Kaushik Dutta: Mind the GAAP - India and IFRS

With India set to adopt IFRS in 2011, a number of legal/regulatory issues need addressing for a smooth transition to the globally-followed accounting standard.

The Securities and Exchange Commission (SEC) on August 27, 2008, issued a roadmap of transition to International Financial Reporting Standards (IFRS) by US domestic companies from 2014. The issues relating to the roadmap will soon be set to debate and public comments. This move of the US to endorse and participate in the creation of a truly global GAAP-IFRS, puts aside their pride in their national GAAP (Generally Accepted Accounting Principles), and is a significant move towards the emergence of IFRS as a global accounting language.

India will be adopting IFRS from 2011 which means our national GAAP will be the same as that practised in over 100 countries today.

The Indian GAAP has conceptual differences with IFRS and our legal and regulatory frameworks need to be amended for us to adopt IFRS as written by the International Accounting Standards Board (IASB), the standard setting body of IFRS. IASB requires that compliance to IFRS be explicit and in an unreserved manner. The bridge between Indian GAAP and IFRS needs legal sanctions through Parliament for the adoption of IFRS in India.

Concept of a group
The Companies Act (The Act) treats Indian companies as separate legal entities, while IFRS promotes a group concept, where individual legal entities lose their individual relevance to the overall economic entity, the group, except for legal or tax compliance. The Act does not specifically deal with consolidated accounts or their auditors’ reports. Hence the form of accounts adopted by a group can be different from the format specified by the Act for individual companies.

Our tax laws assess individual entities as separate units for tax and do not asses the group as a single taxable entity. Hence the role of consolidated accounts has no relevance for tax purposes. In many countries like the US, the group could be the primary unit for tax assessment in one legal jurisdiction and the consolidated accounts then become relevant.

Fixed assets
There is a significant distinction between the Act and IFRS for fixed assets — the descriptttion of assets itself. The Act defines a class of assets whereas IFRS promotes a concept of components of fixed assets based on their usefulness. This means that various significant components embedded in an asset having different useful lives will be depreciated separately. It would be appropriate to depreciate the engines and airframe of an aircraft using different lives. Another key difference with the Indian GAAP and the Act is on the definition of cost. Under IFRS, the fair estimate of the retirement obligation of an asset is discounted to a fair value and recognised as a liability. The corresponding costs are capitalised with the fixed assets. In India, future costs are not allowed to be discounted and capitalised and they are recognised as a liability when they become an obligation.

The Companies Act prohibits depreciation on revaluation of fixed assets to be reflected in the profit and loss account as such depreciation is netted off against the reserve specifically created on revaluation in the balance sheet. IFRS is based on fair value concepts and where a company revalues its fixed assets to reflect its current value, the depreciation of the revalued assets is routed through the income statement and affects the earnings.

Capital and reserves
If we look at the capital side of the balance sheet, the Companies Act requires capital instruments to be separately disclosed as equity and preference shares and there are separate provisions that govern the issue of these  instruments and their relative legal rights. Similarly, convertible debentures or bonds, whether they are in Indian or foreign currency, have specific rules relating to their issue and disclosure in the accounts. There are also foreign exchange regulations which would also come into play relating to these bonds. IFRS treats debentures, bonds or preference shares that are convertible into equity shares as compound instruments, that need to be segregated into a debt and an equity portion based on their relative fair values. Similarly, a redeemable preference share for cash will normally be a debt. Such re-classification of preference shares to debt or equity or creating equity instruments from bonds or debentures will need sanction of the Companies Act, which lays down rules on how such instruments are to be issued and shown in the accounts. Mere segregation by using IFRS principles will not comply with the Act, nor will it retain the legal rights and obligations that are associated with these instruments. This leaves a gap between our current laws and IFRS.

Reserves in a balance sheet are a result of past profits following Indian GAAP and are available to shareholders either as dividend or distributed on dissolution. Upon transition to IFRS, an entity will have an increase or deduction of reserve just by the application of the new GAAP. A shareholder could have more distributable reserves or conversely if the reserves get wiped out, it could leave him poorer due to such a change.

How changes in GAAP affect the wealth or earnings of the shareholders will be the cornerstone of decisions.

IFRS and initial public offerings
Some other areas of attention would be the rules relating to initial public offerings (IPO). Under the current laws, five years of audited financial accounts under Indian GAAP form the base financial information for an IPO. When we transition to IFRS in 2011, we are not sure whether all the five years of accounts for a company need to be under IFRS or the law will allow a part thereof, say, three years. The efforts a company needs to make if they are to re-cast their accounts to IFRS for the past five years will be significant. How the Act and Sebi will define this requirement will be important for companies looking for an IPO in the next few years.

Correction of past errors
Correction of errors under IFRS can be made in the years they pertain to, even if they are audited and adopted by the shareholders. Currently, past errors in India are shown as adjustment relating to previous years in the current year as no changes can be made to the accounts as adopted by shareholders. Furthermore, no specific disclosure relating to the error is required to be made. If we go the route of IFRS, the restatement of material errors is a feature that Indian companies and their auditors will need to be aware of. Whether or not this triggers a number of lawsuits in the future against the company and their auditors, only time will tell.

These are some of the indicative areas where an amendment to the law needs to be made if we are to converge with IFRS. We have a choice of having specific differences in India between the accounting principles followed here and those under pure IFRS. These divergences are euphemistically referred to as ‘IFRS Lite’ and are not considered by the SEC and IASB as explicit compliance of IFRS. IFRS promotes the principle that the same economic transaction happening in New York, New Delhi or São Paulo will have the same accounting result. The question is, how different India wants to be in this regard.

The writer is the national leader of the IFRS practice of PricewaterhouseCoopers