FINANCIAL REPORTING DOSSIER

This article
provides (a) key recent updates in the financial reporting space
globally and in India; (b) insights into an accounting topic, viz., accounting
for development costs; (c) compliance aspects of disclosure of NCIs’
interest in group activities and cash flow under Ind AS; (d) a peek into an
international reporting practice in the Director’s Report, and (e) an
extract from a regulator’s speech from the past on high-quality financial
information

1      KEY RECENT UPDATES

1.1   IFRS: Covid-19 Accounting for ECL

On 27^th
March, 2020 the IASB issued a document for educational purposes, viz. IFRS
9 and Covid-19 – Accounting for Expected Credit Losses
(ECL) highlighting requirements within IFRS 9 – Financial
Instruments that are relevant to preparers considering how the current
pandemic affects ECL accounting. The document acknowledges that estimating ECL
on financial instruments is challenging under the present circumstances and
highlights the importance of companies using all reasonable and supportable
information available – historic, current and forward-looking to the extent
possible in the measurement of ECL and in the determination of whether lifetime
ECL should be recognised on loans.

1.2   IFRS: Covid-19 – Related Rent Concessions

On 24^th
April, 2020 the IASB issued an Exposure Draft: Covid-19 – Related Rent
Concessions proposing amendments to IFRS 16 – Leases to make it
easier for lessees to account for the pandemic-related rent concessions (rent
holidays, temporary rent deductions, etc.). The proposed amendments exempt
lessees from having to consider whether Covid-19 related rent concessions are
lease modifications, allowing them to account for the changes as if they were
not lease modifications. The amendments would apply to Covid-19 related rent
concessions that reduce lease payments due in 2020.

1.3   USGAAP: Accounting for Leases during Pandemic

The FASB on
10^th April, 2020 issued a Staff Q&A on Accounting for Leases
during Covid-19 Pandemic. The interpretations provided in the
Q&A include: (i) it would be acceptable for entities to make an election to
account for Covid-19 related lease concessions consistent with extant USGAAP
(Topics 842 and 840) as though enforceable rights and obligations for those
concessions existed, and (ii) an entity should provide disclosures about
material concessions granted or received and the related accounting effects to
enable users to understand the nature and financial effect of Covid-19 related
lease concessions.

1.4   PCAOB: Covid-19: Reminders for Audits Nearing
Completion

Earlier, on
2^nd April, 2020, the PCAOB released a staff spotlight document, Covid-19:
Reminders for Audits Nearing Completion to provide important reminders to
auditors in light of Covid-19 considering the breadth and the scale of the
pandemic that may present challenges to auditors in fulfilling their
responsibilities and require more effort in audit completion.

Key
takeaways from the document include: (i) new audit risks may emerge from the
effects of the pandemic, or assessments of previously identified risks may need
to be revisited, (ii) auditors may need to obtain evidence of a different
nature or form than originally planned which may affect considerations of its
relevance and reliability, (iii) some financial statement areas may present
challenges to the auditor’s evaluation of presentation and disclosures, e.g.
subsequent events, going concern, asset valuation, impairment, fair value,
etc., (iv) significant changes to the planned audit strategy or the significant
risks initially identified are required to be communicated to the Audit
Committee, and (v) including additional elements in the auditor’s report such
as explanatory language / paragraph when there is substantial doubt about the
ability of the company to continue as a going concern.

1.5   ICAI Guidance on Going Concern

On 10^th
May, 2020 the ICAI issued its Guidance on Going Concern – Key Considerations
for Auditors amid Covid-19. The Guidance focuses on the implications of
Covid-19 for the auditor’s work related to going concern including: (a) matters
the auditor should consider for going concern assessment, (b) management and
auditor’s respective responsibilities, (c) period of going concern assessment,
(d) additional audit procedures required, and (e) implications for the
auditor’s report. The Guidance includes FAQs to deal with various situations in
the current environment.

