It’s the circle of life, with no room for IFRS 9!

Here’s how one website defines “circular debt” in a Pakistani context:

  • Circular debt is a unique but not necessarily unheard of problem. Two entities ultimately owe debt to each other but cannot balance out their debt because it is indirectly owed through additional entities. At least three parties must be involved. In the simplest terms, A owes money to B, who owes money to C, who completes the circle by owing money to A.
  • The phrase “circular debt” first became popular due to an electricity crisis in Pakistan. The entities involved in this example are the government, power distributors, power producers, fuel suppliers and the consumers.
  • Because the Pakistani government is struggling financially and experiencing a slow economy, it is unable to pay subsidies to power distributors. The power distributors in turn do not have enough money to pay the power producers, who cannot purchase fuel to keep the plants running and therefore fail to provide electricity owed to the consumers, who also often refuse to pay their bills for electricity that doesn’t work. In turn, consumers are expected to pay taxes to the government, bringing the debt full circle.

Against that backdrop, Pakistan’s Business Recorder recently reported on exemption requests made by some power generators for “permanent exemption from the applicability of financial instrument of international financial reporting standard 9 (IFRS-9) for IPPs due to their financial woes.” It explains:

  • The Power Company has highlighted that circular debt situation has continued to worsen as huge receivables have accumulated on books of LPTL and other IPPs. This is after steps have been taken to settle circular debt through settlements under the PPA amendment agreements signed with many IPPs wherein outstanding balances have been partially settled through payments in instalments.
  • However, a lot more still needs to be done to address the issue of circular debt…
  • The company believes that the complete resolution of circular debt will take some years depending upon the government’s course of actions. “IFRS-9 requires us to recognize a loss for the overdue receivables due mainly because of their aging.
  • LPTL overdue amounts from CPPA-G are not by its own choice but are the direct result of circular debt. The application of the impairment model provided in IFRS-9 will result in huge impairment losses on these late overdue amounts resulting in significant dilution of profitability and erosion of our retained earnings,” the letter notes adding that “therefore, the Company has requested Power Division to recommend to SECP for a permanent exemption from the application of IFRS-9 on trade debts on the same grounds as were applicable previously some of which are as follows:
  • (i) application of IFRS- 9 will increase the variability of IPPs results from one period to another due to the abnormal payment pattern being followed by the Government of Pakistan (GoP). This volatility in results from one period to another may give misleading results to the users of the financial statements. Furthermore, as there is no firm timeline from CPPA-G for settlement of these receivables, it would be very difficult to estimate the loss. Also, different assumptions by different companies and auditors will significantly affect the comparability of numbers between different companies;
  • (ii) impairment on government-guaranteed receivable will deteriorate the credibility of the GoP. This will end a negative image of the GoP to domestic and international investors and can hamper future foreign direct investments;
  • (iii) the large impairment losses due to the application of IFRS-9 will deteriorate the already declining capital markets of the country as a result of panic amongst the shareholders of these IPPs;
  • (iv) the impairment loss will also adversely impact the lenders’ covenants and may result in breach of loan covenants. This will also negatively impact the ability of IPPs to borrow money in these times of financial crunch;
  • (v) the application of IFRS-9 will restrict the ability of IPPs to declare dividends to their shareholders.

I don’t know about Pakistan, but I find it hard to imagine Canadian regulators granting an exemption in a comparable situation. Some of the factors cited (estimation difficulties, differing assumptions, possible volatility) are merely generic observations about the operation of the standard (or accounting standards in general), albeit possibly present here to a higher than usual degree. It doesn’t appear that the recoverability of the receivables is assured beyond any doubt, especially when the time value of money is taken into account, so it’s hard to argue that the impairment losses lack any conceptual basis. Some of the adverse effects described, such as the negative light in which the accounting treatment might place the government, might as well be listed as reasons why the application of the standard is appropriate, if perhaps rather brutally so (from the description provided, it’s hard to follow why dividend payments would be  appropriate in the present climate). On the other hand, I suppose it might be argued that the basic situation in which these entities find themselves can be made plain enough to stakeholders through disclosure, regardless of how it’s represented in accounting terms.

Anyway, an interesting case study. As at the time of writing, I couldn’t find out whether the application had actually being granted…

The opinions expressed are solely those of the author

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