1) How IFRS got its position from GAAP
Even today, when one hears people from Nilgris, Tamilnadu, India lost Re10 Crores to an unknown financial company, one’s mind goes back to 1930, when the great depression wiped out the whole capital of many investors in USA. Investors in USA craved for accounting standards and hence “Generally Accepted Accounting Principles” were developed by Certified Public Accountants, duly authorised by the government. It originated with words like financial statements, assets, liabilities, equity, revenue, expenses etc. Other countries just followed U.S.A. and thus evolved GAAP in every country. Auditors or bankers proudly accepted those financial statements, duly authorised and highly relied upon for investment, expansion or raising resources. The whole world can move capital and help the nations to raise their economies. It enabled the investors to increase their income to unknown limits.
But the unison call to make Europe as a single political entity and exploit its economic wealth by mutual investments from member countries posed new challenges. Some felt of common accounting principles exclusively for Europe and thus “International Financial Reporting Standards” with variations from GAAP were created. It believes in dealing with the current developments and providing for them. Being conservative in approach, it treats income on long period as one for each year while expects losses for future and start providing for the same from current year onwards. IFRS was introduced in 2006.
2) Why Indian accounting standards merged with IFRS
To enable India to converge with IFRS, meaning, making some adjustments in Indian Accounting Standards to suit our economy, India got Ind ( AS) which had been notified by Ministry of Corporate Affairs, Government of India vide its communication dated 18th January 2016.
Reserve Bank of India vide its communication dated June 23, 2016 advised all Banks to submit Performa Ind (AS) Financial Statements, for the half year ended September 30, 2016 latest by November 30, 2016 in new formats which were included with its communication.
The formats of Ind AS Financial statements were named as under:-
(a) Balance Sheet including Statement of Changes in Equity
(b) Profit and Loss Account
RBI further advised the banks that the formats which were included with the communication of RBI were only for submission to them and not for replacing the financial statements for the financial years 2016-2017 and 2017-2018 in the current Performa. This clearly explains the fact that the common share holder will continue to get his financial statements as usual in the current formats for the said financial years. This is to enable the banks to understand the new accounting standards and get prepared for the same. Those banks which would not be in a position to both standalone and consolidated Performa Ind AS statements for the financial year ended September 30, 2016 will submit standalone statements only.
The banks were advised to disclose significant accounting policies including, inter alia, the following:
1) Financial assets and liabilities, including use of fair value option in designating financial assets or financial liabilities at Fair Value through Profit or Loss (FVTPL) upon initial recognition.
2) Impairment of financial assets with the following details:
- Methodology for computation of expected credit losses (ECL)
- Level of segmentation in the portfolio used
- Criteria used for determination of movement from Stage 1 (12 month ECL) to Stage 2 and Stage 3 (lifetime ECL)
- The method used to calculate lifetime ECL
- The manner in which the forward looking information would be incorporated in the ECL estimates- the information to include discussion of judgement required and how it would be applied in determining the allowance
- The treatment for non-fund based facilities
- The methodology for revolving credit facilities
- The impact of movement from the current approach to ECL approach
The banks were informed by RBI to finalise policy on expected credit loss provisioning, taking into account the impairment requirements under Ind AS standard No. 109. The banks were also advised to maintain flexibility while designing the systems and processes in regard to derivatives, de- recognition of financial assets and financial liabilities, employee benefits, offsetting financial instruments and income taxes. The banks would have to adopt Ind AS 101 First time Adoption of Indian Accounting Standards while changing from present Indian Accounting Standards to Ind AS standards.
But the fundamental question for an average banker is how does RBI letter affect him with his deposits, advances (fund based and non-fund based), and can anyone explain in simple terms the calculation of cost of capital for banks? Most of the books on IFRS explain in technical terms the implications of implementation of the standards and how to do it.
As a banker with vast experience in both Indian and global, I want to start from the beginning..
