Implementation of IFRS Implications on Corporate Governance

Corporate Governance and Ethical Decision Making

April 9, 2011 Dr. Paritosh C. Basu

Discussion Flow
Accounting and Reporting in Changing Environment Corporate Governance Revisited Striking Features of IFRS Challenges in Forward Path Key Questions from Audit Committee and Board of Directors Transition to IFRS Significant Impacts

Accounting and Reporting in Changing Environment

Path to the Pinnacle?

Challenges, risks and sustenance

What is the frequency?

Ideal - Monthly + many more one-offs

What are the Frameworks?

Conceptual, Institutional, Regulatory, Legal

For whom it is done? What do we do?

Stakeholders, Governance Group and Management

Transaction > Measure > Recognise > Record > Report

Let us revisit each question in every step of forward path

Accounting and Reporting in Changing Environment .. 2

Relevance and Time value of Corporate Financial Information
Value and Relevance (%)

120 100 80 60 40 20 0 1 2 3 4 5 6

Internal Value External Value

Global

Span and perspective of Corporate financial reporting

Stakeholders Capital / Debt Market Transactions Multiple Regulators Relevance

Country

Entity Division

The Big Question - Is Good Corporate Governance GAAP Agnostic?

Corporate Governance Revisited

Corporate Governance Revisited

Factors that Influence Ownership structure Co-existence of multiple categories * Composition of Board of Directors and its Sub Committees Independent Directors Positions in too many corporate houses Financial Structure External debt vs. equity * Socio-economic environment * Effective Audit Committee Risk Management * Value - Maximise creation and minimise destruction * Multiplicity of Tools * Statutes, Rules, Regulations, Regulators Discipline in Capital and Bond Market Systemic problems related to investor friendly information Demand / compulsive * Monitoring costs Dissemination Accounting *, Financial * and Operational * * To be directly or indirectly impacted more by IFRS / IND AS
6

Corporate Governance Revisited

Issues and Controversies Questionable ethics * Behaviour and tone at the top True independence of the Board

Doctrine of Indoor Management Lifting the corporate veil * Aggressive earnings management * Gaps and Ineffectiveness in accounting and reporting * Faulty executive compensation practices * Outdated rule based accounting disregarding substance * People are important than process * Senior management not responsible for control * Lack of engagement on the part of shareholders * To be directly or indirectly impacted more by IFRS / IND AS Fishes start rotting from the head
7

Corporate Governance Revisited 3

Attributes and Facets of Good CG Depends on the culture in which the corporate operates * Honesty, integrity and transparency beyond regulation * DNA and value system of the Group Ethical code of conduct Top management in a state for readiness to Face challenge * Deal with fear factor Responsive to dynamic environment * Good CG is philosophy and matter of attitude * Non compromising, adaptable, and scalable * Trustworthy for all stakeholders * Sustainability * Oriented towards Tipple P Bottom Line * To be directly or indirectly impacted more by IFRS / IND AS
Protect Existing + Enable Growth = More Results for Stake Holders
8

Striking Features of IFRS

9

History of IASB
1973 - Nine worldwide professional accountancy bodies agreed to formulate the International Accounting Standard Committee (IASC) May 2000 IASC was renamed as International Accounting Standard Board (IASB) and a Group of Trustees was appointed

Main objective is To develop a single set of globally acceptable and enforceable accounting standards which will produce high-quality financial information to help participants in the world's capital markets to make economic decisions

10

Framework of IFRS Standard Setting

International Accounting Standard Committee Foundation 22 Trustees provide oversight Appoints the members of the SAC*, the IASB and the IFRIC Monitors the IASB's effectiveness, raise funds, approve the IASB's budget and take responsibility for constitutional changes IFRIC - Interprets IFRS The interpretations tend to deal with reporting issues where unsatisfactory practice has arisen or where the Standards lack guidance in particular business circumstances
* Standard Advisory Council
11

Need for Common Accounting Standard

Deutsche Bank group prepared its consolidated financial statements under US GAAP until Dec. 31, 2006. Due to the requirement of European Union, the group had to adopt IFRS from Jan. 1, 2007. Under US GAAP, for the year ended Dec. 31, 2006, the groups total assets were 1.126 billion Euros, while under IFRS they were 1.572 billion Euros. Such dissimilarities weaken the usefulness of financial statements and hence there is a case for uniform financial statement reporting standards.

