Chapter 3

What is IFRS?
IFRS stands for international financial reporting standards. It’s a set of accounting rules and
standards that determine how accounting events should be reported in your business’s
financial statements. Issued by the International Accounting Standards Board (IASB), IFRS
aims to make financial statements consistent, comparable, and transparent across the world.
The United States is one notable country that doesn’t prescribe to IFRS, instead following a
system called GAAP.
Understanding IFRS
The purpose of financial statements is to provide information on a company’s financial
performance and position to help current or prospective stakeholders make reliable financing
decisions. It is a company’s primary means of communication with them.
So, the information presented in the records should be relevant, reliable, accurate, and
comparable. To ensure it, companies started observing regionally accepted accounting
standards. However, comparing different companies across countries became difficult due to
a lack of uniformity in their accounting guidelines. As a result, companies had to prepare
several sets of financial statements for different jurisdictions.
With the emergence of multinationals having a presence in multiple countries, the need for a
global accounting framework gained momentum. It gave rise to the formation of IASB. The
IASB is an independent group with hybrid experts in finances, auditing, accounting
standards, and education. The task of board members is to issue and publish financial
accounting standards.
The IASB was created with the sole purpose of designing an international financial reporting
system that will ensure smooth processing, interpretation, and comprehension of financial
statements, business transactions, and foreign investments. IASB introduced IAS and later
IFRS that laid down a framework of universally recognized principles for accounting.
The IFRS establishes accounting standards and practices that every company adhering to it
must observe. It is a rule book that must be followed while recording business transactions in
the books of accounts. Also, as it yields transparency and consistency in financial reporting
governments use it to regulate direct and indirect foreign investments.
It is accepted worldwide as it facilitates the free flow of capital. In other words, any U.S.
investor will be more confident to invest in, suppose, an Indian company after scrutinizing its
financial records prepared in conformity with this accounting standard. This is because
following the internationally-approved standards eliminate accounting risks associated with
such investments.
However, note that the U.S. government enforces GAAP on their companies. Therefore,
there is often a widespread debate on IFRS vs US GAAP when it comes to compliance.
IFRS is lengthy and flexible compared to GAAP. As it is principle-based, its rules are open to
multiple interpretations. However, both IFRS and GAAP serve a common objective of
uniformity and openness in maintaining financial statements.
Objectives of IFRS
International Financial Reporting Standards represents an international financial reporting
system and serves multiple purposes. Some of its significant goals in the financial world are
as follows:
#1- Create a Common Law
One of its key objectives is to ensure that common law is introduced and adopted by as many
jurisdictions and countries as possible to bring everyone on the same page. It ensures that
everyone follows the same guidelines and adopts a universal way of reporting business
activities.
#2 – Aid analysis
It helps stakeholders in analysing a company’s performance and interpreting its financial
position. For example, corporations and governments use these standards to make credible
financial statements. It aids in categorizing and reporting financial data with accuracy and
consistency. Such financial records promote better comprehension and help decision-making.
#3 – Assist in preparation of reliable financial records
By following International Financial Reporting Standards, the data presented in the books
of accounts are likely to be accurate, reliable, uniform, and appropriate within the bounds of
its rules. The high quality of financial records assists investors in making informed economic
decisions.
#4 – Ensure comparability, transparency, and flexibility in reporting
The consistency in reporting accounting practices enables easy comparison of the financial
records of compliant companies across nations. Such comparisons allow investors to identify
risks and opportunities before investing. As a result, it promotes foreign trade and investment.
Also, it requires full disclosure of all relevant information to its stakeholders. However,
being principle-based, the rules are not very rigid and allow companies to adapt to them in
their own way.
Uses of IFRS
This standard is a multi-layer set of rules and guidelines prepared like a blueprint to follow in
accounting. Its main uses are as follows:
#1 – Financial Tool
The International Financial Reporting Standards bring efficiency, accuracy, and data
transparency to serve public interests for growth, trust, and sustainability of the
world economy For example, the International Organization of Securities Commissions
(IOSCO) is working with the IFRS to set up a new body by November 2021 to postulate
mandatory global standards on climate change in company disclosures. The IOSCO will
also eliminate any errors or conflicts by going interoperable with the global baseline.
#2 – Principles and Guide
The companies run their whole business and represent their financial data and information as
per the IFRS accounting principles. If they fail to do so, they may be penalized for it. Hence,
it assures the trustworthiness of a company.
