By Jamil Khatri, Akeel Master, Chartered Accountants
IFRS
One of the important aspects of convergence is that financial
reporting will be better aligned to the true economic substance of a
transaction. ‘Substance over form’ is one of the most important principles on
which International Financial Reporting Standards (‘IFRS’) are based. Detailed
Implementation Guidance (IG) and Basis of Conclusion (BC) for the accounting
treatment prescribed in the respective standards explain the underling economic
rationale for such treatment, which acts as a guide in implementation of the
intent behind the standards.
In general, Indian GAAP also tends to be principle focussed.
However, there are a number of areas where accounting guidance deviates from the
underlying economic substance (e.g., accounting for business
combinations, service concession arrangements or multiple element deliverables)
or in other situations tends to be prescriptive in nature (e.g.,
accounting for loan impairment losses by a bank, accounting for depreciation on
property, plant and equipments based on minimum rates prescribed). Similarly,
accounting is often governed by the terms of the legal contract.
This article highlights some of the important areas where the
accounting under IFRS is closer to the economic substance of the transactions as
compared to Indian GAAP.
Revenue arrangements with multiple deliverables (IAS 18) :
IAS 18 requires, in certain circumstances, to apply the
recognition criteria to each separately identifiable component of a single
transaction in order to reflect the underlying substance of the transaction.
Thus, under IFRS, multiple deliverable transactions (e.g., product sales
and subsequent servicing) are viewed from the perspective of the customer. What
does customer believe that he is buying ? If the customer believes that he is
buying a single product, the recognition criteria should be applied to the
transaction as a whole. Conversely, if the customer believes that there are a
number of elements to the transaction, then the revenue recognition criteria is
applied to each element separately.
Similarly, in certain cases the standard requires the
recognition criteria to be applied to two or more transactions together when
they are linked in such a way that the commercial effect cannot be understood
without reference to the series of transactions as a whole. Once again, the
focus is on the substance and the economic rationale for the transactions.
Example
Entity A sells software with an annual maintenance service
for a total consideration of Rs.1000. Entity A also provides similar annual
maintenance service to other customers at a consideration of Rs.200. In this
case, the sale of the software and maintenance contract would be regarded as
separate components. Revenue from the sale of the software Rs.800 (1000 — 200)
will be recognised when the software is delivered and other revenue recognition
principles are met, and revenue from rendering of maintenance services will be
recognised on a straight-line basis over one year. Now consider a situation
where the same contract is structured in a different manner and the sales
contract itself provides that the ‘price’ of the software is Rs.900 and the
price of the annual maintenance service is Rs.100. Typical practice under Indian
GAAP is to recognise revenue of Rs.900 upfront and recognise only Rs.100 as the
revenue over the maintenance period. Thus, what gets accounted is the legal form
of the contract and not the true economic substance of the sale transaction.
However under IFRS these two transactions will be linked together and each
component i.e., sale of software and annual maintenance service will be
accounted at its fair value i.e., Rs.800 and Rs.200 irrespective of the
values denominated in the contract, thereby reflecting the true economic
substance.
Consolidation based on control (IAS 27, IAS 28 and IAS 31) :
Definition of control under Indian GAAP is different from the
definition under IFRS. Indian GAAP permits consolidation based on the
ownership of majority of voting power or the ability to control the
composition of Board of Directors. Thus, under Indian GAAP it is possible for
two entities to have ‘control’ over one investee company and both companies will
need to account the investee as a subsidiary.
The definition of control under IFRS has two parts, both of
which need to be met in order to conclude that one entity controls another :
(a) ‘the power to govern the financial and operating
policies of an entity’
(b) so as to obtain benefits from its activities.
The implication of the control principles under IFRS is that
companies cannot consolidate an entity only based on holding of current voting
interests. Since consolidation is based only on control, only one holding entity
will practically be able to demonstrate such control and hence there will never
be a scenario where the same entity is being consolidated by two separate
holding entities as a subsidiary.
