1. These are challenging times in many respects. A global financial meltdown in which India cannot escape without hurt, a gruesome terrorist attack on 26/11 on the financial capital of India i.e., our dear Mumbai, politicians’ continuous play and ensuing election and what not. In the field of Accounting and Auditing also we are expected to start a new reporting procedure, namely, IFRS. It is stated to be applicable from 1st April 2011. However in reality, one will have to start looking at the accounts in accordance with IFRS requirements much earlier, say, from 1st of April 2009.
2. In this background, it is thought fit to take a bird’s-eye view of the entire journey from the base of ‘Classical Accounting’ to the present-day IFRS. I do not pretend to be an expert in the field of IFRS. I however, being a Chartered Accountant and forever a student of accountancy, love this subject and it is my intention to have glimpses of the journey right from 1200 to 2008. A study of history is not merely a study of the past events, but often tends to be a proper guide for what is there in store for future.
3. I wish to cover this history as under :
(a) Bookkeeping and accounts for a trader.
(b) Accountancy problems of a machine age.
(c) Stakeholders demanded accounting policies and principles.
(d) Early development of Accounting Standards.
(e) Development of IFRS.
II. Bookkeeping and accounts for a trader :
1. All of us have studied in the first year of college lectures the golden rules of bookkeeping, leading us to various types of accounts. Through the medium of real, personal and nominal accounts, we have also learnt the basis of preparation of ledger account, periodical trial balance and a statement of final accounts, namely, profit & loss account and a balance sheet. These were taught as golden rules of bookkeeping and accountancy and have stood the test of time for approximately over 800 years.
2. The earliest evidence of present-day bookkeeping traces back some 800 years, to an Italian Banker. The Italian monk Luca Paciolo, for the first time documented these bookkeeping principles. He did not claim to be an originator or an author of the system, but only a describer of a practice to write the books of accounts. Even the book that documents this ‘Bookkeeping’ is a book ‘Summa’ which is essentially a book on mathematics, containing some 36 chapters on bookkeeping and accounts. Since it is a part of a book on mathematics, the present golden rules of bookkeeping have been expressed in the said book in the form of algebraic equations and not in descriptive narration. Since every business transaction has a two-way effect, it was easy to put it in the form of an algebric equation. Truly, mathematics is the mother of all sciences.
3. The reason for giving a brief account of the otherwise well-known origin of bookkeeping is to emphasise that :
(a) Certain principles are fundamental and are not subject to the normal notion of ‘Change’.
(b) IFRS is making a sincere attempt to make the figures in Comprehensive Income Statement (earlier equivalent of P & L A/c) and Statement of Financial Position (earlier equivalent of Balance Sheet) more mathematics-based and avoiding hypothetical figures based on assumptions. It involves a lot of valuation, but again the valuation is based on mathematical modules.
4. In any event, the primary objective of bookkeeping and accounts is to understand the results of business operations for a particular period (either positive or negative) and to understand the position of assets and obligations on a given date. Over a period of 800 years of bookkeeping and accounts, this primary objective has also not undergone any change.
5. What has changed over the year however is the trade or commerce in the following aspects :
(a) The nature of trade and commerce
(b) The volume and value of trade
(c) The geographical spread
(d) Entities carrying on the business.
(e) Number and groups of persons who need to know the results of operations.
6. In early days, persons carrying on trade and commerce across the globe were essentially individuals, although they might be undertaking a Caravan in a group. Such an individual was adventurous and enterprising, brave and astute, knowledgeable and intelligent, but was essentially a loner and wanted to know the results of his operations for his own calculations.
7. A simple double-entry bookkeeping for recording transactions manually, leading to the preparation of final accounts of a trader were sufficient for him to take future decisions. He was not required to disclose the results of his operations to anyone except perhaps two other dominant persons, whose patronage as well as blessings were considered important by him. In today’s terminology these two persons could be described loosely as stakeholders. These stakeholders were the kings of the regions he traded in and of course the religious heads of the place he belonged to.
8. The king would demand mostly an ad hoc amount of the booty depending on mutual needs and also the relative power enjoyed. The share demanded in such a case hardly related to the results of operations, but the trader knew his calculations and would pay depending on his business profits.