#3 – Promotes Decision Making
The standards help investors make wise decisions regarding their investment by providing a
clear picture of company reports and financial statements. It is possible because of its
singular and universal language, making it easy to comprehend.
#4 – Improves Economy
Globally, investors are more open to investing in companies with IFRS-compliant financial
records. Again, it is because such reports are presumed to be authentic, easily understandable,
and comparable. This credibility opens the economy to foreign investment and thereby paves
the way for economic progress.
Importance of IFRS
It is treated as an international accounting standard and holds great importance for many
countries and the world economy. Here is its significance:
1 – Transparency
It encourages transparency and accountability of financial statements prepared by companies,
small firms, and government agencies. As a result, it minimizes the margin of error and
manipulation of any holdings and irregularities of funds, transactions, and balances. Besides,
it also motivates consistency and clarity of work.
2 – Uniformity and Comprehensive
The International Financial Reporting Standards are developed to set uniformity in the
presentation and understand ability of statements. When everyone follows and recognizes the
standards, it becomes easy for companies and agencies to follow a common law that helps
world economies compare their growth comprehensively. Also, it is easy to read for
everyone.
3 – Security and Flow
It helps track the flow of transactions, records funds information, and works towards attaining
a security level for direct and indirect foreign investments across nations. This accounting
standard is essential when we are dealing with significant assets or getting into heavy
transactions.
4 – Accountability
It strengthens accountability by bridging the gap of incompetent financial reporting. If not
complied with it, the companies may face penalties. For example, last year, the Johannesburg
Stock Exchange fined a sugar firm Tongaat Hulett Ltd Its financial statements, account
reports, and other information details did not comply with IFRS and were incorrect.
Convergence to International Financial Reporting Standards
Introduction
The IFRS (International Financial Reporting Standards) convergence has gained momentum
all over the world and India is no exception. As the world is going global on a massive scale,
the need for convergence seems all the way more important. The need for common
acceptable standards have been felt the world over and as of date, approximately 100
countries either have adopted fully or have converged IFRS standards with their own
standards. The ultimate goal of convergence is to have common acceptable standards, which
is practiced world over ensuring transparency & utility of financial information.
Indian Scenario
The Institute of Chartered Accountants of India (ICAI) develops Accounting Standards.
India officially decided in 2007 to converge with IFRS. The ICAI and IASB (International
Accounting Standard Board) then decided to work together, collaborate and develop quality
and comparable accounting standards instead of fully adopting the IFRS standards
completely. The ICAI decided to adopt IFRS and set the target period as April 2011 but
delayed implementation due to procedural and operational reasons. Finally, The Ministry of
Corporate affairs has announced the implementation of new standards effective from
1ST April 2016 over a period of four years till 1 st April 2019. All applicable & existing
standards would cease after the target date of implementation. The Ministry of Corporate
affairs have notified the implementation dates as below.
 Listed Companies with more than 500 crores of net worth – 1st April 2016
 Listed Companies with more than 250 crores of net worth – 1stApril, 2017
 Banks, Insurance & Financial Service Companies – 1st April, 2019
Need for Convergence
The need for IFRS convergence in India is necessary due to the following reasons:
 To ensure a general understanding of best accounting practices
 To make the financial statements reliable, comparable & transparent
 To standardize financial accounting & reporting across the globe
 To promote foreign Investment & spur Industrial growth
 To eliminate information barriers for users of financial statements
Benefit
1. Easy access to global financial capital markets – Indian companies would be able to
procure investments from abroad on cheaper favourable terms, which in turn can fund their
growth and expansion.
2. Cross Border trade & Investments – Indian firms following IFRS would be able to do
business by listing abroad and this would facilitate more trade & investment in unrepresented
geographies.
3. Eliminate differential reporting – Indian Companies having business abroad would be able
to do away with preparing separate financial statements, as they would be following IFRS
standards. This would reduce duplicity in financial reporting & eliminate unnecessary
reporting.
4. Improved quality & comparability of financial reporting – The converged IFRS standards
are of high quality, easily enforceable and globally acceptable which in turn increases
reliability & comparability. Lenders and Investors will have more confidence in Indian
businesses because of the commonly followed Accounting standards & procedure thereby
improving trust & confidence.
5. Accounting Profession – Accountants & Finance persons working in financial reporting
domain would also benefit by highlighting their expertise & talents abroad. They will be
more competent to take up challenging global roles worldwide.