Under IFRS, rights of each shareholder need to be carefully
evaluated by examining the shareholder’s agreement to determine the entity,
which has control, for consolidation. For example, an entity may own more than
50% of the voting rights in another entity and accordingly is able to
consolidate that entity with itself, currently under Indian GAAP. However due to
certain veto rights given to minority shareholders contractually, it may not be
in a position to unilaterally control that entity, and therefore may not be able
to consolidate that entity under IFRS as a subsidiary.
Example :
Two companies A and B come together to form a company X in
which company A holds 75% with 3 directors on the board of company X and company
B holds 25% with 2 directors on the board of company X. By virtue of majority
holding, company A consolidates Company X as a subsidiary under Indian GAAP. The
Articles of Association of company X states that for certain decisions, a
unanimous approval of the board of directors is required. These decisions
include approving the annual and semi-annual budgets of the company and
selection and appointment of senior management personnel. In such a case, under IFRS, company A does not control company
X, instead it shares joint control over it along with company B. Hence it shall
not consolidate company X as a subsidiary but account for it as a joint venture
arrangement. However, under Indian GAAP, A would continue to consolidate X,
though it does not have control over the operations, which do not reflect the
true economic substance of the transaction.
Acquisition method of accounting for business combinations (IFRS 3) :
Business combinations are the acquisitions of controlling stakes in entities and businesses like mergers, acquisition of a subsidiary or purchase of net assets of a division. Indian GAAP has limited guidance on the first-time accounting for such transactions and allows the pooling of interests method or the purchase method of accounting; IFRS recognises only the acquisition method for accounting for these transactions. Hence under IFRS, all business combinations are accounted for at fair value as on the acquisition date (excluding the specific scope ex-emptions given in the standard). This process involves the identification of intangibles subsumed within goodwill like customer relationships, favourable leases; fair valuation of contingent liabilities, contingent consideration and all other acquired assets and liabilities whether recognised or unrecognised in the acquiree’s balance sheet.
The objective of this accounting is to ensure that all items where the acquirer saw value and hence paid for it, are brought onto the books of accounts at their fair values. This would ensure appropriate reflection of the factors that affected the negotiation process of the transaction in the financial statements and bring accounting closer to the economic attributes inherent in the business combination.
Initial recognition of financial assets and liabilities at fair value (IAS 39) :
Under IFRS, initial recognition of all financial assets and liabilities is mandatorily required at its fair value. This helps in reflecting the true substance of a particular transaction. Consider the following situations:
- Low interest loans given to subsidiary: Under Indian GAAP these are accounted at transaction value, however, under IFRS these are recorded at the fair value and the initial loss is considered as an investment in the subsidiary and the subsidiary accounts for it as a capital contribution. In the subsequent years the unwinding of the initial fair value loss is treated as an interest income by the parent and interest expense by the subsidiary.
- Low interest loans given to employees: Under Indian GAAP these are accounted at transaction value, however, under IFRS these are recorded at the fair value and the initial loss is accounted as an employee cost based on the loan terms, thereby reflecting the true intent of compensating the employees in the financial statements.
- Interest-free security deposit for leased premises: Under Indian GAAP these are accounted at transaction value, however, under IFRS these are recorded at the fair value and the initial loss is accounted as a prepaid rent, which is amortised over the lease period, thereby reflecting the true operating expense (rental expenditure) in the financial statements.
- Sales tax deferral schemes: Under Indian GAAP these are accounted at transaction value, however, under IFRS these are recorded at the fair value and the initial gain is accounted as a government grant, which is deferred over the grant period, thereby reflecting the true operating results of the company each year.
Contracts denominated in ‘third currencies’ (IAS 39) :
Sale or purchase contracts in the ordinary course of business may include payment terms denominated in a third currency i.e., a currency which is not the currency of either of the contracting parties. In such circumstances, the foreign currency element in the contract should be accounted for separately from the underlying contract, unless the payments required under the contract are denominated in one of the following currencies:
- the currency’ in which the price of the related goods or service being delivered under the contract is routinely denominated in commercial transactions around the world; and
- the currency that is commonly used in contracts to purchase or sell non-financial items in the economic environment in which the transaction takes place.
