Subject : Recent Global Developments in International Financial Reporting Standards
Venue : IMC Hall, Churchgate, Mumbai
Speaker : N. P. Sarda, CA, Past President, ICAI
Date : 25th November, 2009
1. Bird’s-eye view of Development of International Accounting Standards from inception to date :
1.1 In 1973, Accounting Standards Committee was formed to propose International Accounting Standards. In 2001, the name of the committee was changed to International Accounting Standard Board and the standards that were prescribed by the Board were titled as International Accounting Standards (IAS). The Accounting Standards hitherto published will be merged with IFRS. In the course of time, new standards may be formulated which will get added. Under the old regime of IAS, forty-one International Accounting Standards were introduced, out of which 12 standards were withdrawn or superseded by new standards, leaving twenty-nine International Accounting Standards. There are nine IFRS already in existence. The 9th IFRS has been issued on 12th November 2009.
1.2 So far, several interpretations were issued on International Accounting Standards (IAS). Henceforth, interpretations on new Standards (IFRS) will be included in literature on IFRS.
2. The global developments, their present status and issues embedded therein :
2.1 In India in 1987, decision was taken to set up at our Institute’s level an Accounting Standard Board. After its formation, it was decided to formulate our own independent Accounting Standards (AS), rather than verbatim adopting their international counterpart. Subsequently, in 2007, it was decided to convert present Indian standards to IFRS.
2.2 In 1997, it was decided to achieve comparability and to improve existing standards. It was decided to revise ten Accounting Standards, such as AS-2 Valuation of inventory, AS-7 Accounting for construction contracts, etc.
2.3 In 2003, another improvement project was undertaken by International Accounting Standard Board of revising fourteen Accounting Standards.
2.4 There exist three types of Accounting Standards, viz. US GAAP evolved by US, International Accounting Standards and National Accounting Standards of each country. US GAAP was competing with International Accounting Standards. On many issues. However, it was decided to co-ordinate and close down the differences by taking up long term/short-term projects in that direction.
2.5 There is one fundamental difference between US GAAP and International Financial Reporting Standars, namely, US GAAP lays down the rules, whereas IFRS sets out the principles.
2.6 On 15th November, 2007 a decision was taken that companies located outside the US can follow principles of IFRS which need not be reconciled with US GAAP. But, if any company has to enter US capital market, then it must reconcile its accounts with US GAAP requirement.
2.7 The European Union with its twenty-seven member countries and their respective parliaments decided that consolidated financial statements of listed companies should be as per IFRS. As regards unlisted companies or stand-alone units like holding companies and their subsidiaries it was left to discretion of member states. The trend of thinking of these governments is to make IFRS mandatory even to unlisted companies and stand-alone accounts. Thus, there are three-tier arrangements presently existing for dealing with presentations, disclosure requirements and the rules applicable to listed companies and stand-alone companies.
2.8 Pursuant to this decision, the UK Parliament has passed legislation that all listed companies and even stand-alone companies will have to prepare consolidated account statements as per IFRS principles. For unlisted companies, IFRS applicable to SME i.e., Small & Medium Enterprises sector will be used and for very small enterprises (Micro Units) another standard as prescribed will be used. Similarly, for companies in the US, there are three-tier arrangements for presentation and consolidation.
3. IFRS for SMEs :
3.1 The printed materials by way of Accounting Standards, Interpretation iterature in case of US GAPP runs into 17,000 pages and in case of IFRS, this runs into 2,500 pages. For small and medium sector companies, IFRS printed material is only 250 pages which, such SMEs will have to follow.
3.2 In Europe, all the 27 member countries took a decision to totally adopt and follow IFRS and parliament passed suitable legislations accepting IFRS.
3.3 Countries like Australia, New Zealand, Korea, and Sri Lanka have adopted IFRS, subject to their right to exercise their option about additional disclosures.
3.4 A need to have a second look at the disclosure requirements of IFRS is being felt. A project called project on evaluation of disclosures is being undertaken to avoid conflict between IFRS requirements about disclosures, local requirements and economic situation in India. A decision is taken keeping in mind the strong view taken by IFRS that though guidance note can be provided, it should not conflict with principles pronounced in IFRS. Such guidance notes will not form part of the standards prevailing in the country. The IFRS Board is very assertive on this point. This makes it a difficult task to convert Indian Standards into IFRS with narrow scope for variation. In Europe, its twenty-seven member countries as well as countries in rest of the world have decided to go nearer to IFRS, but at the same time, retaining their right to deviate if local situations so demand. Though many changes are not permitted, the countries can decide about the dates/years from which the new standards will become applicable. So, many countries have decided to go for modified standards which will be close to IFRS instead of adopting IFRS directly.