Challenges
1. Training & Awareness – Many do not know the IFRS standards & lack of knowledge &
awareness makes it a difficult task of implementation. Finance professionals will have to be
adequately trained and than the standards can be implemented consistently and uniformly in
right spirit.
2. Changes in Indian regulation – Current regulations governing the financial regulation
would need a complete overhaul to implement the IFRS standards. The Companies Act 1956,
SEBI act 1992, IT Act 1962 etc. will have to be amended to bring them in line with IFRS
regulations. These legal hurdles is a major constraint in the path of IFRS convergence.
3. Fair Value system of measurement – The IFRS considers the fair value system of asset
measurement and the Indian GAAP recognizes historical system. This divergence of system
would create volatility and subjectivity in financial statements. This would lead to different
results for performance & earnings of the Company.
4. IT systems – Financial accounting software and tools used for reporting would have to be
completely changed resulting in substantial investment in IT infrastructure for Indian
Companies. Indian companies are habitually reluctant when any proposal involves cost, time
& effort.
5. Small & Medium businesses – The SME sector in India is comparatively larger than other
Countries. The cost of convergence far outweighs the advantages of convergence for these
small businesses. The dearth of resource and skills in financial knowledge adds up to the
problem of implementation in this sector. In addition, SME’s cannot be ignored, considering
the role they play in the Indian economy.
Conclusion
The road to IFRS convergence with the Indian Accounting standards is certainly a difficult
task. All stakeholders should agree & convince themselves of the gains that would accrue
once the standards are converged. Most importantly, this will increase credibility of the
Indian businesses in the International financial market & they will reap significant benefit out
of it. Indian businesses cannot afford to be complacent any further as India has already been
lagging behind. The process of convergence & transition has been slow as of now and if
required Indian businesses may seek help and advice from counterparts in advanced countries
who were successful. The Government should set up a task force, which will recommend
changes in existing laws facilitate regulatory compliance and monitor implementation to
ensure completion by the agreed timelines.

Critical differences between IFRS and IND AS

History: IFRS had existed since 2001 and is the result of a convergence process that started
in the 1980s when the International Accounting Standards Committee (IASC) was formed.
IND AS was introduced in India in 2016 as part of a broader effort to converge Indian
accounting standards with IFRS.
Scope: IFRS are global accounting standards that are used in more than 140 countries around
the world. On the other hand, IND AS are Indian accounting standards only applicable in
India.
Issuing body: IFRS are issued by the International Accounting Standards Board (IASB),
while IND AS are issued by the Institute of Chartered Accountants of India (ICAI).
Implementation: IFRS is mandatory for listed companies in many countries worldwide,
including the European Union and many countries in Asia and Latin America. IND AS is
mandatory in India for listed companies and large and medium-sized companies.
Differences in the standards: While IFRS and IND AS are based on similar principles, there
are some differences between the two standards. For example, IND AS includes additional
guidance on joint ventures, construction contracts, and financial instruments, which are not
covered in IFRS.
Ongoing development: IFRS and IND AS are subject to ongoing development and revision.
The International Accounting Standards Board (IASB), responsible for developing IFRS,
regularly issues new standards and amendments to existing standards. Similarly, the Institute
of Chartered Accountants of India (ICAI), responsible for developing IND AS, regularly
issues new standards and amendments.
Level of detail: IFRS tends to be more principles-based and provides less detailed guidance
than IND AS. This can make it more challenging to apply IFRS in practice, as practitioners
may need to use their judgment to interpret the principles and apply them to specific
situations.
Convergence with IFRS: The ICAI has been working to converge IND AS with IFRS, and
the two standards are expected to converge mainly in the future.
IND-AS1 Presentation of Financial Statements
Introduction: The Indian Accounting Standards (IND AS) were introduced in India in 2015,
with the aim of bringing greater transparency and consistency to financial reporting. One of
the key standards is IND AS 1 – Presentation of Financial Statements. This standard sets out
the principles and requirements for the presentation of financial statements, which are the
primary means of communicating financial information to users.
Scope of IND AS 1
IND AS 1 applies to all entities that prepare financial statements in accordance with IND AS.
The standard sets out the requirements for the presentation of financial statements, including
the balance sheet, income statement, statement of changes in equity, and statement of cash
flows. It also specifies the minimum requirements for disclosures in the notes to the financial
statements.
Purpose of IND AS 1
The purpose of IND AS 1 – Presentation of Financial Statements is to ensure that financial
statements provide information that is relevant, reliable, comparable, and understandable to
users. This standard sets out the principles and requirements for the presentation of financial
statements, which are the primary means of communicating financial information to users.