1.6   ICAI Guidance on Physical Inventory
Verification

And on 13^th
May, 2020, the ICAI issued Guidance on Physical Inventory Verification –
Key Considerations amid Covid-19. It highlights the use of alternate
audit procedures where it is impracticable to attend physical inventory
counting (on account of the pandemic) that include: (i) using the work of the
internal auditor, (ii) engaging other CAs to attend physical verification, and
(iii) use of technology. The corresponding implications for the Auditor’s
Report being (a) where such alternate audit procedures provide sufficient
appropriate audit evidence, the auditor’s opinion need not be modified (in
respect of inventory), and (b) if it is not possible to perform alternate audit
procedures, the auditor should modify the opinion per SA 705 (Revised).

2      RESEARCH: ACCOUNTING FOR DEVELOPMENT COSTS

2.1   Introduction

Development
is ‘the application of research findings or other knowledge to a plan or
design for the production of new or substantially improved materials, devices,
products, processes, systems or services before the start of commercial
production or use’. Expenditure incurred internally on development by a
company could be either charged off to expense or capitalised as an intangible
asset and the accounting treatment is a function of the GAAP applied.

2.2   Setting the context

An analysis
of a sample of three companies’ data based on their annual reports filed with
the regulators is provided in Table A below.

As can be seen from the table above, the expenditure in the P&L
related to development costs and the intangible asset recognised on the balance
sheet arising out of development costs is a function of the GAAP applied.
Development costs are expensed under USGAAP while IFRS / Ind AS requires
capitalisation if specified criteria are met. IFRS for SMEs and the US FRF
accounting frameworks that apply to SMEs also differ in the accounting
treatment for this topic.

In the
following sections, an attempt is made to address the following questions:

1.     What is the current position with respect
to accounting for development costs under prominent GAAPs?

2.     Is there consistency among GAAPs with
respect to the accounting treatment?

3.     What have been the historical developments
globally with respect to accounting for development costs?

4.     What are the different accounting methods
that were considered by global accounting standard setters?

5.     Is accounting information for development
costs provided under current accounting frameworks useful to investors?

2.3   The Position under Prominent GAAPs

USGAAP

Extant ASC
730 – Research and Development requires costs incurred on both Research
and Development to be charged to the income statement when incurred
(ASC 730-10-25-1).

Tracing the
historical developments, in October, 1974 the FASB issued SFAS No. 2 – Accounting
for Research and Development Costs. In developing the standard, the Board
considered certain alternative methods of accounting for R&D costs. These
included:

i)   Charging all R&D costs to the income
statement when incurred,

ii)  Capitalising all R&D costs when incurred,

iii)  Capitalising R&D costs when incurred if
specified conditions are met and charging all other costs to expense, and

iv) Accumulating all costs in a special category
until the existence of future benefits can be determined.

The Board
decided to adopt the accounting alternative of expensing R&D costs when
incurred considering the uncertainty of associated future benefits. USGAAP
literature has special capitalisation criteria that are industry specific
(e.g., software developed for internal use, software developed for sale to
third parties, etc.). It may be noted that USGAAP allowed capitalisation of
development costs prior to the issue of SFAS No. 2.

SFAS No. 86
– Accounting for the Costs of Computer Software to be Sold, Leased or
Otherwise Marketed, issued in August, 1985 specified that costs incurred
internally in creating a computer software product should be charged to expense
when incurred as R&D until technological feasibility has been established
for the product (which is upon completion of a detailed programme design or, in
its absence, completion of a working model). Thereafter, all software
production costs should be capitalised and subsequently reported at the lower
of the unamortised cost or net realisable value. (Current codification – ASC
985-20-25-1.)

IFRS

IAS 38 Intangible
Assets requires an intangible asset arising from development (or
from the development phase of an internal project) to be recognised if
an entity can demonstrate: (a) technical feasibility of completing the
intangible asset, (b) its intention to complete the intangible asset and use or
sell it, (c) its ability to use or sell the intangible asset, (d) how the
intangible asset will generate probable future economic benefits, (e) the
availability of adequate technical, financial and other resources to complete
the development and to use or sell the intangible asset, and (f) its ability to
measure reliably the expenditure attributable to the intangible asset during
its development.

If the capitalisation criteria are not met, then an entity is required to
expense the same when incurred unless the item is acquired in a business
combination and cannot be recognised as an intangible asset, in which case it
forms part of the amount recognised as goodwill at the date of acquisition (IAS
38.68). It may be noted that as per IFRS 3 – Business Combinations, an
acquirer is required to recognise at the acquisition date, separately from goodwill,
an intangible asset of the acquiree irrespective of whether the asset had been
recognised by the acquiree before the business combination.

