Anand Sinha: Financial reporting in the context of financial stability - a
regulator's view on some accounting issues
Address by Mr Anand Sinha, Deputy Governor of the Reserve Bank of India, at an event
organized by Muscat Chapter of the Institute of Chartered Accountants of India (ICAI),
Muscat, Sultanate of Oman, 21 December 2011.
* * *
Inputs provided by P R Ravi Mohan and Amarvir Saran Das are gratefully acknowledged.
1. Dr. Ashraf Nabhan Al Nabhani, Dean, College of Banking and Financial Studies,
Mr. Kishore Rabi, Chairman, ICAI Muscat Chapter and other delegates. It gives me great
pleasure to address this august gathering organised by the Muscat Chapter of the Institute of
Chartered Accountants of India (ICAI). I am given to understand that the Muscat Chapter, the
19th overseas chapter of the ICAI is amongst the most active chapters of the ICAI and has
been engaging in capacity building for Omani accountants and imparting professional
education in the Sultanate. A key initiative is its tie up with the College of Banking and
Financial Studies (CBFS) in assisting them with their accounting curriculum. This Chapter's
engagement with the College of Banking and Financial Studies is just one of the many ways
in which the banking community and regulators can benefit from the technical knowledge
base of the accounting community.
2. The history of the Indian accounting profession can be traced back to the enactment
of the Companies Act in 1857 that introduced for the first time the concept of preparing
balance sheet on a voluntary basis by companies. We have come a long way since then and
the ICAI, established in 1949 by an act of Parliament, is today the world's second largest
professional accounting body after the American Institute of Certified Public Accountants
(AICPA), with over 180,000 members. Over the six decades of its existence, it has played a
vital role in nation building through its services.
3. In line with its motto of "Ya Aeshu Suptaeshu Jagruti" (a person who is awake
amongst those that sleep) and its emblem of the Garuda, the "vahana" of Lord Vishnu, the
Institute is playing a key role in keeping a watchful eye on financial statements, ensuring that
they represent a true and fair view of the state of affairs.
4. As regulators and supervisors of India's banking system, the Reserve Bank of India
(RBI) places a significant amount of reliance on inputs provided to us by your profession
through the statutory audit and long form audit reports of banks as well as our annual
interactions with the statutory auditors of commercial banks. We also have periodic
interactions with senior members of the Institute at various fora and take a keen interest in
the latest developments in this field.
5. RBI has closely worked with the Institute on accounting issues in the banking sector.
In October 2001, the RBI set up a Working Group under the Chairmanship of Shri N D Gupta
the then President of the Institute to identify gaps in compliance with accounting standards
issued by ICAI and also recommend steps to eliminate such gaps. Based on the
recommendations of the committee, landmark guidelines on compliance with accounting
standards were issued to banks in March 2003 to ensure strict compliance with accounting
standards and avoid qualifications in financial statements.
6. RBI had formed a committee in 2000 to study the observance of international
standards and codes in India in various individual areas of the overall financial system. With
respect to Indian accounting and auditing standards, it was found that there were several
gaps when compared to the international standards and recommendations were made to
reduce this gap. I am happy to note that the ICAI has since issued many accounting
standards, which have substantially reduced this gap.
7. While on the subject of RBI's insistence on adherence with international best
practices and our ongoing benchmarking against these standards, I would like to draw your
attention to the Report on Observance of Standards and Codes (ROSC), a joint initiative
between the IMF and World Bank in 2004 which among others, reviewed the strengths and
weaknesses of the corporate accounting and auditing practices in India. Some of the major
recommendations were to bridge the gaps between International Financial Reporting
Standards (IFRSs) and Indian accounting standards, strengthening the monitoring and
enforcement mechanism, introducing practices to ensure compliance with code of ethics by
auditors of public interest entities and taking steps for improving professional education and
training arrangements.
8. India also participated in the Financial Sector Self Assessment Programme (FSAP),
a joint initiative of the International Monetary Fund and the World Bank that attempts to
assess the stability and resilience of financial systems in member countries. Based on India's
experience in the FSAP and subsequent self-assessments, the Government of India, in
consultation with the Reserve Bank, constituted the Committee on Financial Sector
Assessment (CFSA) to undertake a comprehensive self assessment of India's financial
sector, the report of which was submitted in 2009.
9. The CFSA made an assessment of Indian accounting and auditing standards and
came up with some key recommendations that proved critical for the Institute. The report,
inter-alia, suggested convergence with IFRS at the earliest and creating awareness among
auditors and others involved in the process to ensure that systems and procedures are in
place to comply with the IFRSs. Another important recommendation is that India should
contribute significantly in the agenda setting of the IASB and its technical output. The
challenge before the Institute is to take this up in right earnest by identifying persons with
requisite competence to participate in global forums, the benefits of which will flow to the
profession at large.