IND AS 1 establishes the minimum requirements for the presentation of financial statements,
including the balance sheet, income statement, statement of changes in equity, and statement
of cash flows. It also specifies the minimum requirements for disclosures in the notes to the
financial statements.
By setting out the principles and requirements for the presentation of financial statements,
IND AS 1 ensures that financial statements provide a fair and accurate representation of an
entity’s financial position, performance, and cash flows. This helps users to make informed
decisions about the entity’s financial health and prospects, and promotes transparency and
accountability in financial reporting.
Key principles of IND AS 1
Accrual Accounting: IND AS 1 requires entities to use the accrual basis of accounting to
recognize revenue and expenses in the financial statements. Accrual accounting recognizes
revenues and expenses when they are earned or incurred, regardless of when cash is received
or paid. This provides a more accurate picture of an entity’s financial performance and
position.
Going Concern Assumption: IND AS 1 assumes that an entity will continue to operate for the
foreseeable future, unless there is evidence to the contrary. This allows financial statements
to be prepared on a basis that assumes the entity will continue to operate, which is important
for making meaningful financial projections and evaluating an entity’s long-term viability.
Consistency of Presentation: IND AS 1 requires entities to present financial statements in a
consistent manner from one period to the next. This includes using consistent accounting
policies, formats, and classifications. This principle ensures that users can compare an
entity’s financial performance and position over time and make informed decisions based on
this information.
Materiality: IND AS 1 requires entities to consider the materiality of information when
presenting financial statements. Materiality refers to the significance of information in the
context of the financial statements as a whole. This principle ensures that financial statements
focus on information that is relevant and useful to users.
Fair Presentation: IND AS 1 requires entities to present financial statements fairly, which
means that the financial statements must be free from material misstatements and errors. Fair
presentation also requires entities to provide adequate disclosures in the notes to the financial
statements, which helps to ensure that users have a complete understanding of the financial
statements.
Requirements of IND AS 1

Balance sheet
When preparing a balance sheet in accordance with IND AS, there are certain key
requirements that must be met. Here is a guide to drafting a balance sheet in compliance with
IND AS:
Asset Classification: Assets should be classified as current or non-current. Current assets are
those that are expected to be realized or consumed within 12 months, while non-current
assets are those that are expected to be held for more than 12 months.
Liability Classification: Liabilities should be classified as current or non-current. Current
liabilities are those that are expected to be settled within 12 months, while non-current
liabilities are those that are expected to be settled after more than 12 months.
Equity: Equity should be presented separately on the balance sheet, and should include any
reserves or accumulated profits. The components of equity should be clearly disclosed,
including any changes in equity during the reporting period.
Valuation: Assets and liabilities should be valued at fair value, unless the standard
specifically requires a different valuation basis. Fair value is the amount that would be
received to sell an asset or paid to transfer a liability in an orderly transaction between market
participants. Off-Balance Sheet Items:
Off-balance sheet items should be disclosed in the notes to the financial statements. This
includes any contingent liabilities or assets that may have an impact on the financial position
of the entity.
Comparative Figures: The balance sheet should include comparative figures for the previous
reporting period, unless this is not practicable.
Disclosure: The balance sheet should include adequate disclosures to enable users to
understand the financial position of the entity. This includes details of significant accounting
policies, estimates and judgments, and any material events or transactions that have occurred
during the reporting period.

Income statement
When preparing an income statement in accordance with IND AS, there are certain key
requirements that must be met. Here is a guide to drafting an income statement in compliance
with IND AS:
Revenue Recognition:
Revenue should be recognized when it is earned, and it should be measured at the fair value
of the consideration received or receivable. Cost of Sales: The cost of sales should be
recognized as an expense in the same period as the related revenue is recognized.
Operating Expenses:
Operating expenses should be recognized in the period in which they are incurred, and should
be classified by nature (e.g. selling and distribution expenses, administrative expenses, etc.).
Finance Costs:
Finance costs should be recognized in the period in which they are incurred, and should
include interest expense on borrowings and other financing costs.
Income Taxes:
Income tax expense should be recognized in the period in which the related income is
recognized, using the applicable tax rate.
Earnings per Share: Earnings per share should be disclosed on the income statement,
calculated using the weighted average number of shares outstanding during the reporting
period.
