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Category: Accountancy and Audit

ACCOUNTING FOR CROSS HOLDING

INTRODUCTION

There is no existing guidance under Ind AS for the accounting of cross holdings. This article provides guidance on the accounting of cross holdings between two associate companies. Consider the following fact pattern:

Entity Ze has an associate Ve (20% of Entity Ve and significant influence).

Entity Ve has an associate Ze (20% of Entity Ze and significant influence).

Both Entity Ze’s and Entity Ve’s share capital is 200,000 shares at 1 unit each.

Entity Ze’s profit excluding its share in Ve = INR 1000; Entity Ve’s profit excluding its share in Ze = INR 1000.

ISSUES

•    How does an entity account for cross holdings in associates in accordance with paragraph 27 of Ind AS 28 Investments in Associates and Joint Ventures in the Consolidated Financial Statements?
•    Does an entity adjust EPS calculation for the cross holdings?

RESPONSE
References to Ind AS
Paragraph 26 of Ind AS 28 applies consolidation procedures to equity method of accounting as follows:

‘Many of the procedures that are appropriate for the application of the equity method are similar to the consolidation procedures described in Ind AS 110. Furthermore, the concepts underlying the procedures used in accounting for the acquisition of a subsidiary are also adopted in accounting for the acquisition of an investment in an associate or a joint venture.’

Paragraph 27 of Ind AS 28 states:

‘A group’s share in an associate or a joint venture is the aggregate of the holdings in that associate or joint venture by the parent and its subsidiaries. The holdings of the group’s other associates or joint ventures are ignored for this purpose. When an associate or a joint venture has subsidiaries, associates or joint ventures, the profit or loss, other comprehensive income and net assets taken into account in applying the equity method are those recognised in the associate’s or joint venture’s financial statements (including the associate’s or joint venture’s share of the profit or loss, other comprehensive income and net assets of its associates and joint ventures), after any adjustments necessary to give effect to uniform accounting policies (see paragraphs 35 and 36A).’

Paragraph B86 of Ind AS 110 Consolidated Financial Statements states:

‘Consolidated financial statements:… (c) eliminate in full intragroup assets and liabilities, equity, income, expenses and cash flows relating to transactions between entities of the group (profits or losses resulting from intragroup transactions that are recognised in assets, such as inventory and fixed assets, are eliminated in full).’

Paragraph 33 of Ind AS 32 Financial Instruments: Presentation states:

‘If an entity re-acquires its own equity instruments, those instruments (“treasury shares”) shall be deducted from equity. No gain or loss shall be recognised in profit or loss on the purchase, sale, issue or cancellation of an entity’s own equity instruments. Such treasury shares may be acquired and held by the entity or by other members of the consolidated group. Consideration paid or received shall be recognised directly in equity.’

GROSS APPROACH
Entity Ze’s profit and Entity Ve’s profit are dependent on each other, which can be expressed by simultaneous equations as follows:

a = INR 1000 + 0.2b
b = INR 1000 + 0.2a

Solving the simultaneous equation results in:

a = INR 1250 and b = INR 1250

Therefore, Entity Ze’s profit is INR 1250, and Entity Ve’s profit is INR 1250.

NET APPROACH

This approach ignores the cross holding and simply takes up the investor’s share of the associate’s profit, excluding the equity income arising on the cross shareholding. Thus, the additional profit in the financial statements of both Entity Ze and Entity Ve is limited to INR 200 each (1000*20%).

A literal view of paragraph 27 of Ind AS 28 is that Entity Ze recognises its share of Entity Ve’s profits, including Entity Ve’s equity accounted profits. However, in the case of cross holdings this approach results in a portion of Ze’s profits being double counted. Consequently, the net approach, which only accounts for 20% of the associate’s profit, is more appropriate. In this fact pattern, the net approach results in Entity Ze and Entity Ve both recognising profit of INR 1200 (rather than INR 1250 as per the gross approach). The difference of INR 50 represents the equity effect of the cross holdings and therefore is not recognised in profit. In other words, the INR 50 represents (with respect to the associate that is preparing its consolidated accounts) a portion of its own profit being double counted.

