The other day while chatting with some of my accountant friends and budding managers, I realised that some issues regarding IFRS were bothering them. A question that came up time and again was whether it’s possible for a regulator to monitor compliance of ‘principle-based accounting standards’. Some felt that compliance of rules can be monitored more effectively than monitoring compliance of principles.
There cannot be two opinions on that. But the question is whether ‘effectiveness of monitoring by regulators’ should be the guiding principle in formulating financial reporting standards. It should not be. Managers need flexibility in formulating accounting policy because firms operate in different business environments and, it is difficult to formulate a general set of accounting rules that fit all the firms, even if they are operating in the same industry.
Moreover, while compliance of accounting rules can be monitored more effectively, rule-based financial reporting standards provide significant opportunities for accounting engineering and thus provide huge scope for managing financial statements. Therefore, after the Enron episode, all concerned with financial reporting standards debated the issue vigorously and came to the conclusion that principle-based accounting standards are superior to rule-based accounting standards.
Also, today business models change fast, resulting in rapid innovations in structures of contracts and transactions. Financial reporting standard setters take notice of those innovations only when substantial number of firms start using the new structures of contracts and transactions. This delays rule-formation. Another reason for significant delay in framing new rules is that the due-diligence process that standard-setters follow is quite lengthy, although necessary.
Therefore, standard-setters lag much behind management innovations. Principle-based accounting standards set out accounting principles and thus, obviates the need for change with every change in the structure of a contracts/transactions. I believe the debate on whether principle-based accounting standards are superior to rule-based accounting standards is closed.
Another question is whether international financial reporting standards are principle-based or they are rule-based. Some argue that IFRS is close to rule-based accounting standards because each standard provides detailed application guidance and illustrative examples. While application guidance forms part of the financial reporting standard, illustrative examples do not form part of the IFRS. While application guidance forms part of the financial reporting standard, illustrative examples do not form part of the IFRS.
The guidance and examples should not be perceived as rules. Those are provided only to facilitate understanding of the principles stipulated in the reporting standard. It is true that if transactions in any of the examples exactly match with the transactions under consideration, it is easy for us to implement the reporting standard.
However, if none of the illustrations match with the transactions under consideration, we should not stretch to apply methods applied in those examples directly to our business situations and transactions. This is likely to impair the true and fair presentation of financial position and operating results. We should formulate methods that comply with accounting principles stipulated in the reporting standard. Rule-based accounting standards seldom allow this flexibility.
IFRS-3, which deals with accounting for business combinations, may be a case in point. IFRS-3 is applicable only to transactions involving acquisition of business. In case of acquisition of a group of assets and liabilities, which is not a business, the purchase consideration (i.e. the acquisition cost) is allocated to individual assets and liabilities in proportion to their respective fair values at the date of purchase.
In that case, the question of recognition of goodwill etc. does not arise. Therefore, the first step to account for a transaction involving acquisition of a group of assets and liabilities is to determine whether the acquisition constitute a business. IFRS-3 provides application guidance. According to the guidance, a business consists of inputs and processes applied to those inputs that have the ability to create outputs.
It provides details guidance and further stipulates that in determining whether a particular set of assets and activities is a business should be based on whether the integrated set is capable of being conducted and managed as a business by a market participant. Thus, in evaluating whether a particular set is a business, it is not relevant whether a seller operated the set as a business or whether the acquirer intends to operate the set as a business.
The guidance articulates the factors, which should be considered to evaluate whether an integrated set of assets and activities is business. Application of this guidance requires judgement. This set of guidance cannot be equated with rules. It cannot be applied directly to any transaction.
It is the fiduciary duty of the board of directors to timely issue financial statements that present a true and fair view of the financial position, operating results and cash flows of the company. The board has to apply its mind collectively to formulate the appropriate accounting policy that complies with IFRS.
It should also ensure that the accounting policy is applied correctly in the preparation and presentation of financial statements. Although, formulating the accounting policy and monitoring its implementation come within the purview of the audit committee, other members are not exonerated from their fiduciary duty because they are not members of the audit committee.
Therefore, it is important that all the members of the board should acquire literacy in IFRS. It is a tough task to train reluctant adults, but it is worth taking that initiative.