Comparative Figures: The income statement should include comparative figures for the
previous reporting period, unless this is not practicable.
Disclosure: The income statement should include adequate disclosures to enable users to
understand the entity’s financial performance. This includes details of significant accounting
policies, estimates and judgments, and any material events or transactions that have occurred
during the reporting period.
Statement of changes in equity
When preparing a statement of changes in equity in accordance with IND AS, there are
certain key requirements that must be met. Here is a guide to drafting a statement of changes
in equity in compliance with IND AS:
  Opening Balance: The statement should begin with the opening balance of equity at
the beginning of the reporting period.
 Changes in Equity: The statement should include all changes in equity during the
reporting period, including the effects of any adjustments or corrections made during
the period.
 Comprehensive Income: The statement should disclose the components of
comprehensive income for the reporting period, including any items of income or
expense that are recognized directly in equity.
 Dividends: The statement should disclose any dividends or other distributions made
during the reporting period.
 Share-Based Payments: The statement should disclose the effects of any share-based
payment transactions during the reporting period.
 Reconciliation: The statement should include a reconciliation between the opening
and closing balances of each component of equity, including share capital, share
premium, retained earnings, and any other reserves.
 Comparative Figures: The statement should include comparative figures for the
previous reporting period, unless this is not practicable.
 Disclosure: The statement should include adequate disclosures to enable users to
understand the changes in equity during the reporting period. This includes details of
significant accounting policies, estimates and judgments, and any material events or
transactions that have occurred during the reporting period.
Statement of cash flows
When preparing a statement of cash flows in accordance with IND AS, there are certain key
requirements that must be met. Here is a guide to drafting a statement of cash flows in
compliance with IND AS:
 Operating Activities: The statement should begin with the net cash inflow or outflow
from operating activities, which should be prepared using the indirect method.
 Investing Activities: The statement should disclose the net cash inflow or outflow
from investing activities, which includes cash flows related to the acquisition and
disposal of long-term assets, investments, and other financial instruments.
 Financing Activities: The statement should disclose the net cash inflow or outflow
from financing activities, which includes cash flows related to the issuance and
repayment of debt, equity instruments, and other financing activities.
 Reconciliation: The statement should include a reconciliation between the opening
and closing balances of cash and cash equivalents, which should include the effects of
exchange rate changes.
 Non-Cash Transactions: The statement should disclose any significant non-cash
transactions that have affected the entity’s financial position during the reporting
period, such as the issuance of shares in exchange for assets or the conversion of debt
into equity.
 Comparative Figures: The statement should include comparative figures for the
previous reporting period, unless this is not practicable.
 Disclosure: The statement should include adequate disclosures to enable users to
understand the entity’s cash flows during the reporting period. This includes details of
 significant accounting policies, estimates and judgments, and any material events or
transactions that have occurred during the reporting period.
Other Comprehensive Income
Other Comprehensive Income (OCI) is a reporting category in financial statements that
reflects gains and losses that are not recognized in the income statement. OCI includes items
that affect the financial position of a company but are not part of its normal operations. These
gains and losses are usually recognized directly in equity, bypassing the income statement.
The concept of OCI is important because it allows for a more comprehensive view of a
company’s financial performance and position. Here are some of the items that are commonly
included in OCI:
 Unrealized Gains or Losses on Available-for-Sale Securities: Companies must record
any changes in the fair value of securities they hold as available for sale. These
changes are recorded directly in OCI, rather than in the income statement.
 Foreign Currency Translation Adjustments: Companies that operate internationally
must account for exchange rate fluctuations. OCI is used to record gains and losses
that arise from these fluctuations.
 Changes in the Fair Value of Derivatives: Companies that use derivatives such as
futures, options, or swaps to hedge their exposure to market risks must record any
changes in the fair value of these derivatives in OCI.
 Pension Plan Gains and Losses: Companies that offer defined benefit pension plans
must record any gains or losses that arise from changes in the value of plan assets or
from changes in actuarial assumptions in OCI.
 Revaluation Surplus: Companies that revalue their fixed assets to reflect changes in
their market value must record any resulting gains or losses in OCI.
 While these items do not impact the company’s bottom line, they can have a
significant impact on its financial position. By recording these items in OCI, investors
and analysts can get a more complete picture of the company’s financial performance
and position. Companies are required to disclose the items included in OCI in the
notes to their financial statements, along with any tax implications of these items.

What Is Transfer Pricing?