3.5 The regulators of Accounting Standards in India hold the same view. The Ministry of Corporate Affairs, SEBI, RBI, IRDA & ICAI are unanimous on issuing Indian Standards and not to endorse IFRS directly.
3.6 Global situation : The countries in Europe, Australia, New Zealand made their own standards. The countries like Korea, Sri Lanka, Hong Kong followed the IFRS verbatim. But, Singapore and Philippines accepted some of the standards and dis-agreed with some others. For example Interpretation Note No. 2 & 15 were not accepted by Singapore. Obviously, they cannot certify IFRS compliance. Some countries like India have made new standards applicable from 2011. So also Pakistan, Indonesia, Taiwan, Vietnam are trying to go nearer to IFRS in next four years. China has prepared thirty-eight Accounting Standards, which are at par with IFRS.
4. Issues and controversies arising from IFRS :
4.1 Recent global development and the financial crisis : In the last two years, a lot of debate has generated on whether crisis is due to accounting failure or due to some other reasons. The final view is that the crisis is attributable to failure of economic system. Banks were advancing loans on mortgage of properties. Attention was given only to value of property and not to repayment capacity and integrity of borrower. This practice worked well till property prices were rising. But this over-optimism brought about the disaster when property prices started dwindling. The borrowers opted to surrender properties, overflowing the banks’ balance sheets with properties in place of recoverable loans. In India, however, due to proper monitoring by RBI about secured loans against mortgage, restricting the discretion of banks on the extent to which such loans can be given, the disaster could be avoided to some extent.
4.2 Another reason for the economic crisis was that in India, the bankers not only look into the sufficiency of security but also verify integrity of bor-rower. But in the USA the scenario was that when loans were transferred to another bank, the portfolio of investments held as security were also transferred as financial products. The insurance companies gave guarantee. But when portfolio became bad, the recovery of debt became doubtful. The financial products, valuation of which is complex, when transferred to other bank, no conservative principles were followed. So also, when loans were given against property, the erosion in value of property resulted in losses to lender institutions. In the process of finding solution, it was decided that the standard-setters of financial reports should come out with new standards. As financial products are complex for evaluation, the standard-setters should give guidance on principle to be followed for financial instruments. IAS-39 is proposed to be revised by issuing IFRS-9. Another reason for the crisis was that many companies are having financial commitments which remain outside the books and do not get reflected in balance sheets. To illustrate, companies enter into Derivative contracts, the profit or loss gets crystallised when contracts are settled or options are exercised at future dates. Some companies enter into forward contracts for covering foreign exchange risk pertaining to purchase/import of raw materials. The fluctuations in import prices are very high. So, very often companies suffer heavily on actual settlements of contracts entered into, say, before 12 or 24 months. Such obligations do not get reflected in the accounts. This is a lacuna. In March, 2008, the Institute came out with Notification about derivative instrument in AS-30 which is not yet made mandatory, but recommendatory. Still, if a company desirous of following it, keeping in mind concept of prudence as per AS-1, can make suitable provision for losses that are likely to arise in derivatives, forward contracts and make account statements transparent and realistic. The financial failures of business enterprises due to such contracts of derivatives also have contributed to economic crisis.
4.3 As a step in the direction of solution, Financial Advisory Board was appointed by International Accounting Standard Board. US Financial Advisory Board is advised to study the situation and submit its report and recommendations.
4.4 The Board has observed that failure of the economy is not due to erroneous accounting but due to inherent system failure in incorporating liabilities and losses arising from derivatives, forward contracts, credit policies of granting loans against properties and financial instruments. It also recommended simplification of Accounting Standards on Financial Instruments (IAS-39) by issue of guidance note. International Accounting Standard Board took review of IAS-39. The issues arising therefrom touching subjects of presentation, disclosures were incorporated in IAS-32 issued in 1995. The other complex issues like recognition, measurement and valuation and other difficult issues were taken up in 1999, which were incorporated in IAS-39. For presentation and disclosures, IFRS-7 was issued. Now the AS-32 will contain only disclosure requirements. Some radical changes were made in basic concepts in accounting hitherto followed. For example, in IFRS, redeemable preference shares are not treated as capital or shareholders’ funds. It is a liability and not equity. Similarly, for IFRS, fully convertible debentures are considered as equity and not liability. Hence, when AS-32 will become effective, Schedule VI of the Companies Act will have to be revised. For IFRS, substance is more important than form. Therefore, for giving effect to IFRS, changes will have to be made in Financial Instruments Standard by simplifying it. These changes will be necessary in IAS-32 on financial instruments and in IFRS-7 on disclosures. The impact of financial instruments of liabilities arising through forward contracts, derivatives and other liabilities not appearing in balance sheet, age analysis of credit risks, portfolio valuation based on rate of interest. All present disclosures in standards on fixed assets and inventory does not cover issues arising in financial instruments.