Accounting issues in the context of the financial crisis
10. The global financial crisis and the consequences thereof exposed some
weaknesses in the accounting and auditing aspects. During the course of my presentation
here I would like to place before you some issues relating to financial reporting in the context
of financial stability.
11. There was widespread criticism that certain accounting practices either contributed
to or at the very least, exacerbated the severity of the crisis, in view of its failure to deal with
illiquid markets and distressed sales. The G20 Working Group on "Enhancing Sound
Regulation and Strengthening Transparency", in which I had an occasion to work actively,
recommended that accounting standard setters should strengthen accounting recognition of
loan loss provisions by considering alternative approaches for recognizing and measuring
loan losses that incorporate a broader range of available credit information. Accounting
standards setters and prudential supervisors were advised to work together to identify
solutions that are consistent with the complementary objectives of promoting the stability of
the financial sector and of providing transparency of economic results in financial reports.
12. G20 report also recommended that the IASB should enhance its efforts to facilitate
the global convergence towards a single set of high-quality accounting standards and also
opined that accounting standard setters should accelerate efforts to reduce the complexity of
accounting standards for financial instruments and enhance presentation standards. These
recommendations together with the recognition within the accounting and audit profession
that there were certain drawbacks in the current standards has necessitated large scale
revision of various standards especially those relating to financial instruments and Fair Value
Accounting. During the global financial crisis, the International Accounting Standards Board
(IASB) and the US Financial Accounting Standards Board (FASB) established a Financial
Crisis Advisory Group comprising senior leaders with broad international experience to
address accounting issues emerging from the global crisis. The key issues identified by the
FCAG involved:
the difficulty of applying fair value ("mark to-market") accounting in illiquid markets;

 the delayed recognition of losses associated with loans, structured credit products,
and other financial instruments by banks, insurance companies and other financial
institutions;
 issues surrounding the broad range of off-balance sheet financing structures,
especially in the US; and
 the extraordinary complexity of accounting standards for financial instruments,
including multiple approaches to recognizing asset impairment. Some of these
weaknesses also highlighted areas in which IFRS and US generally accepted
accounting principles (US GAAP) diverged.
13. While these aspects were identified by accounting professionals, regulators
expressed concerns on systemic risk arising out of procyclicality in accounting standards.
Procyclicality in policy making refers to financial developments and policies that add
momentum to the economic cycle and have an amplifying effect on economic fluctuations.
The procyclicality embodied in capital regulation and accounting standards was among the
identified causes underlying the global financial crisis. The in-built procyclicality amplified
business cycles, affecting both the degree of credit expansion in benign conditions and the
degree of credit contraction in the downturn.
14. The requirement to use fair value accounting for assets and liabilities in illiquid
markets has serious disadvantages from the point of view of regulators, and of systemic
financial risk. A mark-to-market approach i.e. fair value accounting contributes to excessive
leverage during boom periods and leads to excessive write-downs in busts. Under such
accounting irrational exuberance in asset prices can feed through to high published profits
and perhaps bonuses, encouraging more irrational exuberance in a self-reinforcing fashion:
when markets turn down, it can equally drive irrational despair. If all market participants
attempt simultaneously to liquidate positions, markets which were previously reasonably
liquid will also become illiquid, and realisable values may, for all banks, be significantly lower
than the published accounts suggested.
15. Volatility in financial statements is also a concern for the regulator. Fair value
accounting introduces volatility into financial statements through the following channels:
 Volatility on account of changes in underlying economic parameters. For instance if
interest rates increase, the fair value of bonds reduces and vice versa.
 Volatility produced due to measurement errors and/ or changing views regarding the
economic prospects through the business cycle. Fair value measures generally
represent the present value of a stream of expected cash flows. Very often the
determination of expected cash flows involves statistical techniques which may have
some amount of estimation errors as well as other errors.
 Volatility arising on account of using a mixed measurement model i.e. one that uses
fair value for some categories of assets and liabilities and amortised cost for others
thereby reducing the netting effects that a full fair valuation of assets and liabilities
would produce.
16. Another area which has received focus is the delayed recognition of impaired
assets. Accounting standards today rely more on an "incurred loss" model to recognise
losses where an event such as non-payment of dues for 90 days triggers the provisioning.
