Currently Indian banks make provisions on loans based on RBI guidelines. As such they don't have to make any judgement. The process is very mechanical and requires little use of judgement.
In IFRS the judgement of the banks is a high requirement. There are no specific instructions the bank need to follow. Every case of significant importance has to be assessed with reference to the facts and circumstances.
For instance, if there is a very strong circumstance that suggests that future cash flows relating to a loan will not be recovered, only then that loan account would be classified as impaired and would be assessed at present value using effective rate of exposure as the discount rate. No provisions for expected losses are allowed. Only provisions for specific losses are allowed.
Similarly, for investments, in addition to the credit standing of the issuer, fair value is considered.
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The banks will have to improve to their information gathering process to assess the credit risk management function. In addition to this they have to improve and strengthen their loss forecasting mechanism.
Under Indian Standards, the lower of the cost or the net realisable value is the fair cost is the measurement basis.
Fair value measurement which requires considerable personal judgement is the basis of measurement under IFRS. It is on the bank to justify the fair value they have taken. Moreover unrealised gains may also be required to be taken into consideration.
Derivatives and hedge accounting
Derivatives would be required to be measured on fair value basis, the change being reflected in the P/L statement. This requires stringent documentation and mandatory effectiveness test to determine the fair value
De recognition of financial assets
Under IFRS, de-recognition of financial assets follows the principle of transfer of risks and rewards. In the Indian context, this will mainly have an impact on the securitisation activity.
Securitisation transactions - where credit collaterals are provided or guarantee is provided to cover credit losses in excess of the losses inherent in the portfolio of assets securitised - may not meet the de-recognition principles given in IAS 39.
This will lead to de recognition of financial assets in the bank's statements which will have a considerable impact on rations such as capital adequacy ratio and return on assets.
IAS 27 specifies that if a company has power to control the entity, irrespective of anything, to obtain economic benefit, the entity will be considered as a subsidiary. As a result IFRS may result in a consolidation of larger number of companies in comparison to the Indian Standards which has very narrow set of tests (more than 50% of equity control or control over the majority of board members)
In all the above cases, IFRS focuses on personal experience and judgement to justify the action taken. IFRS requires disclosures on various issues but gives enough freedom to make judgements. Strategic decisions would have to be made by the banks which will have a considerable impact on the financial statements. The banks will have to improve their information management system to take effective and fair decision. They will have to gear up with professionals who have considerable knowledge to make a fair judgement. In addition to the aforementioned financial accounting impact, the implementation will entail several changes to the financial reporting systems (including IT systems) and processes adopted by banks
Oil and Gas
Earlier IFRS 1 required full retrospective implementation of IFRS. This posed a problem for oil and gas industry which used cost based accounting method for valuing production. Retrospective application would require information about historical cost and amortization levels to bring it in line with IFRS. This information may not be easily available especially for older assets because change of reserve base over time. But with amendment in IFRS applicable from January 1, 2010, the oil companies will get an exemption from applying IFRS retrospectively.
Realty and Infrastructure
Under the Indian GAAP, there are no specific guidelines for investment in property. They are either treated as investments or part of fixed assets. If they are treated as investments they are to be shown at cost or net realisable value. On the other hand if they are treated as fixed assets, revaluation is allowed (the gain taken to capital reserves), but they have to be depreciated over their useful life. In either case the real estate company loses since the increase in price is not reflected in the financial statements.
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With the implementation of IFRS, the real estate companies will be able to show their investment property at fair value wherein the losses or gains will be routed through P/L statement. In addition to this the company need not depreciate because IFRS recognizes the fact that usually the market values of land appreciates over the long term.
IFRS will have a major impact on the recognition criteria of sales in the real estate industry. In India sales are generally made before the completion of the project typically as soon as the project is launched. Indian GAAP treats this as sales and allows proportionate recognition of profits over the period the project takes to complete.
IFRS recognizes such transfers under three heads:
Construction Contract - the buyer has the control over the design of the property
Agreement of Service - the buyer provides the material for construction.
Sales - all other deals are considered sales.
IFRS allows proportionate recognition of profits only in case of construction of contract. However if the sale of land can be separated from the sale of property, revenue on sale of land can be recognized separately
In some cases the landowner gets a part of the developed property in consideration of land property.
Indian AS does not recognize such barter. As such this transaction is not recorded in the books of accounts.
IFRS recognizes such barter and provides specific instructions as to how the transaction is to be recorded. The purchase of land is accounted for at fair value of development cost of landowner's share. The revenue from for the construction of landowners' share is recognized when the property is handed over to the landowner. Hence for residential projects, the barter will also have an impact on the profit and loss statement. It may happen the fair value of land is higher than the value of construction services. In such case the profits would be higher.
