IFRS: Ready, Steady, Go..

This article has featured in ICAI's 1st IFRS e-Newsletter of October 2, 2014.

Introduction 

While hearing the budget speech by our Hon’ble Finance Minister of India Shri Arun Jaitely in July 2014, I was enthused to hear that he actually spoke about IFRS implementation in India. It shows India’s clear vision and positive approach towards the long due IFRS implementation process in India.

He proposed for voluntary adoption of IFRS in financial year 2015-16 and mandatory from 2016-17. Institute of Chartered Accountants of India (ICAI) has played a vital role in formulation of Ind ASs, giving comments to International Accounting Standards Board (IASB) on Exposure drafts / Discussion papers, imparting training and dissemination of knowledge on IFRS. 

What is IFRS?

As the economy develops, it is exposed to International environment and commercial transactions. There is a need to lay down standard principles of accounting for making the financial statements comparable and bring them closure to the substance of transaction. ‘IFRS’ which stands for International Financial Reporting Standards, are these principle based standards that focus on substance over form.

IFRS broadly includes Reporting Standards, Accounting Standards and Interpretations on Accounting and Reporting, apart from Conceptual framework and Preface to IFRS.

The effective pronouncements as on date comprises of 15 IFRSs, 28 International Accounting Standards (IAS), 18 interpretations from International Financial Reporting Interpretation Committee (IFRIC) and 8 interpretations of Standard Interpretations Committee (SIC). This makes the tally to 43 Standards and 26 Interpretations under the framework of IFRS.

There is a separate framework of IFRS for Small and Medium size Entities (SME), which are referred as IFRS for Small and Medium Sized Entities.

So, are we prepared for IFRS financial statements?

First thing that I see as a prerequisite is change in approach of management in perceiving the way the transaction will be measured, reported and disclosed in financial statements. IFRS calls for transparency in financial statements for readers, investors and stakeholders amongst others. It calls for a change in perception and outlook of the readers as well, who have been accustomed to Indian GAAP financial statements.

Differential Characteristics of IFRS Financial Statement for the Preparers and Readers of Indian GAAP:

a.       Measurement:

i.        Cost v/s Fair value

Under Indian GAAP, we use the cost convention for recording transactions as against IFRS which has a concept of day 1 P&L, which means that every transaction has to be recorded at fair value at the date of its initial recognition. Any value over or below fair value is passed through P&L.

Other than initial recognition, IFRS prescribes fair value measurement for certain financial assets and liabilities such as Investments in equity shares, debentures, etc for measurement at every reporting date, unlike Indian GAAP which requires such items to be at cost.

ii.      Time value of money

It is said that time is money, IFRS has rightly considered this substance in its recognition and measurement principles. This has vital application in banking and finance transactions, to make it simpler, an entity borrowing Rs 100 Crore for 4 years @ 8% interest p.a with a clause asking upfront fees of Rs 6.5 crores, effectively leads to effective cost of borrowing to 10.05%. IFRS requires to record borrowing at Rs 93.5 crores and recognize interest @10.05% i.e. Effective Interest rate (EIR). Table 1 explains the discussed concept.

Table : 1		Coupon	8%	IRR / EIR	10.053%	Rs in Crs
Period	Principle	Upfront fees	Interest	Cash flows	Effective Int. Rt.	O/s Carrying Value
0	100	(6.50)	-	93.50	-	93.50
1	-	-	(8.00)	(8.00)	9.40	94.90
2	-	-	(8.00)	(8.00)	9.54	96.44
3	-	-	(8.00)	(8.00)	9.69	98.13
4	(100)	-	(8.00)	(108.00)	9.87	(0.00)
			IRR	10.053%

iii.    Substance based

Here the transactions are recognized with careful assessment of the real commercial substance, where trade and finance transaction are embedded in the same invoice, similarly where the service revenue includes sale of goods element. In these cases, it is important to split the embedded component and recognize both the components separately at their fair value.

Take for example, Sale of goods at extended credit terms. Sale price would include an interest element and hence the entity should record revenue at fair value, which would lower, if goods are sold at market credit period. At the same time separately accrue interest on the receivable to match the receipt from customer at the end of the credit period.