12

IFRS Implementation World Scenario

Countries that have already adopted IFRS are shaded with blue Countries in the process of adoption of IFRS are shaded in grey (Source. www.iasb.org)

No blackout period expected from IASB in transition course up to 2014 Substantial changes expected in Standards - Revenue, Consolidation Deferred Tax, Lease, Financial Liabilities Uncertainties about schedule in the USA albeit expected by 2014 / 15 Implementation challenges Scarce resources and IT solution Change in mindset of all concerned - Substance over Form
13

IFRS Striking Features visvis--vis IGAAP

1. More similarities with IGAAP than differences 2. Two striking differences from IGAAP are that IFRS is driven by Fair valuation of assets and liabilities resulting in unrealised gains and losses Arms length basis for assessment of transaction even between holding and subsidiary companies 3. Becomes difficult at times to appreciate the combined impact of such fair valuations on financial results vis-a-vis actual business performance 4. IFRS, therefore, suggests and demands a. Exhaustive disclosures of Accounting Policies b. Large number of clarificatory notes for almost every line item disclosed in Income Statement and Balance Sheet c. Sensitivity Analysis of certain elements that may affect results due to variations, e. g., rate of exchange, floating rate of interest on loan, etc. d. Disclosure of results out of Managements annual review of: Efficacy of risk hedging instruments Credit risks and so on e. Mandatory annual assessment of Useful Life of assets by management

14

IFRS Striking Features visvis--vis IGAAP

5. Functional Currency may be the one of that country which significantly influences operations and financial results (IAS 21) 6. Presentation of Financial Statements (IAS 1R) is significantly different from IGAAP Certain examples a. Clean segregation of Assets and Liabilities into Current and Non Current groups b. Statement of Other Comprehensive Income (SoCI) c. Statement of Changes in Equity (SoCE) including Dividend d. Functional grouping of expenses (generally preferred) e. Prohibition in disclosure of Extraordinary Item unlike AS 5 f. Disclosure of Critical judgment of management in applying accounting policies Key sources of estimation uncertainty that have significant risks Information that enables users to evaluate entitys objectives, policies and process of managing capital

15

Challenges in Forward Path

16

Challenges in Forward Path

Information content Protective confidentiality vs. complete transparency Completeness vs. Invasion by analysts, who till recently knew IGAAP More volatility in Income Statement Relevance for stakeholders Recognition and transaction processing with flexibility for Corporate reporting Substance over Form, Tax Accounts and Return Historical Cost vs. Fair Valuation Least possible application of Regulatory framework of accounting Test of Functional Currency Unlearning and relearning Research, Reading, Benchmarking Guidance of EAC of ICAI, RBI Replaced by IFRIC, SIC and IND AS Schedule VI and Regulatory Provisions Revised Revenue recognition Retail, Automobile, Construction, Airlines, etc.

17

Challenges in Forward Path

Mandatory tests and measurements Covenant compliance Classification of Current liabilities Test of Going concern Debt and Interest - in Preference Shares and Quasi Equity Instruments Modeling and valuation of Options and other Derivative contracts ERP System under new standards Automated process vs. Worksheets in excel with associated risks Handling of GAAP differences for conversion Annual Business Plan preparation under converged IFRS Standards Emerging needs of Direct Tax Code and Goods and Service Tax

18

Challenges in Forward Path

Socio Economic Impacts of IFRS Some researched out thoughts . Introduction of IFRS should be re-examined from at least two distinct perspectives: 1. the use, misuse, and abuse of principle-based Fair Value Accounting (FVA) in the wider arena of socio-economies . FVA should be re-examined as a specific mode of information that changes the epistemic, operational and control frameworks of various organisations 2.The long term consequence of adoption or convergence which would affect the Sovereign Right and National Strategy to control Indias socio-economy for the sake of sustainable growth . The mode of international standards should be reexamined for whether it will affect the power balance between Indian Government and international organizations (Page 3) We are not concerned with isolated corporate scandals. . concerned about the indirect , long term, mental impacts of the new accounting on the socio-economies in India. (Page 114) Contd. ..
19

