When companies prepare their first financial statements compliant with the International Financial Reporting Standard (IFRS), they will have to use IFRS-1—First-time Adoption of International Financial Reporting Standards. IFRS-1 prescribes procedures that a company has to follow while preparing its opening IFRS balance sheet at the beginning of the so-called comparative (comparing with the previous corresponding period) period. Thus, Indian companies preparing IFRS financial statements for the period beginning 1 April 2011 with one year comparatives would need to prepare the opening IFRS balance sheet as on 1 April 2010.
One important aspect to be kept in mind is that the preparation of the opening IFRS balance sheet will be based on the IFRS guidance as prevalent at the annual reporting date (i.e., 31 March 2012) and not at the transition date (1 April 2010). This is in line with the principle of applying consistent accounting policies to all periods presented, so that the results are comparable for the periods.
IFRS-1 lays down four basic rules for the preparation of an IFRS-compliant opening balance sheet. The first principle is to recognize all assets and liabilities. For example, IFRS requires restructuring provisions to be recognized based on constructive obligation, whereas Indian GAAP, or generally accepted accounting principles, allow it based on contractual or legal obligations. Therefore, if an entity had any constructive obligations on the opening balance sheet date, then provision for this will be required. Similarly, off balance sheet items such as derivatives need to be recognized under IFRS.
The next rule is to derecognize all assets and liabilities not permitted by IFRS. For example, deferred revenue expenditure relating to share issue expenses will have to be adjusted against opening reserves and cannot be carried forward in the opening IFRS balance sheet. Further, all assets and liabilities have to be classified in accordance with IFRS. Investments will no longer be classified under current and long-term categories; rather, they would need to be classified under “fair value through profit or loss”, “available-for-sale” or “held-to-maturity” buckets, according to current accounting provisions related to “Financial Instruments: Recognition and Measurement”.
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Lastly, all assets and liabilities have to be measured in accordance with IFRS. For example, an entity would need to measure investments classified as “at fair value through profit or loss” at opening fair values with resultant impact flowing into equity and reserves. Similarly, long-term receivables and payables would need to be recorded at their present discounted values.
The above principles essentially imply that the opening IFRS balance sheet will present a financial picture as if IFRS were being followed all along—it will mean a full retrospective application of IFRS. However, IFRS-1 also recognizes that in certain areas, it will be difficult and cost a lot for a full retrospective application of IFRS principles, which will outweigh the likely benefits to users of financial statements. Hence, it provides 14 voluntary exemptions and four mandatory exceptions to the rule of retrospective application.
Consider business combinations (or mergers and acquisitions) and property, plant and equipment (PPE). With regard to business combinations, entities can either restate all previous business combinations or do this after a particular date. Therefore, if there have been significant business acquisitions in the recent past, the management may wish to apply this provision, since it provides a superior choice over the existing Indian GAAP by allowing the capture of fair value. Else, the company may adopt this provision only after 1 April 2010.
With regard to PPE, the relevant IFRS provision recognizes that entities may find it difficult to apply component approach under the accounting principle on “Property, Plant and Equipment” retrospectively. This provision provides an option to fair value various components of PPE at the date of transition to IFRS. These values will become deemed cost for subsequent applications of the relevant accounting principle.
On the four mandatory exceptions, IFRS-1 prohibits retrospective derecognition of financial assets and financial liabilities, use of hedge accounting, change of estimates and for assets classified as held for sale or discontinued operations. Regarding estimates, IFRS-1 does not allow the use of hindsight to change previous estimates. Other prohibitions on retrospective application aim at avoiding the use of hindsight as well.
A company also must apply IFRS-1 in any interim period report prepared within its first financial reporting period. As a result, companies must be capable of generating a comparative IFRS profit and loss account not only for the full year, but also for the quarters.
Lastly, IFRS-1 also requires certain disclosures to be made in the financial statements—namely, reconciliation of its equity reported under previous GAAP to its equity under IFRS as on the date of transition and at the end of the latest period presented under previous GAAP as well as reconciliation of the profit or loss reported under previous GAAP to its profit or loss under IFRS for the latest period. These disclosures will enable investors and users of financial statements to better understand the impact of convergence with IFRS.
As this overview has shown, in order to make informed decisions regarding voluntary exemptions, Indian companies will need to assess a variety of factors, including the cost of retrospective application, the availability of required information and the conversion selections made by peer companies.
India will move to IFRS starting 2011. Navin Agrawal is a director with Ernst & Young India Pvt. Ltd. This is the seventh in a series that analyses the impact of IFRS on industries and regulatory issues pertaining to its convergence with Indian GAAP. Respond to this column at email@example.com