To have or not to have IFRS: CB should not make hasty decision

Monday, 9 March 2015 00:10 -     - {{hitsCtrl.values.hits}}

Dropping IFRS should not be an arbitrary and hasty decision to be made by the Central Bank’s current management. Before they reach such a decision, they should listen to both sides and that should be a part of Central Bank’s good governance     Blaming IFRS for CB losses After the ‘My View’ titled ‘Questionable Governance when loss incurred CB has made a profit transfer to the Government’ was published last week (available at: http://www.ft.lk/2015/03/02/questionable-governance-when-loss-incurred-cb-has-made-a-profit-transfer-to-government/), several readers have raised two issues with this writer. One is whether the loss incurred by CB in 2013 has been due to its following International Financial Reporting Standards or IFRS as its accounting template. The contention here is that had CB prepared its financial statements in terms of the provisions in the Monetary Law Act or MLA, there could not be a loss as reported. The other is whether IFRS which is meant for profit seeking commercial enterprises is relevant to a central bank. In view of this, it has been suggested that the Central Bank management should seriously consider dropping IFRS as its accounting template. Both these questions are valid and merit further discussion. A discussion of the subject is especially important because these arguments can penetrate the thinking of the top officials of the Central Bank and persuade them to drop IFRS as the Bank’s accounting template.   Losses are not what the P & L account shows but depletions in net-worth The answer to the first question is that IFRS or for that matter any other accounting template used by the Bank has nothing to do with the losses incurred by it in 2013. Losses are the outcome of structural weaknesses of the Bank and not of the reporting format. The format only correctly captures the picture. The argument that losses arise from the accounting template being used is faulty. That is because it wrongly presumes that losses are numbers that arise in the profit and loss account – in the case of the Central Bank, the Income Statement – of an organisation. If this account generates a surplus, then, it is considered as ‘profit’ adding value to the organisation. By the same token, the losses would bring the opposite results. However, in advanced accounting theory, profits or losses are to be ascertained from the changes in the net-worth of an organisation and not merely from its profit and loss account. Any increase in the net-worth represents the profits made by it and any decrease in the net-worth is the losses it has made. This is because the profit and loss account is only an intermediary account whose results are fed to the net-worth of the organisation in question.   MLA procedure in calculating profits need updating When the procedure laid down in the Monetary Law Act is followed in preparing the financial statements, the revaluation losses or the surpluses of the external assets of the Central Bank do not go through its Income Statement. Instead, they are directly debited or credited to a special account titled International Reserve Revaluation Account or IRRA which is a part of the net-worth of the Bank. If there are revaluation losses, then, those losses do not affect the profit figure in the Income Statement but they cause the net-worth to decline indicating that the Bank has in fact made a loss. Therefore, it is not the accounting template which should be blamed for the losses of the Central Bank but its structural weaknesses.   Sterilisation of revaluation losses and profits by John Exter It is important to examine why John Exter, the architect of the Central Bank, had this special procedure provided for in the Monetary Law Act. As explained by Exter, the purpose is to sterilise such profits or losses thereby preventing the Central Bank from using them for credit expansion in the economy. Says Exter in his report on the establishment of a central bank: “The purpose of this clause is to provide that all profits and losses of the Central Bank resulting from the changes in the par value of the Ceylon rupee or from changes in the parities of the exchange rates of other currencies with respect to the Ceylon rupee should be sterilised. (....) These are actually book-keeping profits and losses which the Central Bank in effect assumes for the country as a whole” (p 23). Thus, such profits are kept out of the reach of the Central Bank administration or the government. Accordingly, they cannot be used for credit expansion or for paying out to the government as profit transfers. If there are losses, they cause to reduce the net-worth of the Bank needing further infusion of capital. Hence, though revaluation losses are not posted to the Income Statement, the end result is a loss that cannot be used by the Bank for appropriation.   IFRS has added value to CB The second question whether IFRS are relevant to a central bank was debated extensively and intensively within the Bank when it went for International Accounting Standards or IAS in 2001. When the Bank embarked on its modernisation project in 2000, one issue before it was how to present the financial statements acceptable to all its stakeholders, especially those prospective investors in any bond which Sri Lanka would issue in the international markets. The first thing which any investor would do when Sri Lanka offered to issue a sovereign bond in the international markets was to look at the financial accounts of the country’s central bank. This is because the repayment of government’s public debt is being guaranteed by the Central Bank and if the Bank does not maintain its accounts in accordance with globally accepted accounting practices, such guarantees would simply become mere words of the Central Bank managements. Thus, if the Central Bank did not follow an acceptable accounting template, it would be hard for the country to sell its financial credentials to prospective investors. As such, it was necessary for the Central Bank to gain that capability by adopting a suitable accounting template.   Before IFRS, CB had an unreliable accounting system Up to that time, the Central Bank had been presenting its financial statements strictly in accordance with the provisions in the Monetary Law Act. Accordingly, a simple accounting procedure had been adopted by the Bank just to ascertain the surplus after deducting its operational expenditure from the annual revenue. The assets of the Bank had not been depreciated according to the standard rates. Debtors had been carried in the books forever without analysing the age profile or the recoverability of the debt owed by them. One example pointed out was the case relating to the bankrupt finance company, The Mercantile Credit. The Central Bank had advanced in late 1980s a substantial amount of money to this company in a bid to resuscitate it. But the company could not be brought back to business and as a result, these advances had become non-performing. Yet, in the books of the Bank, the outstanding amount had been carried forward without charging it to the income of the Bank. Thus, the assets of the Bank had been overstated but the accounting system adopted by the Bank did not require it to do so.   