Ernst & Young’s view on the path toward a single global accounting standard

Ernst & Young believes there should be a single set of high quality global accounting standards adopted globally, and Sri Lanka should not be left behind. Convergence with International Financial Reporting Standards is an important step towards this goal.

Hence the introduction of new Sri Lanka Accounting Standards (Sri Lanka Financial Reporting Standards, comprising of SLFRSs and LKASs) equivalent to International Financial Reporting Standards by the Institute of Chartered Accountants of Sri Lanka is considered a gigantic step taken towards transparency in financial reporting. 

Application of Sri Lanka Financial Reporting Standards is mandatory for all entities from 1 January 2012. This has given rise to a number of concerns regarding the impact of the new principles on operations of the entity’s any how they will be reflected in the financial statements. Managing expectations of shareholders, employees, financial analysts, and maintaining debt covenants will be some of the key issues in 2012 for most CEOs.

Assurance Leader of Ernst & Young, Manil Jayesinghe says: “The biggest governance challenge facing most of the listed companies in Sri Lanka in recent times will be the conversion to Sri Lanka financial Reporting Standards. Although a handful of companies have commenced work on the conversion, most of the companies are still labouring under the illusion that Sri Lanka Financial Reporting Standards is not much different from current accounting standards. But nothing is further from the truth.”

He adds: “Among the key issues for boards and CEOs is how to monitor the quality and integrity of companies’ internal conversion process, and how to ensure that the communication to investors of the impact of SLFRS on reported results does not have an adverse share price impact that is not justified by the underlying facts.”

Jayesinghe stresses that it is imperative that Board of Directors, Audit Committees and Key Senior officials need to understand the implications of accounting requirements on the business organisation. They need to gear up the operational teams to face the consequences of accounting reporting. Further, organisations should not pass up the opportunity presented through the conversion in strategically steering the entity to maximise the benefits.

Challenges

The fact that many of the standards are new, and the interpretations and guidance on them are evolving further complicates the matter and increases the implementation risk, while the increased earning and equity volatility that arises from the fair value approaches required by the standards increases the investor relations risk.

A glimpse at what is ahead

• Application of accounting standards requires input from various business units as opposed to the traditional method of application of accounting standards by the finance department.

• Currently entities apply accounting requirements to the trial balance in preparing financial statements. With the new accounting standards this will not be feasible. It will be necessary to reengineer business processes and IT systems to capture data at the initiation of transactions.

• The application of certain accounting principles will heavily involve expertise in order to comply with measurement requirements.

The role of the Board and Audit Committees

Who is responsible?

Although no board would deny that it has ultimate responsibility for the quality and integrity of the financial statements and with the new financial reporting requirements, the SLFRS conversion. It would be the responsibility of Boards to manage the impact and most importantly to communicate such impact to the capital markets and manage expectations. Our experience is that there are very different views among boards and audit committees about how this responsibility should be discharged.

The more commonly held view, however, is that audit committees must understand the rationale behind management decisions for selecting particular accounting policies, in addition to understanding and monitoring the process.

As one chairperson put it, “The accounting change is huge. Significant resource is needed. Internal controls need to stand up to these new standards.” Another explained, “As audit committee chair, I have been interested in this as a communication process. There is also a behavioural component about how to manage the company differently.”

IFRS conversion is far more than a technical accounting exercise

Clearly, it is important for the board to be confident that the finance personnel in the group have an appropriate degree of SLFRS financial competence, that appropriate guidance on the application of the company’s SLFRS accounting policies is made available, and that the SLFRS conversion project is well planned and managed. 

However, the responsibility of board members goes beyond monitoring the IFRS conversion process.

Conversion is not just a technical accounting exercise because it may have significant impacts on the way companies operate and how SLFRS may affect transaction structures.

For example:

• Sales contract pricing may include embedded derivatives that need to be accounted for separately.

• Information systems must be able to collect data to meet the new accounting recognition and measurement requirements in relation to revenue recognition on long term contracts or components of fixed assets previously regarded as single assets.  

• Treasury operations and systems may be affected by the highly prescriptive SLFRS hedge accounting rules. Far greater use of valuation models, together with the data required and the assumptions to be employed, will be required in order to apply SLFRS.

• Pensions, share-based payments, asset impairment, and financial instruments will all require the use of models and assumptions about future performance and cash flows.  

• Capital instruments previously classified as equity may have to be classified as debt under SLFRS (or bifurcated with an element being treated as debt and the balance as equity), thereby affecting gearing.

Of great importance for senior management and boards, the accounting recognition and measurement changes brought about by SLFRS will affect the measures used by companies and investors to assess the performance of companies and, as a consequence, may lead to a realignment of management’s performance targets and performance-related remuneration. Boards will have to assess the impact of the changes resulting from SLFRS on dividend policy.

Boards need to understand the significance of these issues in order to assure themselves that management has addressed them properly. For example, boards or their audit committees need to be able to assess the appropriateness of the assumptions used by management, as quite small adjustments to the underlying assumptions may give very different results.  

It is therefore essential that those charged with governance should develop a good understanding of the organization’s approach to conversion and receive regular progress reports and summaries of key issues.

Are you already late?

Management in every company will be responsible for the operational planning and implementation of the SLFRS transition, but ultimate responsibility lies with those charged with governance. Time is fast running out for boards which have not so far played their full role.