“The uniqueness of IFRS for SMEs” by Maria Madeira R. Vestil (June 20, 2011)

SUITS THE C-SUITE By Maria Madeira R. Vestil
Business World (06/20/2011)

The International Accounting Standards Board (IASB) developed International Financial Reporting Standards (IFRS) to provide companies worldwide with reliable, consistent standards for financial reporting.

However, the IASB also recognizes that organizations, such as small- and medium-sized entities (SMEs) that are not publicly accountable, have significantly different reportorial requirements.

IFRS can be complex and costly to implement for private companies, which is why the IASB has provided a subset of rules, called IFRS for SMEs.

In the Philippines, the Securities and Exchange Commission (SEC) requires SMEs to comply with the Philippine Financial Reporting Standard for SMEs (PFRS for SMEs). This is the Philippine equivalent of IFRS for SMEs that took effect on Jan. 1 last year, unless a company was exempted by the SEC.

The SEC defines SMEs as: entities with total assets of between P3 million and P350 million, or liabilities of between P3 million and P250 million; entities that are not issuers of securities to the public; are not in the process of issuing any class of instruments in a public market; and are not holders of secondary licenses issued by regulatory agencies.

Exempt entities include companies that report under PFRS for group reporting purposes, such as subsidiaries of parent companies reporting under PFRS and subsidiaries of foreign parent companies moving towards IFRS.

The key difference between full IFRS and IFRS for SMEs is that the accounting requirements for assets (property, plant and equipment; investment property; intangible assets; and borrowing costs) have been simplified under the standards set for SMEs.

Property, plant and equipment

Property, plant and equipment (PPE) are measured at cost, less accumulated depreciation and impairment losses.

Under full IFRS, an entity may opt to use the revaluation model for PPE where the assets are carried at fair value, less accumulated depreciation and impairment losses. “Fair value” is defined as the market value of the asset, normally determined by professional appraisers.

By limiting the measurement to the cost model, SMEs need not spend on obtaining professional market revaluation to ensure that the carrying amounts of these assets do not differ materially from the fair value of the assets at the end of the reporting period.

And since there are no fair value changes in these assets that affect the profit or loss statement of an entity, there is also less volatility in financial reporting.

Investment Property

Investment property is property (land or building, or part of a building or both) held by the owner or by the lessee under a finance lease to earn rentals or for capital appreciation or both.

In IFRS for SMEs, if the fair value of investment property can be measured reliably, without undue cost or effort on the part of management, an entity carries such property at fair value, with changes recognized in profit or loss.

Otherwise, the property is deemed to be an item of PPE and is accounted for using the cost-depreciation-impairment model.

This assessment is determined on a property-by-property basis, considering the underlying circumstances of each property.

Management can use the latest available fair value as its deemed cost until a reliable measure of fair value becomes available again. When an investment property interest is held under a finance lease, only the interest in the lease is recognized, not the underlying property.

Transfers to or from investment property apply when the property meets or ceases to meet the definition of an investment property. A property may be carried as an investment property in one reporting period, and PPE the next period.

Thus, the recognition and measurement as an investment property under IFRS for SMEs is driven by the underlying circumstances of the properties involved, as well as the reasonableness of the expected cost and effort in determining fair values.

Management then also needs to define what constitutes “undue cost or effort” for consistency of application in the measurement of its various investment properties.

Under full IFRS, the cost and fair value models are options in measuring investment property, and are driven by the accounting policy adopted — whether cost or fair value model — and not by the surrounding circumstances of an investment property.

Intangible assets

All internally generated intangibles are expensed.

Expenditures on internally developed intangibles, including research and development costs, are expensed as incurred, unless these are part of the cost of another asset that meets the recognition criteria.

In full IFRS, all research costs are incurred as expenses, but development costs incurred after the project is deemed to be commercially viable are capitalized.

Direct expensing of these development costs are expected to be advantageous, since the ability to assess whether a project is commercially viable on an ongoing basis may be limited for SMEs, and capitalization of these costs may not really provide useful information to the entity regarding its operations.

Intangible assets, including goodwill, are considered to have finite lives and are amortized over their estimated useful lives.

If an entity cannot reliably estimate the useful life of an intangible asset, this lifespan is presumed to have a maximum amortization period of 10 years. Moreover, impairment testing is required only when there is an indicator of impairment.

In full IFRS, goodwill and intangible assets that are considered with indefinite useful lives, are not amortized and are mandatorily subject to detailed annual impairment testing.

This accounting treatment under IFRS for SMEs is for cost-benefit reasons, rather than conceptual reasons.

For example, information on impairment may not really be reliable, as smaller entities have less capability to accurately and promptly make impairment calculations, compared to larger or listed entities.

Goodwill is also not recognized as collateral by most lenders, so the benefit of accurately assessing these given the resources involved is less useful to SMEs.

Borrowing costs

All borrowing costs are expensed in profit or loss in the period in which they are incurred.

In contrast, under full IFRS, borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset as part of the cost of that asset are capitalized.

All other borrowing costs are expensed.

Thus, SMEs do not need to compute the borrowing costs to be capitalized.

However, in some industries, such as real estate, expensing borrowing costs may be disadvantageous as the costs will be recognized in profit or loss in the period in which they are incurred, which may lead to greater volatility in earnings.

Therefore, entities need to consider this factor in their financial forecasts or budgets.

Since most SMEs aspire to eventually grow into larger companies, it would be prudent to comply with IFRS requirements that are unique to SMEs.

In doing so, they can already establish sound practices in financial reporting that adhere to global standards. In the long run, this will ease their transition from being an SME to a major player in any industry.

(Maria Madeira R. Vestil is a Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.