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1. The challenge in IFRS accounting
IFRSs (IND ASs being the Indian version) are now applicable in India for all listed and non-listed majors too including the requirement to prepare group financial statements. Chartered accountants in particular have to apply due diligence to measure and recognise fair values of financial assets, financial liabilities, financial derivatives and various other items on such bases as have been specified in relevant IFRSs. However, the big challenge is how do you identify the basis and the relevant technique that is required to be applied to get the correct IFRS number?
2. Pre-requisites for the practice of IFRS accounting
CAs should have a firm grip on the application of the (a) assumptions and fundamental concepts of a market economy and (b) risk management. This is because determining IFRS numbers is driven by market valuations –what they are today instead of the historical price and are dependent on the type and degree of risk assumed and actually taken by business entities.
Basic Assumptions in Economics deal with how to make certain choices with your money in the wake of unlimited wants. As an individual, you face the problem of having only limited resources to fulfill your wants and needs. Risk management helps you understand the implication of risk at the point of decision rather than afterwards i.e. anticipating risk and are less likely to have made a mistake that could slow you down.
With this basic knowledge of the application skills in Economics and Risk Management, a CA and other concerned professional should move to the next stage of computing IFRS numbers.
3. How to get an IFRS value?
Your start point should be how to identify the bases and technique to be used to get a proper IFRS value.
Bases refer to what methods of valuation have been prescribed under say a relevant IFRS 9 on financial instruments? You will note that IFRS 9 requires all financial instruments to be valued initially at fair value and subsequently at either FVTPL or FVOCI or Amortised Cost.
Techniques refer to such as Market Value, Income Approach and Cost Replacement. These are the three techniques on which an asset or liability should be fair valued under IFRS 13 Fair Value Measurement. IFRS 13 prescribes a uniform application of approaches in computing fair value of an asset or liability.
Additionally, there are a vast number of sub-techniques that have been prescribed under different IFRSs (example, effective interest rate, amortised cost method, FVTPL, FVOCI, etc. in getting an IFRS fair value.
Remember that bases and techniques are not interchangeable. What this mean is that only the appropriate ones should be selected and applied to get a proper IFRS value. This selection requires expertise of different IFRSs, no guess work!
4. What areas and how to compute fair value under IFRS?
Get ready. Given below is a list of important accounting areas where financial reporting professionals are expected to develop expertise:
(a) Time value of money is the hallmark of IFRSs comprising present and future values of an amount. A present value problem is one in which we know or can estimate the amount of money that will come in future but wish to know how much we need to spend to get it. A future value problem is one where you know how much you will invest today but want to know how much your investment will grow in n years?
Example of present value (PV): what will be the PV of Rs 10,000 to be received in future if you invest @ 4.5% being the market rate for a 3 year investment and given your risk profile? To get PV, on calculator, type 10,000÷1.045press=9569.38=9157.30=8762.97.
Example of future value (FV): if you invest Rs 10,000 for 3 years at market rate of 4.5% given your risk profile, the FV at the end of each of the three years will be: type on calculator 1 + 0.045 x 10000 press =10450=10920.25=11411.66.
You can also compute PV and FV of annuities by applying respective formulas.
(b) Discount rate (DR): is used to discount future cash flows of a financial instrument to yield their present value. DR should be so chosen that it takes into account risk of owning & operating a business, opportunity cost, inflation and liquidity cost. All of these costs combine to determine the interest rate on an account, and that interest rate in turn is the rate at which the sum is discounted.
Example: suppose you expect Rs 1,000 in one year’s time (FV =1,000). To determine the present value, you would need to discount it by some interest rate (i). If this discount rate were 5%, the Rs 1,000 in a year’s time would be the equivalent of Rs 952.38 to you today (1000/[1.00 + 0.05]).
Applying discount rate is highly technical and judgmental as you need to estimate properly the future cash flows based (knowing well your business) on the specific techniques, have a good practical knowledge of market and other types of risk. DR may sound simple here but is covered by challenges in actual application and thus is a complex and important area in IFRS.
(c) Effective interest rate (EIR): EIR is not defined in law or by regulators, as nominal interest rate. EIR is used to compare the annual interest (nominal or stated interest rate) between loans with different compounding terms (monthly, quarterly, semi-annually or annually). Banks as lenders would quote a lower say 8% nominal rate whilst the actual interest payouts by borrowers would be higher, whilst they would quote a higher interest rate say 8.5% being the actual interest yield to their depositors, as compared to the lower 8% nominal rate.
Examples of EIR: a nominal interest rate of 6% compounded monthly is equivalent to an effective interest rate of 6.17%. 6% compounded monthly is credited as 6%/12 = 0.005 every month. After one year, the initial capital is increased by the factor (1 + 0.005)12 ≈ 1.0617 -1 = .0617 x 100 = 6.17% (i.e., 1.005 x 1.005 press = 11 times to get 1.0617).
