IFRS for Private Entities - Research Paper Example

Introduction Understanding the needs of separate IFRSs for private entities (SMEs) is commendable on the part of IASB. It reflects that IASB actually means business in practical sense by spreading the culture of accounting standardization. IASB has already done a great deal of work in this regard and circulated draft standards for SMEs. An effort has been made in this write up to analyze and state in simple terms the provisions of Exposure Draft1 of proposed IFRS for SMEs and other related issues for creating an awareness of the objectivity and practical applicability of these standards. Contents Introduction Need for special reporting standards for private entities (SMEs) Opposition to separate IFRS for SMEs Definition of SMEs Types of simplification introduced Omissions of certain irrelevant topics for SMEs Simplest version of existing IFRS Simplification of recognition and measurement Disclosures required Conclusion References Need for special reporting standard for private entities (SMEs) There is no doubt that accounting standardization among member nations of IASB will provide opportunities to listed companies to enlarge their horizons for raising funds and spreading business activities world over, as their financial statements will be in the same language as are understood in other parts of the world. It is also true that asking private entities (SMEs) to follow same set of regulations, that have been developed keeping in view the needs of listed companies, is like putting extra burden on SMEs. IFRSs are fast becoming the accounting language of businesses. Presently some countries have made it compulsory for all businesses to follow IFRSs irrespective of differences in their sizes, whereas some nations have made the application of IFRS mandatory only for listed companies. Under these circumstances is it advisable to develop a separate set of IFRS for SMEs when already some SMEs are following full IFRS in some nations? The argument in favor of separate SMEs at this stage is that not all the nations have not yet made the application of IFRS mandatory. Even a country like US is still making convergence efforts before the applicability is made mandatory. Secondly demand for separate set of IFRS for SMEs is not the issue that has arisen in 2008. IASB is working on the project since the year 2000. That means demand for separate IFRS for SMEs actually arisen even prior to that. Moreover the objectivity of the conceptual framework is to help IASB in “promoting the harmonization of regulations, accounting standards, and procedures relating to presentation of financial statements by producing the number of accounting treatments permitted by international standards.” (Dr. Philip E Dunn May 2005)2. Continuous discussions on different aspects of the issue were on during all these years and finally a draft of IFRS for SMEs was circulated in February 2007. Accordingly the realization of need for separate SMEs is not a current issue but an issue where already a great deal of work has been done. Hence it must be understood that there is a need for separate SMEs and that need genuinely erupted as soon as it was realized that there should be a common accounting language. It can be analyzed that IFRS for SMEs are not completely different for existing IFRS, but those are filtered IFRS that have practical applicability from the point of view of private entities. Also this development will not entitle SMEs to claim that they are following IFRS, as their version of IFRS would only be an abridged version of complete IFRS. It will also be seen that even this abridged version meant for private entities will be instrumental in creating more comparable and better understood financial statements. The private entities that are already following the IFRS would have done that after realizing the overall benefits of IFRS. Therefore on following the abridged version advantages will be more specific to their efforts and indulgence. Abridged version will also bring in more clarity and efficiency in application of IFRS by private entities. In this respect it is very correct to say that “developing a set of standards for SMEs is consistent with the IASB mission.”(Basis for conclusion SMEs, page 11)3 Opposition to separate IFRS for SMEs Those who oppose separate set of IFRS for SMEs insist that complete IFRS should be applicable to all entities and provide the following arguments favoring this stand: Complexities are not caused by the regulations but by the engineered financial products. If present set of standards are complex then those are complex for all entities and accordingly need to be simplified for all and not merely for SMEs by issuing separate IFRS. Accounting professional will be divided into two sets of experts. Some expert will only be in application and analysis of standards for SMEs, whereas the other will practice the applicability of full set of IFRS. An unprecedented division will be created among accountants. “IASB lacks the power to require any company to use its standards, the adoption of IFRS for SMEs will be a matter for each country to decide.” (Barry J. Epstein and Eva K Jermakowicz, page 45)4 Definition of SMEs ISAB has changed the complete outlook of private entities by defining the SMEs differently. ISAB is considering separate set of IFRS only for those entities those have no public accountabilities. In other words SMEs are entities that have not issued debt and equity securities through public issues; and it do not hold assets in a fiduciary capacity for a broad group of outsiders, for example banks, insurance companies, pension funds, mutual funds, and investment banks. That means size of capital investment or public funding is no criteria. The objective of definition of SMEs is that when the entity is responsible to the public either by way of seeking public funds or otherwise by holding fiduciary assets, then such an entity cannot be termed as SME.. In a way “IASB has drastically simplified the definition of SMEs, stating them to be entities that do not have public accountability.”