The corporate sector is closely monitoring the changes in the
accounting and tax frameworks — Implementation of International Financial
Reporting Standards (IFRS), and Goods and Services Tax (GST).
Interestingly, IFRS (for large entities) and GST
principles/rules apply with effect from a common date i.e., 1 April 2011. While
the changes in the accounting and tax frameworks would have a substantial impact
on the Indian industry, there is a need felt for more clarity on some of these
impact areas. Further, the differences in recognition and measurement principles
under the revised accounting and tax frameworks would lead to additional efforts
of maintaining different accounting records — one for accounting purposes and
the other for tax purposes. This article attempts to illustrate some of the
practical challenges relating to the adoption of IFRS and GST frameworks.
Date on which the tax will be levied :
Under current excise law, the levy of excise duty is at the
point of manufacture of goods. However under GST framework, the levy of tax will
be on ‘sale’ of goods. However, it is unclear today whether the date of levy of
GST will be the date of invoice, date of dispatch of goods or the date on
recognition of revenue as per books of accounts (i.e., depending on the delivery
terms in the sales contract).
If the levy of tax will be on the date of recognition of
revenue in the books of the entity, then the date of levy of GST might differ
depending on whether the entity follows Indian GAAP or IFRS. Under IFRS, apart
from the transfer of risk and rewards to the buyer along with effective control,
IFRS also prescribes an additional condition in relation to the continuing
managerial involvement to the degree usually associated with ownership of goods.
Thus revenue recognition under IFRS might be later than that under Indian GAAP.
If the levy of GST is based on the invoice date or the
dispatch date, then under certain circumstances the timing of revenue
recognition under IFRS may not be the same as the date of levy of GST. This
difference in recognition of revenue under the accounting and taxation
frameworks will need to be periodically reconciled.
Barter sales :
Unlike Indian GAAP, IFRS prescribes specific accounting
guidance on barter transactions. Under IFRS, a barter transaction shall be
recognised as such only when there is an exchange of dissimilar goods. As such
there is no accounting implication in case of exchange of similar goods.
It is widely anticipated that the GST framework shall levy
tax on barter transactions. However, more clarity is awaited on whether GST
would be applicable on exchange of similar goods, even though these are not
recognised as sale for accounting purposes.
Intangible asset model under service concession arrangements
:
Under IFRS, IFRIC 12 provides guidance on accounting by
private sector entities (operators) for public-to-private service concession
arrangements.
In some arrangements, the operator is not awarded a fixed
consideration, but is awarded a right to collect toll fees for a fixed period of
time. Accounting under IFRS for such arrangements is similar to the barter
transactions, whereby the operator renders construction services (and recognises
construction revenue) in lieu of a right to collect toll fees from the users of
the infrastructure facility (i.e., intangible asset which is depreciated over
the concession period). Thus the construction service (revenue) is exchanged for
an intangible asset that provides the operator the right to collect toll
revenue. This accounting treatment is akin to accounting for barter
transactions. The subsequent collection of toll revenue is recognised as
separate revenue, while the depreciation on the intangible asset represents the
cost for the operator.
Currently no indirect taxes are levied on the construction
services provided by the operator under a service concession arrangement. The
indirect tax incidence, if any, is on the collection of toll revenue. It would
be interesting to see whether the GST framework shall also view such service
concession arrangements as barter revenue in line with IFRS accounting. If the
current indirect tax treatment is retained under GST framework, the revenue from
construction and other services needs to be periodically reconciled with the
revenue for accounting purposes.
Branch transfers :
As widely deliberated, GST will also be levied on the stock
transfers from one location of the entity to the other. Like Indian GAAP, IFRS
shall not recognise the branch transfers as revenue of the company. This
difference in recognition of branch transfers under the accounting and taxation
frameworks needs to be periodically reconciled.
Discounts and rebates :
IFRS requires all discounts including cash discounts given by
way of separate credit notes, free goods to the buyer to be reduced from
revenue. Further, the cash discounts and volume rebates need to be recognised on
an estimated basis as at the date of sale. Like the current indirect taxes, GST
is expected to be levied on the transaction value as per the invoice after
deduction of discount as specified on the invoice. This difference in
recognition of discounts under the accounting and taxation frameworks needs to
be periodically reconciled.
Customer loyalty programmes :
Customer loyalty programmes, comprising offering of loyalty
points or award credits, are offered by a diverse range of businesses, such as
supermarkets, retailers, airlines, telecommunication operators, credit card
providers and hotels. Award credits may be linked to individual purchases or
groups of purchases, or to continued custom over a specified period. The
customer can redeem the award credits for free or discounted goods or services.
IFRS requires an entity to recognise the award credits as a
separately identifiable component of revenue and to defer the recognition of
revenue related to the award credits. The revenue attributed to the award
credits takes into account the expected level of redemption. The consideration
received or receivable from the customer is allocated between the current sales
transaction and the award credits by reference to fair values. The component of
the revenue pertaining to award credits is deferred until the redemption of the
award credit against the future sale.Cash flow from operations — in terms of stabil-ity, timing and certainty — if the target does not prepare a cash flow statement merely because it is not mandatorily required to do so, it is no excuse for the FDD team not to carry out this analysis. The FDD team would be well advised to develop the cash flow statement of the business with the aid of two balance sheets and the profit and loss account for the intervening period and to then analyse the same. One lesson that the Enron debacle has taught us is that ‘Cash is king’ and that if one is able track where cash is being generated and where it is deployed, potential accounting ‘juggleries’ tend to get exposed.