Consequently, there is an overstatement of interest income in the early life of loan. When a
series of defaults during a downturn trigger provisioning requirements, there is no stock of
provisions available to absorb credit losses. These losses directly impact the income
statement of the bank and constrain further bank lending, thus exacerbating the
procyclicality. This cycle-neutral approach to provisioning failed to account for the excessive
deterioration in loan portfolio associated with excessive credit growth. There is broad
international agreement on the need to have provisioning based instead on an "expected
loss" basis where life time losses are recognised early, i.e. provisions are increased in good
times for the possibility that the environment may deteriorate in future. However, the
implementation of such a model has its own difficulties with regard to the estimation of
expected losses and the International Accounting Standards Board (IASB) and the US
Federal Accounting Standards Board (FASB) are still engaged in deliberations on the
modalities of implementing such a model.
17. The IASB has issued exposure drafts with an expected loss model which attempts
to mitigate these shortcomings by recognizing losses and making provisions thereof earlier
during the life of the loan. However, presently, IASB and FASB's deliberations revolve
around a three bucket approach to capture the pattern of deterioration in credit quality. Under
this model, loans are classified into three categories depending upon the possibility of
expected losses. Loans, where there are no events with a direct relation to possible future
defaults, are placed in the first bucket. The second and third buckets are used for loans
affected by events that have a relationship to possible future defaults such as a drop in
housing prices i.e. a trigger event to which the default possibility of a loan/ portfolio of loans
is sensitive to has occurred. In the second bucket, expected credit losses are not identifiable
for individual loans whereas in the third bucket expected credit losses are individually
identifiable. The provisioning requirements also differ according to the bucket. Whereas
entities are expected to provide expected life time losses for the second and third buckets
the proposed approach for the first bucket is to make provision for 12 month of expected
losses though this is yet to be agreed upon. Since there is no direct relationship to possible
future defaults, lifetime expected losses are not required to be recognised for loans placed in
the first bucket. Further, the criteria and guidelines for transfer between categories are still at
the discussion stage.
18. Let me dwell upon some of the proactive measures initiated by RBI to mitigate the
effect of procylicality in the Indian context. Recognising the procylicality caused by
provisioning norms, the RBI has tried to build buffers through provisioning requirements.
 Firstly, banks are required to maintain provisions on assets that are classified as
standard and are not showing signs of impairment. Sector specific provisions
requiring banks to provide more for standard assets in certain sensitive sectors have
also been prescribed.
 Secondly, banks are required to classify accounts as NPA where there are inherent
weaknesses observed in the account even if there are few credits recorded before
balance sheet date to avoid NPA classification. Banks are also required to put in
place appropriate internal systems to eliminate the tendency to delay or postpone
the identification of NPAs, especially in respect of high value accounts.
 Thirdly, in 2009, observing the trend in profits being made by banks, the
Provisioning Coverage Ratio (PCR) requirement for banks was introduced to
address apprehensions about asset quality due to exuberant lending during the
boom phase. Banks were required to build up a PCR of 70% of gross NPAs by
September 2010. PCR was intended to be an interim measure and it was hoped that
it would be replaced by a forward-looking counter-cyclical provisioning methodology
being developed by the Basel Committee on Banking Supervision (BCBS) and
IASB. Since this is taking time, RBI is working on a methodology similar to Spanish
dynamic provisioning framework as an interim measure.
19. As regards PCR, it was decided to freeze the PCR with reference to the gross NPA
position in banks as on September 30, 2010, since in the absence of a calibrated
methodology it would be difficult to allow banks to use the countercyclical provisions built up
under PCR freely and there were certain design issues too,. The buffer (surplus of provisions
over specific provisions) will be allowed to be used by banks for making specific provisions
for NPAs during periods of system wide downturn, with the prior approval of RBI.
20. The financial crisis also led to heavy criticism of accounting rules that permitted
certain structured/ special purpose entities and exposure to remain off-balance sheet. A key
concern with such instruments and vehicles is that they have a tendency to veil the risks
off-balance sheet and a robust accounting framework that provides for the recognition and
disclosure of these risks is a prerequisite to their introduction. The IASB has tried to rectify
the situation by introducing IFRS 10 on Consolidated Financial Statements while the FASB
has also worked towards toughening off-balance sheet accounting rules.
21. In India, the RBI has always followed a cautious and gradualist approach towards
complex exotic financial products and has taken steps to reduce and contain the regulatory
arbitrage between the banking and the shadow banking sectors (mainly the Non Banking
Financial Companies i.e. NBFCs) by considerably upgrading the prudential rules for NBFCs.
22. Overall accounting for financial instruments had become highly complex and rules
based in the period leading up to the crisis and IASB's project to replace IAS 39 with IFRS 9
is a welcome initiative. However, delays in finalising proposals relating to impairment and
hedge accounting coupled with recent proposals to reopen classification and measurement
of financial assets are a cause of concern. IASB's classification requirements for assets
revolve around the business model approach whereas FASB's approach is based more on
the characteristics of the instrument. Further, FASB's approach may also entail more items in
the balance sheet being carried at fair value.
