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November 2012

Has Indian GAAP Outlived its Utility?

By Dolphy D’Souza, Chartered Accountant
Reading Time 5 mins
With no sight of International Financial Reporting Standards (IFRS) being implemented in India, we are back to looking at whether Indian GAAP fulfills investors and other stakeholder expectations of providing reliable financial information.

Bad standards result in bad accounting
Consider an arrangement where there is an agreement between two parties to jointly share control. The board of directors has equal representation of directors from both parties. Both parties own 50% shares each. Under Indian GAAP, joint control would result in proportionate consolidation. However, it is possible for both parties to achieve full consolidation. One party can do this by adding one more director on the board as its nominee, and the other party can do this by buying one additional share, but with no change in the joint sharing of the control. Therefore, though the arrangement effectively is unchanged; a small structuring can provide a vastly different accounting result.

Bad standards also prevent good accounting
A company takes a US$ loan from a bank which is to be repaid in thirty six equal installments in the next three years. The company does not stand exposed to exchange rate volatility, as the loan installments will be paid out of highly probable and matching future $ revenues. Typically, the hedging standard would allow the company to use hedge accounting for natural hedges and thereby avoid volatility in the income statement because of exchange rate swings. Unfortunately, under Indian GAAP, hedge accounting is not permitted when they contradict a standard that is notified under the Companies Act. Under Indian GAAP, such exchange gains and losses are recognised in the income statement creating an unnecessary volatility in the income statement, though the company has a 100% natural hedge.

Too many cooks spoil the broth
Consider this – a listed parent entity grants stock option to the employees of its subsidiary. Accounting for stock options is covered under both SEBI’s Guidelines and ICAI’s Guidance Note. ICAI’s guidance note requires the subsidiary company to recognise the expense on share based options irrespective of whether the subsidiary has any settlement obligation towards the parent. As per SEBI Guidelines applicable to listed entities, the parent records the compensation cost. These conflicting requirements create confusion and provide arbitrage to entities, and results in inconsistent application of the principles.

A duck will quack even if you call it a cat
Yes, a duck is a duck. Consider this. Many loans with a defined term and a guaranteed interest rate are structured as preference capital issued under the Companies Act, so that they are classified as share capital under the Indian GAAP. This vitiates the true debt equity ratio of the company. Further, the interest payments are treated as dividends to be appropriated from the P&L account rather than a charge to the P&L account. This is possible because Indian GAAP takes a view that when preparing financial statements, the Companies Act requirements will override accounting requirement of ‘substance over form’. The author believes that accounting should reflect the substance of a transaction. This should not be seen as overriding the legislation, which has been drafted for a different purpose and objective.

Remember the world is changing rapidly
Though the world has changed and is changing rapidly, Indian GAAP remains in the medieval ages. Consider this. Though financial instruments are rampant, the accounting standards relating to financial instruments are not yet notified under the Companies Act. As a result, there has been a lot of confusion, inconsistency and misuse of accounting principles. Under Indian GAAP, a company can structure a loan received from a bank on the pledge of the shares of its subsidiary as a sale of shares, with a right to buy back the same in the future at an agreed price. Typically, this is a financing transaction, but under Indian GAAP one could recognise the sale of the investment and recognise the buy back of the investment in the future. This practice could lead to recognising profit on sale of the investments, not recognising the loan and the corresponding interest expense on the books and obtaining deconsolidation and consolidation at convenience.

Fitting a square peg in a round hole
Financial statements have many uses, but the real objective of any general purpose framework is to provide investors and capital providers with information that is useful for taking decisions. An investor in an investment property company wants to know the fair value of the investment property portfolio, for decision making. The tax authorities are not concerned with the fair values, as they would typically tax rentals or realised capital gains. Standard setters should draft standards for capital providers. Drafting standards that will meet requirements of both capital providers and tax authorities, is like fitting a square peg in a round hole.

There are many travesties under Indian GAAP. The role of robust accounting standards should not be underestimated, in creating a climate of trust for investment. Only when nations create trust, they can raise capital locally and globally. It’s key to providing energy, food, water, education, employment, health and alleviating poverty. Having a variety of accounting standards across the world creates confusion, encourages errors and facilitates frauds. Having a single set of high standards, like IFRS, creates clarity, enhances confidence in financial statements and results in reduced costs of capital.

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