3) Framework for financial statements and their evolution and relevance
Terms of Framework for the preparation and presentation of Financial Statements in line with the original document produced in July 1989 by International Accounting Standards Board remain effective for Ind AS and it is a conceptual framework upon which Ind AS is based. Naturally, it defines how the financial statements are to be produced. It is not an accounting standard. The financial statements quoted above are run with the fundamental assumptions of going concern concept and accrual concept for the banks. The qualitative characteristics of financial statements are understandability, relevance, materiality, reliability and comparability. The elements of financial statements are balance sheet and statement of profit and loss.
The elements of balance sheet are assets, liabilities and equity. One is tempted to know how we understand assets or liabilities which would lead us to Ind AS . An asset is a resource, controlled by an enterprise, as a result of past events and from which future economic benefits are expected to flow to the entity. It is strange that contrary to a common man’s understanding, it is expected to help in future. Let us see how a liability is defined. It is a present obligation of the enterprise (in our case a bank) arising from past events the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits. It is strange it talks of today’s obligations meaning we have to pay them today out of our income.
The elements of Profit and Loss are income and expenditure.
- Income represents increases in economic benefits during the accounting period in the form of inflows or enhancement of assets or decrease in liabilities that result in increase of equity, other than contributions from the equity participants.
- Expense represents decreases in economic benefits during the accounting period in the form of outflows or depletion of assets or increase in liabilities that result in decrease of equity, other than distributions from the equity participants.
4) Ind AS and how RBI viewed its introduction in banks
As soon as the government committed to G 20 conference of nations Indian convergence to IFRS, RBI constituted a committee of all stake holders like banks, ICAI, and others to look into the issues that would arise while implementing the Ind AS since it is totally a new deviation from present Indian Accounting Standards and commits to a new approach. Though two committees were constituted by RBI, the second one incorporated all the recommendations of the first and we would deal with the second one only.
After holding extensive discussions with all stake holders, the group structured its recommendations into the following key areas with special emphasis on financial instruments:
- Classification and measurement of financial assets
- Classification and measurement of financial liabilities
- Hedge accounting and derivatives
- Fair value measurement
- Impairment of financial assets
- Presentation of financial statements and disclosure
- DE recognition, consolidation, and other residuary issues
The working group also devised formats for financial statements of banks under Ind AS and application guidance thereon which were also given at the end of the report as annexure. An instrument wise valuation requirements under existing GAAP and Ind AS along with recommendations thereon were also given for guidance. The group also identified the RBI instructions that are at variance with Ind AS 109 and would need change in future.
5) Classification of financial assets
After, initial recognition, as per Ind AS, 109, financial assets may be classified a subsequently measured at (a) amortised cost, (b) fair value through profit and loss (FVTPL) or (C) fair value through other comprehensive income (FVOCI).
Ind AS 109 allows subsequent measurement at amortised cost for debt instruments only if they satisfy both business model test as well as characteristics of cash flow test.
Under business model test, the asset is held within a business model whose objective is to hold assets in order to collect contractual cash flows. Under cash flow test, the contractual terms of financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.
Principal is the fair value of the financial asset at initial recognition. Interest consists of consideration for the time value of money, for the risk associated with the principal amount outstanding during a particular period of time and for other basic lending risks and costs, as well as profit margin. Ind AS 109 explains further how to measure at FVOCI or FVTPL. To implement Ind AS in Indian banks, it may be essential to explain what type of business model and how its performance is reported to the Key Management Personnel. RBI will give detailed guidelines or allow the banks to put up an exhaustive write up to the Board with a copy to RBI as well other stake holders about implementing the new standards.
Interests in subsidiaries, associates and joint ventures would be accounted for in accordance with Ind AS 110: Consolidated Financial Statements, Ind AS 27: Separate Financial Statements, Ind AS 28: Investments in Associates and Joint Ventures. Various issues were raised by banks about classification of financial assets (debt instruments) under amortised cost or FVOCI or FVTPL. Some banks wanted to know whether the current instructions on securities classified currently as held till maturity, Available for Sale or Held for Trading would meet the requirements of Ind AS 109 instructions. It was decided by the working group that RBI instructions in 39 circulars issued earlier as well some legislative amendments for section 15 and under section 29(4) and third schedule need changes to be initiated to implement the new standards. This will be done before April 1, 2018.
