K C Chakrabarty: Introduction of International Financial Reporting
Standards (IFRS) - issues and challenges
Speech by Dr K C Chakrabarty, Deputy Governor of the Reserve Bank of India, at the
inauguration of a national level seminar on International Financial Reporting Standards
(IFRS), Mumbai, 11 February 2011.
* * *
Dr Naresh Chandra, Principal, Birla College, Former Pro Vice Chancellor, Mumbai
University, Dr Shyam Agrawal, eminent eye surgeon, Shri M. M. Chitale, veteran CA and
Chairman NACAS, Shri U. Venkataraman, CEO-Currency Derivatives Segment & Whole
Time Director, MCX-SX, Principal of PDL College of Commerce and Economics and my dear
student Dr N. N. Pandey, Prof D. M. Kadhi, Convenor, other distinguished guests, ladies and
gentlemen. I am delighted to be present here amongst you all on the occasion of the National
Level Seminar on IFRS. Needless to say, it is a very topical area which has been engaging
the attention of the standard setters, government authorities and regulatory bodies for quite
some time. I shall share with you a few of my thoughts on the issue.
Reading financial statements
Let me begin by talking about the most elementary and fundamental area of commerce and
accountancy which is "How to read a Financial Statement". To a lay man, financial
statements comprise the Balance Sheet and Profit and Loss Account. However, the numbers
given in these alone do not give the correct picture to the reader unless one carefully goes
through the notes to accounts, cash flow statements and qualifications, if any, in the Auditor's
Report and also appreciates the accounting policies followed by the enterprise. In some
cases, ratio analysis, trend analysis and an industry peer comparison can be done to obtain
a better perspective. A thorough study of all these aspects is required before a user can
make an informed decision.
The objective of financial statements is to provide information about the financial position,
performance and cash flows of an enterprise that is useful to a wide range of users in making
economic decisions. Corporate financial statements with the notes and narratives
surrounding them, are intended to enable investors to predict cash flows, determine returns
generated on capital invested, assess the business liquidity, and evaluate management's
performance. Financial statements are prepared by drawing an artificial line of cut-off at the
year end, even though the business continues as a going concern. In many transactions, one
leg of a transaction may be completed, while the other, leg may still have to take place. For
instance, questions arise on several issues such as to whether unsold goods at the end of
the accounting period can be valued at cost or realizable value and the applicable cost
formula, alternative method for evaluating depreciated/amortized value of fixed assets, how
to ascertain the value of a number of assets/liabilities, claims and counter-claims and the
correct treatment of uncertainties involved in evaluating a particular transaction. Therefore,
there is an imperative need for evolving appropriate accounting policies and accounting
standards to deal with these questions.
Importance of accounting standards
Accounting as a "Language of Business" communicates the financial results and health of an
enterprise to various interested parties by means of periodical financial statements. Like any
other language accounting should have its grammar and these sets of rules are Accounting
Standards. The objective of Accounting Standards is three fold. Firstly, they help to
standardize the diverse accounting policies and eliminate the incomparability of financial
statements within an entity and across entities. Secondly, they facilitate the presentation of
high quality, transparent and comparable information in financial statements. Thirdly, they
reduce to accounting alternatives and thereby eliminate the element of subjectivity in
financial statements.
India has a long tradition of framing accounting standards in the country. The Institute of
Chartered Accountants of India (ICAI) set up under an act of Parliament had constituted an
Accounting Standards Board (ASB) in April 1977 and the ASB has been framing the Indian
Accounting Standards for the last three decades.
International financial reporting standards
Globalization of financial markets has meant an increased focus on international standards in
accounting and has intensified efforts towards a single set of high quality, globally acceptable
set of accounting standards. Financial statements prepared in different countries according
to different set of rules, mean numerous national sets of standards, each with its own set of
interpretation about a similar transaction, making it difficult to compare, analyse and interpret
financial statements across nations.
A financial reporting system supported by strong governance, high quality standards, and
firm regulatory framework is the key to economic development. Indeed, sound financial
reporting standards underline the trust that investors place in financial reporting information
and thus play an important role in contributing to the economic development of a country.
Needless to mention, internationally accepted accounting standards play a major role in this
entire process.
It is in this context that the role of an independent, global standard-setting body such as the
International Accounting Standards Board (IASB) is of critical importance. The principal
objectives of the IASB are:
a. to develop a single set of high quality, understandable, enforceable and globally
accepted international financial reporting standards (IFRSs) through its
standardsetting body, the IASB;
b. to promote the use and rigorous application of those standards;
c. to take account of the financial reporting needs of emerging economies and small
and medium-sized entities (SMEs); and
d. to bring about convergence of national accounting standards and IFRSs to high
quality solutions.