Transfer pricing is an accounting practice that represents the price that one division in a
company charges another division for goods and services provided.
Transfer pricing allows for the establishment of prices for the goods and services exchanged
between subsidiaries, affiliates, or commonly controlled companies that are part of the same
larger enterprise. Transfer pricing can lead to tax savings for corporations, though tax
authorities may contest their claims.
How Transfer Pricing Works
Transfer pricing is an accounting and taxation practice that allows for pricing transactions
internally within businesses and between subsidiaries that operate under common control or
ownership. The transfer pricing practice extends to cross-border transactions as well as
domestic ones.
A transfer price is used to determine the cost to charge another division, subsidiary,
or holding company for services rendered. Typically, transfer prices are reflective of the
going market price for that good or service. Transfer pricing can also be applied
to intellectual property such as research, patents, and royalties.
Multinational corporations (MNCs) are legally allowed to use the transfer pricing method to
allocate earnings among their subsidiary and affiliate companies that are part of the parent
organization. However, companies sometimes can also use (or misuse) this practice by
altering their taxable income, thus reducing their overall taxes. The transfer pricing
mechanism is a way that companies can shift tax liabilities to low-cost tax jurisdictions.
Transfer Pricing and Taxes
To better understand how transfer pricing impacts a company's tax bill, let's consider the
following scenario. Let's say that an automobile manufacturer has two divisions: Division A,
which manufactures software, and Division B, which manufactures cars. Division A sells the
software to other carmakers as well as its parent company. Division B pays Division A for
the software, typically at the prevailing market price that Division A charges other carmakers.
Let's say that Division A decides to charge a lower price to Division B instead of using the
market price. As a result, Division A's sales or revenues are lower because of the lower
pricing. On the other hand, Division B's costs of goods sold (COGS) are lower, increasing the
division's profits. In short, Division A's revenues are lower by the same amount as Division
B's cost savings—so there's no financial impact on the overall corporation.
However, let's say that Division A is in a higher tax country than Division B. The overall
company can save on taxes by making Division A less profitable and Division B more
profitable. By making Division A charge lower prices and pass those savings on to Division
B, boosting its profits through a lower COGS, Division B will be taxed at a lower rate. In
other words, Division A's decision not to charge market pricing to Division B allows the
overall company to evade taxes.
In short, by charging above or below the market price, companies can use transfer pricing to
transfer profits and costs to other divisions internally to reduce their tax burden.
Transfer Pricing and the IRS
The IRS states that transfer pricing should be the same between intercompany transactions
that would have otherwise occurred had the company done the transaction with a party or
customer outside the company. According to the IRS website, transfer pricing is defined as
follows:
The regulations under section 482 generally provide that prices charged by one affiliate to
another, in an intercompany transaction involving the transfer of goods, services, or
intangibles, yield results that are consistent with the results that would have been realized if
uncontrolled taxpayers had engaged in the same transaction under the same circumstances.
As a result, the financial reporting of transfer pricing has strict guidelines and is closely
watched by tax authorities. Auditors and regulators often require extensive documentation. If
the transfer value is done incorrectly or inappropriately, the financial statements may need to
be restated, and fees or penalties could be applied.
However, there is much debate and ambiguity surrounding how transfer pricing between
divisions should be accounted for and which division should take the brunt of the tax burden.

The main issues and challenges related to transfer pricing include:

1. Arm's Length Principle: The arm's length principle requires that related entities price
their transactions as if they were unrelated parties. This means that transfer prices
should be comparable to what unrelated parties would charge in similar transactions.
Determining a suitable arm's length price can be challenging, as finding comparable
transactions in unrelated markets is not always straightforward.
2. Documentation and Compliance: Many tax jurisdictions have stringent documentation
requirements for transfer pricing. Companies must maintain detailed records and
documentation to justify their transfer pricing policies. Compliance with these
regulations can be time-consuming and resource-intensive.
3. Multiple Jurisdictions: Transfer pricing involves transactions between entities located
in different countries with different tax regulations. It can lead to disputes between tax
authorities from different jurisdictions over the appropriate allocation of profits and
tax liabilities.
4. Complexity of Transactions: MNEs often engage in complex transactions involving
intangible assets, intercompany services, and cost-sharing arrangements. Determining
the appropriate transfer prices for these transactions can be highly intricate.
5. Risk of Tax Audit and Penalties: Transfer pricing is a high-risk area for tax audits. If
authorities determine that the transfer prices do not comply with the arm's length
principle or are used for profit shifting, companies may face penalties, interest, and
adjustments to their tax liabilities.