The applicable standards are :
IAS-32 for Presentation
IAS-39 on Recognition Measurement and Valuation
IRRS-7 on Disclosures
4.5 IAS-39 on Recognition, Measurement and Valuation is being discussed globally on simplification. In India, on this issue AS-30, AS-31 & AS-32 are introduced; AS-30 deals with Recognition and Measurement. AS-31 is on Presentation and AS-32 is on Disclosure. The contents of these standards are at par with corresponding International Standards, but they are yet to be made effective. A project is undertaken in three parts by International Accounting Standards Board.
4.6 In the first part, issues on recognition, measurement and valuation are dealt with.
In the second part, impairment of investment and in third part, issues on hedging will be dealt with.
The first part is completed on 12th November, 2009 called IFRS-9. The second and third part will be completed in last quarter of 2010.
5. Classification, recognition & valuation of financial instruments :
5.1 There are four categories — Financial instruments include investments, loans and advances, deriva-tives and other financial assets and on liability side it includes every debt and equity other than current liability. The principles of valuation in IFRS-39 require adoption of fair value and not market value. So, if the inflow of actual yield of interest and amount due on maturity is known, then the fair value will have to be arrived at. To illustrate, investment of Rs.100 is purchased at Rs.91 which on maturity after 3 years will fetch Rs.100 and in inter-mediary years, it is fetching interest @ 7% and market value is, say, Rs.95. For fair value, one has to find out discounted value. In this case, the inflow will be @ 7% for 3 years and Rs.100. On maturity. after three years, suppose, discounted value is Rs.97, then for IFRS, the historical cost of Rs.91 as well as market value of Rs.95 is not relevant but discounted value Rs.97 will have to be adopted. This method of valuation is called amortised cost method. There are two methods in IFRS either amortised cost or fair value. This method can be followed if inflow is known and certain. The present value of such inflow is considered.
5.2 In IFRS-9, there are three methods of classification. First is fair value and second is amortised cost or discounted cost. Third is loans and advances to be valued at amortised value. To illustrate, if the loan of Rs.10 crores is given on security of property of Rs.8 crores and recovery is not likely, then under IFRS, for valuing security offered, the time that will be required for realisation of security will be taken into account. If the time for realisation is, say, 3 years, then discounted value of security of Rs.8 crores will be considered at say Rs. 5.50 crores. The difference between loan of 10 crores and present worth of securities i.e., Rs. 4.50 crores will be charged to Profit & Loss account by way of provision for bad and doubtful debt. The value of secured advance will appear at Rs. 5.50 and not Rs.8 crores for IFRS and the advance will become performing asset for presentation in balance sheet. So, the time value of money plays an important role in IFRS.
5.3 In IFRS-4, the following principles are extremely important. They are :
1. Historical costs do not play any role. It is always the present worth or discounted value, because user of financial statements is not interested in historical cost but present worth or fair value. For arriving at fair value, allowance is to be given to discounted value.
2. Time value of money : If the asset subjected to valuation carries normal interest which is realisable, then no discounting is necessary. But where no interest is likely to be received, then the value of asset needs discounting.
3. Substance over form : This is illustrated by a hypothetical case. If a company has declared VRS for its employees giving certain time allowance to opt, the company expects that, say 10 employees will accept retirement. But, actually, say, only 3 employees have opted and the company accepted their retirement. Then, as per IFRS, the provision for liability should not be only for three employees, but for all the likely employees, since the liability exists on balance sheet date. Such liability can be discounted. So, though legal obligation has not arisen, the constructive obligation requires consideration under IFRS.
In case of holding and subsidiary companies, for deciding whether consolidation will be required, the company will have to consider effect of the powers vested in holding company. If company ‘A’ is holding 49% of shares of company ‘B’ and under a contract or a MOU, the right to appoint managing director and finance director is vested in company ‘A’, then though holding is less than 50%, still the company ‘A’ holds right to decide effective financial management of the company ‘B’. Hence, consolidation of both Balance Sheets will become necessary. The same situation will prevail if majority of directors can be appointed by the company ‘A’. So, lead control test is satisfied. Thus, in IFRS substance over the form requires consideration.