Challenges in Forward Path

Socio Economic Impacts of IFRS Some researched out thoughts Countries such as China and India may require tight control of, for example insurance industry, for the protection of a large population that should not be subjected to the logic and power of international institutional investors whose main interests are investment return.
(Pages 114-115)

Once the global accounting standards are implemented, the performance of Indian companies and industries is likely to be compared with that of other countries without taking social needs and context into account. (Page 115) Convergence is a carefully crafted although it may not be commonly understood definition or the one desired by IASB. (Page 115) Chinese political leaders have treated accounting as a matter of national strategy . Converted accounting as a governmental tool to transform communist business organisations into modern economic entities. (Page 121) Source: Socio-Economic Impacts of IFRS on Wider Stakeholders in India
Tomo Sujuki and Jaypal Jain, Said Business School, University of 20 Oxford, 2010 [v.2.3.2]

Brawl out Challenges in GAAP Conversion Advices from Audit Committee

Know your Financial Statements (FSs) more under IGAAP Study FSs under local GAAP in details for last three years Identify critical and major transactions including one-off kind List accounting under regulatory requirements Trace back all work sheets and valuations for measurement

Identify work content, assess time and resources

Identify GAAP differences vis--vis IFRS List items to be done / redone with owners for each work group Transactions, Measurements, Disclosures, Sensitivity Table Assess requirements, efforts in-house capabilities and external support with Plan B if required Brief top management and operating team for support required

Actions, Execution, and Monitoring

Identify a Mentor and set up a Steering Committee Prepare and monitor Action Taken Report Job description, Information inputs, Dependency, Timeline Review progress with focus for critical items Review draft accounts with iterative perfections
21

Key Questions to be Answered For The Audit Committee and Board of Directors
22

Key Questions to be Answered for AC and BoD

Revenue Recognition and Accounting Industry specific changes - Retail, Vehicle, Telecom, Constn. etc. Approaches to revisit measurement and recognition IT enablement of the process Articulation of disclosure for policy and measurement Fixed Assets Institutionalised Process Fair valuation on first adoption Componentisation of assets Annual review of useful life and residual value Annual tests for impairment and accounting of outcomes Instances of leases under Take or Pay Arrangement (IFRIC 4) Tax implications for all the above Current and Deferred Assets and Liabilities Current & Non Current
Covenant compliances for Loans and consequent changes Split Pref. Shares and Combined Instruments into Debt , Equity and Interest Restricted Cash & Cash Equivalents
23

Key Questions to be Answered for AC and BoD

Business Combinations Effects on transactions planned for future Impacts of changes due to fair valuations of assets and liabilities Future exit strategies Investments in Associates and Joint Ventures Changes in number of entities under Equity Accounting method Modifications required in Joint Venture agreements Alignment of policies and procedures for measurement and accounting Taxes Deferred Tax Balance Sheet based approach Overall impact on Current IncomeTaxes Effect on Indirect Taxes due to changes in Revenue accounting Contingent Liabilities Reassessment and categorise into Remote, Possible, or Probable Provision requirement for probable cases Transparent disclosures after detailed review

24

Key Questions to be Answered for AC and BoD 3

Financial Statement Presentation Changes in Formats and Classifications Functional vs. natural grouping of expenses Volatility in Income Statement EBITDA not a defined measurement Additional Comprehensive Income and Changes in Equity Capital Management Policy Objective, Debt and Equity Assessed adjusting events post Balance Sheet date Sensitivity Analyses Currency Exchange Rate and Interest Financial Risk Management Credit to Customers Currency Exchange Rate Exposures Liquidity Maturity Profile of Loans, Creditors, Derivatives Commodity procurement Communication strategy and presentation to Analysts
25

Transition to IFRS Significant Impacts on Corporate Reporting

26

Significant Impacts - Revenue Recognition

Technology, Media and Telecom Bundled service commitments with handsets / data cards deferred till delivery Retail, Motor Car, Airlines Deferment for Fair Value (FV) of Liability against loyalty programme, future delivery of commodity, services or extended warranty Incentive to be netted-off from Sales instead as selling expenses Advertisement Barter transactions Reliably measured FV of services received or provided Construction, Realty and Infrastructure Terms of agreement are critical for revenue recognition At backend on delivery or Proportionate completion basis
27

