The biggest controversy surrounding International Financial Reporting Standards (IFRS) framework is its extreme bias towards fair value. IFRS allows business entities to capture the upside in asset prices, allowing gains to be recognized in the income statement. In one way it is reflective of the market conditions, but the worry is that the markets are never perfect. They move from extreme optimism to extreme pessimism. The bias towards fair value may result in sharp fluctuations in earnings from one reporting period to another.
The unrealized gains on paper just evaporate when the market tanks. When there is distress in the market, even buyers are difficult to find, so how does one justify the concept of a fair value driven accounting? People will definitely argue what is better—“fair value” or the “lower of cost and market value”. Should unrealized gains and losses be disclosed separately and accounted for in a different manner than what is currently prescribed? This is an ongoing debate.
Another worry is accounting for derivatives. Few people actually understand what derivatives mean; even fewer people have the expertise to predict how their fair values will behave.
Under IFRS, it would be possible to defer recognition of losses on derivatives if it is possible to demonstrate the hedge’s effectiveness. This is quite a cumbersome task. Another problem is that some large derivative transactions may be one-to-one brokered arrangements, where the underlying market may not exist or may not have requisite depth and liquidity to provide a fair value comparable in the strict sense. In such cases, the valuation is done not on a mark-to-market but on a mark-to-model basis. These are all very complex matters and involve a fair amount of estimation.
If board and audit committee members and auditors do not have sufficient knowledge of these matters, there is grave exposure of blindly placing reliance on the work of a so-called expert.
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So far in India, we have been untouched by restatements that have caused great stress to investors worldwide. To offer a perspective, the number of restatements filed by US companies rose from around 116 in 1997 to 1,538 in 2006. In India, how our economic and regulatory environment will react to incidences of restatements is yet to be seen. This will be a real challenge because it will need a significant change in our mindset and huge efforts in terms of educating investors and managing public relations.
So far, India does not have a very litigious environment, unlike the US. With these sweeping changes coming in, one can expect the index of litigation risk to go up.
One of the major concerns noted in the implementation of IFRS is that individual countries have embraced IFRS with certain exemptions and changes. This has also been echoed by the US Securities and Exchange Commission (SEC), since it affects the comparability advantage that convergence seeks to attain. But, it would be a tall order to expect that local governments will accept IFRS in totality.
In India, one can expect that there will be regulatory overrides regarding the implementation of IFRS. It will be fair to evaluate any set of standards and principles and adopt what makes sense for the country, but not at the cost of diluting the very essence of IFRS.
A question that has often been asked is whether the advent of IFRS will have an impact on the cash flows of a company. The obvious answer is “no”. So, is this all much ado about nothing? There is no ready answer to that. Perhaps, investors and analysts need to start looking beyond the mere numbers that a GAAP (generally accepted accounting principles) framework throws up, such as economic value added or corporate sustainability reporting which are non-GAAP measures for evaluating corporate performance.
Another concern is the lack of commensurate industry specific guidance in IFRS. Comparatively, US GAAP is more detailed in this aspect, including critical areas such as revenue recognition. IFRS, being principle-based, will involve a greater use of judgement.
Also, more clarity is required in terms of defining what “fair value” is and converging this with the principle on Fair Value Measurements under US GAAP.
The good news is that the International Accounting Standard Board (IASB) is well aware of these concerns and is working closely with the Financial Accounting Standards Board of the US on critical improvement so that IFRS can gain unconditional acceptance across the globe. It is also working on a concise IFRS GAAP which will apply to small and medium enterprises. IASB should also look at optimizing the quantum of disclosures, since that is one area where reporting entities have generally faced lot of difficulties in complying.
On a concluding note, the world is becoming more integrated with each passing day. We need to have a common accounting language and IFRS is the logical answer to that. In a survey conducted by the International Federation of Accountants in which 143 leaders from 91 countries participated, 90% affirmed that a single set of reporting standards was important for economic growth. SEC has already allowed the top 100 US firms to follow IFRS from 2009.
There is only one take-away: Its high time to start looking at IFRS, what it entails for all of us, the impact it will have and how do we prepare ourselves best to welcome it in 2011.
India will move to IFRS starting 2011. Navin Agrawal is a director with Ernst & Young India Pvt. Ltd. This is the last of a 10-part series analysing the impact of IFRS on industries and regulatory issues pertaining to its convergence with Indian GAAP. Respond to this column at firstname.lastname@example.org