Most credit card companies, for example, compound interest on a monthly basis — meaning they increase your outstanding balance by one-twelfth of the annual interest rate each month. In other words, if your credit card offers a 12-percent interest rate but it compounds monthly, your balance will increase by one percent each month. The 12-percent rate is the nominal rate, which gives you a monthly nominal rate of one percent.
In practice, EIR is again widely prescribed under various IFRSs and requires specific application for bullet financial instruments and amortised financial instruments. A high level of expertise is required for computing EIR. Again EIR needs be computed in different manner for contractual cash flows and expected cash flows.
(d) Internal rate of return (IRR): IRR is again widely prescribed to be used to get an IFRS accounting number. IRR is a derived discount rate where PVB = PVC. IRR is a derived rate of expected return on investment i.e., a discount rate where PVB of incremental cash inflows = PVC (cost of asset). Discount rate is built from the investment’s future cash inflows which are discounted at an ‘arbitrary’ rate, such that PVB equals PVC.
IRR indicates what is that rate of return which if used as a discount rate for all estimated incremental cash inflows over asset’s economic life will equal the cash outflow (cost of the new asset or project). Future incremental cash inflows are discounted, using the IRR rate.
Example: management of a manufacturing entity is considering to replace an old machine with a new one. The new machine will be capable of performing some tasks much faster than the old one. The installation of machine will cost 8,475 and will reduce the annual labor cost by 1,500. The useful life of the machine will be 10 years with no salvage value. The minimum required rate of return is 15%.
Required: Should the entity purchase the machine? Use internal rate of return (IRR) method for your conclusion.
Solution:
To conclude whether the proposal should be accepted or not, the internal rate of return promised by machine would be found out first and then compared to the company’s minimum required rate of return.
The first step in finding out the internal rate of return is to compute a discount factor called internal rate of return factor. It is computed by dividing the investment required for the project by net annual cash inflow to be generated by the project. The formula is given below:
Formula of internal rate of return factor:
In our example, the required investment is 8,475 and the net annual cost saving is 1,500. The cost saving is equivalent to revenue and would, therefore, be treated as net cash inflow. Using this information, the internal rate of return factor can be computed as follows:
Internal rate of return factor = 8,475 /$1,500
=5.650
After computing the internal rate of return factor, the next step is to locate this discount factor in “present value of an annuity of $1 in arrears table”. Since the useful life of the machine is 10 years, the factor would be found in 10-period line or row. After finding this factor, see the rate of return written at the top of the column in which factor 5.650 is written. It is 12%. It means the internal rate of return promised by the project is 12%. The final step is to compare it with the minimum required rate of return of the entity. That is 15%.
Conclusion:
According to internal rate of return method, the proposal is not acceptable because the internal rate of return promised by the proposal (12%) is less than the minimum required rate of return (15%).
(e) Fair value (FV): in recent years, international accounting standards setters like IASB & FASB have begun to favour the use of fair value over historical cost accounting, to improve the relevancy of the information in the financial statements. Fair value measurements, produces increase or reduction in earnings of an entity, as fair value reflects current market conditions.
FV is a widely prescribed basis in IFRSs. All that IFRS 13 has done is to provide a uniform method to get fair value. On the whole, whilst getting to “fair value” demands analytical and market-cum-equity-oriented skills.
“Market price” is the price at which one can transact or market price is just the economic price at which goods and services are sold, depending on demand and supply.
“Market value” is “the true underlying value” according to theoretical standards (e.g., market takes into account future growth potential of entity and then determine whether entity’s market value is adequate or under or overvalued compared to its book value or net asset or some other measure. Usually stocks are valued this way).
Example of FV: Let’s assume entity Z’s stock currently sells for 20 per share. Z just introduced a new product line, redesigned its packaging, and hired some new managers away from a competitor. Although these changes do not directly appear on the Z’s financial statements, they may improve Z’s competitive advantage in key markets. For these reasons, investors may assume a stock’s future cash flows will be much higher going forward. They could then take their estimated growth rate and calculate the fair value of the stock at 50 per share, or 30 more than what it is currently selling for.
5. Final comments
IFRS is a vast and complex accounting literature that is being followed in more than 100 jurisdictions. It is not the purpose of this write up to cover every bit of IFRSs. It takes years of hard and dedicated work to understand and practice IFRSs. Preparers of IFRS financial statements could develop expertise in certain of its areas whilst may develop a working knowledge in its other areas, depending on the applications of various IFRSs to an entity.
However, chartered accountants are generally expected to have expert knowledge of IFRSs, having regard to the laws and international practices. Therefore, for professional accountants, the learning can never stop –it must continue on a regular basis.
By: CA. Anand Varma, retired finance & accounting Professional
