Following the system

Following the system

With the intensification of competition worldwide, Indian firms need to employ better accounting systems, which could considerably improve profitability. With more and more countries adopting international Financial Reporting Standards (II RS), it becomes imperative for India to follow suit. Ashruti Kak lays down the pros and cons of implementing the standard

Today, we face an enormous opportunity in the field of financial accounting-an opportunity that goes by the name of International Financial Reporting Standards (IFRS). Although India follows Indian Generally Accepted Accounting Principles (I-GAAP), which is inspired by International Accounting Standards (IAS), IFRS is being rooted as ‘the’ accounting framework that has the potential to become the standard GAAP in the near future.

It all started in 2005 after the EU made IFRS mandatory for all its listed companies. Since then more than 100 countries have shifted to, or based their local standards on IFRS.

Need for IFRS

“IFRS principles are generally more complex to apply, as they involve more judgment and increased used of fair values. This will also result in greater volatility in the income statement. Expectations of different stakeholders (including investors and analysts) will need to be managed such that they fully understand the impact of adopting the new standards”

– Jamil Khatri Executive Director and Head-Accounting Advisory Services

KPMG

“Since the world does not understand I-GAAP, raising foreign capital by Indian companies is costly because of the risk premium. If IFRS financial statements are used, the cost of raising foreign funds would go down. Also, IFRS is good news for investor’s because of the extensive disclosure requirements in IFRS as compared to I-GAAP”

– Dolphy D’souza Partner

Ernst&Young

“The most important reason for convergence is that the world is speaking in one language (IFRS) and we cannot afford to speak in any other language. There are 100 countries which have already adopted IFRS, and this number is likely to go up to 150 in the next two to three years. By then, countries not using IFRS will be very few,” says Dolphy D’Souza, Partner, Ernst & Young. “We just have to align our standards with the world,” he adds.

Jamil Khatri, Executive Director, Head-Accounting Advisory Services, KPMG, concurs, “With the advent of globalisation and transnational convergence of business interests, the world has become one common market place, thus it becomes pertinent for all stakeholders that all participants follow one common accounting language such that performance of all companies is comparable and net worth of all market participants is based on common set of principles.” He continues to say, “In pursuit of this objective, accounting standard setting bodies across the world have converged or are converging to one accounting framework ie IFRS.”

While there is a momentum in India to move towards IFRS by issuing standards which are largely aligned, at present there is still significant difference between I-GAAP and IFRS. Khatri explains, “The accounting guidance under IFRS covers not only the substance of transactions but also provides detailed comprehensive guidance for complex areas such as share based payments, financial instruments and business combinations, which are either not covered under I-GAAP or where guidance under I-GAAP is limited and dated.”

Ultimately, the fact remains that all countries will be adopting IFRS in the near future, so, it is for the better that we adopt the standard now instead of later, in order to have enough time to at least help shape the international accounting standards.

Vantage ground

IFRS adoption can yield many benefits for the Indian market. According to Khatri, Indian pharma companies over the past few years have gone global and have made acquisitions in various parts of the world. This has necessitated a need to raise funds across international borders, and thereby, a need to present its financial statements in a form which is acceptable to international investors. “IFRS will eliminate barriers to cross-border listings, give better access to global capital markets by ensuring that financial statements are more transparent and are understood in the same manner the world over,” he says.

D’Souza elaborates, “Since the world does not understand I-GAAP, raising foreign capital by Indian companies is costly because of the risk premium. If IFRS financial statements are used, the cost of raising foreign funds would go down. Also, IFRS is good news for investor’s because of the extensive disclosure requirements in IFRS as compared to I-GAAP.” He goes on to say that IFRS is mostly from an investor’s perspective. It would provide a lot of information to the investors so that it is much more transparent than I-GAAP.

Also, an accountant’s knowledge of the universal accounting language ie IFRS, gives him the flexibility to work in any part of the world. Job opportunities for Indian accountants will improve once the world realises and acknowledges the fact that accounting in India is identical to that in Europe. “A lot of professionals familiar with IFRS can provide a lot of impetus to the BPO business (services sector) with respect to all the IFRS subcontracting coming from all parts of the world,” adds D’Souza.