‘Routinely denominated’, as noted under the first bullet above, should be interpreted narrowly, so that an oil transaction denominated in U.S. dollars is one of the few transactions that qualifies for this exemption.
The separation of foreign currency derivatives would reflect the true risks that the entity has indirectly exposed itself to, on entering into the host contract. Such an embedded derivative is carried at fair value through profit and loss account.
Example:
An Indian entity contracts to lease an aircraft from a US entity for 12 months with prices denominated in Euros. Since Euro is not the functional currency of either of the contracting parties, both the seller and the buyer are indirectly exposing themselves to fluctuations of a foreign currency by way of the underlying contract to lease the aircraft. This would be considered an embedded derivative which requires separation and would be carried at fair value in the financial statements of both the contracting parties until the settlement of the underlying contract i.e., every month the fluctuation in exchange rates attributable to unpaid lease rentals will be recognised in the income statement (like accounting for a notional forward cover to buy Euros for the remaining period) and the monthly lease payments will be recorded based on the INR/ Euro exchange rate on the contract date.
Hence although the host contract would not specify the existence of a derivative; looking at the transaction in substance would result in the identification of an embedded foreign currency derivative (notional forward) and reflect the foreign currency risk that the entity is indirectly exposed to due to the arrangement. The ultimate reporting in the financial statement would result accounting for lease rentals at a fixed rate on the contract date (which is the real commercial transaction) and all other fluctuations in the exchange rate from the contract date to the monthly payment dates will be classified as a foreign exchange gain/loss.
Embedded lease contract (IFRIC 4) :
Companies sometimes enter into normal business transactions that share many features of a lease (lease is defined in paragraph 4 of IAS 17 Leases as ‘an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time’).
Unlike Indian GAAP, under IFRS, all arrangements meeting the definition of a lease should be accounted for in accordance with IAS 17 regardless of whether they take the legal form of a lease. This determination is based on the assessment of whether:
i) the fulfillment of the arrangement (commercial transaction) is dependent on the use of a specific asset or assets; and
ii) the arrangement conveys a right to use the asset.
Examples of such transactions include:
- outsourcing arrangements,
- take or pay contracts in which purchasers make specified payments regardless of whether they take delivery of the contracted products or services.
Example:
Company A enters in a purchase contract with company B to purchase 1,000 units of C every month @ Rs.25 per unit. Product C can be manufactured on a specific machine M by company B. In case of shortfall every month, company B will compensate company A Rs.10 per unit of short-fall and entire output from machine M is availed by company A.
Under Indian GAAP, the above transaction is accounted as a normal purchase transaction @ Rs. 25 per unit. In case there is a shortfall, the payment amount is expensed as a penalty.
Under IFRS, this transaction is broken into its two constituents i.e.,
1) Lease of machine M given that company A is in substance paying a fixed amount of Rs 10 per unit to company A towards availability of machine for company A
2) Processing charges for manufacture of product C
Service concessions arrangement (IFRIC 12) :
IFRS contains specific guidance on public-to-private service concession arrangements under IFRIC 12. It applies to arrangements, wherein the public entity (referred to as grantor) is able to control the use of the infrastructure by specifying the nature of service, the recipient of the service and the price to be charged, and to retain significant residual interest in the infrastructure. In such cases, infrastructure is not recognised as property, plant and equipment of the private entity (referred to as operator) as the arrangement does not convey the use of the public service infrastructure to the operator. The operator, in turn, recognises and measures revenue in accordance with IAS 11 or IAS 18 for the service it performs i.e., construction, up gradation, operation, etc. The operator recognises the consideration receivable based on its nature as a financial asset or intangible asset or partly a financial asset and partly as intangible, based on the specific terms of the arrangement.