Converging to global accounting standards i.e. IFRS facilitates comparability between
enterprises operating in different jurisdictions. Thus, global accounting standards would
remove a frictional element to capital flows and lead to wider and deeper investment in
markets. Convergence with IFRS is also in the interest of the industry since compliance with
them would be able to create greater confidence in the mind of investors and reduce the cost
of raising foreign capital. It is also burdensome and costly for enterprises operating across
several countries to comply with a multitude of national accounting standards and convert
them to a single standard for group reporting purposes. Convergence would thus help reduce
both the cost of capital and cost of compliance for industry.
In pursuit of its objectives, the IASB works in close cooperation with stakeholders around the
world, including investors, national standard-setters, regulators, auditors, academics, and
others who have an interest in the development of high-quality global standards. Progress
toward this goal has been steady. All major economies have established time lines to
converge with or adopt IFRSs in the near future and more than hundred countries require or
permit the use of IFRSs.
Though Indian Accounting Standards are framed based on standards issued by the IASB,
there are certain differences due to the legal and regulatory environment prevailing in the
country, conceptual issues and the economic environment. In 2007 the ICAI decided that
India should converge towards IFRS in a definite time frame in the wake of developments
taking place in other major jurisdictions which had set up time schedules for migrating
towards IFRS.
Lessons from the financial crisis - review of standards for financial instruments
One of the most destabilizing elements of the global financial crisis has been the pro-cyclical
amplification of financial shocks through the banking system, financial markets and the
broader economy. The tendency of the market participants to behave in a pro-cyclical
manner has been amplified through a variety of channels, including through accounting
standards for both mark-to-market assets and held-to-maturity loans, margining practices
and through the build up and release of leverage among the financial institutions, firms and
consumers. Failure to capture major on-and off-balance sheet risks as well as derivative
related exposures, was also a key destabilising factor.
The provisions of IAS 39-Financial Instruments-Recognition and Measurement issued by the
International Accounting Standards Board (IASB), establishes the principles for recognizing
and measuring financial assets and financial liabilities. This standard is of particular
importance to the banking sector and NBFCs which deal primarily in financial instruments.
IAS 39 includes provisions about classification of financial instruments, their ongoing
measurement (including when impairment is required) and derecognition. The provisions of
IAS 39 are currently applicable globally in respect of financial instruments.
Following the crisis, there was widespread criticism that the accounting standards, more so,
fair value accounting significantly contributed to the financial crisis 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 G 20 Working Group on "Enhancing Sound Regulation and Strengthening
Transparency" 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. The
G 20 Working Group also recommended that the International Accounting Standards Board
(IASB) should enhance its efforts to facilitate the global convergence towards a single set of
high-quality accounting standards by sharing the experience of countries that have
completed this process and by providing technical assistance. Another significant
recommendation was that accounting standard setters should accelerate efforts to reduce
the complexity of accounting standards for financial instruments and enhance presentation
standards to allow the users of financial statements to better assess the uncertainty
surrounding the valuation of financial instruments.
In April 2009, in response to the input received on its work responding to financial crisis, and
following the conclusions of the G 20 leaders and the recommendations of international
bodies such as the Financial Stability Board, the IASB announced an accelerated timetable
for replacing the principal standard for recognition and measurement of financial
instrumentsIAS 39. IAS 39 is sought to be replaced by IFRS 9 in three phases. The first phase was
completed with the issue of the portion of IFRS 9 which deals with the classification and
measurement of financial assets and financial liabilities. The second and third phases are in
the area of Hedge Accounting and Impairment, where currently work is underway. It is
expected that IFRS 9 will replace IAS 39 in its entirety by June 2011.
IFRS Convergence - implementation in the Indian context and challenges
In the backdrop of the developments after the global financial crisis, the Ministry of Corporate
Affairs (MCA), GOI set up a high-powered Core Group under the chairmanship of Secretary
(MCA) to study the impact of IFRSs and to understand the preparedness of the Indian
companies for converging with IFRSs. The Road map towards IFRS convergence for
corporates from April 1, 2011 has been finalized by the Ministry of Corporate Affairs in
January, 2010.
Convergence also entails maintaining consistency with legal and regulatory requirements
prevalent in the country. Towards this end, amendments need to be made to existing laws
and regulations, notably the Companies Act, 1956 provisions and schedules that detail the
requirements of financial statements need to be harmonized with IFRS requirements and
converged Indian Accounting Standards need to be notified under section 211 (3C) of the
said Act. Additionally there are also issues relating to taxation under an IFRS converged
environment.
There is also a need to improve awareness in general and build technical competence for the
accounting and auditing profession on IFRS. The ICAI has already included a comparative
study of Indian Accounting standards with international standards in its syllabus for CA Final
Advanced Accountancy and is also offering courses and seminars for its members to update
them in the field. The RBI too has been holding periodical seminars and workshops to
educate its staff on IFRS provisions.