Like the current indirect tax treatment, the GST may be levied on the transaction value of the goods. Thus on the initial sale transaction, GST may be levied on the entire sale value, whereas the accounting revenue as per IFRS would be lower to the extent of the fair value of award credits (that is deferred). Subsequently, as the buyer is provided other goods free of charge in lieu of the award credit, GST may not be levied as there is no sale consideration. For accounting purposes, the fair value of the award credit that was deferred on initial recognition will now be recognised as revenue. Thus the accounting revenue would be recognised subsequently, though there would be no revenue for GST purposes.
This difference in recognition of benefits provided under customer loyalty programmes under the accounting and taxation frameworks needs to be periodically reconciled.
Multiple deliverables within a contract :
Oftentimes a contract involves multiple deliverables such as sale of goods, installation services, warranty benefit and maintenance services. For revenue recognition, IFRS requires identification of different revenue components, allocation of the contractual revenue to each component based on their relative fair values and recognition of revenue for each component based on compliance with the revenue recognition criteria for each such component. The timing and amount of revenue recognition may not strictly follow the contractual arrangement.
GST is expected to be levied on the transaction value that is based on the contract. Hence there will be a need for reconciliation between the revenue as per IFRS and revenue as per GST. An entity may be required to maintain this reconciliation on a periodic basis.
Sales on deferred payment terms :
Deferred payment term is a credit term that is higher than the normal credit term. In case of deferred payment term, IFRS requires the sales to be recognised by discounting the future receivables to its present value. The difference between the nominal value and discounted value shall be recognised as interest income over the credit term.
Under the GST framework, if the levy of tax would be on the invoice value, then it might be viewed as if GST is levied on interest income as well (From an accounting perspective under IFRS, the invoice value comprises two parts — Revenue and Interest Income). More clarity is required on the assessable value of goods and services for GST purposes.
Lease deposits received by lessor :
Under IFRS, lease deposits are classified as financial instruments that are measured at fair value on initial recognition. When a lessor provides a leased asset to a lessee on a non-cancellable operating lease, the fair value of interest-free lease deposits is not equal to the nominal value (i.e., face value). The fair value of the lease deposit would be the present value of the future cash flows under the contract discounted at the market interest rate. The difference on initial recognition between the nominal value and the fair value of the lease deposits would be recognised as lease income received in advance. This advance lease income is recognised on straight-line basis over the lease term. Correspondingly the deposit liability would accrete interest expense over the lease term. Thus the lease income as per IFRS would be higher than the contractual lease rent.
Like the practice under current indirect tax laws, GST may be levied on the contractual lease rent without the impact of the notional lease rent on account of interest-free lease deposit. Thus the lessor will need to reconcile the lease revenue between IFRS and GST on a periodic basis. This would have a substantial impact on leasing companies.
Embedded leases :
Under IFRS, there is specific guidance on accounting for certain arrangements which include lease components. If the contract involves use of dedicated assets by a service provider, then such contract needs to be assessed from the perspective of a lease. Determining whether an arrangement is, or contains, a lease shall be based on the substance of the arrangement and requires an assessment of whether : (a) fulfilment of the arrangement is dependent on the use of a specific asset or assets (the asset); and (b) the arrangement conveys a right to use the asset.
For the purpose of applying the requirements of lease accounting, payments and other consideration required by the arrangement shall be separated at the inception of the arrangement into those for the lease and non-lease elements on the basis of their relative fair values.
Further, the entity may need to determine the classification of lease into operating or finance lease. In case of operating lease, the entity needs to recognise the lease component of the non-cancellable arrangement on a straight-line basis. In case of finance lease, the lessor would recognise the sale of the leased assets upfront and interest income over the lease period. The lessor shall recognise the non-lease components based on the accounting guidance from other relevant IFRS standards.
While the accounting for embedded leases could get complicated in practice, the GST is expected to be levied based on the same principles that are currently in existence i.e., transaction values. Thus when an arrangement is classified as a finance lease under IFRS, the earnings would comprise sale of ‘leased’ asset and interest income, whereas it would be taxed as job work charges in the hands of the service provider. The entity needs to periodically reconcile the impact of different measurement principles relating to revenue recognition under IFRS and GST.
Interest-free loan to job worker :
Under IFRS, loans are financial instruments that are initially recognised at fair value. In case of interest-free loans, the loans are initially recognised at fair value by discounting the future cash flows. The discounted value accretes interest expense over the term of the loan. The difference between the nominal value and fair value is recognised as notional job work charges over the tenure of the loan.
Under the current excise valuation rules, where a customer provides an interest-free loan to the job worker and the loan has influenced the price charged, then a notional interest is added to the assessable value of the goods sold by the job worker.
The GST framework so far is silent on the assessable value of goods/services. It would be interesting to see whether the notional interest and the notional job work charges are also to be added to the computation of assessable value for the purpose of levy of tax.
While industry believes that the changes in the accounting and taxation frameworks are steps in the right direction, they are unable to estimate the exact impact on their business. Further, unless some more clarity emerges in the near future, the industry shall face challenges around maintaining an efficient and planned tax structure. Further, some of the apparent transition implications, where the IFRS and tax treatment is relatively clear, indicate maintenance of two sets of records — one for accounting purpose and the other for tax purposes.
The financial and taxation aspects relating to the IFRS/ GST convergence need to be planned and tested in advance of the implementation date. In view of this, the Industry needs to start their transition process early, preferably now. Global experience has shown that the early adopters are generally more successful in managing the overall IFRS and GST 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.