6) Classification and Measurement of Financial Liabilities
Ind AS 109 requires initial measurement of financial liabilities at fair value irrespective of the category in which it will be subsequently categorised. It would also include transaction costs that are directly related to the acquisition or issue of the financial liability. Valuation technique is used wherever needed. The following clarifications related to various popular bank financial liabilities were offered in the report:
- Question: Current deposits are basically maintained at zero interest and are always recognised at fair value. The question raised was whether to have fair value of the deposits using valuation technique? Similarly, banks are permitted to offer various rates of interest depending upon banks and their requirements though they do maintain a similar rate throughout the nation. Is there a need to have a valuation technique by comparing market rate?
- Answer: Paragraph 47 of Ind AS 113 states that “ the fair value of a financial liability with a demand nature ( e.g., demand deposit) is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid.” As such, no change from the transaction price is visualised. As regards savings or fixed deposit rates, the banks have been forced by market players to offer the best rate they can afford or as per their requirements over a period of time. It is pertinent to observe that one foreign bank is offering Savings bank deposit interest rate as equivalent to the fixed deposit rate offered for one year by a nationalised bank. In foreign countries, it is not uncommon to sell the deposits on day to day basis and adjust by buying liabilities to make required profits.
- Ind AS 109 provides for two measurement categories for financial liabilities, viz. fair value through profit and loss (FVTPL) and amortised cost. Those who are held for trading are measured through FVTPL while other liabilities are measured at amortised cost, unless fair value option is used.
7) Hedge Accounting and Derivatives
In India, various derivative instruments are permitted and regulated by various bodies like RBI, SEBI and Forward Market Commission (FMC). RBI which issues instructions on hedge and derivative accounting has based its calculations on product specific and therefore conceptually disconnected. In contrast Ind AS 109, instructs all financial derivatives to be measured at fair value irrespective of the derivative product/type. Under Ind AS 109, except for those derivatives which form part of an effective hedging relationship, gains and losses would be invariably recognised in Profit and Loss account. In view of the differing instructions issued by RBI so far, to restrict real profit or loss making by banks, Ind AS 109 categorises all derivatives like interest rate swaps, forward rate agreements, and exchange traded interest rate derivatives to be categorised under FVTPL. To meet the expectations of new standards, RBI has agreed to issue new directions to banks.
8) Fair Value Measurement
As per current RBI instructions, only investments are subjected to fair value measurement. Ind AS 113, has the objective of defining fair value, setting out a single IFRS framework for measuring fair value and specifying disclosures about fair value measurements. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e. an exit price at the measurement date from a prospective of a market participant who holds the asset or owes the liability). Where active markets exist for securities which are quoted in stock exchange and available for exchange, the market prices are to be used for fair value measurement. Expert bodies like FIMMDA may be requested to provide valuation based on market based /market corroborated inputs taking into Ind AS 113 into consideration to ensure uniform application among the banks. Detailed category wise investments, summarised RBI guidelines as applicable today, and Ind AS requirements as well as the recommendations of the working group have been given as annexure in the main report. It is realistic to expect further action at RBI/banks level to implement revised standard requirements.
