Ind As – Learnings From Phase 1 Implementation Tips For A Smooth Implementation (Part 2)

Introduction

The first human landing on the moon was
aptly described by Neil Armstrong as “One small step for man, but a giant leap
for mankind.” For Phase 1 Ind AS conversion process one may say, “One small
step for the regulators, but a giant leap for the profession and the corporate
sector.”

In accordance with the road map, phase 2
entities have started providing quarterly results under Ind AS starting from
the first quarter of 2017-18 with comparative Ind AS numbers for 2016-17. Under
Ind AS 101, the first time adoption choices are open and can be changed till
the preparation of the first annual financial statements for 2017-18. Also,
quarterly results do not include the disclosures required in the Ind AS annual
financial statements. It is therefore worthwhile for Phase 2 entities to learn
from Phase 1 Ind AS implementation. Some important tips were included in Part I
of the article. With Part II, we conclude this topic.

Make the 
Ind AS conversion process a system driven process and not a manual
process

For many Phase 1 entities, transition was
not a smooth process. Most companies used short cuts such as doing the Ind AS
conversion process using spread sheets. Fixed asset registers were not updated
for the Ind AS impacts. Neither did the entity consider the impact of Ind AS
conversion on internal financial controls. Reliance was placed more on manual
controls rather than automatic IT controls. Tax accounts were generated offline
and consolidation was done on spread sheets instead of using an accounting
package. The conversion processwas dependent entirely on a few people and was
not institutionalised. Therefore it became a people driven activity rather than
a process driven activity. With the departure of those critical people, some
entities may haveexperienced severe difficulty.

Phase 1 entities grappled with a lot of
challenges simultaneously, such as, GST, ICDS, Company law, Audit rotation, MAT
and Ind AS. As a result of lack of time and an
unstable platform, it was probably not possible or efficient for Phase 1
entitiesto make the Ind AS change a system driven process. In contrast, Phase
II entities have a relatively stable platform, more time and have already dealt
with some other challenges, such as audit rotation or Company law. Phase II
entities should therefore make the Ind AS conversion a system driven process.

Closely consider matters relating to control
and consolidation

The definition of control and joint control
under Indian GAAP and Ind AS are significantly different. For companies that
have a lot of structured entities or strategic investments, Ind AS may have a
huge impact in the consolidated financial statements (CFS). Consider an
example.

The Insurance Laws (Amendment) Act, 2015
provides specific safeguards relating to Indian ownership and control.
Currently, FDI is allowed only upto 49%. Many Indian companies have set-up
insurance companies in partnership with foreign partners. Though the Indian
company owns 51% of the shares, but through the shareholders agreement, the
foreign partner was having effective control or joint control of the insurance
company.

Under Indian GAAP, the Indian partner fully
consolidated the Insurance subsidiary, based on 51% shareholding.

Under Ind AS, the insurance company is not a
subsidiary of the Indian partner, since it does not have the effective control.
The auditors insisted that the company cannot be consolidated by the Indian
partner under Ind AS; whereas, the Insurance Regulatory and Development
Authority (IRDA) wanted the Indian partner to consolidate the entity since as
per the Insurance Laws (Amendment) Act, the Indian partner should have the
control of the insurance company. In a particular case, the shareholders
agreements was changed to enforce IRDA’s guidelines on ‘India Owned India
Controlled’. Another example of legal challenge relates to real estate. The
regulations on Urban Land Ceilings (ULC) would restrict the quantum of land
owned by a real estate company. As a result, real estate companies own land
through several structured land holding entities, which are not subsidiaries
under Indian GAAP and therefore not consolidated. Till such time the outdated
legislations are amended, these strategies will have to be evaluated, after due
consideration of the Ind AS requirements.

Similar issues may arise in e-retail,
defence, hospital, education, payment banks, etc. where FDI norms or
other regulations apply. These issues are very complicated and would need
careful consideration, legal opinions and timely planning.