Under Indian GAAP, there is no specific guidance and this has resulted in varied practices. Generally, the operator capitalises the infrastructure cost in its books as fixed asset and revenue is recognised as services are rendered with the infrastructure. This asset is depreciated in accordance with the company’s depreciation policy or over the period of the service concession arrangement. Thus the revenue is not recognised as and when the efforts are expended and increases the volatility in the income statement with losses in initial period of a service concession arrangement and higher margins in the later period, which may not reflect the correct economic activity for a given period.
Example:
A grantor awards a concession to an operator to build and operate a new road. The grantor transfers to the operator the land on which the road is to be constructed, together with adjacent land that the operator may redevelop or sell at its discretion. Construction is expected to take 5 years, after which the operator will operate the road for 25 years. During these 25 years the operator has a contractual obligation to perform routine maintenance on the road and to resurface it as necessary, which is expected to be three times. At the end of the arrangement the road will revert to the grantor. The road is to be used by the general public. Toll for use of the road is set annually by the grantor. This arrangement is a public-to-private arrangement as the road is constructed pursuant to general transport policy and is to be used by the public. This would fall under the scope of IFRIC 12. Accordingly the operator will not recognise the road as property, plant and ‘ equipment; however he will recognise an intangible asset for the right to operate the road and collect toll from it.
Deferred taxes on unrealised profits of joint ventures/associates (IAS 12) :
Currently, under Indian GAAP, profits of subsidiaries, branches, associates and joint ventures (‘investee companies’) are included in consolidated profits of the parent company. The consolidated performance results and net worth are accordingly reported to the shareholders of the parent under Indian GAAP. However one important aspect that is not reported is the impact of tax leakage when the profit earned by the investee companies will be transferred to the parent. Accordingly the consolidated profit and the net worth reported under Indian GAAP is grossed up to that extent, since the overall tax impact on the consolidated profit available to the parent company is not completely recorded in the books of account. Such deferred tax impact is accounted for in the consolidated financial statements under IFRS.
For example:
Parent company P consolidates undistributed profits of Rs.100 crores of associate company A in its consolidated financial statements. The dividend distribution tax rate in A’s jurisdiction is 15% and dividend received is exempt from tax in the hands of P. In this case, P should recognise a deferred tax liability of Rs.15 crores (at a rate of 15% on Rs.100 crares) in its consolidated financial statements which will ensure a correct presentation of the net worth to the shareholders.
Presentation of financial statements:
In India, Schedule VI of the Companies Act, 1956, which prescribes a detailed format for preparation and disclosure of financial statements, lays great emphasis on quantitative information such as quantitative details of sales, COGS, production capacities, amount of transactions with related parties, CIF value of imports and income and expenditure in foreign currency, etc. Contrary to the same, IFRS if more focussed on qualitative information for the stakeholders such as terms of related party transactions, risk management policies, currency exposure for the Company with sensitivity analysis, etc. To more correctly report the liquidity position of the Company, IFRS requires disclosure of all assets/ liabilities, whether they are current or non-current. Presently under Indian GAAP even long-term deposits and advances are disclosed under current assets,loans and advances, thereby not disclosing the true liquidity profile of the entity.
Conclusion:
IFRS aims to present financial statements which are a reflection of the business and economic environment in which a company operates. The standard-setters strive to formulate principles which would help a company in applying judgment and reaching the ultimate goal of accounting which is closer to the economic value of transactions. This is clearly evident in the above discussions of accounting for business combinations, consolidation, embedded leases, embedded derivatives, etc. However, to achieve this goal, it is important that the principles are applied in their true spirit and in the manner in which they are intended.
Convergence brings a new perspective for Indian companies from the traditional Indian GAAP. It challenges them to look beyond the legal language of arrangements, shifting the focus to the substance of arrangements. Indian companies need to be prepared to face this new age of accounting and keep up with the evolving changes that are taking place in IFRS itself.