Additionally, the equity method of accounting employs consolidation-type procedures such as the elimination of unrealised profits. Income arising on an investment held by a subsidiary in a parent is eliminated under paragraph B86(c) of Ind AS 110 Consolidated Financial Statements. Consequently, in applying consolidation procedures in equity accounting, income arising from associate’s investment in the investor should also be eliminated.

Consequently, the net approach is the only acceptable method.

EPS CALCULATION

The number of ordinary shares on issue is adjusted using the net approach. Consequently, an adjustment reduces the entity’s equity balance and its investment  in the associate by its effective 4% interest (20*20%) in its own shares. The result is similar to the treatment of treasury shares that are eliminated from equity and, accordingly, excluded in determining the EPS. In calculating earnings per share, the weighted average number of ordinary shares is reduced by the amount of the effective cross holding. Therefore, Entity Ze’s and Entity Ve’s ordinary shares are reduced to 192,000 (200,000*[100-4]; i.e. 96%) for the purpose of the earnings per share calculation.

Some may argue that the associate is not part of the group and therefore the shares held in the investor are not ‘treasury shares’ as defined in Ind AS 32. However, it may be noted that the view in the preceding paragraph does not rely on viewing the associate’s holding as treasury shares. Rather, it relies on the fact that Ind AS 28.26 states that many of the procedures that are appropriate for the application of the equity method are similar to the consolidation procedures described in Ind AS 110. If a subsidiary holds shares in a parent, these are eliminated under paragraph B86(c) of Ind AS 110. The same procedure should therefore apply to equity accounting.

Though this issue is discussed in the context of cross holdings between associates, it will apply equally to jointly controlled entities that are equity accounted.

HOW AND FOR WHAT PURPOSE?

The interpretation of ‘How and for what purpose’ to determine whether a contractual arrangement contains a lease under Ind AS 116 Leases can be very tricky and complex. This article includes an example to explain the concept in a simple and lucid manner.

The provisions in Ind AS 116 Leases relevant to analysing whether an arrangement contains a lease are given below:

9. At inception of a contract, an entity shall assess whether the contract is, or contains, a lease. A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration.

B9 To assess whether a contract conveys the right to control the use of an identified asset for a period of time, an entity shall assess whether, throughout the period of use, the customer has both of the following:

(a) the right to obtain substantially all of the economic benefits from use of the identified asset; and

(b) the right to direct the use of the identified asset.

B24 A customer has the right to direct the use of an identified asset throughout the period of use only if either:

a. the customer has the right to direct how and for what purpose the asset is used throughout the period of use; or

b. the relevant decisions about how and for what purpose the asset is used are predetermined and:
 

i) the customer has the right to operate the asset (or to direct others to operate the asset in a manner that it determines) throughout the period of use, without the supplier having the right to change those operating instructions; or

ii) the customer designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use.

B25 A customer has the right to direct how and for what purpose the asset is used if, within the scope of its right of use defined in the contract, it can change how and for what purpose the asset is used throughout the period of use. In making this assessment, an entity considers the decision-making rights that are most relevant to changing how and for what purpose the asset is used throughout the period of use. Decision-making rights are relevant when they affect the economic benefits to be derived from use. The decision-making rights that are most relevant are likely to be different for different contracts, depending on the nature of the asset and the terms and conditions of the contract.
 

B26 Examples of decision-making rights that, depending on the circumstances, grant the right to change how and for what purpose the asset is used, within the defined scope of the customer’s right of use, include:

a. rights to change the type of output that is produced by the asset (for example, to decide whether to use a shipping container to transport goods or for storage, or to decide upon the mix of products sold from retail space);

b. rights to change when the output is produced (for example, to decide when an item of machinery or a power plant will be used);
 
c. rights to change where the output is produced (for example, to decide upon the destination of a truck or a ship, or to decide where an item of equipment is used); and

d. rights to change whether the output is produced, and the quantity of that output (for example, to decide whether to produce energy from a power plant and how much energy to produce from that power plant).