Watch-out for Unintended Consequences

A lot of puritanical accounting required by
Ind AS can create challenging situations for Indian entities. Consider an
example.

Example 1

Telecom companies are required to pay
license fees on their revenue. As per the Honorable Supreme Court judgement,
revenue includes treasury income. Under the Companies Act 2013, a loan to a
subsidiary company should be interest bearing and the interest rates are market
linked. However, a telecom company may have subscribed to redeemable preference
capital issued by a subsidiary that provides only discretionary dividend.
Consequently, this would require the Telecom Company to present the preference
share investment in Ind AS financial statements at a discounted amount, and
subsequently recognise P&L credit arising from the unwinding effect. This
is elaborated in the example below.

A day prior to transition, Parent gives 10
year INR 1000 interest free loan to Subsidiary.

A similar accounting would be required when
the Telecom Company provides a financial guarantee to a bank on behalf of its
subsidiary. P&L will also be credited for the unrealised fair value gains
on mutual fund valuation, when the net asset value of the mutual fund has
increased.

From an accounting point of view, counting
the chicken before they are hatched, may be appropriate as it represents the
substance of the transaction or the fair value at the date of the balance
sheet. Consequently, regulators may argue that telecom companies are required
to pay license fee on such artificial income recognised in accordance with Ind
AS. Similarly, if the Telecom Company is in the Minimum Alternate Tax (MAT)
regime, all the above artificial income would be included in book profits and
subjected to a MAT tax. Is it fair, that an accounting change should have
such severe unintended consequences for Indian entities? These are some
unintended consequences of implementing Ind AS, which in the opinion of the
author should have been taken care of by the authorities much before the
implementation of Ind AS was announced.

Phase II companies should not
underestimate the business consequences of implementing Ind AS, and carefully
plan for these unintended consequences. For example,
in the above situation, if the Telecom Company had converted the loan into
equity prior to the TD, the above consequences can be mitigated. However, there
may be other tax consequences of converting loan into equity. Therefore,
entities should strategize after obtaining appropriate tax advice.

Do some out of the box thinking

Some out of the box thinking will always
help. For this purpose, the entity will need to be assisted by  people 
with  many  years 
of Ind AS experience and expertise. Consider an example. With respect to
joint ventures, some entities may have preference for the proportionate
consolidation method, because it helps the consolidating entity to show a
higher revenue and a larger balance sheet size. Other entities may have
preference for the equity method of accounting for joint ventures, because it
reduces the debt and the leverage in the consolidated balance sheet. Under
Indian GAAP, joint ventures are always consolidated using the proportionate
consolidation method. However, Ind AS invariably requires the equity method of
accounting for jointly controlled entities. The actual impact in the case of a
tower infrastructure company is given below.

It may be noted that under Ind AS 108, Operating
Segments, the segment operating results do not have to be prepared based on
the accounting policies applied in the preparation of the financial statements
of the entity. The segment disclosures are presented in the financial
statements, based on how those are reported to the Chief Operating Decision
Maker (CODM) for the purposes of his/her decision making. It is therefore
possible for an entity to present the segment disclosures in which the jointly
controlled investee is consolidated using proportionate consolidation method
though for the financial statements it was consolidated using the equity
method. This strategy can be applied only if the CODM actually uses the segment
information for decision making prepared on the basis of proportionate consolidation
method.

There will be many such situations where an
entity will be required to do some out of the box thinking.

More planning required for mergers and
amalgamations (M&A)

Entities will need to rethink their
strategies around M&A because Ind AS requirements are very different
compared to Indian GAAP. More importantly, the Companies Act now requires an
auditor’s certificate to certify that the accounting given in the M&A
scheme submitted to the court is in compliance with the accounting standards.
This requirement applies irrespective of the listing status of the company.
Many companies faced situations where they did not have any clarity on the
M&A accounting, particularly those that happened prior to the TD or in the
comparative Ind AS period. The end result was that the M&A accounting
particularly those prior to the TD and in the comparative period ended up all
over the place. Trying to explain all that is meaningless, and will sound
gobbledegook.

