To have or not to have IFRS: CB should not

make hasty decision

Dropping IFRS should not be an arbitrary and hasty decision to be made by the Central Banks
current management. Before they reach such a decision, they should listen to both sides and that
should be a part of Central Banks good governance

Blaming IFRS for CB losses- March 9, 2015

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-whenloss-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 Banks accounting template.
Losses are not what the P & L account shows but depletions in networth
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 countrys central bank. This is because the repayment of
governments 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 writers 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
Banks 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 Banks 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&a
mp;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 Banks current management. Before they reach such a
decision, they should listen to both sides and that should be a part of
Central Banks good governance.
(W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri
Lanka, can be reached at waw1949@gmail.com.)