Accounting Framework for Small and Medium Entities (SMEs)

SEMINAR AT ICAP PRESENTED BY: SHABBIR YUNUS KHAIRULLAH

September 21, 2006

Presentation Outline
Need for Developing SME Standards Local Accounting Framework ICAP Initiative Differential Reporting Status in Other Countries Basis of Development Proposed Three Tiers The New Standards Status of the SME Standards
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Need for Developing SME Standards

SMEs are more than 75% of the total entities operating in Pakistan Significant growth in SMEs in last two decades Concept of SMEs introduced in Tax and other regulations International Financial Reporting Standards designed primarily for multinationals and public listed entities Differing users of the financial statements Differing level of public accountability New and revised IAS/IFRS have added complexities to preparation of financial statements. This is becoming increasingly burdensome for small and medium business enterprises Lack of adequate technical expertise and resources due to smaller size Current framework available only for listed corporate entities
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Local Accounting Framework

Corporate Listed The Companies Ordinance, 1984 specifies that Subject to the provisions of this Ordinance, such International Accounting Standards and other standards shall be followed in regard to the accounts and preparation of the balance-sheet and profit and loss account as are notified for the purpose in the official Gazette by the Commission Almost all International Accounting Standards have been notified by SECP for this purpose. A few accounting standards issued during last couple of years are in the process of notification. The format of audit report specified in the Companies Ordinance, 1984 requires the auditor of all companies (whether listed or not) to report that in our opinion and to the best of our information and according to explanations given to us, the balance sheet, profit and loss account, cash flow statement and statement of changes in equity together with the notes forming part thereof conform with approved accounting standards
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Local Accounting Framework Contd..

Corporate Unlisted and Private Although the provisions of Companies Ordinance do not specify listed or unlisted, the notifications for various IASs state that following accounting standards shall be followed in regard to the accounts and preparation of the balance sheet and profit and loss accounts of listed companies The format of audit report specified in the Companies Ordinance, 1984 is the same for all companies whether listed or not. The term approved accounting standards has not been defined any where but it is taken to mean the IASs as notified and the accounting requirements of various statutes in place. Partnerships and sole proprietorships None
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ICAP Initiative
Accounting and Auditing Standards Committee (AASC) formed a sub-committee to look at various initiatives around the world and propose draft standards for Pakistan till the time an internationally agreed framework is in place
The sub-committee comprised of following members of AASC and a nominee of SECP Mr. Abdul Aleem, Mr. Syed Iftikhar Anjum, Mr. Riaz A. Rehman Chamdia, Mr. Nadeem Yousuf, Mr. Naresh Kumar, Mr. Farrukh Rehman, Mr. Shabbir Yunus, and Mr. Salman Shoaib Mr. Fayyaz Mahmud Director Professional Services SECP Directorate of Technical Services ICAP
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Differential Reporting
What is differential reporting ? Differential reporting is the notion that some entities should be allowed to depart from particular requirements of accounting standards or entire accounting standards in preparing financial statements.

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Differential Reporting
Two Approaches Integral Approach: Exemptions are given from compliance of individual accounting standards. Distinct Approach: Separate standards comprising all the issues that are addressed in the IAS/IFRS but which are relevant to SMEs.

September 21, 2006

Status in Other Countries

Countries like Australia, New Zealand, US and UK had taken initiatives in differential reporting more than 10 years back and are making further improvements to it Mixed trend for both integral and distinct approaches in different countries Both approaches are based on existing financial reporting frameworks, may it be IFRS or self developed.

September 21, 2006

Status in Other Countries

Integral Approach Australia New Zealand Canada Malaysia South Africa India Distinct Approach USA UK Hong Kong Srilanka UNCTAD IASB*

*International Accounting Standards Board (IASB) is in the process of developing SME standards based on the Distinct approach. IASB has started SME Standards project, which is expected to be completed in 2007.
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Basis of Development
Based on analysis of: - user needs - cost benefit consideration, and - limitations in accounting expertise available to SMEs separate set of Standards (distinct approach) was considered appropriate for application in Pakistan.

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Basis of Development
In Developing SME standards, the Institute examined: The draft Framework for Differential Reporting issued by Confederation of Asian & Pacific Accountants (CAPA) An exposure draft of proposed SME Financial Reporting Framework (SME-FRF) and Financial Reporting Standard (SME-FRS) issued by Hong Kong Institute of Certified Public Accountants (HKICPA).