According to CII’s Journey to IFRS—A guide on transition to IFRS, in addition to the above, adoption of IFRS will enable companies to gain a broader and deeper understanding of the entity’s relative standing by looking beyond country and regional milestones. Further, adoption of IFRS will facilitate companies to set targets and milestones based on global business environment, rather than merely local ones. Escape Multiple Reporting Convergence to IFRS, by all group entities, will enable company managements to get all components of the group on one financial reporting platform. This will eliminate the need for multiple reports and significant adjustment for preparing a certified financial statement (CFS) or filing financial statements in different stock exchanges.

Another benefit, as per the CII guide, would be that IFRS will reflect true value of acquisitions. For example, in I-GAAP, business combinations (collaborations), with few exceptions, are recorded at carrying values and not at fair values of net assets taken over. Purchase consideration paid for intangible assets not recorded in the acquiree’s books is usually not reflected separately in the financial statements; instead the amount gets added to goodwill. Hence, true value of the business combination is not communicated through financial statements. IFRS will overcome this flaw as it mandates accounting for net assets taken over in a business combination at fair value. It also requires recognition of intangible assets, even though they have not been recorded in the acquiree’s financial statements.

Challenges to IFRS convergence

Even though it would be relatively easier for India to converge with IFRS, considering that historically Indian standards have been based on it, given the nature of accounting and peculiarities of the Indian economic environment, IFRS implementation can have its own set of problems.

“Companies would need at least a year or more to converge with IFRS. Many are not prepared, though some are in the process of implementing it or awaiting clarification from the regulatory authority so that they can get started. If we have to implement IFRS countrywide by 2011, the laws will have to change now,” says D’Souza. Another challenge is that companies need to start training, and the audit committees need to be well versed with IFRS. “Companies need to start working on the differences, prepare their senior management, who will be making presentations to the board of directors and the audit committee. Then they should form and train a team, and start looking at their financial statements, because all these things will not only have an accounting impact but will also have a significant business impact,” he adds. According to him, some MNCs have already initiated these steps and commenced basic training sessions, “but it still needs some more serious efforts as they are still in a very preliminary stage,” he says. Probably they are waiting for a final clarification from the Government.

Khatri informs that The Institute of Chartered Accountants of India (ICAI) has released a Concept Paper on Convergence with IFRS in India, which proposes the strategy and roadmap for convergence of I-GAAP with IFRS with effect from April 1, 2011. The Ministry of Corporate Affairs (MCA) also clarified in May 2008 that the Government will continue harmonisation of Indian accounting standards with IFRS with the intention of achieving convergence by 2011. “However, several important matters need to be addressed urgently if India hopes to achieve the planned convergence,” he says.

There are some critical challenges to IFRS convergence that would need to be addressed. Firstly, as D’Souza mentioned earlier, at the onset of convergence, there is a need for change in several laws and regulations governing financial accounting and reporting in India. This will be the most significant challenge facing IFRS convergence in India. Secondly, we need to amend the current education system to ensure that people are adequately trained to apply the global principles.

“IFRS principles are generally more complex to apply, as they involve more judgment and increased used of fair values. This will also result in greater volatility in the income statement,” says Khatri. Also, “Expectations of different stakeholders (including investors and analysts) will need to be managed such that they fully understand the impact of adopting the new standards,” he adds.

As per CII’s guide, as financial accounting and reporting systems are modified and strengthened to deliver information in accordance with IFRS, entities need to enhance their IT security in order to minimise the risk of business interruption-particularly to address potential fraud, cyber terrorism, and data corruption.

Khatri informs, “The reporting requirements in India currently for companies are guided by the Companies Act, 1956. In addition to accounting standards, there are legal and regulatory requirements that determine the manner in which financial information is reported or presented in financial statements. As per the preface to the Indian accounting standards, if a particular accounting standard is found not be in conformity with a law, the provisions of the said law will prevail and the financial statements shall be prepared in conformity with such law. The Government shall have to frame and revise laws in consultation with National Advisory Committee on Accounting Standards (NACAS) to facilitate convergence with IFRS.” For example, he adds, the Companies Act, 1956 determines the classification for redeemable preference shares as equity of a company, whereas these are to be considered as a financial liability under IFRS.

“Also, Schedule VI of the Act, which currently prescribes the format for presentation of financial statements for Indian companies, is substantially different from the presentation and disclosure requirements under IFRS. Accordingly, for IFRS convergence to be successful, the Companies Act, 1956 will need to be amended to remove all possible conflicts,” says Khatri.

