Law of the land over-rides accounting standards

ACCOUNTANCY

The preparation and presentation of financial statements involve aggregation and disaggregation of accounting data. Appropriate presentation of accounting information in financial statements enhances the information value to users of financial statements. Therefore, accounting standards and regulators stipulate the format and/or principles for the preparation and presentation of financial statements.

The presentation of financial statements by firms in India is governed by Accounting Standard (AS) 5 and Schedule VI of the Companies Act, 1956. As a general principle, the law of the land over-rides accounting standards. Therefore, Schedule VI overrides AS-5 to the extent the principles stipulated in AS-5 are in conflict with the requirements of Schedule VI. Although Schedule VI is applicable to limited liability companies only, it has become the benchmark for other entities.

Accounting principles and approach have changed significantly since the last revision of Schedule VI. Therefore, it is necessary to revise the schedule.

As the Institute of Chartered Accountants of India (ICAI) has decided in favour of complete convergence of Indian accounting standards with the International Financial Reporting Standards (IFRS), effective from April 1, 2011, the government should revise Schedule VI in the light of IAS 1 and other relevant international accounting standards. There are some major differences between the principles stipulated in IAS 1 and those stipulated in the Indian GAAP. Application of IAS 1 will definitely improve the presentation of financial statements.

Schedule VI does not require a company to classify assets and liabilities into current and non-current categories. IAS 1 requires an entity to present current and non-current assets and current and non-current liabilities as separate classifications on the face of the balance sheet except in certain circumstances.

IAS 1 defines an asset as current asset if the management expects to consume or realise the same within the normal operating cycle or within twelve months after the balance sheet date, whichever is longer.

Current assets include cash and cash equivalents, and assets that are held primarily for the purpose of being traded. If the normal operating cycle is not clearly identifiable, its duration is assumed to be twelve months. Operating cycle is the time between the acquisition of assets (e.g. raw materials and components) for processing and their realisation in cash or cash equivalent. Normal operating cycle may be perceived to be a process and an asset (other than cash) which is in that process is a current asset. If it is outside the process, it is a non-current asset.

For example, non-moving and slow moving stock is outside the process of operating cycle and, therefore, should be classified as a non-current asset. Similarly, receivables that are not expected to be collected within the normal operating cycle or within twelve months after the balance sheet date, whichever is longer, should be classified as non-current asset.

However, in India, total inventories, including slow moving and non-moving items, and total receivables are classified as current assets.

Schedule VI requires assets to be classified as fixed assets, investments and current assets. Assets that cannot be classified either as fixed asset or investment are classified as current assets. In the balance sheet format provided in Schedule VI, "current assets, and loan and advances" are classified together. It is assumed that all loan and advances are short term. This is inappropriate. Loan and advances that are recoverable after twelve months after the balance sheet date should be classified as non-current asset.

Similarly, deposits that are recoverable after twelve months after the balance sheet date, such as deposits with customs and other authorities, should be classified as non-current assets. An analyst should be conscious that all items are classified as "current assets, loans and advances".

In India, investments are classified as current investments and long-term investments. In analysing financial statements, current investments should be included in current assets.

Until Schedule VI is amended, companies should provide additional disclosure on current and non-current assets and liabilities. This will improve the transparency in financial reporting and add information value to financial statements.

Indian companies, except a few, are quite reluctant to disclose information voluntarily. They do not want to disclose more than what the minimum is required by accounting standards or regulators. The mind set has to change.

"Transparency" should be the guiding principle. Moreover, Indian companies should start disclosing information that is required to be disclosed by the IFRS and not by the Indian GAAP voluntarily; and if possible they should present financial statements prepared using the IFRS, as a part of voluntary disclosure. This will reduce the pain of transition from the Indian GAAP to IFRS.