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Basis of Development
Prevailing Frameworks for SMEs Accounting and Financial Reporting Guidelines for Small and MediumSized Enterprises (SMEGA) issued by Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting (ISAR) under the banner of United Nations Conference on Trade and Development (UNCTAD), an organ of United Nations SLASSE Sri Lankan Accounting Standards for Smaller Enterprises issued by the Institute of Chartered Accountants of Sri Lanka.

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Basis of Development
In developing the SME Framework and Standards, the Guidelines laid down by ISAR were primarily adopted The new Financial Reporting Framework for SMEs in Pakistan identifies three tiers of entities with Tier 2 and 3 being SMEs.

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Proposed Three Tiers

To provide a comprehensive framework of accounting and financial reporting that: covers all entities of varying sizes addresses the degree of public interest involved in such entities, The proposed three tiers are: Tier 1: Tier 2: Tier 3:
September 21, 2006

Publicly Accountable Entities Medium Sized Entities (MSEs) Small Sized Entities (SSEs).
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Proposed Three Tiers

In line with international practice, the criteria for classification of Tiers is based on: Public accountability Separation of owners/management Size

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Proposed Three Tiers Tier 1

Tier 1 - Publicly Accountable companies Includes listed companies ; it has filed, or is in the process of filing, its financial statements with the Securities and Exchange Commission of Pakistan or other regulatory organisation for the purpose of issuing any class of instruments in a public market; it holds assets in a fiduciary capacity for a broad group of outsiders, such as a bank, insurance company, securities broker/dealer, pension fund, mutual fund or investment banking entity; it is a public utility or similar entity that provides an essential public service; or it is economically significant on the basis of criteria such as total assets, total income, number of employees, degree of market dominance, and nature and extent of external borrowings.
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Proposed Three Tiers Tier 1 Contd..

The criteria for economically significant would be as follows: Turnover in excess of Rs. 1 billion, excluding other income Number of employees in excess of 750 Total borrowings (excluding normal trade credit and accrued liabilities) in excess of Rs, 500 million In order to be called economically significant any two of the criteria mentioned in (i), (ii) and (iii) above have to be met. The criteria followed will be based on the previous years audited financial statements. Entities can be delisted from this category where they do not fall under the criteria as aforementioned for two consecutive years. Tier 1 entities should comply with Approved Accounting Standards i.e. IASs as notified + relevant statute requirements.
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Proposed Three Tiers Tier 3

Tier 3 Small Sized Entities Small Sized entities are those entities that: have paid up capital plus undistributed reserves (total equity after taking into account any dividend proposed for the year) not exceeding twenty five million rupees; and have annual turnover not exceeding two hundred million rupees, excluding other income. In order to qualify as a small entity, both of the above mentioned conditions must be satisfied. Tier 3 entities should comply with The proposed Standard on Accounting and Financial Reporting by Small Size Entities + relevant statute requirements.
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Proposed Three Tiers Tier 2

Tier 2 - Medium Sized Entities Includes all entities which are not Tier 1 or Tier 3 Should comply with the proposed Standard on Accounting and Financial Reporting by the Medium Sized Entities + relevant statute requirements

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The New Standards

Tier 2 Medium Sized Entities (MSEs) Tier 3 Small Sized Entities (SSEs).

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Draft Standards for Medium Sized Entities

Comprises of 17 Standards dealing with accounting for the regularly encountered transactions by this size of entities and a general framework (about 60 pages). ISAR document was based on IASs applicable in 2002 These guidelines were reviewed and updated to incorporate subsequent changes in IASs The ISAR document included guidelines on 15 topics. Two new topics added to these topics being relevant to most MSEs in Pakistan Investments Employee benefits The Framework covers objectives of financial statements, underlying assumptions, qualitative characteristics, elements, recognition and measurement criteria.
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Draft Standards for Medium Sized Entities Contd..

For transactions not covered by these standards, look for guidance in full IAS/IFRS issued by IASB; interpretations issued by SIC and IFRIC; appendices to standards issued by IASB; implementation guidance issued by IASB; the definitions, recognition criteria and measurement concepts set out in the conceptual framework of IASB; and pronouncements of ICAP that use a similar conceptual framework to develop accounting standards; other accounting literature; and accepted industry practice, to the extent that these are consistent with IFRS.

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Draft Standards for Medium Sized Entities Contd..

