IFRS hits new roadblock

To avoid criticism, do nothing, say nothing and be nothing: Elbert Hubbard, the American writer. The International Accounting Standards Board (IASB) has been regularly receiving its share of criticism since embarking on an ambitious project to make International Financial Reporting Standards (IFRS), the default global accounting standard. Muted protests in 2005 when IFRS was introduced turned vehement when IAS 39 on Financial Instruments was issued.

With remnants of the global financial crisis still lurking in the shadows, the protests have now turned into a call not to make IFRS mandatory for small and medium enterprises. A recent report by the House of Lords Economic Affairs Committee into IFRS amongst other matters could act as the latest roadblock to the IASB.

Incurred loss model

The epicentre of the current tirade against IFRS is the incurred loss model vis-a-vis the expected loss model to provide for losses. During the financial crisis, criticisms were raised against the current IFRS impairment model for financial assets (the incurred loss model). The issue with the incurred loss model is that impairment losses (and resulting write-downs in the reported value of financial assets) can only be recognised when there is evidence that they exist (have been incurred). Reporting entities are not allowed currently to consider the effects of expected losses.

There is a view that earlier recognition of loan losses could have potentially reduced the cyclical moves in the recent crisis. The expected loss model is more subjective in nature compared to the incurred loss model, since it relies significantly on the cash flow estimates prepared by the reporting entity which are inherently subjective. Therefore some safeguards need to be built into the process such as disclosures of methods applied and periodical back testing and immediate reflection of the results of the back testing in the models applied for the future.

There has been support from some stakeholders for an impairment model that is counter-cyclical, in particular for a model which includes through-the cycle reserves or provisions, for example the dynamic provisioning model currently required by the Bank of Spain wherein funds are allocated in good times to meet requirements in bad times - the traditional accounting concept of prudence. Also, there has been some support for the creation of a general reserve which would be a regulatory buffer against unexpected impairment losses in prudential reporting, but not in the general purpose financial statements.

Suggestions

The Committee concluded that obvious benefits should flow from global adoption of common accounting standards for a global economy. But there is a corresponding risk that the lowest common denominator will prevail. So all concerned need to insist on the highest possible standards of rigour, clarity and quality of accounting and audit. IFRS also has specific defects, such as its inability to account for expected losses. The weaknesses of IFRS are especially serious in relation to bank audits. It recommended that the profession, regulators and the Government should all seek ways to defend and promote the exercise of auditors' traditional, prudent scepticism and concluded that prudence and going concern cannot be overridden.

The committee opined that the Government and regulators should not extend application of IFRS beyond the larger, listed companies where it is already mandatory and a prudent interpretation of IFRS as applied to banks is needed including sober valuation of financial instruments .The incidental advantage of the above would be reducing the scope for banks to pay bonuses on the basis of profits struck without taking account of possible losses - a topic that has caused much ire. The IASB has been quick to think of revising their standards to provide for an expected loss model. Everyone who is someone concurs with the fact that achieving IFRS-compatible global accounting standard would take time, effort and a revision of existing IFRS pronouncements.

Though there is a lull in the conversion to Ind-AS in India with no clarity on the date, there is a general feeling that the Reserve Bank of India's Prudential norms – which mandates a provision coverage ratio of 70 per cent - would be more than sufficient in case the expected loss model is adapted. The Institute of Chartered Accountants of India (ICAI) has been communicating with the IASB on the impracticality of an incurred loss model in India. While it would be quite some time before the mom-and-pop companies move over to Ind-AS, the experience of the grandfather companies - the first set of entities- in moving over to Ind-AS could provide useful indicators on the good, bad and ugly areas.

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

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