditions.

AS

AS 11, The Effects of Changes in Foreign Exchange Rates defines the reporting currency and does not adopt the functional currency approach. The standard does not specify the currency in which an entity presents its financial statements although it states that an entity normally uses the currency of its country of domicile. It may be noted that the reporting currency is rule-based under the Companies Act.

The translation of financial statements of foreign operations is principles-based under AS 11 and is extracted below.

(a) Integral foreign operations (Business carried on as if it were an extension of the reporting entity’s operations).

A change in the exchange rate between the reporting currency and the currency in the country of foreign operation has an almost immediate effect on the reporting enterprise’s cash flow from operations. Therefore, the change in the exchange rate affects the individual monetary items held by the foreign operation rather than the reporting enterprise’s net investment in that operation (AS 11.18).

(b) Non-integral foreign operations (Business carried on with sufficient degree of autonomy).

When there is a change in the exchange rate between the reporting currency and the local currency, there is little or no direct effect on the present and future cash flows from operations of either the non-integral foreign operation or the reporting enterprise. The change in the exchange rate affects the reporting enterprise’s net investment in the non-integral foreign operation rather than the individual monetary and non-monetary items held by the non-integral foreign operation (AS 11.19).

Snapshot of Position under Prominent GAAPs

A snapshot of the position under prominent GAAPs is provided in Table A.

                                     Table A

Case Study

In 2010, the US SEC noted that the subsidiaries of Deswell Industries (US listed entity) changed their functional currency and accordingly required it to provide a comprehensive analysis regarding the appropriateness of the change. Extracts from the Company’s response⁴ (correspondence available in the public domain) is provided below:

Through our subsidiaries, we conduct business in two principal operating segments: plastic injection moulding and electronic products assembling and metallic parts manufacturing. Two Macao subsidiaries function as our sales arms, marketing products to, contracting with, and ultimately selling to, our end customers located throughout the world, principally original equipment manufacturers, or OEMs, and contract manufacturers to which OEMs outsource manufacturing. Our Macao sales subsidiaries subcontract all manufacturing activities to our subsidiaries in the PRC.

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3    AICPA’s – Financial Reporting Framework (FRF) for SMEs, a special purpose framework that is a self-contained financial reporting framework not based on USGAAP

Catalyst for change in functional currency to US$: In the fourth quarter of fiscal 2009, we experienced a significant increase in the proportion of sales orders from customers in US$. Such increase, which we considered a material change from our historical experience, was the stimulus that caused us to assess whether our then use of HK$ and RMB as our functional currencies remained appropriate.

Criteria used in assessment: In making our assessment, we reviewed the salient economic factors set forth in SFAS 52.

Conclusion to change our functional currency: Having reviewed the above economic factors individually and collectively, and giving what our management believes is the appropriate weight to, among other things, the increases in, and predominance of, US$ denominated sales, our reliance on US$ sales generated by our Macao sales subsidiaries to fund the PRC operations and the transfers of excess funds as dividend payments to the ultimate parent; and albeit of less influence, the lower percentage of total costs and expenses in RMB for the PRC operations, our management concluded that the currency of the primary economic environment in which we operate is the US$ and that the US$ is the most appropriate to use as our functional currency.

In Conclusion

The functional currency approach originated in USGAAP (effective 1982), IAS followed suit in 2005 coinciding with the EU’s adoption of IFRS, and made its entry in India under the Ind AS framework from April, 2015.

The functional currency approach lays emphasis on the underlying economic environment and not on the home currency. Management judgement is involved in the process of determination. Since there is no free choice, the leeway with management to decide the measurement currency in order to influence the accounting exchange gains / losses in P&L is removed.

The underlying principles are the same under both USGAAP and IFRS, albeit the determining indicators differ. Ind AS is aligned with IFRS in this accounting area. The IFRS for SMEs framework follows the functional currency approach.

The reporting currency concept prevails under the AS framework (previous version of IAS 21) and the USFRF framework. These are simplified accounting approaches not based on underlying economics. It may be noted that the AS framework is mandatory for applicable companies in India while the USFRF for SMEs is non-mandatory.