4. For IFRS, the balance sheet plays more important role. Normally, the Profit & Loss account is considered important, since it decides profit for the year, the tax liability, the quantum of staff bonus, the dividend policy and other effects. In IFRS, balance sheet is supreme, since user of financial statements is more concerned with real state of affairs of the company. He needs an assurance that all provisions are made for actual or constructive liabilities and assets are valued not by historical cost but at fair value by making provision for impairment. At the same time, extra prudence through excessive provisions should not harm the interest of existing shareholders. The balance be-tween interests of existing and prospective shareholders is expected to be maintained. IFRS-9 will become mandatory from the year 2012.
6. Difference between IAS-39 and IFRS-9 :
6.1 Instead of the above four categories of principles in IAS-39, the fourth terminology for categorisation of shares and securities, is securities available for sale. Where securities cannot be termed as trade investments or long-term investments or other investments, then the same can be categorised under the head ‘Securities available for sale’. If value of such investments have materially appreciated, then the difference can be recognised by considering investment at fair value or realisable value and crediting other comprehensive income which shown in the balance sheet under ‘Reserves’.
6.2 In IFRS-9 instead of four methods only two methods are suggested, namely, fair value and amortised cost or discounted value of future proceeds. The intention for making investment will decide its category. Considering practical difficulties in determining fair value, International Accounting Standards Board, in its exposure draft has provided guidance on measurement of fair value. If there is active market for investments, then such value or in absence of active market, there is an alternative formula in finding out fair value. First level is evidence of trend of active market, second level is comparison of your security with similar security in active market. The third level is to consider cost of investment as surrogate of fair value.
6.3 When security is intended to be held till maturity and its amortised cost is considered, the variations in market value will have no effect on value, since it is to be held till maturity. But, if any of such securities are disposed of before maturity, still as per IFRS-9, revaluation need not be carried out. In IAS-39 on valuation of investment there were different rules to deal with appreciation and depreciation. In IFRS-9, these rules are substituted by simple principles viz., the impairment is to be identified with specific investments.
6.4 As regards valuation of equity shares, the principle in IAS-39 deals with embedded derivatives. In derivative contracts, what a party can receive or pay depends on price of commodity, rate of inflation or rate of exchange or rate of interest. An embedded derivatives are still complex. If asset is given on lease and if the rent is made depend on say rate of inflation say if inflation goes up by 1% the rent will go up by say 20%. This is contract of embedded derivative where outcome cannot be preciously determined. IFRS-9 covers only financial assets and not financial liabilities. Impairment of holding are to be considered later.
7. The present status of IFRS-9 & IAS-39 applicable to India :
7.1 The concerned authorities in India are ICAI, Ministry of Corporate Affairs, SEBI, RBI, Insurance Authority and the companies. The issues to be tack-led are — whether IFRS is to be adopted in total in the same form whereby Indian standards will cease to exist.
7.2 The trend of thinking of the above authorities is that IFRS can be applied only to public interest entities and Indian Standards will continue to apply to other entities.
7.3 Public interest entities need to be defined. It will include top listed companies or corporations, which have borrowed abroad or companies having subsidiaries abroad or have issued equities abroad. Therefore, IFRS will be applicable from 1-4-2011 to Insurance, Banking and Financial Institutions.
7.4 From 1-4-2013, the IFRS will be applicable to category 2 companies which will include all listed companies or companies having turnover over Rs.2,000 crores or borrowing more than Rs.500 crores.
7.5 For all the rest of companies, the question is whether they should follow existing AS or IFRS. These categories are SME’s (Small & Medium Enterprises), which are not equipped with advanced knowledge, required for IFRS. They can follow simpler accounting standards in India and progressively be prepared to follow IFRS by knowing its under-lying principles. A change in their mindsets and taking steps towards appreciating differences between Indian Standards and IFRS is the need of the day.
The learned speaker thereafter replied the questions raised from audience and concluded his speech.
The meeting was terminated with vote of thanks to the speaker.
to sense it and stub it.
- that the pro-active action the Chairman, prevented a brewing crisis in human relations which would have adversely impacted the company’s operations.
- the importance of HR policies and timely action.
- that HRD keeps its finger on the ‘pulse’ of the organisation.
