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February 2009

Finding the Sweet Spot

By Dolphy D’Souza, Chartered Accountant
Reading Time 6 mins

Accounting Standards

Accounting standards are becoming increasingly complicated.
Though the standard-setters have their heart in the right place, and would want
to simplify the standards, the end result is that accounting standards are
becoming incomprehensible. The more the standard-setters try to simplify, the
worse it gets. One reason may very well be that businesses are getting
complicated, and transactions are not as simple as they used to be. A few years
ago, Indian GAAP had only 15 accounting standards; now that number has more than
doubled. Even International Financial Reporting Standards (IFRSs) would soon
cross 3000 plus pages.

Indian standards are inspired by IFRS. Therefore it would be
more appropriate to look at the development of IFRSs. These standards were
written over several years and with the assistance of different national
standard-setters. Consequently the lay out of the standards, the manner of
drafting and the use of English differ substantially. Recent IFRSs are drafted
more methodically, with a clear segregation of scope, definitions, recognition
and measurement, measurement after recognition, retirement and disposal,
disclosures, basis of conclusion, implementation guidance, etc. Therefore it is
of utmost importance that all old IFRS be drafted afresh, to make them
consistent with the recently issued standards.

There are a number of terms (see box) that have been used
frequently throughout the standards, which could mean different things to
different people; particularly given the fact that IFRSs would be used worldwide
and English in different countries is influenced by local culture. Therefore, a
term such as ‘may be accounted for in the following manner’ may be
interpreted in India as providing an alternative, though that may not be the
intention of the standard-setters. So also terms such as near term, current
period, short term, foreseeable future, long term, etc. or probable terms such
as probable of recovery, possible that it would be recovered, likely that it
would be recovered, highly unlikely that it would not be recovered, certain that
it would be recovered, etc. can create confusion. Firstly, these terms should be
reduced to a few standard terms and they should be used consistently across the
standards. Also, it would be more preferable to put some mathematical threshold
to these terms so that when it is being said that it is probable of recovery, it
should be known whether a 51%, 75% or 95% chance of recovery is applicable. In
India, we have already struggled with these terms, a prime example being the
requirement of virtual certainty with regards to recognition of deferred tax
assets in situations of unabsorbed losses and unabsorbed depreciation. Quite
clearly there is a lot that can be done in this area to clear the clutter.

Another debate is whether standards should be principle-based
or rule-based. It may be noted that though US GAAP is called rule-based
standards, it has a number of principles which are not translated
into detailed rules. So also though IFRS are principle-based, standards on
financial instruments almost read like a detailed rule book. In my view, the
whole argument of whether standards should be rule-based or principle-based is
futile. What we need is to hit that sweet spot where standards can be understood
easily and consistently.

Easier said than done, but with some hard work this can be achieved. Take for example, the accounting of multiple element contracts. Consider an example, where along with sale of software licence, post-contract customer support (PCS) will be provided over the next 6 months to a customer under a single contract. There are many accounting possibilities in this case. If there is price evidence for PCS, the price for software licence could be derived. This is known as the residual method. Alternatively, if there is price evidence for the software licence, the price for the PCS could be derived. This is known as the reverse residual method. Alternatively, the price for both elements may be known, and consequently the over-all discount on the contract may be allocated to the two elements, based on their relative fair values. A fourth possibility is the determination of revenue for the two elements by adding a uniform margin on their respective cost. The fifth possibility would be to keep the margin on the two elements different, to reflect their relative value and pricing in the market place. As can be seen, IFRS lends itself to multiple interpretations. Under US CAAP, the only method that is permitted is the residual method. Therefore under US CAAP, if there is no vendor-specific objective evidence (VSOE) of the undelivered element (in this case the PCS), no revenue can be recognised on the sale of licence. In such circumstances, the entire licence fee revenue is recognised ratably over the period during which the PCS is to be provided, rather than on delivery of the licence. As can be seen from the above example, US CAAP is very harsh and extensively rules-driven in this area. IFRS, takes the other extreme, is nebulous and lends itself to multiple interpretations. Quite clearly, this is an example where the sweet spot can be found and a common ground found between the two extreme approaches. US CAAP’s rule-based approach is founded by the fear that there would be abuse of standards if they are not fairly detailed. However, experience suggests otherwise – those who want to abuse the standards, would abuse them irrespective of whether those are based on principles or rules. Besides in many cases it is easier to abuse rules, by structuring the transaction in a desired manner. This is clearly seen in the area of leases, where lessees structure deals to escape finance lease classification. Another area which needs serious attention is the availability of too many accounting choices under IFRS. For example, fixed assets, intangibles, investment properties can be accounted using either the fair value model or cost model, actuarial differences in the case of employee benefits can be accounted for in a number of ways. Similarly choices are available in the case of government grants, impairment, financial instruments, etc. Too many choices result in inconsistency, lack of comparability and put to question the ability of standard-setters to make up their mind on the appropriate basis of accounting. Accounting is an art, not a pure science, and it should remain that way. Therefore, what is being suggested is not the elimination of judgment in the application of the standards. Nor is it being suggested that standards should be reading like rule books with too many bright line tests. What is being suggested is the use of appropriate and standard terminologies that should be used consistently, the removal of too many accounting choices, and principles that are not only easily understood, but tell you how the accounting should be done.

Adios to the Abyss.

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