Most Indian companies are aware of the requirement to move to international financial reporting standards (IFRS) from 2011. Despite discussion on the accounting aspects of IFRS, there seems to have been little discussion at the board level of the business implications of this change. It becomes especially relevant as the accounts for the current fiscal year ending 31 March can impact the opening balance sheet on 1 April, which needs to be IFRS-compliant.
My intention here is not to reiterate the differences between Indian accounting standards and IFRS, a subject which has been documented in detail. It is rather to alert boards of companies to the fact that managing this migration now constitutes a major governance responsibility with significant spillover effects on their businesses—some of which they would do well to monitor. It is difficult to examine the entire gamut of possible business effects the move to IFRS can cause, and this article is limited to a few instances, parallels of which can be seen in almost all companies.
All modern organizations are just webs of contractual commitments put together in a coherent form. Among the more critical implications that senior management may need to revisit is the legalese of several of their contractual commitments.
As IFRS recommends that both incomes and expenses committed to vary over the life of a contract are smoothed over the life of the transaction; and clauses that govern quantity-based discounts, rental deposits, transaction costs and financial costs, etc., will be accounted for differently from current practice, with unintended profit effects, contracts may need to be examined and perhaps revised.
Managers will also need to prepare for greater transparency in their accounts. In the past, the requirements of accounting standard 17 relating to segmental reporting were interpreted loosely, such that an investor seeking to find details of profitability in a multi-business company would find it almost impossible to do so, owing to seemingly dissimilar strategic business units being clubbed together as a segment.
IFRS uses the more interesting touchstone for segment reporting—the management information that the chief executive of a company views. Since CEOs will usually have the most meaningful information before them, the same segments will need to be reported to the public. This seemingly minor tweak to a standard will imply that shareholders will have a significantly greater ability to interpret the performance of a company, and potentially ask managements to re-examine unremunerated parts of their portfolios more easily than was the case thus far.
It is no secret that accounting standards requiring banks to absorb mark-to-market losses was one of the reasons for the acceleration of the financial crisis in 2008. In the case of banks and non-banking finance companies, reporting for loan losses constitutes a major expense item. These policies are now specified by the Reserve Bank of India and are less amenable to judgement. Under IFRS, the number so quoted involves a greater use of judgement, based on various subjective factors. The application of IFRS may result in different numbers for loan losses and impairment costs, with the consequent impact on critical ratios such as capital adequacy. The senior management needs to understand the basis underpinning these judgements so that when they approve future loan proposals, they may better predict the situations that might trigger loan provisions. Given that financial services propel much of the economy, accounting policy can drive capital into or out of different sectors.
IFRS’ ramifications extend to management compensation policies, choices of capital structure, hiring and benchmarking. In many cases, senior executive compensation is linked to accounting measures and the compensation committee will need to realign incentives in an appropriate manner.
Similarly, debt agreements and financial covenants are frequently tied to various accounting parameters. These numbers will likely change as a result of any change in policy. Audit committees will, therefore, need to be shown a sensitivity analysis of the cash flows and income before interest, taxes, depreciation and amortization under IFRS in their determination of the levels of debt that can be tolerated by the company without breaching loan covenants.
While IFRS delves into the underlying principles of a transaction as opposed to the more prescriptive approaches in other accounting principles, and is therefore somewhat judgemental in nature, its widespread use also makes it possible for investors to compare firms across geographies. In a world where Indian companies compete for global capital, boards will need to examine the choices made by peers as these will affect the perception of a company’s performance.
From a more operative standpoint, IFRS-savvy resources will become more scarce, especially closer to 2011. Given the importance of credible accounts and the onerous fiduciary responsibilities of boards, companies need to develop these resources in-house so they are not held captive by the market for talent. IFRS seems like a subject for a sterile discussion on accounting, but it is more than that. Let not a desire to avoid the dull and the arcane cause boards to miss its far-reaching business implications. Managing the transition to IFRS well can be a competitive advantage.
Govind Sankaranarayanan is CFO, Tata Capital Ltd. He writes every other Friday on issues related to governance. The views expressed here are personal. Write to him at firstname.lastname@example.org