Prior to the issuance of IAS 38 (in 1998), IAS 9 Accounting for
Research and Development Activities (issued in 1978) required both Research
and Development expenditure to be recognised as expense when incurred, except
that a reporting entity had the option to recognise an asset arising from
development expenditure when certain specified criteria were met. IAS 9 limited
the amount of expenditure that could initially be recognised for an asset
arising from development expenditure to the amount that was probable of being
recovered from the asset. In 1993, IAS 9 Research and Development Costs
was issued which changed the previous accounting requirement and required
recognition of an asset from development expenditure when specified criteria
were met.

2.4   Current Position Under Various GAAPs

Table
B:

2.5   Utility to Users of Financial Statements

Current
accounting standards for R&D costs across GAAPs do not lend themselves to
communication of an organisation’s value drivers. Nor do they help in valuation
exercises by investors. Alternate non-financial metrics and models, including
integrated reporting, the balanced scorecard, the intangible assets monitor,
the value chain scoreboard, etc. are being used by corporates globally to
communicate relevant and useful information to shareholders with respect to
their R&D investments. Investors focus inter alia on outcomes of
R&D investment and R&D productivity rather than just the spends that
are reported per GAAP.

The
following case study provides an interesting management view-point on the
relevance of current R&D financial reporting.

Case Study

Amazon.com,
Inc. (listed on NASDAQ, 2019 Revenues – US$ 280.5 billion, USGAAP reporting
entity) does not disclose separately expenditure on R&D in its financial
statements. The company is reportedly the largest R&D spender globally.
Such expenditure is included in the line item ‘Technology and Content
expenses’ (US$ 35.9 billion in 2019 representing 12.8% of revenues).

The
accounting policy of the company is: ‘Technology and content costs include
payroll and related expenses for employees involved in the research and
development of new and existing products and services, development,
design and maintenance of our stores, curation and display of products and
services made available in our online stores, and infrastructure costs. Technology
and content costs are generally expensed as incurred’.

In 2017, the
US Securities and Exchange Commission questioned such non-disclosure. The
management’s response (available in the public domain) is extracted herein
below:

Because of
our relentless focus on innovation and customer obsession, we do not manage our
business by separating activities of the type that under USGAAP ASC 730 are
‘typically… considered’ research and development from our other activities that
are directed at ongoing innovation and enhancements to our innovations.
Instead, we manage the total investment in our employees and infrastructure
across all our product and service offerings, rather than viewing it as related
to a particular product or service; we view and manage these costs
collectively as investments being made on behalf of our customers in order to
improve the customer experience. We believe this approach to managing our
business is different from the concept of planned and focused projects with
specific objectives that was contemplated when the accounting standards for
R&D were developed under FAS 2.

We do not
believe that separate disclosure of the costs associated with activities of the
type set forth in ASC 730 would be material to understanding our business. We
are concerned that separate disclosure of such costs would focus our financial
statement users on a metric that understates the level of innovation in which
we are investing.

3      GLOBAL ANNUAL REPORT EXTRACTS: ‘EMPLOYEE
ENGAGEMENT’

Background

UK Companies
(employing more than 250 employees) are required to include in their Annual
Reports (for the F.Y. commencing 1st January, 2019) a statement
describing action taken to engage with employees. Such a statement is
required to be included as part of the Director’s Report. The relevant
provision of The Companies (Miscellaneous Reporting) Regulations,
2018 that include new corporate governance and reporting
regulations is extracted herein below:

The
Director’s report for a financial year must contain a statement

a)     Describing the action that
has been taken during the financial year to introduce, maintain or develop
arrangements aimed at –

i)      providing employees systematically with
information on matters of concern to them as employees,

ii)     consulting employees or their
representatives on a regular basis so that the views of the employees can be
taken into account in making decisions which are likely to affect their
interests,

iii)    encouraging the involvement of employees in
the company’s performance through an employees’ share scheme or by some other
means,

iv)    achieving a common awareness on the part
of all employees of the financial and economic factors affecting the
performance of the company.

b)     Summarising –

i)      How the Directors have engaged with
employees, and

ii)     How the Directors have had regard to
employee interests, and the effect of that regard, including on the principal
decisions taken by the company during the financial year.

