Notwithstanding the recent representation by a leading
industry body to defer the implementation of IFRS in India, the automotive
industry is watching closely, as the events unfold on the roadmap for IFRS
transition in India. Several phase 1 auto companies that are in the advanced
stage of IFRS transition realise that some of the IFRS related changes could
have a significant impact on the financial and business parameters. This article
attempts to highlight some of the key IFRS impact areas for the auto industry in
relation to (a) Revenue recognition; (b) Property, plant and equipment, (c)
capital structure and (d) group structure.
Revenue recognition
Timing of recognition of revenues
Currently under Indian GAAP (hereafter referred to as IGAAP),
many auto companies recognise revenues on dispatch of the product for sale from
the production unit, which coincides with transfer of legal title of goods.
However, as per IFRS, revenue can be recognised only when significant risk and
rewards are transferred to the buyer and the seller does not retain managerial
involvement or effective control over the goods sold.
For example, for domestic sales, if the company bears the
risk of damage/loss to vehicles before it reaches the dealer/customer, then
revenue recognition may need to be deferred till delivery.
In the auto sector, a significant proportion of revenue comes
from month-end billings. There is a possibility that revenues from such
month-end billing may get deferred to the next quarter or fiscal year when the
revenue recognition criteria are met. This may result in a one-time impact (but
will be balanced out on an ongoing basis) on the company’s financials due to the
IFRS transition. Companies may have to align their internal processes so that
they can fulfill the revenue recognition criteria as prescribed under IFRS.
Customer incentives and discounts
Auto companies offer a range of dealer discounts and
incentives (including free service coupons to ultimate customers) to boost their
sales. Under IGAAP, the majority of such discounts and incentives are recognised
as sales promotion expenses, while the sales are reported gross of such
incentives. Under IFRS, all forms of discounts and incentives to the dealers are
recognised as a reduction of revenue. As such, revenues are presented net of
related discounts/incentives. Though such IFRS adjustment may not have an impact
on the profits for the year, they do impact the revenues and key ratios related
to revenue (for example, gross profit margins).
Warranties
Auto companies usually offer two types of warranties (i)
initial warranty that is bundled along with every vehicle sold without any
additional cost and (ii) extended warranty (commencing after expiry of initial
warranty) that is offered to the customer as per their choice and for a price.
Under IGAAP, as the initial warranty is not identified as a
separate element of the contract, sales are recorded for the full amount at the
time of the delivery of the vehicle. Correspondingly, a provision (calculated at
the amount of expected undiscounted cost to be incurred on meeting the warranty
obligation) is recognised upfront. Under IFRS, similar accounting treatment is
required for ‘normal’ warranties, except that the provision is required to be
discounted.
In case of ‘extended’ warranties, the contract contains
multiple elements i.e. sale of vehicles and sale of extended warranty. Under
IGAAP, there is no specific guidance on accounting for multiple elements in a
contract, and practice varies. Under IFRS, the price attributable to the
extended warranty is required to be deferred and recognised in income statement
over the extended warranty period.
The revenue attributable to the extended warranty may be
calculated based on the relative fair value method (relative fair values of sale
of vehicle and the extended warranty) or the residual fair value method (the
fair value of extended warranty is deferred).
Property, plant and equipment
Component approach for depreciation
Currently, most companies apply schedule XIV rates for
providing depreciation on assets. As such, the entire depreciable amount (i.e.
cost less residual value) is depreciated over the useful life estimated under
Schedule XIV to the Companies Act, 1956. Any replacement of significant
component is generally charged to profits as repairs cost.
Under IFRS, companies would be required to depreciate an
asset over its useful life, which may be different from industry benchmarks.
Further, if the asset includes a component, that can be readily identifiable; is
of significant value in relation to the asset; and has a significantly different
useful life; IFRS requires to treat such components as akin to separate assets.
Such components are depreciated over the component’s useful life and the
replacement of such a component is treated as akin to replacement of an asset
(i.e. disposal and fresh purchase).
As depreciation under IFRS may undergo a change, a
corresponding impact may also arise on valuation of inventories.
Contracts with suppliers
Automobile companies maintain vendor parks where suppliers
are in close proximity to the main plant to supply components used in the
manufacture of vehicles. Most of these vendors exclusively serve the plant, and
the automobile company enters into take-or-pay arrangements (such as a minimum
procurement guarantee or a per unit fee along with a fixed annual fee), whereby
the vendor will recover their capital costs irrespective of the actual off-take
from the company. In substance, under IFRS, maintaining exclusive assets against
fixed recoveries of capital costs make it a lease arrangement where the auto
companies are deemed to have taken the vendor’s assets on lease. Under IGAAP,
such contracts are not construed as a lease. Once the arrangement is classified
as a lease, it is further classified as an operating or financial lease
depending on the terms.