B30 A contract may include terms and conditions designed to protect the supplier’s interest in the asset or other assets, to protect its personnel, or to ensure the supplier’s compliance with laws or regulations. These are examples of protective rights. For example, a contract may (i) specify the maximum amount of use of an asset or limit where or when the customer can use the asset, (ii) require a customer to follow particular operating practices, or (iii) require a customer to inform the supplier of changes in how an asset will be used. Protective rights typically define the scope of the customer’s right of use but do not, in isolation, prevent the customer from having the right to direct the use of an asset.

Example – ‘How and for what purpose’ analysis in a hotel stay

Fact pattern

A customer books a room in a hotel for a one-day stay. As per the terms and conditions of the hotel, the customer cannot use the hotel for any illegal activities or cannot sub-lease the room. The room is a specific identified asset, the substitution rights (if any) are not substantive and the customer obtains significant economic benefits from occupying the room. Whether the arrangement between the hotel and the customer contains a lease?

Analysis

Having determined that the room is a specific identified asset, the substitution rights are not substantive and the customer obtains significant economic benefits from occupying the room; the next step in the lease analysis is whether the customer has the right to direct how and for what purpose the asset is used throughout the period of use, as required by B24.
 
The room can be used only for the purposes of room stay; it cannot be sub-let by the customer. To that extent, the how and for what purpose is predetermined. Additionally, the customer cannot use the room for illegal activities. Those are protective rights that the hotel has and do not impact the assessment of whether an arrangement contains a lease in accordance with B30.

The following how and for what purpose decisions are not predetermined and are controlled by the customer and affect the economic benefits to be derived by the customer from the use of the room during the period of stay:

  •        Use of air-conditioner or refrigerator or television or other devices in the room;
  •        Use the room to sleep or to make conference calls;
  •        Use the room to have lunch or dinner, etc.

Therefore, the customer has the right to direct how and for what purpose the asset is used (to the extent those are not predetermined) throughout the period of use (see B25).

CONCLUSION

The arrangement between the hotel and the customer contains a lease. The customer is a lessee and would be entitled to the exemption with respect to short-term lease or low value lease. Additionally, the lessee will have to comply with certain presentation and disclosure requirements as required by Ind AS 116.
 
The hotel (lessor) is not entitled to exemptions from short-term lease or low value lease. From the perspective of the hotel, the single-day lease would qualify as an operating lease. The lessor will have to comply with certain presentation and disclosure requirements as required by Ind AS 116.

Whilst the above example may not have any significant implications for the hotel or its customer, the example is provided to explain the concept of ‘How and for what purpose’ in evaluating whether a contract includes a lease arrangement.

Realisation is not acquisition of anything new, nor is it a new faculty. It is only removal of all camouflage

—  Ramana Maharshi

One who neglects or disregards the existence of earth, air, fire, water and vegetation disregards his own existence which is entwined with them

—  Mahavira

FRAUD RISK MANAGEMENT IN INTERNAL AUDIT

BACKGROUND

The incidence of fraud is increasing every day. With more frauds and their consequences befalling the stakeholders (shareholders, employees and the government, among others), the regulators are increasing the level of regulation, including disclosures to either prevent or get red flags at an early stage, or to highlight cases to set examples to deter others. The current environment is increasing the pressure on the internal auditor.

In this article we shall discuss the current regulations in India and the steps to be taken by the internal auditor to manage the ‘fraud risk’ and add value to the internal audit function.

In our opinion, frauds may be classified into two types – first, a fraud perpetrated by owners / top management and, second, all cases other than the first one. In case the internal auditor encounters a fraud perpetrated by management, he or she has few options – either become a whistle-blower and report the fraud, or walk away. Each action of the internal auditor will have consequences which he / she may have to decide based on choice and circumstances. Failure to act with integrity and to be just a bystander, or become knowingly or unknowingly a part of the management fraud, has its own set of risks and consequences.

We have a number of cases which have been discussed in the public domain to understand the above, some of the major cases being the ‘Satyam case’, ‘Cox & Kings’ and so on. One major high-profile case cited for an internal auditor to be a whistle-blower is that of ‘Enron’.