9) Impairment of Financial Assets
Ind AS 36 defines impairment loss as the difference between carrying amount of an asset and the recoverable amount and is recognised in profit and loss account. Even after the occurrence of heavy floods which damaged a large number of houses and other properties in India, banks did not revalue the assets and make the required loss allowance. Our current procedures provide for the impairment to occur and then step in to rectify the situation. To obviate this “ too little, too late” approach, which is governed by IAS 39, a forward looking “expected credit loss” framework for recognising impairment on financial assets has been developed. RBI has given the detailed analysis which has been quoted from the RBI working group report (page 64, impairment of financial assets, para 6.1, 6.2)
“The IFRS 9 ECL requirements are applicable to all financial assets classified under amortised cost, FVOCI, lease receivables, trade receivables, commitments to lend money and financial guarantee contracts. Initially, on origination or purchase of a financial instrument, 12 month expected credit losses are recognised in profit or loss account and a loss allowance is established (stage 1). Subsequently, if the credit risk increases significantly and the resulting credit quality is not considered to be low credit risk, full time expected credit losses are recognised ( stage 2). Once the credit risk of a financial asset increases to the point that it is considered credit-impaired, interest revenue is calculated after netting the impairment allowance from the gross carrying amount (stage 3).
This contradicts the present RBI guidelines which advise the banks to make provisioning based on criteria established by the RBI, which are predominantly based on days past due concept ( 90 days norm). All the banks currently follow this practice. If this practice is replaced by ECL, the banks may have to provide more loss allowance which may affect the profit and loss account. RBI in consultation with Government of India may allow a few banks who have developed sophisticated credit modelling skills to adopt the new system.
10) Presentation of Financial Statements and Disclosures
The current financial reporting framework for banks is guided by the Banking Regulation Act, 1949 (Section 29 read with the Third Schedule) supplemented by instructions issued regularly by RBI in tune with current Accounting Standards. However, Ind AS on the basis of following standards requires different formats for financial statements:
- Ind AS 1: Presentation of Financial Statements
- Ind AS 32: Financial Instruments Presentation
- Ind AS 107: Financial Instruments Disclosure
- Ind AS 109: Financial Instruments
The working group considered various formats used by international banks incorporated in European Union (EU). After detailed discussion, RBI prescribed the following financial statements to be prepared by the banks:
- Balance Sheet of ——-( name of the bank) as at March 31,—–; Statement of changes in equity of —-( name of the bank) as at March 31,—-
- Profit and Loss Account of ——-( Name of the bank) as at March 31,——
- Notes to Financial Statements ( 25 ) in number
The beginning of this article speaks details of new additions which would transform the reporting standards of banking most since independence. A detailed study of these returns would be undertaken in the future
For the first time like international banks, Indian banks would incorporate details of net gain /(loss) on fair value changes , impairment losses on financial instruments, classification of assets and liabilities under amortised cost, Fair value through comprehensive income, Fair value through profit and loss account etc. These new changes require a bank employee to update, understand and apply new standards reflecting the outstanding levels of excellence achieved by Indian Banks. Previously, we were often quoted the examples of foreign banks for raising our output and show better financial standards. Now with new financial reports based on modern expectations, Indian banks would be forced to follow international standards. Whenever India needs to raise a $1billion or more, our financial reports based on Ind AS would meet international approvals. A person from any part of the world would just look at Indian Banks’ financial statements and would show no hesitation in investing in their ventures. For the fastest growing economy like India, it brightens up its horizon.
- RBI Working group report submitted by Sudarshan Sen, Chairperson vide letter dated September 8, 2015. Report can be viewed from rbi.org.in
- Illustrated Guide to Indian Accounting Standards (Ind AS) by B.D. Chatterjeee and published by Taxmann Publications Pvt Ltd, New Delhi
- Ministry of Corporate Affairs web site http://www.mca.gov.in/MinistryV2/Stand.html
About the author : Subramanian Natarajan C.P.A. (USA), M.Sc., CAIIB took voluntary retirement in 2000 from Punjab National Bank after handling various facets of banking like deposit mobilization, foreign exchange, auditing and borrower accounts. After living in USA for 12 years during which period he worked in international auditing firms specializing in international tax, auditing, IFRS etc. He can be reached at firstname.lastname@example.org. Tel: 7503562701, 9015613229. He currently lives in Delhi. His name appears as tax consultant in web site of American embassy, New Delhi.