If the arrangement contains a financial lease, the fair value
of the asset is recognised on the automobile company’s balance sheet, increasing
its asset base and debt levels, while the impact on the income statement will be
in the form of depreciation on the leased asset and interest payment for the
lease. Under IGAAP, such expenditure would be recognised as part of operating
expenses. This treatment would have a positive impact on the EBITDA of the
company.
From the perspective of inventory valuation for the auto company, the entire payments may be construed as the cost of inventories under IGAAP. However, under IFRS, as charge to the income statement over a period of time would be in the form of depreciation on the leased assets and interest on lease obligation, the interest component may not be considered as cost of inventories.
Intangibles with indefinite useful lives
IGAAP requires all intangibles to be amortised over their useful life, though there is a rebuttable presumption that the useful life of an intangible asset will not be greater than ten years. Under IFRS, there is an additional category of intangible asset i.e. intangible assets with indefinite useful life. The term ‘indefinite’ here does not denote ‘infinite’; instead it denotes a useful life that is relatively long and is not certain eg: brands if they meet certain conditions as detailed in the standard. Such intangible assets are not amortised; rather they are tested for impairment atleast once annually.
Capital structure and borrowing costs
Sales tax deferral loan
Auto companies that have set up plants in certain notified areas are eligible to collect sales tax from customers and are required to pay the same after a few years without any interest charge, based on their total investment in the region. Under IGAAP, such interest-free loans are recognised at the amount collected throughout the tenure of the loan.
Under IFRS, such loans would be considered as financial liabilities and hence recognised at the present value of future cash flows. The difference between the nominal value (i.e., the amount collected from customers) and the present value of the loan would be recognised as a deferred government grant. The difference between the present value and the nominal value of the loan would be recognised as reduction in the value of the underlying fixed assets, or as a deferred income over the depreciable life of the underlying asset.
Borrowing costs
The borrowing costs under IGAAP are primarily determined based on the coupon rates on the financial instrument. As such, the borrowing costs in most cases represent an actual and separately earmarked cash outflow.
Under IFRS, the borrowing cost also includes the effects of routine non-lending transactions that also comprise a financing element. Consider, for instance, the above mentioned sales tax deferral loan. As stated above, the loan liability, which is initially calculated at the present value of future cash flows, shall subsequently be measured at amortised cost and the effects of unwinding of the discount would be recognised as borrowing costs.
Further, if the borrowing cost is attributable to the construction of a qualifying asset as defined under IAS 23, then such effects of unwinding of the loan liability shall also be capitalised to the carrying value of qualifying asset though there is no separate payment of interest made on the loan.
Securitisations
Stringent conditions for securitisation of loans will impact the financing arms of auto companies. Under IGAAP, an entity may de-recognise its assignments of loans and advances with credit enhancements as a ‘sale’ transaction.
Under IFRS, the assessment of retention or transfer of risks and rewards is a critical criterion to determine if de-recognition is appropriate. Legal transfer is not sufficient criteria to achieve ‘sale’ accounting.
Qualitative factors such as credit enhancement facilities provided by the originator to the special purpose trust or to a counterparty in the case of a direct assignment will also have to be evaluated to assess if the de-recognition criteria is met.
This may result in grossing-up of the balance sheet for ‘sold’ assets and related debt (sale proceeds). This, in turn, may impact debt equity ratios.
Group structure
Joint arrangements Under IFRS, consolidation is based on the control (both direct and indirect) over the entity rather than ownership. This may result in consolidation of some current JVs and associates and de-consolidation of certain JVs and subsidiaries based on contractual arrangements.
In the auto industry, the partnerships between Indian and foreign auto companies, where the Indian company may hold a majority stake but has shared control with the foreign company, may be impacted under IFRS eg: veto power with the foreign partner for approval of annual budgets and operating plans etc.
Based on the above guidance, if the consolidated entity is classified as an associate or a joint venture, the company would not be able to disclose the entire revenue of the investee in its consolidated financial statements.
Special Purpose Entity (SPE)
IFRS provides indicators to determine whether an entity controls an SPE, including an assessment of an entity’s exposure to the majority of risks and rewards of ownership of the SPE. Therefore, if the ‘control’ criteria over the SPE are met, the entity will be required to consolidate the SPE in its financial statements, even though it may have no legal ownership of the equity shares of the SPE.
In the automotive sector, the entity operates through a wide network of auto component manufacturers that work on an auto-pilot mechanism or are funded by the automotive company. Such arrangements need to be assessed for SPEs. If such entities are classified as SPEs and meet certain criterias, the SPEs are consolidated with the entity. Thus, all the assets and liabilities of these SPEs are recognised in the entity’s consolidated financial statements, thereby affecting key ratios of the entity. IGAAP does not provide for such guidance.
The financial and non-financial aspects relating to IFRS convergence need to be planned and tested in advance of the implementation date. Global experience has shown that the early adopters are generally more successful in managing the overall IFRS transition. The early-mover advantage not only provides adequate time to carry out required changes, but protects critical decisions being taken within the constraints of time and resources.