9. The religious head, on the other hand exercised a lot of moral influence. Through the medium of ‘Confession’ according to the Christianity or in the name of Allah in Islamic traditions or in the name of ‘Dharma’ as per Hindu philosophy, voluntary contributions were made for the cause of religion by traders from time to time. I would, however, not call them stakeholders of a trader, but sharers of the income without there being an obligation to disclose the results of business operations. Essentially, therefore, simple bookkeeping sufficed for the businessman to know for himself where he stood.
III. Accounting problems of machine age :
1. The situation however dramatically changed with the discovery of engines and machineries for the purpose of trade because of the following developments :
(a) Invention of machines creates the possibility of large-scale production. It was never a trading in simplicity, but it turned out to be manufacturing and or processing and trading on a very large scale.
(b) Development of banking system and monetary economics enabling a manufacturer and trader, to have a large volume for which large funds could be availed through multiple credit creation system described by the classical economists as multiplier effect of a bank deposit.
(c) Development of a joint stock company system of organisation creating a two-tier ownership — some people owned and managed a business; the others were passive owners through different types of stock and debt instruments.
(d) Establishment of a rule of law and administrative and judicial system to regulate the legal framework and a judicial system to oversee the administration having a nation-based sovereign sanction.
2. I have just noted the above four contributory factors without any historic elaboration, since our readers are well aware of these historic developments. However, the importance of all the above factors lies in the fact that the number of stake-holders in a business entity increased by leaps and bounds. The bookkeeping results were not only meant for the owner trader or sole proprietor himself, but it was necessary to share the results of operations with larger number of persons. These large number of persons would come from different culture, speaking different language and also due to geopolitical and national differences, held different perceptions based on their own motives and objectives.
3. The mere bookkeeping and accounts was not enough, and the classification of income and expenses, classification of assets and liabilities became more prominent. At the end of the day, it is really a classification between Capital v. Revenue, either income or expenses. The classified capital expenditure occupied the assets side in a balance sheet, whereas the classified revenue expenditure occupied a place in profit and loss statement. Similarly classified capital receipt occupied the liability side of a balance sheet; the classified revenue receipt occupied the credit or income side of Profit & Loss Statement.
4. Although laws were made and the rules laid down, the difference between capital and revenue, either expenditure or receipt has led to volumes of literature since the 17th Century till the beginning even of the 21st Century. So much so that various judicial and legal brains have tried this several times and still would conclude that the differences could be sorted out by long-drawn out arguments and litigations and equally efficiently by the toss of a coin.
5. This acute and fierce fight between capital and revenue arises basically because of ever conflicting interests of the stakeholders. The bare-bodied bookkeeping and accountancy, fully transparent like naked human beings of early civilisation, started wearing clothes and more fancy clothes as the times changed. We have fancy clothes depending on an occasion like party, marriage or other ceremony, official function, sports, evening dress and what not. Similarly, our primitive bookkeeping and accountancy started wearing different clothes. The owner management was interested in showing its best operating results when it came to its own remuneration or when it wanted finance for its operations from financers like bankers or passive owners. It tried to pretend like a pauper when it faced the labour force which got more and more organised or the revenue collecting authorities created by legal frameworks.
IV. Stakeholders demand more transparency :
1. The large majority of passive owner stakeholders, the financial stakeholders were however not satisfied with the skeleton reporting, frauds and manipulations and window dressing of accounts. The owner managers were also equally skeptical in making complete disclosures for various reasons and this created a tug of war, a game of chess between them and selective disclosure followed.
2. The legal framework of a region invariably created an independent agency like that of an Auditor, who specialised in examining the books of accounts maintained in accordance with prescribed legal frameworks, and it really did its job to the best of its ability. The auditing profession has developed and adopted not only auditing procedures and standards but also participated in a great measure even for establishment of common language in accounts through the medium of accounting principles and policies. MAOCARO order in India in the year 1975 is only one such example.
3. In spite of this all-round development, accounting manipulations basically arising as a result of differing perceptions and conflicting interests of various stakeholders did take place from time to time and of various dimensions.