Implementation of IFRS in India
23. The convergence to IFRS in India is a work-in-progress and I would like to dwell
upon the implementation issues and challenges with particular reference to the Indian
banking system.
24. As part of the G20's efforts to evolve a single set of global high quality standards,
the Ministry of Corporate Affairs (MCA), Government of India released a roadmap that
provided for a gradual convergence to IFRS in a phased manner commencing from April 1,
2011. In terms of the road map, commercial banks in India are required to converge with
IFRS with effect from accounting periods beginning April 1, 2013. While the MCA placed on
its website thirty five IFRS converged Indian Accounting Standards (Ind AS) in 2011, it stated
that the standards will be implemented after various issues including taxation are resolved.
25. In order to address the implementation issues and facilitate formulation of
operational guidelines to facilitate the IFRS convergence for the Indian banking system the
RBI has formed a Working Group. Specific issues relating to (i) classification and
measurement of financial assets, (ii) classification and measurement of financial liabilities
and hedge accounting, (iii) amortised cost and impairment, (iv)fair value measurement,
(v) presentation, disclosure and balance sheet formats and (vi) derecognition, consolidation
and residuary issues are being dealt with by the Working Group.
26. With respect to the financial sector in India, there are special issues and challenges
in view of the large scale revision of standards pertaining to financial instruments (IAS 39)
which are of central importance to the banking system. IASB had indicated that the period
2009 to 2011 will be kept as a stable platform by them to facilitate convergence by many
countries during this period. However, the global financial turmoil and the consequences
thereof in the accounting scenario necessitated large scale revision of various standards
especially those relating to financial instruments and fair value accounting.
27. As India attempts to transition to IFRS, the biggest challenge to the banking sector
which is of equal concern to us as regulators, is the lack of clarity and uncertainty regarding
the finalisation of IFRS 9: Financial Instruments (scheduled to replace IAS 39) and its
convergence with US GAAP. One of the intentions behind scheduling banks for a later
convergence was to avoid having them first apply IAS 39 and immediately transition
thereafter to its replacement viz. IFRS 9. Countries like Canada which have recently
converged to IFRS found it easier on account of pre-existing standards being fairly well
aligned with IAS 39, which is not the case in India. With the delay and uncertainty in
finalisation of IFRS 9, the convergence process has become almost equal to chasing a fast
moving target.
28. The finalisation of impairment provisions of IFRS 9 at an early date is a critical issue
which needs to be addressed by the IASB and FASB. Our apprehensions are that the current
proposals contained in the exposure draft or the three bucket model for provisioning are
difficult to implement and operationalise. Further, in countries like India, there may not be
enough data available to apply the highly quantitative and statistical techniques to implement
a robust expected loss model to recognise impairment losses. Therefore, the Working Group
has suggested through its comment letter to the IASB, the need for a practical expedient that
allows for a simpler rule based model specified by the regulator at least in the initial years.
We hope that the IASB will consider this while finalising the requirements on impairment.
29. In a country like India, where financial markets are still developing and are not as
deep and liquid as in developed countries there are specific concerns regarding the
implementation of fair value accounting in the absence of quoted prices and illiquid markets
for several instruments. Consequently, the implementation of fair value accounting would
necessitate a dependence on valuation techniques using unobservable inputs which would
also bring in a fair share of estimation errors.
30. There are also some major technical issues arising for Indian banks in the course of
convergence. Differences between the IFRS and current regulatory guidelines on
classification and measurement of financial assets, focus in the standard on the business
model followed by banks and the challenges for management in this area, lack of adequate
number of skilled staff and modifications to IT systems and processes are some of the other
challenges that may need to be tackled in due course.
31. Apart from being preparers of financial statements, banks are also significant users
of financial statements and base their lending and investment decisions on the financial
statements of their customers. This aspect makes skill building all the more important for
Indian banks as IFRS implementation will not only impact their accounts and finance teams
but will pervade to their credit and investment analysts and decision makers. The RBI has
been proactive in facilitating skill building by conducting seminars and training programmes
as well as providing faculty support to some institutions. I am glad to learn that the ICAI too
has incorporated IFRS in its curriculum for students and has introduced a certificate course
on IFRS for its members. There is also scope for the RBI, banking system and the ICAI to
work together to build skills in this area.
32. Let me conclude by stating that there are several areas of common interest between
regulators, bankers and accountants and frequent interaction and interface between these
groups would be of mutual benefit to all. I thank you for this opportunity to share a regulator's
perspective on some current accounting issues.
References
1. Report of the Financial Crisis Advisory Group(2009)
2. Report of the Committee on Financial Sector Assessment (2009)
3. Fair Values and Financial Statement Volatility, Ms. Mary E Barth (2004)