Another example would be say 10% discount vouchers for subsequent purchases by retailer of electronic goods. The retailers will have to consider the impact of discount on the first sale and book revenue accordingly instead of booking first sale at full value and the second sale at 90%. Under IFRS, both, first as well as the second sale will be booked at 95%, assuming that the customer will return for the second sale.

iv.     Continuous involvement with assets

This is one of the principle test applied when an entity has to consider whether it can book a sale or no. This is very commonly seen in factoring arrangement i.e. discounting of bills receivables. If the discounting is done with recourse, the entity cannot take the credit to receivable account, instead it has to book the same as a short term loan. This is because, if the debtor fails, the discounting bank will come to the entity for recovery of the underlying receivable.

This test is applied before derecognition of assets as well as while applying revenue recognition principles i.e. Goods sold but lying in godown on behest of buyer.

b.      Disclosures:

i.        Critical Estimates, Judgments and Assumptions

While preparing financial statements, management is required to make estimates for many things such as provision for expenses, virtual certainty for deferred tax assets, net realizable value, cash flows for impairment testing, useful lives of assets, etc.

Similarly, there are areas of judgments such as applying the Possible, Probable and Remote test for contingent liabilities,  in recognition and de-recognition of assets, liabilities, expenses and revenue, etc. Critical estimates and Judgments are to be disclosed separately after accounting policies.

Assumptions are the ones used in testing impairment, arriving at present value of liabilities, etc. They are not only disclosed but a few critical ones are also subject to sensitivity analysis. This means that if the assumptions change by say 5% + or -, what would the impact on financial statements, commonly seen in Goodwill impairment testing note in financial statements.

ii.      Exposure & Sensitivity Analysis

Entities are exposed to many variables which impact their performance and profitability. These include foreign exchange rates, variable interest rates, commodity prices, etc. For an entity that manufactures goods locally and exports goods is exposed to foreign exchange rates. Thus if the exchange rate goes up, the profitability will improve and if it goes down, it will reduce. Since these variables are not going to be fixed, sensitivity of these variables on entity’s profitability provides the reader with a fairer view on future periods profitability and performance expectations.

Example: Table 2:

Carrying amounts of the Entity’s financial assets and liabilities in different currencies and sensitivity to income statement is as follows:
As at March 31,	20XX ($ million)
	Financial assets	Financial liabilities	Effect of say 5% strengthening in foreign currency	Effect of say 5% weakening in foreign currency
Indian Rupees (INR)	2,345	1,000	N.A.	N.A.
United States Dollar (USD)	298	2,400	(105.10)	105.10
Euro (EURO)	201	765	(28.20)	28.20
Great Britain Pound (GBP)	-	223	(11.15)	11.15
Others	12	-	0.60	(0.60)

Note: Entity will have to do sensitivity analysis for assets and liabilities held in any currency other than its functional currency. In the above table 2, INR is assumed to be the functional currency and USD is the Presentation currency.

c.       Presentation of Financial Statements

Current & Non current presentation was the first difference noticed when we compared any IFRS Balance Sheet and Indian Balance sheet. After Schedule VI format was revised for making it in line with IAS 1, this difference has been bridged.  However, the preparers will still be impacted when they converge to IFRS because there are still a few differences that still exist between Revised Schedule VI and IAS 1. These differences will drastically change the ratios such as debt to equity, current to non-current and similar. Refer table 3 below for further insights.

Table 3: Few differences between Revised Schedule VI & IAS 1

	Revised Schedule VI		IAS 1 / Ind AS 1
1	Functional classification in Profit & loss statement is not permitted.		Classification using Functional as well as Nature approach is permitted.
2	Retirement Benefits - Can be current as well as non-current.		Retirement Benefits - Default Non current.
3	Share application Money pending allotment - classified as Quasi Equity		It is either Clear Equity or Liability
4	Interest accrued on Borrowings - grouped under other liabilities.		Borrowings - accounted using effective interest method and hence inclusive of interest.
5	Redeemable preference shares - classified as Equity		Redeemable preference shares - classified as Borrowings
6	Convertible Bonds continue to be classified as Debt with disclosure of conversion terms.		Convertible Bonds are split into Debt and Equity.
7	Contingent assets are not part of Off balance sheet disclosures.		Contingent assets are to be disclosed in notes
8	Continue non-current classification if lender has not recalled the loan before approval of FS		Need unconditional right at the balance sheet date irrespective of action from Bank

 

IFRS convergence will bring in the above differential characteristics in Indian entity’s financial statements and make it comparable with International Peers.

CA. Sanjay Chauhan