Challenges for banks and non-banking financial companies
In respect of banks and NBFCs, in view of the special issues involved (finalisation of IFRS 9
expected in the middle of 2011), a separate road map was prepared in March 2010 for
convergence with IFRS for the banking industry and NBFCs. The convergence process
would be from period beginning April 1, 2013, with a phased approach for urban banks and
NBFCs. This gives the banking system some time to adopt to the standards in a smooth and
non-disruptive manner.
It has to be noted, however, that banks will be significantly affected by the IAS
39 replacement project and a number of other accounting developments including those
relating to financial instruments, fair value measurement, financial statement presentation
and consolidation. Some of the major changes pertain to certain critical areas such as
classification and measurement of financial assets, classification and valuation of liabilities,
impairment provisions and fair value measurement. One area of concern has been the
drawback of the incurred loss model of IAS 39 and the need to introduce more forward
looking provisioning.
The IFRS convergence process will involve significant challenges for the banking system in
general. Banks would need to upgrade their infrastructure, including IT and human
resources, to face the complexities and challenges of IFRS. Some major technical issues
arising for Indian banks during the convergence process would be 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, application of fair values for transactions where not much
guidance is available in India in terms of market practices or benchmarks, and expected
changes in impairment rules.
Key non-accounting issues
Let me now draw your attention towards certain key non-accounting issues which are equally
crucial in the IFRS convergence process. The desired results will not come if non-accounting
issues are not addressed along with the accounting issues. The first challenge is integrity of
data and information. Most Scheduled Commercial Banks in India have either already
migrated or are in the process of migrating to Core Banking Solutions (CBS). In this context,
data integrity and data validity would be of critical importance especially due to data intensive
requirements of IFRS converged standards. The present system of compilation and
submission of data which forms the backbone of preparation of financial statements
compromises on data quality. The scope of erroneous data entry of even malicious wrong
reporting cannot be ruled out. Lack of adequate data results in absence of information on
"returns" at activity level and segmental reporting in a granular manner. Incorporating
suitable capability in CBS for enabling automated data flow/generation of MIS would be a
facilitator in accurate reporting and financial statements prepared from such data as the
basis would reflect a "true and fair" picture of the financial position of the entity. RBI has set
up a group to work on this area. Preparatory work in this regard would enable us to counter a
basic challenge in our effort towards IFRS convergence.
Secondly, we come to the issue of "Ethical Standards" which are of critical importance in the
field of accountancy where users rely heavily on the statements made by accounting
professionals. Maintaining ethical standards and values is a key part of financial reporting.
Without a strong code of ethics and adherence to those ethics, financial reporting would fail
to inspire and ensure public and investor confidence in entities. Thus, along with high levels
of technical competence, accounting professionals also need to have unquestionable and
impeccable professional integrity. Therefore, professional bodies have codes of ethics for
their members and disciplinary procedures for those who infringe upon these rules. However,
one of the causes of the recent financial crisis was also the poor adherence to ethics by
some accounting professionals who exploited "form over substance", rather than "substance
over form" to hide weaknesses in their financial position and misstate profits.
Thirdly, adaptability and compatibility of existing IT solutions used by banks to the new
requirements imposed by IFRS convergence is also a major challenge. Software which has
been written keeping in mind Indian GAAP requirements may have to be modified
substantially to incorporate features of IFRS requirements. Similarly, compatibility between
software and hardware would have to be addressed to take care of the new requirement.
RBI has always believed in the fact that accounting standards and the integrity of its
implementation has a very important role to play in the financial system as reflected in the
Report of the Committee on Financial Sector Assessment, wherein the importance of the
convergence process of Indian accounting standards with IFRSs has been emphasized. RBI
has set up a Working Group to address Implementation Issues in IFRS for non-disruptive
migration of the Indian banking system with members from ICAI, IBA and the regulatory and
supervisory departments of RBI.
Conclusion
Training, education and skill development is one of the cornerstones of a successful IFRS
implementation. All the stakeholders including investors, accountants, auditors, customers,
software and hardware vendors, rating agencies, analysts, audit committees, actuaries,
valuation experts and other specialists would need to develop and understanding of IFRS
provisions to varying degrees and what they need to do. Educational institutions need to play
a pro-active role and students must also strive to develop a strong conceptual understanding
of the new framework and academic institutions should include it in their curriculum. It is not
only the accounting issues but how we address the non-accounting issues that will determine
how successfully we make a transition to IFRS. It is in this backdrop, and considering the
ongoing changes in the standards both globally and in the Indian context as well as the
amount of work involved in the convergence process, that this National Seminar on IFRS
assumes importance. I wish the deliberations in this Seminar all success.