1. 2. 3. 4. 5. 6. 7. 8. 9. Presentation of Financial Statements Cash Flow Statements Property, Plant and Equipment Leases Intangible Assets Inventories Government Grants and Other Government Assistance Provisions Revenue
Contd

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Draft Standards for Medium Sized Entities Contd..

10. 11. 12. 13. 14. 15. 16. 17. Borrowing Costs Income Taxes Accounting Policies Foreign Exchange Transactions Events after Balance Sheet Date Related-Party Disclosures Investments Employee Benefits.

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Draft Standards for Medium Sized Entities Contd..

Topics not covered by these standards (generally considered as not relevant to this size of entities) Share based payment, Business combinations, Insurance contracts, Non-Current assets held for sale and discontinued operations, Construction contracts, Segment reporting, Consolidated and separate financial statements, Investments in associates, Financial reporting for hyperinflationary economies, Interests in joint venture, Financial instruments (disclosure and recognition), Impairment of assets, Investment property
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Draft Standard for Small Sized Entities Tier 3

Requires entities to prepare financial statements at least annually The minimum set of primary financial statements to include: (a) A balance sheet; (b) An income statement; and (c) Explanatory notes. Entities may wish to include other statements e.g. Cash Flow Statement Use of going-concern and a simplified accrual basis of accounting Separate classification of current and non-current assets and current and non-current liabilities Disclosure of the movement in owners equity during the financial year

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Draft Standard for Small Sized Entities Tier 3 Contd..

The face of the income statement to include line items that present the following amounts: (a) revenue; (b) the results of operating activities; (c) finance costs; (d) tax expense; (e) net profit or loss for the period Property, plant and equipment to be measured at cost less accumulated depreciation (no revaluation option) All leases to be accounted for as operating leases (in line with tax treatment) Basic revenue recognition criteria in line with IAS 18. Inventory accounting basic principles in line with IAS 2. General impairment guidelines
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Draft Standard for Small Sized Entities Tier 3 Contd..

For material transactions or events not covered by this standard, reference shall be made to the Tier 2 standards.

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Status of the SME Standards

Status at the ICAP Status at the SECP Status at the IASB

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Status at the ICAP

The draft MSE and SSE standards were exposed to the members of the Institute and the stakeholders in January 2006 and again in May 2006 upon the request of the SECP and some members Round Table conferences / discussions were organized by the Institute in Karachi and Lahore on May 05 and June 26, 2006, respectively, with the objective of conducting an open discussion with the members and stakeholders in order to obtain their feedback on these Standards Feedback received from members and stakeholders (through mail, other discussions and discussions in the Round Table) is considered by the relevant committees of the Institute and the Standards have been amended accordingly Feedback has also been received from the Institute of Chartered Accountants of India, Sri Lanka and Bangladesh which have been duly considered by the ICAP
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Status at the ICAP

SECP (the regulator), the SBP and the CBR have been taken into confidence for issuance of the MSE and SSE standards by ICAP and the proposed three tier applicability criteria The revised standards were submitted to the Professional Standards and Technical Advisory Committee (PS&TAC) of the ICAP who approved the same in its meeting held in July 2006 and recommended it to the Council for their approval The Council of the ICAP has approved these standards in its meeting held in July 2006 and the standards are in the process of being formally issued through a Council Directive. In this regard, it is expected that TR-5 previously issued by the ICAP will be withdrawn / amended. It is pertinent to mention here that the South Asian Federation of Accountants (SAFA) has also adopted the SME standards developed by the ICAP
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Status at the SECP

SECP will be submitted a final DRAFT in due course. The SECP is yet to introduce necessary amendments in Companies Ordinance, 1984 to provide legal coverage for use of these standards in Pakistan. The format of Auditors Report will have to be changed. Necessary amendments in Section 234 of CO84 will also need to be introduced. This is currently under consideration by the Corporate Laws Review Commission (CLRC) of the SECP, to which recommendations have been submitted by the ICAP.

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Status at the IASB

A draft of an Exposure Draft (ED) has been compiled by the IASBs staff to develop an IFRS for the review of IASB. The IASB has not approved this Draft. No comments are invited at this stage. The IASB expects to publish an ED for public comment later this year. Earliest application will be with effect from periods beginning on or after January 1, 2008 (which will be applicable to companies in Pakistan w.e.f the year ending June 30, 2009) .

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