FRAUD DEFINITION

As per Webster’s Dictionary, a fraud is (a) deceit, trickery, specifically: intentional perversion of truth in order to induce another to part with something of value or to surrender a legal right; (b) an act of deceiving or misrepresenting.

Fraud is defined by Black’s Law Dictionary as A knowing misrepresentation of the truth or concealment of a material fact to induce another to act to his or her detriment.

Consequently, fraud includes any intentional or deliberate act to deprive another of property or money by guile, deception or other unfair means.


Types of fraud

The Association of Certified Fraud Examiners (ACFE) has given the following classification for ‘types of fraud’ which summarises the various types as follows –

Fraud against a company can be committed either internally by employees, managers, officers or owners of the company, or externally by customers, vendors and other parties. Other schemes defraud individuals rather than organisations.

Internal fraud

Internal fraud, also called occupational fraud, can be defined as ‘the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the organisation’s resources or assets.’ Simply stated, this type of fraud occurs when an employee, manager or executive commits fraud against his or her employer.

Although perpetrators are increasingly embracing technology and new approaches in the commitment and concealment of occupational fraud schemes, the methodologies used in such frauds generally fall into clear, time-tested categories.

External fraud

External fraud against a company covers a broad range of schemes. Dishonest vendors might engage in bid-rigging schemes, bill the company for goods or services not provided, or demand bribes from employees. Likewise, dishonest customers might submit bad cheques, falsified account information for payment, or might attempt to return stolen or knock-off products for a refund. In addition, organisations also face threats of security breaches and theft of intellectual property perpetrated by unknown third parties. Other examples of fraud committed by external third parties include hacking, theft of proprietary information, tax fraud, bankruptcy fraud, insurance fraud, healthcare fraud and loan fraud.

Fraud against individuals

Numerous fraudsters have also devised schemes to defraud individuals. Identity theft, Ponzi schemes, phishing schemes and advance fee frauds are just a few of the ways criminals have found to steal money from unsuspecting victims.

Regulatory drivers in India necessitating action by internal auditors

Irrespective of the regulations given below, the internal auditor has to work along with management towards building a structure for prevention and / or detection of fraud in an organisation and build fraud prevention and / or detection objectives in the internal audit programmes.

The Companies Act, 2013 has introduced a requirement under sub-section 12 of section 143 which requires the statutory auditors to report to the Central Government about the fraud / suspected fraud committed against the company by the officers or employees of the company. It states, ‘Notwithstanding anything contained in this section, if an auditor of a company, in the course of the performance of his duties as auditor, has reason to believe that an offence involving fraud is being or has been committed against the company by officers or employees of the company, he shall immediately report the matter to the Central Government within such time and in such manner as may be prescribed.’

The procedures for reporting to the Board or the Audit Committee, reporting to the Central Government, replies and observations of the Board or the Audit Committee and reporting to the Central Government with the external auditor’s comments and other procedures are laid out in the law.

Primary responsibility for the prevention and detection of fraud rests with both those charged with governance of the entity and the management. In the context of the 2013 Act, this position is reiterated in section 134(5) which states that the Board report shall include a responsibility statement, inter alia, that the directors had taken proper and sufficient care for safeguarding the assets of the company and for preventing and detecting fraud and other irregularities.

Requirement of CARO 2020 With Respect to Fraud – According to a clause in CARO 2020 with regard to fraud and whistle-blower complaints, an auditor needs to report whether any fraud on or by the company has been noticed or reported during the year; if yes, the nature and amount involved is to be indicated; in case of receipt of whistle-blower complaints, whether the complaints have been considered by the auditor.

The Securities and Exchange Board of India has issued the SEBI (Listing Obligations and Disclosure Requirements) (Third Amendment) Regulations, 2020 w.e.f. 8th October, 2020 whereby, inter alia, in case of initiation of forensic audit (by whatever name called) a listed company is required to make the following disclosures to the stock exchange:

Initiation of a forensic audit along with the name of the entity initiating the audit and reasons for the same, if available; and

Final forensic audit report (other than for forensic audit initiated by regulatory / enforcement agencies) on receipt by the listed entity along with the comments of the management, if any.