Significant Impacts - Revenue Recognition .. 2

Banks Upfront fees income against loans to be amortised over loan period on effective yield basis Substantial reclassification and fair valuation of investments Capital Goods Unbundling of installation services and recognition on completion NPV differential against deferred payments treated as finance income Change in Nature of Revenue Manufacturing / Service nature to Leasing Income if IFRIC 4 is applied Manufacturing to Service Revenue Free service coupon by Motor Car Industry Sale of Goods Physical control and ownership change CIF Exports - Bill of Lading vs. delivery Domestic FOR Destination Contract - Lorry Receipt is not the criteria
28

Significant Impacts - Income Statement

EBIDTA (Not recognised as a measured value in Income Statement) Automobile Component, Power Generation Arrangement
Charges for components under take or pay arrangement may attract IFRIC 4 and be treated as Depreciation under Financial lease

Banks
Provisioning against NPAs as per RBI directives to be replaced by Impairment of future cash flow based on objective evidence

Income Statement PBT & PAT Combined impacts of

Revenue and Cost recognitions FV and Reassessed Life on Depreciation of Fixed Assets and Int. Assets

Functional Currency Change may impact all items in Income Statement

29

Significant Impacts - Income Statement .. 2

Income Statement PBT & PAT (Contd.) Capital profit on business combination FV of investment property in Realty sector Interest cost against Preference Share on treatment as loan Amortisation of Upfront Fees for loans over door to door period Deferred Tax Asset / Liabilities against all fair valuation gains / losses Changes due to adjudged adjusting events post balance sheet date Provision for Contingent Liability Probable, Possible and Remote

Senior Executives may have to renegotiate Profit linked Variable Pay

30

Significant Impacts - Balance Sheet and Net Worth

Reclassification of Loans as Current Liabilities, if waiver against covenant defaults not obtained within year end
Prescriptive provision and not substance over form May have implications on Going Concern assessment and repot by Auditors

Replace Fixed Assets by Long Term Receivables if IFRIC 4 applies to Take or Pay or servicing contracts with specific assets Preference Shares reclassified as Debt FV of Inter-company Borrowings at concessional rate Split of Convertible Instruments into Debt and Equity FCCB, Debenture Effective Hedge Accounting for derivatives FV impact on Net Worth Adjusting Loans for Effective Interest Method and Upfront Charges Reassessment of dffective Useful Life and Residual Value of Fixed Assets

31

Significant Impacts - Balance Sheet and Net Worth .. 2

Functional Currency change Impact on Fixed Asset Valuation and CTR Current and Noncurrent approach towards Balance sheet Goodwill - Amortisation vs. impairment Deferred Tax Provision with Balance Sheet approach Revaluation and FV of Fixed Assets Business Combinations First Time Adoption Depreciation method Changes due to assessed Adjusting Events post balance sheet date Provision for Contingent Liability Probable, Possible and Remote

32

Additional Notes and Disclosures for More Transparency

Financial Risk Management - Objectives and Policies covering Credit Risk on Customers Currency Exchange Exposures Liquidity Risk - Maturity Profile for Loans, Creditors, Derivatives, Lease Commodity Price Risk Restricted Cash Capital Management Policy - Objective, Debt, Equity Tax Reconciliation and Analyses Reconciliation at Effective Rate Component-wise Analysis of Deferred Tax Sensitivity Analyses
Interest Rate on Loan Portfolios with Reset Clauses or Floating Rate Exchange Variations on Financial Assets and Liabilities

Analyses of Contingent Liabilities - Probable, Possible and Remote

33

Significant Impacts on Performance Indicators

Current Ratio - Mostly likely to be Adverse even Cash Equivalents may be Non Current Assets Fixed Assets to Loan - Movement may be Both Ways depending on FV, reassessment of Life and Residual Value Debt Equity Ratio - Likely to be Adverse due to Reclassification of Preference Share, Convertible Instruments Return on Net Worth - Combined effect may be Both Ways but likely to Improve EBIDTA over Revenue (Not a Standard Measure, may be included in Notes) - Combined effect from revenue and cost recognition Debt Service Coverage Ratio - May have to be recast under IGAAP till Indian Banks takes a policy decision about IFRS application. Analysts to exercise caution while using and comparing such disclosures

34

Further Thoughts

35

Thank You

36