6. Lack of Transparency: The complexity of transfer pricing arrangements can make it
challenging for tax authorities to assess their fairness accurately. This can lead to
suspicions of tax avoidance and calls for greater transparency.
7. Differing National Tax Rules: Each country has its own tax rules and regulations
regarding transfer pricing. Companies must navigate these differing rules to ensure
compliance while optimizing their global tax position.
8. Advance Pricing Agreements (APAs): To reduce uncertainty and the risk of disputes,
companies can negotiate APAs with tax authorities. However, reaching an APA can
be time-consuming, and the terms must strike a balance between the company's
interests and tax authorities' concerns.
9. Effect on Developing Countries: Transfer pricing practices can have a significant
impact on developing countries, as they may lose potential tax revenues due to profit
shifting to low-tax jurisdictions by multinational corporations.
 10. Changing International Standards: Transfer pricing rules and guidelines are subject to
continuous evolution and updates at both the national and international levels.
Companies must keep abreast of these changes and adapt their transfer pricing
policies accordingly.

Types of Transfer Pricing

Comparable Uncontrolled Price Method
The comparable uncontrolled price (CUP) method compares the price and conditions of
products or services in a controlled transaction with those of an uncontrolled transaction
between unrelated parties. To make this comparison, the CUP method requires what’s known
as comparable data. In order to be considered a comparable price, the uncontrolled
transaction has to meet high standards of comparability. In other words, transactions must be
extremely similar to be considered comparable under this method.
The OECD recommends this method whenever possible. It’s considered the most effective
and reliable way to apply the arm’s length principle to a controlled transaction. That said, it
can be very challenging to identify a transaction that’s appropriately comparable to the
controlled transaction in question. That’s why the CUP method is most frequently used when
there’s a significant amount of data available to make the comparison.
An example of the CUP transfer pricing method:
There are actually two ways to apply the CUP method: the internal CUP and the external
CUP. The internal CUP relies on examples of comparable transactions the company has made
with unrelated third parties. The external CUP looks at pricing of comparable transactions
made between two unrelated third parties—which can be difficult to find. For this reason, the
internal CUP method is preferred. The following is an example of the internal CUP method:
A U.S. car rental company needs to determine how to price the use of its brand name and
logo by its Canadian subsidiary. The company’s transfer pricing team must find an example
of a licensing agreement the company has made with an independent third party to use their
branding. If that arrangement is sufficiently comparable, the car rental company can apply the
same price it charges the independent third party to its Canadian subsidiary for the use of the
brand and logo.
2. The Resale Price Method
The resale price method (RPM) uses the selling price of a product or service, otherwise
known as the resale price. This number is then reduced with a gross margin, determined by
comparing the gross margins in comparable transactions made by similar but unrelated
organizations. Then, the costs associated with purchasing the product—such as customs
duties—are deducted from the total. The final number is considered an arm’s length price for
a controlled transaction made between affiliated companies.
When appropriately comparable transactions are available, the resale price method can be a
very useful way to determine transfer prices, because third-party sale prices may be relatively
easy to access. However, the resale price method requires comparables with consistent
economic circumstances and accounting methods. The uniqueness of each transaction makes
it very difficult to meet resale price method requirements.
An example of the resale price transfer pricing method:
A U.S. company that distributes running shoes buys shoes from a related company in Ireland.
It also purchases similar shoes from another, unrelated supplier. Assuming that the terms and
conditions of the related and unrelated party transactions are comparable, the RPM can be
applied to ensure the Irish company charges its related U.S. distributor a price comparable to
the price charged by the unrelated third-party supplier.
The RPM stipulates that the gross margin earned by the U.S. distributor on shoes purchased
from the related company must be the same as the margin earned on sales of shoes purchased
from the unrelated supplier. If the distributor makes a gross profit of $65 on each pair of
shoes from the unrelated supplier sold for $100, the gross profit margin is 65%. This is the
gross margin which must be used to determine the price of the shoes the distributor purchases
from its related Irish supplier.
3. The Cost Plus Method
The cost plus method (CPLM) works by comparing a company’s gross profits to the overall
cost of sales. It starts by figuring out the costs incurred by the supplier in a controlled
transaction between affiliated companies. Then, a market-based markup—the “plus” in cost
plus—is added to the total to account for an appropriate profit. In order to use the cost plus
method, a company must identify the markup costs for comparable transactions between
unrelated organizations.