KPMG recently announced the launch of its IFRS Institute in India. Operational from 4th February 2009, The IFRS Institute has been designed to assist various stakeholders in the planned convergence from Indian Generally Accepted Accounting Principles (GAAP) to International Financial Reporting Standards (IFRS).The institute is a web-based platform, which seeks to act as a one-stop site for all information, updates and views on IFRS implementation in India. In addition to propriety KPMG content, the website will provide links to several other sources of information related to IFRS and its implementation. The site can be accessed by all interested parties at no cost. Additionally, the site provides a facility to register as a member by providing certain minimal information. Registered members would be entitled to receive invitation for KPMG sponsored IFRS events and IFRS web casts. Membership to the website is also free. The website can be accessed at www.in.kpmg.com/ifrsinstitute .Concurrently; KPMG has also launched an online survey to evaluate views of various stakeholders on IFRS implementation in India. There has been widespread debate on whether Indian companies have made sufficient progress on IFRS implementation as compared to other countries such as Canada and South Korea, which have a similar 2011 timeline for IFRS implementation. KPMG recognised that no comprehensive survey has been done in India to evaluate preparedness; therefore, it designed an online survey, which was rolled-out the day the operations started. The survey seeks inputs and views on areas relating to benefits of converging with IFRS, implementation challenges, key impact areas and current level of preparedness. The results of the survey along with the related analysis and benchmarking will be released through a report that will be made publicly available to all stakeholders. The survey can be accessed through the IFRS Institute and all members can participate. Results of the survey along with the detailed report by KPMG will also be made available on the IFRS Institute.

Impact on pharma business

IFRS will have a significant impact on businesses across all industries. Every country converging with IFRS has brought or will bring a new perspective to IFRS from its national accounting standards and corporate culture. “IFRS is principle based on a lot of the current Indian standards that are largely aligned to the existing IFRS. However, it is constantly evolving through issuance of new standards, interpretations etc which will create fresh differences, unless I-GAAP is also constantly modified. Adoption of IFRS should bring a lot of assets in the balance sheet of companies at fair value,” informs Khatri.

As far as R&D is concerned, Khatri says that the guidance in I-GAAP and IFRS is quite similar on accounting for R&D expenditure. However, the entities in this space generally face challenges in accounting for development expenditures that are eligible for capitalisation, subject to meeting all the prescribed criteria. However, because judgment is required to assess capitalisation, differences in practice can exist.

Explaining the impact on revenues, he says, “Under IFRS, revenue is recognised when the significant risks and rewards of ownership have been transferred to the buyer, recovery of the consideration is probable, the associated costs and possible return of goods can be estimated reliably, there is no continuing management involvement with the goods, and the amount of revenue can be measured reliably.” Unlike IFRS, he continues, I-GAAP does not list lack of continuing managerial involvement and measurability of cost among the criteria for revenue recognition. Additionally, I-GAAP also permits revenue recognition when the seller has transferred to the buyer the property in the goods. This can affect accounting for bill and hold transactions in certain cases. Also, the substance of the transaction should be considered to determine whether the various components should be treated as a single contract or accounted for separately.

Role of various stakeholders

In India, the accounting framework is intensely affected by laws and regulation. We have multiple regulators of accounting standards. For example, in case of a listed bank, the accounting norms prescribed by Securities and Exchange Board of India (SEBI), Reserve Bank of India (RBI), ICAI, Companies Act and the Banking Regulation Act are followed. As a consequence, some accounting requirements may clash with each other, and some are definitely in conflict with IFRS.

For IFRS to be successful in India, the regulators of the country will have to significantly participate. “For example, ICAI will have to train their chartered accountants, universities will have to change the curriculum of colleges, ie, do away with I-GAAP and start IFRS, regulators will need to revise the regulations, relook at the tax laws, etc. Pharma associations should hook up with their members for a tie up with regulatory bodies like SEBI, CII, ICAI, the Ministry of Corporate Affairs, to ensure that the implementation of IFRS is smooth and that the changes in regulations are made well in time to avoid a last minute chaotic situation,” says D’Souza.

Khatri agrees, “The Indian Government needs to provide regulatory clarity on the next steps on convergence, including how the above challenges will be addressed. The various pharma bodies and associations should get involved in the process and highlight to the Government the critical challenges the industry will face once India moves to IFRS. They should create enough forums for debate to ensure that all pitfalls are identified upfront.”

aashruti.kak@expressindia.com