With its press release dated 25th February 2011, the Ministry of Corporate Affairs (MCA) notified 35 Indian Accounting Standards converged with IFRS (Ind-AS), thereby eliminating the speculation on the contents of the final standards. However, the press release does not contain the date of implementation of the converged standards. The MCA has clarified that the date of implementation shall be notified at a later date after various issues, including tax-related ones, are resolved.
The final standards notified by the MCA are substantially similar to the current IFRS standards. However, there are certain changes made to the Ind-AS standards as part of the convergence (rather than adoption) process to suit more appropriately to the Indian environment. These changes can be classified into the following categories:
- Mandatory differences as compared to IFRS
- Removal of accounting policy choices available under IFRS
- Additional accounting policy options provided, which are not in compliance with IFRS requirements
- Certain IFRS guidance to be adopted with separate (deferred) implementation dates.
This article attempts to explain the first category of carve-outs i.e., mandatory differences with IFRS and their impact on the financial statements. We will cover the other categories of carve-outs in our subsequent articles.
Foreign currency convertible bonds (FCCB):
Position under IFRS:
FCCB involve an exchange of a fixed number of shares for a fixed consideration that is denominated in foreign currency. Since the cash flows of the issuer entity in its own functional currency (i.e., in rupees) is variable due to changes in exchange rates, FCCB do not meet the definition of an equity instrument under IFRS. Thus, under IFRS, FCCB are classified as hybrid instruments and are initially split between the conversion option (embedded derivative) and the loan liability.
Conversion option: The conversion option is treated like a derivative and is initially recorded at its fair value. Like all derivatives, the conversion option is subsequently marked-to-market (MTM) at every reporting date and the impact is recognised in the income statement.
Loan liability: The loan liability is initially recorded as the difference between the proceeds and the amount allocated to the conversion option. Interest is thereafter recorded based on imputed interest rates. Further, the loan is adjusted for exchange rate movements that are recognised in the income statement.
Position under Ind-AS:
The Ind-AS has modified the definition of financial liabilities under Ind-AS 32 (vis-à-vis IAS 32) to exclude from its definition, the option to convert the foreign currency denominated borrowings into a fixed number of shares at a fixed exercise price (in any currency). Thus, these instruments will be split initially into the loan liability and the conversion option (as discussed above), but the conversion option will be recognised as equity (as against a derivative under IFRS) and therefore will not remeasured subsequently i.e., no subsequent MTM.
Key implications of the carve-out:
The key implication of this is that the conversion option is not subsequently MTM under Ind-AS, while such MTM is required under IFRS.
Under IFRS, the changes in the fair value of the conversion option may have a significant impact and result in volatility in profits. Further, the impact on the profits for the year is inversely related to the movement in the underlying share price; i.e., if the fair value of the underlying shares rises, MTM of the conversion option would lead to losses to be recognised in the income statement and vice-versa.
Under Ind-AS, since the conversion option is recognised as equity and is not remeasured subsequently, the carve-out eliminates the volatility in profits on account of the changes in the underlying share prices of the company.
Let us understand the impact of the carve-out with the help of an example:
On 1st April 2012, Company A (INR functional currency) issued 10,000 convertible bonds of USD 100 each with a coupon rate of 4% p.a. (interest payable annually in arrears). The total proceeds collected aggregated to USD 1 million. Each USD 100 bond is convertible, at the holder’s discretion, at any time prior to maturity on 31st March 2017, into 1,000 ordinary shares of Rs.10 each. For simplicity, transaction costs and deferred taxes are ignored. The following information on the exchange rate (spot) and fair value of conversion option (option) may be relevant:
Under IFRS, proceeds collected would be required to be split into loan liability and the conversion option. The total proceeds from the issue of USD 1 million aggregates to Rs.45 million based on a conversion rate of USD 1 = Rs.45. On initial recognition, the conversion option would be recognised at its fair value (i.e., Rs.4.5 million or 0.1 million USD) and the remaining proceeds (i.e., Rs.40.5 million or 0.9 million USD) would be recognised as loan liability.
The Company shall compute an effective interest rate based on the loan principal received (i.e., 0.9 million USD), loan principal on maturity (USD 1 million) and payments to be made for interest costs @ 4% p.a. on the loan principal of USD 1 million. The effective interest rate in this case works out to 6.4% p.a. The interest cost p.a. shall be computed based on outstanding loan principal (in foreign currency) and the effective interest rate of 6.4% p.a. converted at average exchange rates during the year. Further, the loan liability shall be translated at exchange rate as at the reporting date, with the exchange differences recognised in the income statement.
The conversion option on initial recognition aggregated to Rs.4.5 million, while the fair value of the conversion option as at the end of the year aggregates to Rs.9.2 million i.e., an increase by Rs.4.7 million. IFRS requires such a change in the fair value of conversion option to be recognised in the income statement.
Let us consider the movements in the carrying values of the conversion option and the loan liability:
Under IFRS
There are three costs recognised in the income statement i.e., interest cost on the loan, the exchange differences on the loan and the MTM gains/losses on the conversion option.
Under Ind-AS, the accounting for the loan liability is same as under IFRS. However, the conversion option is to be recognised as equity. As stated above, for simplicity we have ignored the transaction costs and deferred taxes. On initial recognition, the fair value of the conversion option (i.e., Rs.4.5 million) shall be recognised as equity. As at the end of the first year i.e., 31st March 2013, there is no further adjustment required on account of the fair value movements of the conversion option.
The costs to the company on account of FCCB under Ind-AS will be the interest cost and exchange gains/losses on the loan components of the instrument, with the conversion option not being remeasured for changes in its fair value.
Under Ind-AS
Agreements for sale of real estate (IFRIC 15):
Position under IFRS:
IFRIC 15 focusses on the accounting for revenue recognition by entities that undertake the construction of real estate. IFRIC 15 provides guidance on determining whether revenue from the construction of real estate should be accounted for in accordance with IAS 11 (Construction contract) or IAS 18 (Sale of goods), and the timing of revenue recognition.
IFRIC 15 clarifies that IAS 11 is applied to agreements for the construction of real estate that meet the definitio