Two key differences between Indian GAAP
and Ind AS is that under Indian GAAP, the M&A is to be accounted from the
appointed date mentioned in the scheme. Under Ind AS, the M&A is accounted
at the effective date, which is when all the critical formalities relating to
the M&A are completed. For example, in the case
of a merger of two telecom companies, TRAI approval, court order, CCI approval,
etc. would need to be completed and the date when all these important
formalities are completed would be the effective date for accounting the
M&A. The other major difference is that under Indian GAAP, it was easily
possible with a bit of tweaking to either apply the pooling of interest method
or the acquisition accounting method. Contrarily, under Ind AS, M&A between
group companies under common control is only accounted using the pooling of
interest method and M&A between independent companies is only accounted
using the acquisition accounting method. Therefore under Ind AS entities will
no longer have the flexibility that Indian GAAP provided.

It may be noted that under the pooling of
interest method, the M&A is accounted at book values of the net assets of
the transferor company and the difference between the fair value of the
consideration paid and the share capital of the transferee company is adjusted
against reserves. This accounting could therefore significantly dent the net
worth of the acquirer.

A common challenge is whether the M&A is
accounted from the appointed date or the effective date. This would depend on
whether we perceive the Court approval as a substantive hurdle or a mere
procedural formality. The author believes that under Indian jurisdiction, court
approval should be considered as a substantive hurdle. It cannot be considered
as a mere procedural formality.The Madras High Court by way of its order dated
6^th June, 2016 in the case of Equitas passed a very
interesting order. In the said case, the holding company had applied to the RBI
for in-principle approval to establish a Small Finance Bank (SFB). The RBI
granted an in-principle approval subject to the transfer of the two transferor
companies into the transferee company, prior to the commencement of the SFB
business. The Regional Director (RD) raised a concern that the scheme did not
mention an appointed date, and that the appointed date was tied to the
effective date. Further, even the effective date was not mentioned and it was
defined to be the date immediately preceding the date of commencement of the
SFB business. The court observed that under section 394 of the Companies Act
such a leeway was provided to the Company. Further, section 394 did not fetter
the court from delaying the date of actual amalgamation/merger. This judgement
would provide a leeway to the Company to file scheme of mergers/amalgamation
with an appointed date/effective date conditional upon happening or
non-happening of certain events.

M&A prior to TD also lent itself to
numerous tax mitigation or balance sheet sizing opportunities. Consider an
example. Parent acquires business under slump sale before TD from home grown
subsidiary, the book value of which was INR 600 and fair value was INR 650. The
accounting under Indian GAAP is as follows.

 Scenario under Indian GAAP: Apply
acquisition accounting under AS 14

 Under Ind AS, since this is a common control
transaction, pooling of interest method would apply and consequently no
goodwill is recorded.

Scenario under Ind AS: Common control
transaction. Apply pooling of interest method. No goodwill.

In the normal Income Tax computation, when
the M&A was first recorded under Indian GAAP, goodwill will form part of
the gross block of asset and tax depreciation deductions would be available
subject to fulfillment of certain conditions. On the other hand, by applying
Ind AS retrospectively to the M&A, goodwill in the TD balance sheet is
eliminated, and consequently future P&L is protected against any impairment
of that goodwill. This strategy should not taint the tax deductibility of
goodwill, since it is already included in the gross block in the tax computation.

Do not forget that impact of regulations can
be debilitating

Appendix A to Ind AS 11 Service
Concession Arrangements applies to an arrangement in which the Government
regulates the pricing and has residual interest in that project. Hitherto,
under Indian GAAP, an infrastructure company recorded the investment in an
infrastructure project as PPE (INR 100 in example below) and the user charges
collected from users as revenue. Under Ind AS, such an arrangement would be
treated as an exchange transaction between the Government and the
infrastructure company. The exchange involves providing construction
services in lieu of a right to charge users (eg, toll in the case of a
road) or receive annuity from the Government. Accordingly the infrastructure company
would record construction services at fair value (INR 120 in below example) in lieu
of an intangible asset (or annuities) it receives from the Government. This
accounting results in recording a profit of INR 20 (in the example below) as
the construction services are provided.