(Mohan R Lavi, April 12, 2007)5 Types of Simplifications Introduced Exposure draft issued in February 2007 has shortened the full set of IFRS to make it applicable to SMEs. As per an analysis almost 85% of the exiting IFRSs have been deleted to meet the actual requirements of SMEs. It is also believed by IASB that shortened IFRS will typically suit the requirements of SMEs that employs not more than 50 persons. But IASB is also opinion that this shortened IFRS will be technically suitable to very small entities employing only one or two persons. IASB has also taken care of cost- benefit relationships while trimming the IFRS to tailor them for SMEs. Though there are three sets of modifications that have been dealt with by exposure draft but overall simplifications introduced can be divided into five categories as under: Omissions of certain irrelevant topics for SMEs Adoption of simpler version of IFRS where a choice of accountancy police is available. Simplification of recognition and measurement criteria in respect of assets, liabilities, income, and expenses. Requirements of fewer disclosures, and Simplified redrafting of standards Omissions of certain irrelevant topics for SMEs Omission of certain topics from full IFRS is inevitable because “users in a SME environment require less complex and less sophisticated financial reporting since they are less capital market oriented.” (EFRAG, page 2)6Those topics that are generally not applicable to SMEs have been omitted but SMEs can make an application of such omitted standards where the situation warrants their use. Even otherwise the SMEs have option of making a cross reference to omitted topics while using IFRSs for SMEs. This is great flexibility provided to SMEs. In other words it is optional for SMEs to follow omitted topics. But when an SME uses the option to follow an omitted standard, then the principle of consistency demands a regular application of respective standard in the coming financial periods as well. Following is the list of standards that have been omitted for SMES: Hyperinflation: In nations where inflation exceeds 100% over three year period, entities are required to prepare adjusted financial statements with general price level, and that is now not applicable to SMEs. Determining fair market value of agricultural assets Equity- settled share based payment Interim financial reporting Extractive Industries: Exploration expenses will be expensed with. Expenditure on tangible and intangible assets will be dealt as PPE and Intangibles other than goodwill respectively. Lessor accounting for finance leases. Recoverable amount of Goodwill Earning Per Share Segment reporting Insurance: SMEs having insurance business have public accountability and thus they will follow full IFRS. Simpler version of existing IFRS SMEs are allowed to follow simplified versions of certain IFRSs, but they may adopt the laid down version only as per laid down principles of respective IFRS. Under simplified applications of IFRS, SMEs has been given facilities of cross reference of full IFRSs. “In adopting the IFRS for SMEs, an individual jurisdiction could decide not to allow the option that is cross referenced to the full IFRS.” (IASB, 15 Feb 2007)7 The important feature is that SMEs need not declare any accounting policy in that respect. Over and above certain IFRSs are simplified in the exposure draft to enable easy applicability by SMEs. This simplified application is allowed to surpass the recognition of accounting principles envisaged under specific IFRS. IFRS that has been simplified for adoption by SMEs are detailed as under: Cash Flow Statement: The SMEs has the option of not to present the financial statement called ‘Statement of Cash Flows’. Instead they may adopt the indirect method of computing cash flows from operating activities. Under the indirect method, net income is reconciled to cash flows from operating activities. The starting point is net income and three types of adjustments are made. First non- cash revenues are deducted from net income and non cash expenses are added back. Second, gains or loses resulting from sales of investments, property & equipment, or the early retirement of debt are eliminated. Thirdly, changes in the balances of various accrual related accounts, such as accounts receivable, inventory, prepaid expenses, accounts payable, and accrued expenses are added or subtracted. Investment Property: Investment property is the investment in land and/ or building held for the purposes of earning rental income or appreciation value of property over a period of time. SMEs can initially recognize such property at cost. At later reporting dates they may follow costs model or use fair value with value changes effects on profit and loss of the entity. If fair values are adopted then SMEs will have to follow regulations as per IAS 40. Property Plant and Equipments: Initial expenditure to bring the asset to use shall be capitalized. In subsequent period, the entity may use cost model or fair value model. Under cost model depreciation or impairment of carrying value is recognized. Deprecation will be over useful life of asset using the allowed method of depreciation. Impairment will be assessed on each reporting date with impairment loss being charged as expense to revenue. Under fair value model the carrying value is adjusted to fair market value with value effects on profit or loss. The entity will follow regulations as per IAS 16. The asset will be derecognized on disposal or when no future economic values are expected from the asset. Intangible other than Goodwill: Initially intangible will be measured at cost incurred or at fair value when assets swap arrangement are entered into or when intangible acquired as part of business combination. All research and development expenses can be expensed with. However, development expenses can be capitalized only when a commercially viable product is developed. Cost model or revaluation model may be adopted. Under cost model the assets are measured at cost less amount amortized up to the reporting date. Amortization method and useful life of intangible will be reviewed at every reporting date. Under revaluation model is applied as per IAS 38. That means revaluation model is available only when market price is readily available for intangibles. Borrowing Costs: Borrowing costs are interests and other costs on loans and other financial liabilities of the entities. Borrowing costs those occur over a longer period of time may either