Infrastructure companies will be affected by the IFRS provision on "service concession arrangements". Under Indian GAAP, expenditure incurred by the infrastructure provider is capitalized as fixed or intangible asset, which is subject to depreciation usually over the term of the service concession agreement. This has two elements under IFRS. First, it will be treated as a construction contract where revenues will be recorded at fair value of such services (i.e. cost plus profit). Second, the provider will recognize an intangible asset in extinguishment of the receivables on completion of construction. Thus the revenue statement will have considerable impact due to recognition of revenues during the construction period under IFRS.
Moreover long-term payables and receivables, including retention money, would be discounted taking in consideration the market interest rates to reflect the current fair value.
This industry would be least affected due to convergence into IFRS. Most of the leading Indian IT companies are listed in US and have already filed financial statements in line with IFRS with Securities Exchange Commission of US (a mandatory requirement). They are more aware about the implications of IFRS and have more experience in using them to their advantage. Due to the early adoption by leading companies the transition would be smoother compared to that in other sectors.
There will have to be significant changes made in the tax regulatory framework in India so as to meet the various challenges brought by implementation of IFRS.
The major issue would be how to deal with gains and losses arising due to revaluation of various assets. There can be many examples.
Under IFRS a firm trading in securities is allowed to show its investments at fair value. This revaluation will result in profit or loss. Indian tax law taxes securities only on sale. Therefore this will create a deferred tax liability or asset in the books. There are no specific laws for this. The company may adjust its losses against other incomes, though on the other hand it may create a deferred liability for the gains.
Income from agriculture enjoys tax exemption in India but tea and coffee plantations have to pay tax on the assumption that certain portion of income is accrued from business, thus taxable. Under IFRS the plantations have to be revalued every year to show fair value, loss or gain being routed through P\L statement. The tax authorities need to specify how such gain or losses be treated (business or agriculture income).
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The tax authorities will have to gear up to meet these challenges. Since fair value is largely based on personal judgement, the authorities will have to be extra careful so that the companies do not take undue advantage of this fair valuation to fudge taxes. Moreover the changes in Minimum Alternate Tax (MAT) in the new direct tax code (to be also implemented in 2011) which requires taxation on gross assets will have a major clash with the implementation of IFRS. Fair value of assets will become the basis of taxation. During extreme volatile conditions this will create problems
The biggest controversy that surrounds IFRS is its biased nature towards fair value. IFRS over emphasizes on fair value. The problem is that the markets are never perfect. When the markets are rising the company would take market value as fair value but what will happen when the markets fall. In this case ideally the company should devalue the assets, but they won't do this and consider the old value as fair so as to maintain profits. Moreover since the gains or losses are routed through P\L statement, there may be high fluctuations in the earnings from one reporting period to another.
However if market values are needed to be taken as a fair value as a rule, there is no justification for this also. In the current scenario when the world is facing financial crisis, it is difficult to find buyers. So how can one say that the market values are fair?
IFRS is a principle based unlike Indian standards which is rule based. Since personal judgement is required in choosing various policies to be adopted for presenting financial statements and future forecasts, these factors will have a significant impact on the financial position and reported earnings of the company. Management and the audit committee have to gear up for the transition to IFRS. They must understand the various impacts of IFRS on their financial statements and the various alternatives available under IFRS to make a reasonable choice. IFRS has many complexities and this increases the chances of omission and errors. The management have to be extra careful. Moreover IFRS requires retrospective implementation. This will lead to filing of restatements. Usually restatements are looked down upon by the investors. Thus the management has to address this issue effectively. One of the biggest challenges would be to manage shareholder's expectations in terms of meeting targets and key performance indicators especially in terms of dividends and explaining variations and volatility in earnings on a quarterly basis.
Most of the individual countries have adopted IFRS with changes. This really overrules the major benefit of IFRS facilitating same standards all over the world to simplify comparison with global peers. India is also expected to adopt IFRS with some changes to suit the Indian environment. Moreover, ICAI and other regulatory bodies such as IRDA are responsible for providing the guidelines for implementing IFRS. Differences in interpreting IFRS provisions could further reduce consistency in financial reporting and comparability. Moreover
Will IFRS stop cooking of books?
IFRS implementation is favoured basically because they are international standards and allow comparison with companies all around the world. But the big question is that whether it will stop cooking of books? Will it improve the quality of reporting? Enron, WorldCom and Satyam cases prove that managers and auditors can cook books in their favour. Stringent US GAAP could not prevent the downfall of Lehmann Brothers. IFRS being principle based involves personal judgement. Will this not give more freedom to managers to window dress their accounts in the name of fair value. Moreover despite recent scandals US and UK have developed institutional infrastructure to take care of financial reporting regulations.
However, India lacks such institutional infrastructure. India is placed in every measure that relates to conducting business, be it the quality of corporate governance, accounting norms, the quality of corporate governance, corruption, or the rule of law. In all these measures, the US and UK rank in the top deciles. Moreover the investors in India are not educated enough to capture the faults in the financial reports unlike that in the developed country though this didn't prevent the failure of Lehmann Brothers.