The above accounting creates numerous
business challenges, a few of which are given below:

–  Certain
infrastructure projects require a percentage of revenue to be shared with the
Government. The above Ind AS accounting results in a huge revenue recognition
upfront, potentially creating an obligation on the infrastructure company to
pay a share of the revenue to the Government. The amount and the consequences
and the litigation that can follow, can be debilitating to an infrastructure company.

–   For
an infrastructure company that is under MAT regime, it would have to pay MAT on
the artificial income of INR 20. Besides, for a company that is under normal
tax regime, an obligation to pay tax may arise on INR 20, depending on how ICDS
is interpreted.

 –   If
the arrangement entails annuity payments by the Government, then instead of an
intangible asset a receivable from the Government would be recorded at fair
value. This could potentially make an infrastructure company an NBFC, exposing
it to a whole set of financial regulations and RBI requirements.

The above are only a few examples of the
consequences of adopting Ind AS for an infrastructure company. The author
believes that these are unintended consequences, which the authorities should
have resolved before making Ind AS implementation mandatory. The problems faced
by infrastructure companies are enormous. This will further add to their
burden.

Similar challenges also arise in multiple
areas, for example, in the case of leases embedded in service contracts.
However, with careful planning and structuring, an entity may be able to
eliminate or minimise the adverse consequences.

Great opportunity to correct size the balance
sheet

The Ind AS conversion process provides a
once in a life time opportunity to get the balance sheet right, and to execute
tax mitigating opportunities. Consider some examples.

 1.  The
Expected Credit Loss (ECL) model can be applied on the TD for making a
provision against receivables or work in progress. This strategy can reduce
some of the stress on the old receivables, particularly arising from the time
value of money. More importantly, since the provision amount is adjusted
against retained earnings the future P&L will be protected. As per FAQ 6 in
“Clarifications on computation of book profit for purposes of levy of MAT
u/s 115JB of the Income-tax Act, 1961 for Ind AS compliant companies”
issued by CBDT, TD adjustments relating to provision for doubtful debts shall
not be considered for the purpose of computation of the transition amount for
MAT deduction.

 2.  Upward increase in fair
value of PPE, particularly land will improve the net worth of an entity. If all
PPE is fair valued upwards, it may result in higher depreciation charge in
future years. On the other hand, if only land is fair valued, then net worth
may improve significantly without causing any dent on future P&L on account
of depreciation. A downward fair valuation of PPE may be applied in cases when
those assets are on the threshold of an impairment charge. A downward fair
valuation of the PPE, will ensure that future P&L is protected from an
impairment charge.

3.  Perpetual debts are
instruments that do not contain an obligation for redemption or interest
payments. However, they do contain an economic compulsion, such as, dividend
blocker on other equity shares of the issuer or steep increases in the interest
rate for future periods, etc. An entity can achieve a better balance
sheet by using appropriate capital instruments. For example, instruments which
do not contain a redemption obligation would be classified as equity. Therefore,
perpetual debts in the books of the issuer will be classified as equity and the
interest outflow will be treated as dividends and debited to Statement of
Changes in Equity (SOCIE).  One will
also need to consider tax risks of Tax Authority seeking to deny deduction of
interest in normal tax computation and/or seeking to levy Dividend Distribution
Tax u/s. 115-O on the ground that it is in the nature of dividend. Further,
since interest outflow will be debited to SOCIE, the company will lose out on
MAT deduction in the absence of debit to P&L.

Phase II companies should evaluate the
numerous possibilities of getting the balance sheet right.

Conclusion

Phase 2 entities should use the benefit of
lessons learnt on Phase 1 implementation and avoid any pitfalls. It will
require help from an expert, careful consideration of regulatory and business
impacts and timely planning. _