The Hindu Business Line : Accounting standards — Debits and credits of harmonising

That Indian accounting will converge with International Financial Reporting Standards can be good news only if accompanied with radical institutional reforms.

Recently, the Institute of Chartered Accountants of India (ICAI) set up a task force to examine full convergence of Indian accounting standards with the International Financial Reporting Standards (IFRS). According to an ICAI press release, "Full convergence would involve adoption of IFRS in the same form as that issued by the International Accounting Standards Board (IASB)."

What are the implications of adoption of IFRS? Who benefits and what are the costs? How should we go about this exercise? What additional institutional reforms do we need to make this exercise meaningful?

The ICAI's announcement is a landmark in Indian accounting regulation. It is a clear signal that the accounting profession is coming to terms with the globalisation of Indian business. Also, it winds up the ICAI's project of establishing Indian accounting standards. Unfortunately, this project has been often used to dilute the IAS than to make any meaningful adaptation of the administrative services to suit special Indian circumstances.

Full convergence would be a welcome step and it should happen early. The decision to adopt IFRS has major public policy implications and will particularly impact India's systems of accounting and disclosure, corporate governance, tax/company law and securities regulation.

Demand for High-quality Financial Reporting

Increasingly, Indian accountants and businessmen feel the need for convergence with IRFS. Capital markets provide an important explanation for this change. Some Indian companies are already listed on overseas stock exchanges and many more will list in the future. Internationally-acceptable accounting standards will then become the language of communication for Indian companies.

Also, the recent stream of overseas acquisitions by Indian companies makes a compelling case for adoption of high quality standards to convince foreign enterprises about the financial standing as also the disclosure and governance standards of Indian acquirers. Product markets are also an important influence on decisions to adopt international accounting standards. Overseas customers dealing with Indian firms are concerned with the companies' financial performance, especially when long-term relationships are involved. Also, the labour market influences financial reporting quality in several ways. Indian firms need global talent to stay ahead of the competition in their product and capital markets.

Superior financial reporting could be useful in convincing a firm's present and potential employees of its financial soundness, so that as key users of a firm's accounting information they can trust the firm as a dependable employer. The rising use of pay-for-performance plans and the need for international tradability of employee stocks and stock options further underscore the need for respectable accounting rules.

The Challenge for Indian Accounting Regulators

Convergence with IFRS would require several changes in Indian laws and decision processes. As the Companies Act stands now, the Central Government has the power to promulgate accounting standards. The proposed adoption of IFRS will change this because it will not be possible to depart from the IFRS.

I use two examples to illustrate the implications of IFRS for the Indian company law. Schedule VI to the Companies Act lays down the form of the balance-sheet and a departure is allowed only if it is a must. Accounting Standard 11, dealing with the effects of changes in foreign exchange rates, was revised in 2003 to eliminate the earlier practice of adjusting the cost of fixed asset acquired with a foreign currency loan when there was a change in the exchange rates. The reason for the revision is that such a change in the liability does not change the operating/earning capacity of the asset and, therefore, the related gain or loss on the liability should be taken to the profit and loss account.

Also, it is now possible to hedge foreign currency liability and the hedging cost is a financing cost. The revision harmonises AS 11 with IAS 21 and definitely represents better accounting but since Schedule VI retains the old practice, this revision cannot be implemented.

Substance over form

Accounting standards emphasise the importance of the economic substance of transactions over mere legal form, but here again the rigidity of Schedule VI is problematic. For example, the terms of preference shares often place them closer to debt than to equity. Yet, Schedule VI requires them to be classified as equity, going only by their legal form and in complete disregard of their economic substance. Again, convertible debentures should be split into debt and equity components but must be classified as debt under Schedule VI.

There are also a number of other problems with many other schedules and provisions, such as Schedule XIV on minimum depreciation rates and definition of subsidiary. Banks and insurance companies have special forms for financial statements and these too pose difficulties.

If IFRS are adopted, IAS 1 Presentation of Financial Statements and other standards will take precedence over the Schedule VI form. One way is to amend Schedule VI every time an IFRS requires a different presentation. Technically, it is not difficult as a schedule can be amended by the government by a Gazette Notification. However, the Government has not come out with a new Schedule VI despite the ICAI's persistent efforts, suggesting that the process of change through the administrative system is not simple. A better approach would be to specify the minimum level of disclosure for the balance-sheet (as is currently done for the profit and loss account) and leave the form of presentation to IFRS.

True and fair view

The touchstone of "true and fair view" in financial reporting would require a relook if IFRS are to be effective. As the law stands now, it is possible to invoke a true and fair view override when compliance with the requirements of an accounting standard conflicts with the test of true and fair view. A far-reaching amendment that financial statements shall not be deemed to give a true and fair view unless they comply with IFRS has to be a part of the proposed reform.

A related problem is the role of the judiciary in enforcing accounting standards. Companies have questioned the applicability of accounting standards (for example, some leasing companies have obtained an interim stay on the operation of AS 22 on deferred tax). We can expect more such cases when IFRS are made applicable. The courts will have to decide such cases expeditiously with help from experts.

With the introduction of the Minimum Alternative Tax, the determination of accounting profit is also of great interest to the income-tax authorities. The adoption of IFRS will likely result in earlier recognition of expenses and losses and asset write-downs and could adversely affect MAT collections.

Needed, Shareholder Litigation

Prof Ray Ball of the University of Chicago argues in a Brookings Institution paper that adoption of IFRS by Chinese companies and even auditing by reputed accounting firms has not improved accounting quality much.

In contrast, companies that are listed in Hong Kong or in the US have superior accounting quality because of the operation of stringent investor-protection laws, liberal shareholder litigation, and efficient court systems. Raising the risk of shareholder litigation will greatly improve the quality of managers' and auditors' compliance with IFRS.

The proposed reform should be accompanied by a recognition of the rights of individual shareholders to sue directors and auditors for wrong-doing. Without these and other radical institutional reforms, the mere adoption of IFRS will do India no good. On the contrary, we will end up with financial statements based on high standards that are applied inconsistently and improperly. Low quality financial statements that convey a false assurance of high quality would be more dangerous.

(The author is Professor of Finance and Control, Indian Institute of Management Bangalore. The views are personal and not of IIM-B. E-mail: narayan@iimb.ernet.in)