In the next two years finance departments in listed companies will have to ready their firms to report consolidated accounts in compliance with International Financial Reporting Standards (IFRS).

LBR’s Shamindra Kulamannage discussed the possible challenges of this transition with V Venkataramanna an accountant and Executive Director of a ‘big four’ accounting firm, KPMG, in India.

LBR: We know this transition to international financial reporting standards has to happen in Sri Lanka in one year for listed companies, what do you think are going to be the broad impacts on listed firms?

A: I think it’s clearly inline with what companies across the world, and countries across the world are doing. It will bring Sri Lankan companies in line and in sync with what’s happening across the world. Nearly 100 countries have committed to IFRS.

The second wave of IFRS transitions, so to speak, is happening in 2011/ 2012 across various countries. So I think firstly, it’s a good to have common accounting standard or framework.

Having said that, to move to IFRS’s is a significant movement. It could impact companies either positively or negatively, depending on their current accounting policies and practices.

LBR: If companies approach this as something the accounting department or its financial director has to deal with, are they missing the broader picture? Are there going to be impacts in a broader spectrum, say concerning directors or senior management for instance?

A: Companies across the world in their move to IFRS has made this one mistake of viewing this as a financial accounting project when indeed the effects of the IFRS transition are far more pervasive.

Take for example, something like employee compensation, you setout for instance compensation for someone who dose a certain task, you give him a bonus. Under IFRS that targeted or bonus can change. There are also commercial implications, things for examples like loan covenants; how you measures debt to equity ratios in IFRS it’s quite different from how would you have done previously. You need to make sure that you are managing the expectations of all of these stakeholders as you go through this process and certainly not viewing it only as an accounting project.

LBR: The accounting standards coming out in the last three or four years have been largely unidentified by non accountants for their focus on fair value. Is this a fair representation of the new standards? Do they have an overwhelming focus towards fair value and what does this mean?

A: I think this notion is slightly overplayed. There are many parts of IFRS which do not represent fair valuation at all. For instance, if you have any land, building, plant or machinery there is no need to do any fair valuation in IFRS. Quite often as you said, people tend to think about IFRS as being only about fair valuation. There is fair valuation make no mistake about it. But it is restricted only to areas where fair valuation is perhaps most meaningful. For instance, if you are buying a business, there is always a need to fair value that business combination or acquisition.

If you a reader of the financial statement, you should know what you are paying for, you should know how much you are paying and IFRS only asks you to do that. To that extent, fair valuation is used in financial instrument, business combinations, in ESOPs. In a few select areas, these areas are the most relevant, frankly for a reader of financial statements, there are many areas also where fair valuation is neither required not mandated in IFRS.

LBR: You briefly discussed IFRS and its impact across the spectrum of managers and strategic players in a company. If you focus on the board, how should a board of directors approach this transition to IFRS?

A: I think the first and probably most important step is that the board of directors need is to increase their level of awareness of what the IFRS rules and standards are and what does it mean for their respective companies. We have to appreciate, while boards of directors have a very good understanding of what their underlying businesses are, they also need to know how they are going to be measured in a go forward basis. So to that extent I think awareness is very critical.

The second area that a board can play an important role in is making sure the right kind of leadership; make sure the entities approach IFRS with the right level of seriousness. If they were able to do that they would have discharged their duties.

Also bare in mind, if you are in a audit committee in the board of directors looking at IFRS financials for the first time, you need to familiarize yourself with how that set of financials are going to look like, otherwise how you are going to provide that level of value that you will provide to management to auditors and so on, unless you’re yourself familiar and comfortable with what IFRS is.

LBR: If you look at the spectrum of listed companies that may be impact by this transition. There are banks to construction firms to manufacturing firms. Some of these companies may find that their current account practices are very much in sync with IFRS. Where do you think the surprises will come from? What industries will throw up surprises for us?

A: I think in general level IFRS is very much focused on balance sheet valuation. So to that extent you will find that most of companies, for example brokering companies which provides cleaning services or maintenance services, those companies will not be affected by IFRS. But asset heavy companies weather it’s a manufacturing concern which has lot of plant and machinery whether it’s a bank for instance which has lots of assets, these are the companies which are technically affected the most by IFRS. Because even a slight change in how theses assets and liabilities are recorded can effect the profitability more than you may imagine.

Then you also see for instance specific sectors where guidance in IFRS is very specific. Things like real-estate development, pharmaceutical research and development based industries, IT and software companies, the banking and financial services sector; these are the companies where you will see more significant impacts based on past experience.

LBR: Banks are deleing with the impact of two particular international accounts standards IAS 32 and 39 dealing with financial instruments. Looking at the experience in India, for intense, with these tow standards and their implementation, how do you think banks should approach this challenge broadly?

A: I think the challenges that you alluded to is also because these standards are quite complicated. So to start off with people are uncomfortable just reading the standards itself. There is a lot of terminology and jargon in these standards. So you do need to cut through all of that to get to the heart of these standards.

My suggestion would be that banks need to quickly deal with these standards because they are not going to go away. But at the same time you need to realize that you need to fairly pragmatic approach to the principals that are set in these standards.

For an instance not everything in those standards is been written for a Sri Lankan context. So you need to think about how you need to adapt those standards to local context. You should do so in a manner that is feasible to do on an on going basis. Certainly I don’t think either the standards centers or the central bank wants a situation where you just have a theoretical construct around how these standards are applied.

But it does also mean practically that at the heart of the business of a bank, for example lending, is likely to be significantly impacted by the application of these standards. Today for instance the way a non performing loan is recognized in the Sri Lankan banking sector is based on set of rules based on number of dates passed due. IFRS or SLAS 41, 45 which is a local standard, focuses much more on the application on judgment by a bank to determine that. Judgment is a number of factors, its difficult to document, its difficult to consistently apply across an organization itself and certainly even across a sector. So I think there are significant challenges facing banks in this context and I think earlier they start to deal with it the better their position will be.

LBR: Anything you want to add to round off the discussion?

A: I think this is a step in the right direction. We should not overstate or understate the challenge. Its an important one and for Sri Lankan companies to be viewed as full players in the world stage, so to speak, they do need make sure that they recognize the importance of also reporting from a financial perspective in a language the world is increasingly speaking in. It’s a challenge and people need to work through it in a systematic and sensible manner.