Implementing IFRS for SMEs—Lessons from Brazil
This article reflects my personal views and experiences with implementing the International Financial Reporting Standard for Small- and Medium-Sized Entities (SMEs) (IFRS for SMEs) in Brazil. But, in interacting with fellow professionals around the world, I have become convinced that other jurisdictions share these views and, hopefully, will benefit from my experiences and recommendations on possible actions to improve practices.
Let’s begin by establishing the two most important principles:
- There are still some areas where implementation needs to be enhanced by preparers in the SME environment, regarding application of the IFRS for SMEs (currently under review by the International Accounting Standards Board [IASB]); and
- As professional accountants, we have a very important mission: to convince the owners/managers of SMEs as to the advantage they can attain from adopting a sound set of accounting policies and taking other measures to enhance transparency.
Brazil was probably one of the first countries to officially adopt the IFRS for SMEs in November 2009. Presently, it is mandatory for enterprises that are not regulated (that is, those other than listed companies, banks, insurers, etc.) and are below the threshold of R$300 million annual gross revenue (USD$120 million) or R$240 million in total assets (USD$100 million) to adopt what the law calls “accounting principles generally accepted in Brazil,” effectively the IFRS for SMEs, according to Resolutions passed by the Federal Accounting Council.
So, effective since 2010, SMEs have adapted their accounting policies to fit the new framework. Four years on we can now observe that a number of some old practices from the days before the IFRS for SMEs are still in widespread use. This raises the question whether Brazil can claim full adoption and implementation of the standard. What then are the most common areas of “incomplete” compliance with the IFRS for SMEs in Brazil?
1. Implementation of Accounting Policies for Fixed Assets
This is probably the area where implementation of the IFRS for SMEs is at its earliest stage, if it has even started at all. Business profitability is impacted by how the cost of fixed assets gets allocated across periods benefitting from their use.
The general principles seem to be straight-forward: cost means “cost plus any restoration estimated disbursements duly accrued.” Depreciable value is “cost less residual value” (also an estimate). Allocation to periods in a reasonable basis means that the best estimate of useful economic life must be done at inception. Period. Seemingly, so simple, though of course we know that, especially for some industries, practical adoption of such simple rules may bring complicated technical calculations. But estimates are an essential feature of today’s financial reporting.
What we see in practice, in most SME financial statements, is that:
- Future restoration or dismantling costs are not accrued at all;
- Residual value is consistently ignored, leading to full cost being depreciated, which does not reflect real value “used” through the use of assets;
- Useful economic lives of the assets or class of assets are forgotten; and
- The vast majority of enterprises use maximum annual depreciation rates admitted as deductible for local corporate income tax purposes.
Consequently various negative impacts on the reported financial information automatically follow:
- The value of assets in the balance sheet is not necessarily fair or approximate to fair;
- Costs and/or expenses allocated to the periods when the assets are being used are wrong; and
- Gains or losses derived from the disposal of the asset are equally wrong, closing the vicious circle of potentially misleading financial information.
2. The Concept of Impairment and Its Practical Application
The concept of impairment, which we could simply define as “testing the carrying amount of assets so that the balance sheet is not overstated,” has been in use for decades, in some shape or form, typically under different names such as allowance for bad debts, provision for asset obsolescence, adjustment to realizable value for inventories, and provision for losses in investments.
One would have expected, given it was already in use, including by SMEs, and a feature of IFRS for some time, the concept of impairment would have been easily applied more broadly. Under IFRS, this concept applies to practically every kind of asset, except for cash and cash equivalents.
However, in practice, we observe that many Brazilian SMEs fail to have a broader view of the concept and practical implications of impairment. Preparers seem to continue to struggle, perhaps concealing a harsh reality that their businesses are struggling with. Accounts receivable and inventories, the more “traditional” items subject to impairment, continue to receive the right amount of attention, but limited application of the concept can be observed for other asset categories, in particular, investments, fixed assets, and intangible assets.
3. Revenue Recognition
Let’s discuss the issue of revenue recognition related to the main activity of the enterprise, whether that is the sale of goods or the rendering of services.
The underlying IFRS principle is to recognize revenue when the risks and rewards of ownership are transferred to the buyer. However, for many years in Brazil, the main criterion for recognizing revenue was issuing of the respective invoice, regardless of the actual rendering of services or delivery of merchandise. Tax regulation that requires goods be accompanied by an invoice when delivered has tended to encourage the habit of recognizing revenue at the time the invoice is issued. This practice around revenue recognition for goods has also tended to apply to revenue recognition for services, and typically the invoice is issued after the service has been rendered. As a result, revenue is recognized in a different period than when the service was provided and is not matched with the respective cost. These may also be different from the point in time at which the cash was finally collected.
Another common error occurs when retail stores include interest in their prices, in order to offer payment, in 10, 12, or even more installments, at the same price as a cash transaction. Even if it were obvious that a finance transaction had occurred along with the sale, the entire revenue is recognized at the moment the sale is completed. This leads to erroneous recognition, and consequential distortion to reported profit, on two fronts:
- Revenue from sales is recognized in the same period as total financial revenue, which is not essentially true; and
- Financial revenue is recognized upfront, which will likely result in a mismatch with the costs of borrowing that enables the store to offer financing, embedded in the price of the goods to its customers.
4. Finance Leases
The most common type of lease entered into by Brazilian SMEs is for vehicles and machinery over a period of 2 to 5 years.
Income tax regulations allow taxpayers to deduct full monthly payments of leased assets, even when the lease term is shorter than the typical useful economic life of the related asset.
These tax rules have essentially encouraged SMEs to expense the whole monthly installment, without any consideration of residual values, real useful lives, and impact on reported financial information. It is easy to see that this leads to inappropriate expense accounting, mismatching costs, and misallocating the cost of the asset to the periods in which the asset is used.
In addition to that, losses or gains on disposal of the assets are also allocated to the wrong period.
5. Impact on Income Tax Expense Allocation
All of the above impact the amount of income tax expense that should be allocated to each period, and therefore result in erroneous recognition of income tax expense to the periods affected.
I would be interested to hear whether the experiences described above are reflected in other countries that have adopted the IFRS for SMEs.