be expensed with in the period in which those occurred or borrowing costs may be capitalized. When capitalized then that has to be done in accordance with IAS 23. Government Grants: SMEs have to account for all grants or SMEs may measure governments’ grants at the fair value (with effects on profit or loss) of assets that are received or receivable. However, grants that require future performance conditions should be recognized only when those become recoverable and not earlier than that. The regulations of IAS 120- Accounting for Government Grant and Disclosures of Government Assistance are applicable grants are measured at fair value of assets received or receivable. Simplification of recognition and measurement Certain IFRS have been simplified for the application by SMEs. The simplified standards for SMEs are explained here under: Financial Instruments: Simplification in the matter of financial instruments is that SMEs are concerned with only two types of financial assets rather than four types for recognition and measurement of such financial instruments. That means for SMEs there is no botheration about dealings with ‘held to maturity instruments’ and ‘available for sale’ options. The SMEs are concerned with other two types of financial instruments, namely, financial instruments that are financial assets to be recognized at fair value through effects on profits or loss; and loans and receivable. Accordingly the recognition method is now very simple and SMEs do not have to bother about ‘pass- through testing’ and ‘control retention testing’ envisaged under IAS 39. If the transferor has continuing involvement that is considered significant, SMEs do not have to recognize such instruments. IASB believes that SMEs are concerned with following types of risks that require hedging, namely: Interest rate risk involved in debt instruments Foreign exchange risk or interest rate risk arising from firm commitments or forecasts transactions that are highly probable, Price risks in purchase or sale transactions arising from firm commitments or forecasts transactions that are highly probable, and Foreign exchange risks arising from net investments in foreign transactions. The recognition requirement is very simple when compared with recognition method Employed under IAS 39. All that SMEs are to recognize and measure periodically the ineffectiveness of hedges that cover above types of risks. Goodwill impairment Business combinations are to be recorded using purchase method. That means cost of acquisition will be allocation on fair market value of assets that are identifiable including the liabilities. If consideration is more that fair value of net assets acquired the balance will be treated as goodwill. Good will tested annually for impairment on reporting date. Research and development costs SMEs may expenses with all research and development expenses during the period of their occurrence. However, development expenses can be capitalized only when a commercially viable product is developed in accordance with IAS 38 Investments in Joint Ventures There are three types of joint ventures, namely, joint controlled operations, jointly controlled assets, and jointly controlled entities. In case of jointly controlled operations, SME (the venturer) will recognize assets controlled and the liabilities incurred by the SME, and also the income earned and the expenses incurred on joint operations. In case of jointly controlled assets, the venturer will recognize its share of assets and the liabilities incurred by it as well as the income earned and expenses incurred. In respect of joint controlled entities, the measurement will be done using cost method or equity method or proportionately consolidation or fair value method through profit and loss account. So far as transactions between venturer and venture, only the portion of gain or loss attributable to other investors should be recognized. The disclosure about joint venture is required for aggregate amount of commitments. However, contingent liability connected to joint venture should be disclosed separately. Employees Benefits under defined plans Short term employee benefits are measured at undiscounted rate and those are recognized when the services are rendered. Other costs for example annual leave costs are recognized as liability when the services are rendered. Those are however expensed with only when leave is taken. Bonus payable is recognized when obligation to pay arises on the basis of a reliable estimate. Post employment benefits under a defined contribution plan are recognized as liabilities or expenses only when the contributions are made by the employer and employees. On the other hand post employment benefits under defined benefit plans are recognized as liability on the basis of net of present value of define benefit obligation less fair value of assets under the plan on reporting date. Actuarial gains or losses are recognized when they arise. As far as other long term employee benefits are concerned, the present value of those benefit obligation less fair value of assets under the plan shall be recognized. Share based payments Share based payment transactions are settled either through cash or equity. Though equity based payments are not applicable to SMEs under these standards. But for understanding the cash settlements, it is stated that equity settled transactions are measured with reference to intrinsic value. Intrinsic value is difference between fair value of share and the price a party is willing to pay. Intrinsic values are measured on grant day and later on each reporting date with effects taken to profit and loss account. Under cash settlements liabilities are measured and recognized on basis of fair value on three occasions, namely on grant day, on reporting date, and on settlement date. The required adjustments are made to profit and loss account. Finance Leases Under finance lease substantially all the risks and rewards incidental to ownership are transferred to lessee. The main characteristics of financing lease are that ownership is transferred to lessee; the duration of lease is almost for the major part of economic life of the asset; assets that are leased are for specialized purposes; the present value of minimum lease payments are almost equal to fair value of