Extracts
from an Annual Report

Company:
EVRAZ PLC [Member of FTSE 100 Index, 2019 Revenues – US$ 11.9 billion,
employees (Nos.) – 71,223]

Extracts from Director’s Report:

‘Engagement
with employees remains key, and the Board closely monitors the results of the
annual engagement survey which has seen satisfactory levels of improvement.

Two
independent non-executive directors have taken responsibility for engaging with
employees in our businesses in North America and Russia, respectively, and this
is undertaken by their attendance at key staff briefing events and town hall meetings.

Throughout
the year, senior management attend the Group’s board meetings to present the
annual budget for their respective business units, and to present key
investment projects which require the Board to approve significant capital
expenditure sums. All presentations made to the Board consider both the benefit
to shareholders of the proposal and the impact on other key stakeholders.

The
Remuneration Committee receives a detailed presentation from the Vice-President
of HR which outlines remuneration and incentive plans across the whole business
at each level.

A
whistle-blowing arrangement is in place which allows staff to raise issues in
confidence and the responses to the issues are routinely monitored by the Audit
Committee who escalate key issues to the Board.’

4      COMPLIANCE: NCI’s INTEREST IN GROUP
ACTIVITIES AND CASH FLOWS UNDER IND AS 112

Background

Ind AS 112 Disclosure of Interests in Other Entities, inter alia, mandates disclosures with respect to
the interest that non-controlling interests (NCIs) have in a group’s activities
and cash flows. Such disclosures are required in the Notes to the Consolidated
Financial Statements when there is a presence of subsidiaries in a group
structure. Such disclosures are applicable for subsidiaries in a group that are
not wholly controlled by the parent.

One of the
issues in current financial reporting for groups
is that while net income, total comprehensive income and net assets are
allocated between owners of the parent and the NCI, the operating cash flows
are not similarly allocated. Such information is an important input in a
valuation exercise. Ind AS attempts to provide such information by way of
disclosures.

Consolidated
financial statements present the financial position, comprehensive income and
cash flows of the group as a single entity. They ignore the legal boundaries of
the parent and its subsidiaries. However, those legal boundaries could affect
the parent’s access to and use of assets and other resources of its
subsidiaries and, therefore, affect the cash flows that can be distributed to
the shareholders of the parent (IFRS 12, BC 21).

Summarised
financial information about subsidiaries with material non-controlling
interests helps users predict how future cash flows will be distributed among
those with claims against the entity, including the non-controlling interests (IFRS
12, BC 28).

The disclosure requirements are summarised in Table C. It
may be noted that the disclosures are required for each subsidiary (that have
NCIs that are material to the reporting entity).

Table C:
Disclosures – Interests that NCIs have in the group’s activities and cash flows

5      FROM THE PAST – ‘HIGH-QUALITY FINANCIAL
INFORMATION IS THE CURRENCY THAT DRIVES THE MARKETPLACE’

Extracts
from a speech by Mr. Arthur Levitt (former US SEC Chairman) to
the American Council on Germany in New York in October, 1999
are reproduced below:

Information
is the lifeblood of markets. But unless investors trust
this information, investor confidence dies. Liquidity disappears. Capital dries
up. Fair and orderly markets cease to exist.

High-quality
financial information is the currency that drives the
marketplace. And nothing honours that currency more than a strong and
effective corporate governance mandate. A mandate that is both a dynamic system
and a code of standards. A mandate that is measured by the quality of
relationships: the relationship between companies and directors; between
directors and auditors; between auditors and financial management; and
ultimately, between information and investors.

If strong corporate governance is to permeate every facet of our
marketplace, its practice must extend beyond merely prescribed mandates,
responsibilities and obligations. It is absolutely imperative that a corporate
governance ethic emerge and envelop all market participants: issuers, auditors,
rating agencies, directors, underwriters and exchanges. Its foundation must be
an unwavering commitment to integrity. Its cornerstone – an undying commitment to serving the investor.