This has been included under events which shall be disclosed without any application of the guidelines for materiality. Enhancing disclosure requirements is one more step by the regulator, done with a view to disclose potential financial mismanagement to the stock market and the public at large.

Institute of Chartered Accountants of India (ICAI) to come out with Forensic Accounting and Investigation Standards

The Digital Accounting and Assurance Board of the ICAI has issued Exposure Drafts on Standard on Forensic Accounting and Investigation (FAIS) such as FAIS-110 – Understanding the Nature of Engagement; FAIS-120 – Understanding Fraud Risk, and a number of others. These would naturally be the standard in times to come.

As we can see, the regulators are increasing the regulations with the increase in the incidence of fraud. Since the statutory / external auditors are required to report on fraud they necessarily look to internal auditors and expect them to have fraud prevention and / or detection built into their internal audit programmes.

FRAUD RISK MANAGEMENT BY INTERNAL AUDITOR

We have discussed the regulatory drivers but at the same time the Audit Committee and top management does not like any surprise on this count. It is not unheard of now to look to the internal auditor if any untoward incident is uncovered. It is seen that the questions immediately raised are…

When was this area last internal audited?

What was the sample size or why was the entire universe not covered?

Why a particular test could not be built into the internal audit programme to prevent the same?

Why a particular control was not suggested to be designed to prevent such an incident?

What is the size of the incident and for how long is this continuing?

(And many such questions.)

 

We are sure that the internal auditor also would not like any surprises. Frauds cannot be totally prevented but adequate care can be taken to ensure that unless the fraud is a complex one which would have been difficult to be detected under reasonable circumstances, an internal audit exercise should be able to take care of raising the red flag.

 

We would classify the action to be taken by the internal auditor in two parts. First, where the internal auditor is independent but part of the top management team and has a consulting role to play. He or she has negotiated the role of internal auditor as a business adviser to the enterprise. The internal auditor would then be part of designing or testing the design of policies / controls on anti-fraud, etc., which we shall discuss below. The second part is where the internal auditor may not be sufficiently high up but would still have to use / build fraud analytics and other tests into the audit programmes.

 

Where the internal auditor is part of the top management team, he or she would take an active part in designing or testing the design and reviewing the mechanism for anti-fraud controls which would work like a bulwark and deter incidence of fraud or help in raising early warning signals / red flags. Some policies / controls and the mechanisms in place would be –

 

Code of conduct;

Continuous data monitoring / analysis;

Surprise audits;

Regular system of management review;

Anti-fraud policy;

Fraud training for employees;

Job rotation / compulsory vacation;

Whistle-blower policy and rewards for whistle-blowers;

Proper design and review of key controls in ‘Internal Controls over Financial Reporting’.

For internal controls and risk management, the COSO Internal Control and Risk Management guidelines (both are separate guidelines) would be a good source to start looking at understanding and building internal controls, including building anti-fraud controls. The five components of an internal control framework are: control environment, risk assessment, control activities, information and communication, and monitoring.

Each business would have specific controls but to repeat the generic COSO internal control guidelines would be a healthy starting point to understand, build and review internal controls for an internal auditor.

Let us now move to the second part on operational internal auditing where fraud analytic tests based on data analytics are built into each and every individual programme for the internal auditor.

WHAT IS FRAUD ANALYTICS?

Fraud analytics combines analytic technology and techniques with human interaction to help detect potential improper transactions, such as those based on fraud and / or bribery, either before the transactions are completed or after they occur. The process of fraud analytics involves gathering and storing relevant data and mining it for patterns, discrepancies and anomalies. The findings are then translated into insights that can allow a company to manage potential threats before they occur as well as develop a proactive fraud and bribery detection environment.

Case study of a payroll internal audit using Fraud Analytics

The main objective of Fraud Analytics in Payroll is to test the validity and existence of employees and the correctness of pay elements.

