Introduction
The
UK voters’ decision to exit the EU came
as a surprise to many observers, as well as the markets, and the vote has
triggered political, economic and financial uncertainty which is likely to
impact Indian entities having operations in the UK . There has been an
immediate impact on the financial markets, both in the UK and across the world, with the pound
significantly weakening against other currencies and share prices fluctuating
as the market reacts to the decision. The decision is expected to risk upto
75,000 jobs in EUROpe and a loss upto 10 billion pounds in tax revenue as per a
recent article in the financial express.
From
the time of announcement of Brexit till current date, the exchange rates in relation
to the pound have been volatile as given below:
– The pound to EURO rate has moved from
1.31099 in June 2016 to 1.10846 in October 2016.
– The pound to dollar rate has moved from
1.46079 in June 2016 to 1.22144 in October 2016.
– The pound to INR rate has moved from 98.07
in June 2016 to 81.40 in October 2016.
In
fact, the pound to EURO rate post June 2016 has never touched such lower levels
in the past two and half years. Further,
the Bank of England has cut the interest rate to a historic low of 0.25%
post the Brexit announcement.
In
view of this volatility, let us see the possible impact on some of the key
captions in the financial statements from an Ind-AS perspective for Indian
entities having operations in the UK :
Foreign Currency Transactions
Ind-AS
21, the effects of Changes in
foreign exchange rates allows, for
practical reasons, entities to use an appropriately average exchange rate for a
reporting period if it approximates the actual rate. In case of entities who
have operations in the UK which use a
weighted average rate, a sudden and significant change in foreign currency
exchange rates, may
affect the way
the average is calculated.
As
per Ind-AS 21, foreign currency monetary items shall be translated using the
closing exchange rate i.e assets and liabilities to be received or paid in a
fixed or determinable number of units of currency. e.g., entities in India will
have to restate their debtors, creditors, borrowings etc. held in GBP and this
could have volatility in the profit and loss account due to the exchange rate
movement.
Ind-AS
21 defines the concept of functional currency as the currency of the primary
economic environment in which the entity operates. An entity would record all
transactions in its books of accounts in the functional currency. Some factors
which determine the functional currency of an entity include:
Currency
in which sales prices for its goods and services are denominated and settled;
and
Currency
of the country whose competitive forces and regulations mainly determine the
sale prices of its goods and services.
For
Indian entities, with functional currency as INR, the same is not expected to
change. however, if such an entity has a
subsidiary in the UK , it may have to monitor and reassess the UK subsidiary functional currency in light of
the BreXit. this
is because, going
forward, entities may adjust their trading relationships with entities
in the EU and the rest of the world, as
a result of trade negotiation and trade agreements between the UK and other
countries. In these circumstances, entities
need to monitor the primary economic environment in which they operated,
and assess if there is a change in the functional currency.
Investment in Subsidiaries, Associates and Joint Ventures
Entities
in India may have investments in subsidiaries, associates and joint ventures in
the UK. Under Ind-AS, these investments will be carried at cost or at fair
value as per Ind-AS 109.
The volatility in
exchange rates and interest rates
could have a possible impact on the separate financial statements of the Indian
entity from an impairment perspective. e.g., the entity may have to re-build
the underlying cash flow projections for the UK
business considering any change expected in the business outcomes due to
the Brexit. These cash flow projections will have to be further adjusted for
the exchange rate/ discount rate assumptions. Accordingly, this may trigger an
impairment provision in the separate financial statements of the Indian entity.
In
case of consolidated financial statements, the impact of the translation from
the functional currency of the UK
subsidiary (e.g. GBP) to the reporting currency of the parent Indian
entity (e.g. INR) is recognised in other comprehensive income and accumulated
as a separate component of the equity. This is reclassified from equity to the
profit and loss on disposal of the subsidiary investment. As per the standard,
a write-down of the carrying amount either because of losses / impairment does
not trigger any reclass from equity. However,
there could be a possible impairment to the goodwill on consolidation of
the subsidiary/net investment in the associate or the joint venture in the
consolidated financial statements of the Indian entity.
