BackGearing up for the global standard
Gearing up for the global standard
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As India converges with International Financial Reporting Standards (IFRS), there are certain matters that company directors should be aware of. First and foremost, India is converging with IFRS and not adopting IFRS. The Indian IFRS will be called Ind-AS, which would diverge from IFRS on some matters. The level of acceptability of Ind-AS financial statements outside of India will be somewhat discounted as those will not be in compliance with IFRS as issued by the International Accounting Standards Board (IASB). This aspect could be somewhat mitigated by a reconciliation statement between IFRS and Ind-AS in the Ind-AS financial statements.
The impact of Ind-AS on financial statements could range from minimal to significant. For example, companies that have raised funds through foreign currency convertible bonds (FCCBs) typically did not have any charge in the Indian GAAP (generally accepted accounting principles) financial statements. However, under Ind-AS, there would be a significant charge on two counts. First, the market rate of interest would be charged to the income statement and second, the changes in the value of the convertibility option would be taken to the income statement. In some cases, the accounting could change a profit-making entity into a loss-making entity.
Accounting of ESOPs (employee stock ownership plans) would impact the technology industry and financial instruments would affect the banking industry. Accounting of regulatory assets would impact the utility industry, completed contract accounting would affect the real estate industry and lease accounting would impact the manufacturing industry, and so on and so forth.
The central role of the board of directors would be to ensure that Ind-AS financial statements are reliable. Therefore, the first and foremost obligation on board members is to educate themselves on Ind-AS so that they understand these high impact areas and ensure they are properly accounted for. Besides, the board of directors will have to institute a strong control system. For example, with regard to fair valuation of investment property, the oversight may require questioning the management on the valuation model applied, the competency of the valuer, the control on the inputs provided to the valuer and the review of the output of the valuer, including the assumptions.
The board of directors should also keep an eye on future Ind-AS standards. For example, it is expected that in future all leases, irrespective of whether those are under finance lease or operating lease, will be on the balance sheet. This may significantly impact the balance sheet gearing and compliance with debt covenants. Keeping an eye on future standards serves as an important strategic input for current business decisions.
Ind-AS would require extensive application of management judgement and estimates. Particularly, fair valuation can be an onerous and subjective exercise, providing numbers within a range rather than absolute numbers. In a research conducted by Ernst and Young, it was noticed that by making changes to the input variables—all within the allowable parameters of IFRS—option expense as a percentage of reported income was found to vary between 40% and 155%. In emerging economies such as India, markets may not be deep and, at times, there may be no markets to mark to market, which may pose additional problems and lend themselves to management indiscretion. The board of directors should ensure that they exercise judgement in good faith.
When Australia converted to IFRS, the Australian Securities Exchange did not miss a beat and market ratings of companies were not significantly impacted. Many attribute this to effective communication by Australian companies with stakeholders throughout the conversion process. The board of directors should ensure effective communication to various stakeholders of the Ind-AS conversion process, the significant differences between Ind-AS and Indian GAAP, and the impact on Ind-AS results on a regular basis. This will ensure that market ratings of Indian companies are protected.
In India, we have not yet seen companies making any disclosures or preparing stakeholders on the impact of Ind-AS transition. It is important that Indian entities do not take the investors/analysts for granted. For companies that do not prepare analysts and investors for potential volatility or changes in reported numbers, the consequences could be dramatic. In fact this is a good opportunity for Indian entities to improve their overall communication and relationship with the investors/analysts. It is also true that analysts and investors in India do not have sufficient understanding of Ind-AS and its impact on financial reporting. Therefore, Ind-AS education of investors and analysts is imperative for a meaningful understanding of Ind-AS financial statements.
The board of directors should not undermine the risks involved. Incorrect financial statements, or missing the deadline, or lack of communication with stakeholders, could cause embarrassment, regulatory action and a fall in the market valuation of an entity.
This is the second of a three-part series on IFRS, with which India will begin converging in the quarter beginning April. The writer is a partner and national IFRS leader at consultancy firm Ernst and Young.
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