the leased asset; losses of the leasors are borne by the lessee if lease gets cancelled; and risk of residual value is that of lessee. The accounting of finance leases as per IFRS for SMEs is as under: Rights and obligations under finance lease are recognized as assets and liabilities at fair value of the asset. Direct cost to lessee is added to the fair value and recognized along as total value of leased asset. The periodic lease payments are divided into interest and reduction of leased liability. The depreciation on leased asset is calculated over useful life of the asset or leased period. If the sale and leaseback results into finance lease, then excess, if any, is not recognized as profit by the seller. Disclosures required The nature of important and relevant disclosures required under IFRS for SMEs explained here under. The source of this information is Information for Observers8 published by IASB. Disclosures concerning financial statement presentations An explicit and unreserved disclosure shall be made by SMEs that financial statements have prepared according the regulations framed under IFRS for SMEs. Where a SME in its application departs from certain standards for SMEs, then the management of such SME has to make the following declarations: a) That the financial statements of the entity present fairly the cash flows, financial performance, and financial position of the entity. b) That the SME has complied with IFRS for SMEs expect that it has departed in order to present fair financial statements. c) The management has to disclose the nature of departure. It has to explain the reason for non- application of departed standard, and that its application would have been misleading under the circumstances and would have conflicted with objectivity of financial statements. In case SME has departed from a required standard for SMEs in prior period, and such departure is affecting the amounts recognized in current financial period, then it is necessary to make a disclosure explaining the reason for non application in prior period; and that its application would have been misleading under the circumstances and would have conflicted with objectivity of financial statements. There may be an extreme circumstance where management feels that application of a standard would be misleading and conflicting with the objectivity of financial statements. At the same time it is not possible to avoid the application of the standard due to a prohibition on non- application in the standard. Under such circumstance the SME would make a disclosure as under: a) The nature of departed standard will be disclosed along with the reason that application of such standard would have been misleading and conflicting under the circumstances with the objectivity of financial statements. b) The adjustments made by the management in financial statements due to departure of the standard in order to arrive at fair view of financial statements would be explained in the disclosure. When an SME does not prepare its financial statement as a going concern, then a disclosure is required to state the fact that financial statements have been made not as a going concern, and also providing a reason why the SME should not be regarded as a going concern. When there is reclassification of item in financial statements, the SME is required to nature, amount, and reason of reclassification. Comparative information and amounts are required to be disclosed in respect of comparable period. Disclosure in respect of financial statements As usual information regarding name of the entity, change in the name of entity, statements for individual or group of entitles, ending date of reporting period, currency, and level of rounding of are required to be disclosed. Provisions of employees’ benefits and information about classes of capital changes in recognized equities are to be disclosed on face of balance sheet or in notes. A statement of changes in equity showing on face of the statements shall include information about profit or loss for the period, item of income and expense directly recognized in equity separately showing the amounts for parent and minorities, and effect of changes in accounting policies. The entity shall disclose on the face of statement of changes in equity or in notes the amount investment by, and dividend and other distributions to equity holders, balance of retained earning at the beginning and ending of the reporting period, and a reconciliation of contributed capital an income and expenditure directly recognized in equity. Cash flows from interest and dividend received and paid shall be sepeartely disclosed. Cash flows arising from income taxes from operating activities, unless such taxes can be separately calculated for investing and financing activities, shall be disclosed. A management commentary for the amount of significant cash and cash equivalent held by the entity but not available for use due to various reasons shall be disclosed. Declaration in notes to accounts Information about basis of preparation of financial statements and specific accounting policies used Information about standards that is not presented on face of financial statements Additional relevant information that is not presented on face of financial statements A statement that financial statements have been prepared in compliance with IFRS for SMEs. Summary of significant accounting policies applied, and Supporting information in respect of items presented on the face of statements Conclusion Exposure Draft issued by IASB is a revolutionary step because ED “if implemented will radically change accounting for SMEs and is in effect acceptance by the IASB that full IFRS are not appropriate for the non- publicly accountable entity.”(Liam McQuaid)9 The ED provide options to SMEs to deal with different situation with facility of cross reference with full IFRS; but when the option of full IFRS is to be followed the SMEs will be required to adhere to full respective IFRS. Modifications also include a great deal of omissions from full IFRS that are not relevant to small entities being non- public oriented organizations. Still there may be difficulties in accepting these IFRS for SMEs by different nations as is being experienced in convergence of IFRS with local standards. References Read More