Intensive and extensive consultation by the Steering Committee on CB modernisation These matters were taken into account by the Steering Committee that implemented the modernisation project under this writer’s chairmanship. It had two alternative options to follow. One was to adopt the Sri Lanka Accounting Standards, code-named LKAS. But, LKAS had not been upgraded to a level acceptable to the international community. The other option was to accept the International Accounting Standards, known as IAS, as the Bank’s accounting template. The Steering Committee had wide consultations with local and foreign experts on the usability of IAS by the Bank. The long period spent on such consultations was considered necessary since the Bank was to move into a completely different accounting framework and the decision had to be taken after considering all the facts for and against such a move.   The alleged irrelevance of IFRS to CB There were several areas where it was pointed out that IFRS was not relevant to a central bank. IFRS were meant for commercial ventures but central banks differed from them significantly. The main area of contention was that central banks could acquire assets just by assuming a liability which any other commercial venture did not enjoy. As such, there was no meaning or relevance of a cash flow statement in a central bank. Since a central bank could acquire assets simply by assuming a liability, it could also make any amount of profits just by resorting to that practice. For instance, when a central bank invests in a Treasury bill, it earns an interest income. But to invest in a Treasury bill, all what a central bank has to do is to make a simple ‘double-entry’ book entry. It can credit the government account with the value of the Treasury bill and debit its Treasury bill holding account. But this would lead to creating new money in the economy that would be used by commercial banks to create multiple deposits and credit. Thus, the total money supply created in the economy over a period of time would be much larger than the initial creation by the central bank. That would lead to inflation and therefore, a central bank is in a position to make profits by inflating the economy. A normal commercial venture is not capable of doing so. It was pointed out that IAS was not capable of accommodating this particular feature relating to a central bank.   Main areas of disagreement with IFRS Another area of contention was how to treat the profits or losses arising from the revaluation of foreign assets of a central bank. IAS 21 treated them as ordinary profits or losses because it was indeed the case with commercial enterprises. But central banking laws, as explained above, had special provisions to sterilise them so that central bank managements or governments could not grab them for use. Similarly, IAS had not recognised the need for making special reserves by central banks in order to give additional cover for the demand liabilities – currency and demand deposits of banks and government institutions – in the event of an unexpected depletion of the foreign assets held by them. Further, IAS 39 required the fair value presentation by bringing assets to current market value but central banks traditionally preferred to carry them at historical costs to prevent arbitrary revaluations and allow governments to siphon off the unearned profits of central banks. It was mandatory under IAS to prepare cash-flow statements but such cash-flow statements were meaningless in the case of central banks which did not have cash shortages due to their ability to acquire assets by creating liabilities.   Practical way to overcome disagreements Despite these differences, IAS also had many beneficial outcomes. They required the Central Bank to maintain proper documentation, especially in connection with trading and derivative products, follow international good practices with regard to trading and compliance and detailed disclosure of sub items in the balance sheet, called the Statement of Financial Position, and the Income Statement. This would prevent the central bank management from abusing its powers either for personal gain or for delivering unwarranted favours to political masters. In addition, there were intricate risk management practices that were also introduced as a part of the IAS package. Further, the Steering Committee found that the differences outlined above could be tackled without sacrificing the spirit of both central banking and international accounting standards. Accordingly, a separate profit and loss account and a balance sheet were to be prepared by following the provisions in the law to meet statutory obligations. But to the outside world, it was the IAS based accounting template that was to establish the Bank’s financial and operational credibility.   IFRS is not alien to central banks There are many central banks in the world which have adopted IFRS as their accounting template. A report prepared by international accounting and audit firm, KPMG, under the title ‘Current trends in central bank financial reporting practices’ in 2012 has examined the financial statements of 18 central banks. According to the report, six out of 18 central banks had followed IFRS while four had followed IFRS based accounting templates. In the region, the new central banking acts in Nepal and Bhutan have required by law the adoption of IAS as the accounting template by the respective central banks. Hence, IAS templates, now called IFRS templates, are not alien to central banking accounting.   Dropping IFRS by CB leads to a suboptimal decision If the Central Bank of Sri Lanka chooses drop IFRS as its accounting template, there are two options available to it. One is to adopt the Sri Lanka financial reporting standards, called SLFRS and LKAS, issued by the Institute of Chartered Accountants and fully convergent with IFRS and IAS, respectively (available at: www.casrilanka.com/casl/index.php?option=com_content&view=article&id=235&Itemid=339&lang=en ). The other is to go back to its primitive method of preparing financial statements in terms of the Monetary Law Act which was enacted as far back as 1949 and did not foresee the developments that have taken place in financial markets and central banking since then. If it goes for the second option, it has to add all the good features that are there in IFRS in order to win the acceptability from its stakeholders. Then, it becomes wholly the continuation of the current practice. It need not go for the first option since it does not make any difference to its accounting framework in view of the full convergence of the SLFRS and LKAS with IFRS and IAS, respectively. Further, if the Bank drops IFRS at this stage, it will certainly create doubts about the financial strength of the Central Bank among its stakeholders. The Bank should not risk this at this stage.   IFRS will strengthen CB credibility The financial strength of a central bank is considered as essential for its independence and its independence is essential for it to attain its objectives of price stability and financial system stability. A proper accounting framework will ensure both. Further, it will prevent the central bank managements from abusing their powers and misleading the public through creative accounting techniques. This is what the community expects from the Central Bank of Sri Lanka. Hence, dropping IFRS should not be an arbitrary and hasty decision to be made by the Central Bank’s current management. Before they reach such a decision, they should listen to both sides and that should be a part of Central Bank’s good governance. (W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)

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