The Hindu Business Line : The true and fair override

Accounting Standards are sacrosanct and violations are not permitted in preparation of financial statements. In fact, there is a statutory requirement as per Section 211(3B) of the Companies Act, 1956 according to which if the profit and loss account and the balance sheet of a company do not comply with the accounting standards, the company concerned has to disclose the deviation, the reasons for deviation and the financial effect, if any, arising out of the deviation.

As a corollary, the notification issued by the Ministry of Company Affairs dated December 7, 2006, which, while notifying the Accounting Standards, states under General Instructions that “Accounting Standards, which are prescribed, are intended to be in conformity with the provisions of applicable laws. However, if due to subsequent amendments in the law, a particular accounting standard is found to be not in conformity with such law, the provisions of the said law will prevail and the financial statements shall be prepared in conformity with such law”.

In other words, as per the scheme of things, while Accounting Standards are inviolate, they are however, subject to the law of the land. This has been so even before the Ministry of Company Affairs assumed the role of the standard setter.

Sometimes, good intentions do result in unintended consequences. We have had the phenomenon over the years of how this supremacy of law of land over accounting standards was used to create some strange accounting practices. Students of accounting will recall that in accounting for amalgamations, Accounting Standard (AS) 14 “Accounting for Amalgamations” prescribes two methods viz. “Pooling of Interests” and “Purchase”, the selection being dependent on certain criteria.

Two methods

The Pooling of Interests method requires a line by line consolidation. However, schemes of amalgamation sanctioned by High Courts had allowed in some cases where Pooling of Interest method was followed non-revenue reserves in an amalgamating company to be treated as revenue reserves in the amalgamated company which goes against AS 14.

Being sanctioned by High Courts, the treatment (wrong it may be) became mandatory in preparation of post-amalgamation financial statements and the auditors had no choice but to accept. Therefore, the Institute of Chartered Accountants of India (ICAI) came out in 2004 with a prescription whereby in situations such as the one narrated above, required disclosures to be made without qualifying the financial statements or treating the comments as adverse.

The disclosures required are: (a) description of the accounting treatment and that it was adopted because of the Court/Tribunal Order; (b) difference between the accounting standard and that followed by the company; and (c) the financial impact, if any.

Subsequently, when the Ministry of Company Affairs notified the Accounting Standards these requirements were brought into AS 14 as part of the standard although with some difference in the language.

Further developments in this area are, according to press note PR No.300/ 2009 dated September 22, 2009, issued by SEBI, listed companies undergoing corporate restructuring, including mergers and demergers, will have to submit to the stock exchange an auditor’s certificate of compliance with applicable accounting standards. Similarly, unlisted companies intending to make an IPO will have to make disclosures in the Draft Red Herring Prospectus.

While this is the historical background to legally sanctioned deviations from accounting standards in India, IFRS has what is called the “True and Fair Override”. The relevant provisions (paragraphs 19-24) are contained in IAS 1 ‘Presentation of Financial Statements (Revised)’ which provide as described in the following paragraph. At present, there is an Exposure Draft of AS 1 ‘Presentation of Financial Statements (Revised)’ issued for comments which corresponds to IAS 1. Paragraphs 19-24 of AS 1 are similar to paragraphs 19-24 of IAS 1.

There are two situations. In the first, where management concludes that compliance with a requirement in an IFRS would be so misleading that it would conflict with the objective of financial statements set out in ‘The Framework’, the entity can depart from that requirement if the relevant regulatory framework requires, or otherwise does not prohibit such a departure, and the entity discloses all of the following:

i) Management has concluded that the financial statements present fairly the entity’s financial position, financial performance, and cash flows; ii) The entity has complied with all applicable IFRS, except that it has departed from a particular requirement to achieve a fair presentation; iii) The title of the IFRS from which the entity has departed, the nature of the departure, including the treatment that the IFRS would require, the reason why that treatment would be so misleading in the circumstances that it would conflict with the objective of financial statements set out in The Framework, and the treatment adopted; and iv) For each period presented, the financial effect of the departure on each item in the financial statements that would have been reported in complying with the requirement.

When an entity has departed from a requirement of an IFRS in a prior period, and that departure affects the amounts recognised in the current period, it shall make the disclosures as in (iii) and (iv) above.

The second situation is that, departure from IFRS might not be permissible in some jurisdictions, in which case the entity should comply with the standard in question and disclose in the notes that it believes this to be misleading, and show the adjustments that would be necessary to avoid this distorted result as detailed below:

a) The title of the IFRS in question, the nature of the requirement, and the reason why management has concluded that complying with that requirement is so misleading in the circumstances that it conflicts with the objective of financial statements set out in The Framework; and

b) For each period presented, the adjustments to each item in the financial statements that management has concluded would be necessary to achieve a fair presentation.

When assessing whether complying with a specific requirement in an IFRS would be so misleading that it would conflict with the objective of financial statements set out in The Framework, the management should consider the following:

Why the objective of financial statements is not achieved in the particular circumstances; and

How the entity’s circumstances differ from those of other entities that comply with the requirement. If other entities in similar circumstances comply with the requirement, there is a rebuttable presumption that the entity’s compliance with the requirement would not be so misleading that it would conflict with the objective of financial statements set out in The Framework.

IFRS expects that these departures would be rare. In fact, paragraphs 19 and 23 start with the words “In the extremely rare circumstances…”.

This is potent stuff indeed and, therefore, these departures are to be invoked very selectively and in extreme cases only. It remains to be seen how this will influence financial statements in future. One thing is for sure, while already there is a complaint in certain quarters that financial statements are getting unduly confusing and complicated, the override has the potential to compound the confusion.

(The author is a Chennai-based chartered accountant.)

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