The cost plus method is very useful for assessing transfer prices for routine, low-risk
activities, such as the manufacturing of tangible goods. For many organizations, this method
is both easy to implement and to understand. The downside of the cost plus method (and
really, all the transactional methods) is the availability of comparable data and accounting
consistency. In many cases, there are simply no comparable companies and transactions—or
at least not comparable enough to get an accurate, reliable result. If it’s not an apples to
apples comparison, the results will be distorted and another method must be used.
An example of the cost plus transfer pricing method:
A French corporation produces products under contract for its German-based parent company
and needs to determine the appropriate markup (gross cost plus) for the goods it sells to its
German partner. If the French company has made similar comparable transactions with third
parties, the markup used for those transactions can be applied to the sales the company makes
to the related German company. If the French company has made no comparable third party
transactions, then the transfer pricing team can identify several companies similar to the
French manufacturer and apply those companies’ average gross cost plus to the transactions
with the related German company.
Transactional Profit Methods
Unlike traditional transaction methods, profit-based methods don’t examine the terms and
conditions of specific transactions. Instead, they measure the net operating profits from
controlled transactions and compare them to the profits of third-party companies making
comparable transactions. This is done to ensure all company markups are arm’s length.
However, finding the comparable data necessary to use these methods is often very difficult.
Even the smallest variations in product features can lead to significant differences in price, so
it can be very challenging to find comparable transactions that won’t raise red flags and be
questioned by auditors.
4. The Comparable Profits Method
The comparable profits method (CPM), also known as the transactional net margin method
(TNMM), helps determine transfer prices by looking at the net profit of a controlled
transaction between associated enterprises. This net profit is then compared to the net profits
in comparable uncontrolled transactions of independent enterprises.
The CPM is the most commonly used and broadly applicable type of transfer pricing
methodology. As far as benefits go, the CPM is fairly easy to implement because it only
requires financial data. This method is really effective for product manufacturers with
relatively straightforward transactions, as it’s not difficult to find comparable data.
The CPM is a one-sided method that often ignores information on the counterparty to the
transaction. Tax authorities are increasingly likely to take the position that the CPM is not a
good match for organizations with complex business models, such as high-tech companies
with intellectual property. Using data from companies who do not meet the OECD’s
standards of comparability creates audit risk for organizations.
An example of the comparable profits transfer pricing method:
A U.S.-based clothing company with global reach establishes a Canadian distribution
affiliate. The U.S. parent company supplies products, sets business strategies, finances the
global operations, and owns the intellectual property (trademarks, designs, and operational
know-how) for its global affiliates. The parent company needs to determine how much profit
the Canadian distributor should earn for its operations.
The transfer pricing team identifies similar distributors in Canada, calculates their pre-tax
profit margins, and establishes a typical profit margin range. Prices are set to allow the
related Canadian distributor to earn a pre-tax profit that falls within that typical margin range.

5. The Profit Split Method

In some cases, associated enterprises engage in transactions that are interconnected—
meaning they can’t be observed on a separate basis. For example, two companies operating
under the same brand might use the profit split method (PSM). Typically, the related
companies agree to split the profits, and that’s where the profit split method comes in.
This approach examines the terms and conditions of interrelated, controlled transactions by
figuring out how profits would be divided between third parties making similar transactions.
One of the main benefits of the PSM is that it looks at profit allocation in a holistic way,
rather than on a transactional basis. This can help provide a broader, more accurate
assessment of the company’s financial performance. This is especially useful when dealing
with intangible assets, such as intellectual property, or in situations where there are multiple
controlled transactions happening at a time.
However, the PSM is often seen as a last resort because it only applies to highly integrated
organizations equally contributing value and assuming risk. Because the profit allocation
criteria for this method is so subjective, it poses more risk of being considered a non-arm’s
length outcome and being disputed by the appropriate tax authorities.
An example of the profit split transfer pricing method:
A pharmaceutical company affiliate performs research and development (R&D) to bring a
new drug to market. The affiliate bears the costs and risks of launching the new drug. The
two related parties need to determine the right profit split and decide that they’ll use the
contribution PSM to divide profits from sales of the new drug.
The two parties have invested a total of $500 million in bringing the medication to market.
The R&D company invested $375 million—or 75% of the total investment. Therefore, 75%
of the profits will go to the R&D company, with the remaining 25% going to the
pharmaceutical manufacturer.