Impairment of assets with indefinite/ finite useful life
Entities
are expected to have at least a high-level overview on what the effects of
Brexit might be on the key financial assumptions used
to determine recoverable
amounts and other potential consequences for the entity. Cash flow
projections used in impairment assessment should be adjusted for changes in
possible business outcomes due to Brexit. Further, discount rates used should also be reassessed
to reflect the current market assessment of the time value of money considering
the change in the interest rates. Accordingly, recoverable amounts may undergo
a change, resulting in impairment provisions in certain cases.
Similarly,
property, plant and equipment and intangible assets with a finite useful life are
tested for impairment when factors are
present that indicate
the recorded value of a
non-current asset (or asset group) may not be recoverable. This may require
appropriate re-assessment.
Defined benefit plans
Market
volatility could have implications for the measurement of the pension asset or
liability under defined benefit schemes. For example, decline in equity markets
and potential changes
in interest rates
as explained above could have a
significant effect on the fair value of plan assets and the funded status of
plans, as well as the defined benefit obligation. This would have an impact
especially in case of Indian entities having subsidiaries / plan assets for its
branches located in the UK.
Entities/Groups
operating cross border pension schemes within the EU will also need to closely
watch the changes, if any, that could make such schemes no longer operational
e.g., an entity may have UK -based cross-border pension schemes for employees
across the EU may find that those schemes can no longer operate in EU member
states. Conversely, it may be that a cross-border pension scheme that is based
in an EU member state can no longer be used for UK employees. The replacement or relocation of
these pension arrangements will then become necessary and may bring about
change in the pension liabilities recorded.
Income Taxes
Determining
whether deferred tax assets qualify for recognition under Ind-AS12 income taxes
often requires an extensive analysis of the positive and negative evidence for
the realisation of the related deductible temporary differences and an
assessment of the likelihood of sufficient future taxable
income. Volatile economic
conditions add complexity to this analysis and may be a source of
negative evidence.
Provisions
Ind-AS37
Provisions, Contingent liabilities and Contingent assets requires the discount
rate that is used to calculate the present value of expected expenditures to
reflect current market assessments of the time value of money and risks
specific to the liability. Changes in interest rates and other economic
indicators following the outcome of the referendum may well affect the
estimates of future cash flows inherent in the provision. Accordingly,
provisions may be required to be restated.
Due
to stability in exchange rates in the past, entities in the UK may have entered into long term purchase and
sales contracts which may now become onerous due to the significant fall in the
exchange rates. Consequently, losses on such contracts will be required to be
provided for.
Business Combination
Para
45 – 49 of Ind-AS103 deals with the concept of measurement period which states
that, post the acquisition date, if there is any change in the fair value of
assets and liabilities, the
same can be adjusted
back to the purchase price allocation on the
acquisition date only if the adjustment / change takes place during the
measurement period. However, the measurement period shall not exceed one year
from the acquisition date. In case of business combinations which have taken
place in the pre-vote period and where measurement period is over, any further
change in the fair value of assets and liabilities may have an impact in the
profit or loss in the period of change.
Financial Reporting Considerations
As
per Ind-AS1 (para 125) – ‘an entity should disclose information about
the assumptions it makes
about the future, and other major sources of estimation uncertainty at
the end of the reporting period, that have a significant risk of resulting in a
material adjustment to the carrying amounts of assets and liabilities within
the next financial year.’
Entities
should consider whether
the potential effects of Brexit materially change their
previously disclosed judgements and sources of estimation uncertainty, or
whether an entity is exposed to any new factors resulting from the vote. These
disclosures should be tailored to an entity’s facts and circumstances,
including a discussion of the entity’s affected operations and the specific
effects on its operations, liquidity and financial condition.
E.g.,
Changes in the sensitivity of reasonably possible outcomes related to goodwill
impairment assumptions.
Ensuring
valuation methodologies are adequately explained due to market volatility, key
assumptions are disclosed and appropriate consideration is given to the use of
sensitivity analysis e.g. impact due to change in exchange rate by 1%, change
in interest rate by 1% etc.
Reassessment
of going concern assumption for entities exporting significantly to the UK or UK
entities with a high level of import from the EU who do not have
adequate risk management processes in place.
Entities
in India will need to consider some of the above accounting and
financial reporting implications
of this exit and monitor and
assess how subsequent events / government decisions in the UK and the EU may possibly bring a change to
their own operations and/or investment strategies.