At present, global standard setters do not have any stated plans to modify / improve the functional currency approach. While the underlying principle is robust, more guidance on applying management judgement cannot be ruled out in the future considering the complexity, diversity, digitisation of cross-border operations and structuring strategies of global corporates.

3. GLOBAL ANNUAL REPORT EXTRACTS: ‘VIABILITY STATEMENT’

Background

The UK Corporate Governance Code (applicable to companies with a premium listing) published by the FRC requires the inclusion of a Viability Statement in the Annual Report and was first made applicable in 2015. This reporting obligation cast on the Board is in addition to the Statements on Going Concern and is contained in Provision 31 of the 2018 Code (extracted below):

31. Taking account of the company’s current position and principal risks, the board should explain in the annual report how it has assessed the prospects of the company, over what period it has done so and why it considers that period to be appropriate. The board should state whether it has a reasonable expectation that the company will be able to continue in operation and meet its liabilities as they fall due over the period of their assessment, drawing attention to any qualifications or assumptions as necessary.

Extracts from an Annual Report:

Company: Experian PLC (Member of FTSE 100 Index, YE 31^st March, 2020 Revenues – US$ 5.2 Billion)

Extracts from Board’s Strategic Report:

In conducting our viability assessment, we have focused on a three-year timeline because we believe our three-year financial planning process provides the most robust basis of reviewing the outlook for our business beyond the current financial year.

Although all principal risks have the potential to affect future performance, only certain scenarios are considered likely to have the potential to threaten our overall viability as a business. We have quantified the financial impact of these ‘severe but plausible’ scenarios and considered them alongside our projected maximum cash capacity over a three-year cash period.

The most likely scenarios tested included:

Our viability scenario assumptions incorporate a significant shock to GDP in FY21, with no immediate rebound and a slow recovery over a two-to-three-year period in order to adequately assess viability.

Viability Statement

Based on their assessment of prospects and viability, the directors confirm that they have a reasonable expectation that the Group will be able to continue in operation and meet its liabilities as they fall due over the three-year period ending 31^st March, 2023. Looking further forward, the directors have considered whether they are aware of any specific relevant factors beyond the three-year horizon that would threaten the long-term financial stability of the Group over a ten-year period and have confirmed that, other than the ongoing uncertainty surrounding Covid-19, the near-term effects of which have been considered in the analysis, they are not aware of any.

4. COMPLIANCE: IMPAIRMENT OF TRADE RECEIVABLES

Background

The provisioning for, and disclosure requirements for impairment losses on trade receivables is governed (under the Ind AS framework) by Ind AS 109, Financial Instruments and Ind AS 107, Financial Instruments: Disclosures.

Ind AS advocates an expected credit loss (ECL) approach and an entity applies section 5.5, Impairment of Ind AS 109. A simplified approach applies to ECL on trade receivables that do not contain a significant financing component. With respect to trade receivables that contain a significant financing component, an entity can elect, as an accounting policy choice, to account for impairment losses using the simplified approach. The accounting and disclosure requirements w.r.t. ECL on trade receivables are summarised in Table B.

Table B: Accounting and disclosure requirements (ECL on trade receivables)

5. FROM THE PAST – ‘THE PROFESSION WILL GET THE STANDARDS IT DESERVES’

Extracts from a speech by Sir David Tweedie (former Chairman, IASB) to the Empire Club of Canada, Toronto in April, 2008 related to developing financial reporting standards are reproduced below:

‘It is harder to defeat a well-crafted principle than a specific rule which financial engineers can by-pass. A principle followed by an example can defeat the “tell me where it says I can’t do this mentality”. If the example is a rule then the financial engineers can soon structure a way round it. For example, if the rule is that, if A, B and C happens, the answer is X, the experts would restructure the transaction so that it involved events B, C and D and would then claim that the transaction was not covered by the standard.

A principle-based standard relies on judgements. Disclosure of the choices made and the rationale for these choices would be essential. If in doubt about how to deal with a particular issue, preparers and auditors should relate back to the core principles.

Of course, the viability of a principles-based system depends largely on its implementation by preparers and auditors. Ultimately, the profession will get the standards it deserves.’