V. Development of Accounting Standards :
1. Land, labour, capital and enterprise were described by economists as the factors of production. Out of these, except for land, all other factors of production were and are always floating and capable of movement. In spite of various restrictions put forward by sovereign authorities, they would like to cross the barriers of any type put forward by any sovereign authority. For its relatively free movement, various stakeholders required that their stakes in a business entity are safeguarded for which the present system of accounting policies and principles are thoroughly inadequate.
2. In order to iron out the differing treatment to the same set of transactions, efforts were made for establishment of sound accountancy principles and policies. Similarly, the auditing profession was also required to adopt sound and well-documented reporting standards. These however were scattered and fragmented efforts and were sovereign-specific. This created lot of problems for the scattered and diversified group of stakeholders and there was a demand for establishment of Accounting and Auditing Standards. As a result of this movement, Accountancy and Auditing Standards Boards were established by each sovereign power.
3. Even in India, ICAI set up its own Accounting Standards Board and started pronouncing Accounting Standards. The initial pace was of course very slow. Other countries specially the European countries set up various functional bodies and started pronouncing what is known as International Accounting Standards (IAS). These standards were not only followed in Europe, but even the Middle East and far-eastern countries also accepted them. The USA however created its own GAAPs and it considered its standards the best in the world. Anyone wanting to do business by using capital or technical know-how of the USA, was forced to convert his accounts in accordance with US GAAPs.
4. The pace of development was however very slow. These standards were initially only toothless tigers and powerful industrial lobbies hardly paid any attention to them, unless the standard was such as would suit their own policy. These AS in India or IAS were mostly based on intentions, permitted alternative treatment and were flexible to an extent to satisfy business entities. On the other hand US GAAPs were more rule-based and on the face of it appeared very stringent.
5. Although the growth of these standards took place, the last decade of the 20th Century also witnessed terrible business failures in the U.S.A. Another related development was that IAS and AS no longer remained toothless tigers, but acquired necessary bite because of legal compulsions.
VI. Development of worldwide IFRS :
1. The first decade of the 21st Century noticed severe expectation gap between the stakeholders and those who managed the business. Sarbanes-Oxley also played its part. Earlier business failures were also bothering everyone and a need was felt to have a worldwide common accounting language, along with stringent corporate governance provisions.
2. Even the US agreed to modify its own earlier tough stand and accepted in principle the worldwide common accounting language and IFRS has now evolved. Our country has also accepted gradual introduction of IFRS, to begin with, for listed companies.
3. We the Chartered Accountants, in the interest of our professional development, are required to accept them, study them and should take part in their proper presentation. There should be neither an ecstasy nor any agony in the use of a common language.
VII. Conclusion of Part I :
1. An attempt is made to give a bird’s-eye view leading us to the present study of IFRS. The language is purposely kept a non-technical narrative with a scope for the readers to read a lot between the lines to fill up the historical details. Essentially, bookkeeping captured business transactions some 800 years back through mathematical module and we are once again through IFRS, embracing in a way a mathematical base for presentation based on what is known as fair valuation. In the next and concluding part, I propose to cover some broader macro issues and some example-based micro issues again in non-technical language.
2. While I am making more noise on mathematics when dealing with IFRS, let me share with you a story about the present financial crisis in a meeting on the Wall Street (Courtesy : Abhijit Phadnis). One person while talking in the meeting in an angered voice stated that after all, 25/5 = 5. An old man attending the meeting challenged the mathematical equation and stated that 25/5 = 14. Still more angered, the young man asks the old guy to prove. The old man comes to the board and explains his equation as under :
25/5 = 14 because
5/5 = 1
25 – 5 = 20
20/5 = 4
so, two divisions give an answer 14.
The young man got wild with this mathematical knowledge and said that 5 X 5 = 25. Prove your equation in a reverse way. The old man once again said that 5 X 14 = 25 as under :
5 x 1 = 5
5 x 4 = 20
5 + 20 = 25
The lighter vein and a bit of a smile on your face apart, the truth is mathematics is pure, but twisted mathematics can give any answer. What has happened on Wall Street and everywhere in the present situation is all-round confusion, giving rise to a crisis which has given rise to erosion in confidence, leading to depression and doom. I only sincerely hope that IFRS does not get caught by twisted mathematicians in the field of fair valuations. Do you get me, my dear friends?
Author/s : Ashok Dhere, Chartered Accountant