 

An illustrative listing of Fraud Analytics in Payroll is –

  •      Map the payroll transaction file to payroll master file to determine if there are ‘ghost’ employees on record and being paid;

  •      Sort employees by name, address, location and other master fields to identify conflict-of-interest scenarios where managers (supervisors) have relatives working for them;

  •     Check for duplicate employees in the master list of employees by name, date of birth, address, bank account number, permanent account number (PAN No.) as a combination of fields or even independent field level duplicate checks;

  •      Perform a pattern-based fuzzy duplicate match in the master list of employees by name and address to identify potential pattern matches on employee name and address;

  •      Compute plant-wise, machine centre-wise, location-wise, correlation score between wage (pay element outgoes) and overtime payments to identify centres with negative correlation scores like falling wage outgoes and rising overtime payouts;

  •      Extract all payroll payments where the gross amount exceeds the set grade threshold limits as per masters;

  •      Compare time-card (attendance) entries to payroll and check for variances like unaccounted ‘leave without pay’;

  •      De-dup checks to identify employees getting the same net pay at multiple locations of the company in the same month;

  •      Profile employees who have not availed any leave in the last one year;

  •      Isolate individuals continuing to get payroll benefits after retirement;

  •      Detect employees getting signing-on bonus payments and leaving before the minimum service period, where signing-on bonus is not recovered;

  •      Filter out payroll payments to employees where nil deductions (including statutory deductions) have been made;

  •      Employees who have re-joined after leaving and continue to get retirement benefits with standard payroll payments;

  •      Inconsistent payroll master allowances within the same groups like grade, designation, location, etc.;

  •      Inconsistent payroll master deductions within the same groups such as grade, designation, location, etc.;

  •      Capture payments to active employees where leave availed is more than the leave balance on hand;

  •     Outliers in payroll payments where the ratio of the highest to the next highest net payroll payment to employees is irregular and excessive;

  •     Locate employees getting multiple increments and bonus payments within the same payroll period;

  •      Compare vendor addresses / phone numbers and employee addresses / phone numbers to identify conflict-of-interest situations.

 

It is important to note that though fraud analytics plays an important role today in any tests to be performed for an internal audit area like payroll, procure to pay cycle, etc., the other activities like interviews, meetings with vendors and employees, physical verification, etc., play an equally important role. Soft issues like body language of the auditee and dealing with auditees and others to understand the issues at hand for the area under audit, are quite important for an internal auditor.

CONCLUSION

It is clear that the responsibility with regard to fraud prevention and detection is increasing for the internal auditor. The regulators are increasing disclosure requirements and the Audit Committee and top management expect that the internal auditor be on guard to continuously help build and review the controls to prevent any incidence of fraud. In case any fraud incident/s does take place, the management would like to have it detected at an early stage.

A proactive internal auditor has to be on top of all this at all times and would most likely have a good fraud risk management programme to –

– increase the bottom line for the organisation (add value to corporate performance);

– ensure compliance with laid-down policies (internal), laws and regulations (external);

– send a clear anti-fraud message;

– enhance the organisation’s image and reputation; and

– get early warning signals / red flags to take pre-emptive action/s.

CARO 2020 – ENHANCED AUDITOR REPORTING REQUIREMENTS

BACKGROUND

The MCA in
exercise of the powers conferred on it under sub-section (11) of section 143 of
the Companies Act, 2013 has issued Companies (Auditor’s Report) Order, 2020
(hereinafter referred to as ‘CARO 2020’) on 25th February, 2020
which was initially applicable for audit reports relating to F.Y. 2019-2020.
However, the corona pandemic rescued the CA’s as its applicability has been
deferred to the financial years starting on or after 1st April,
2020. The legacy of such reporting by auditors dates back to 1988 when it first
started with reporting on about 24 clauses under the Manufacturing and Other
Companies (Auditors Report) Order, 1988. However, with the passage of time,
such reporting has seen many amendments; the reporting was reduced to 12
clauses in 2015 but then increased to 16 in 2016. With the changing
environment, increasing corporate scams and misstatements in financial
reporting by corporates, the authorities felt the need for the auditors of
companies to provide greater insight and information to the stakeholders and
users on specific matters relating to financial statements and business, which
has given rise to CARO 2020. The order now requires auditors to report on
various matters contained in 21 clauses and 38 sub-clauses.

 

APPLICABILITY

The applicability and exemptions
to certain classes of companies remain the same as in the predecessor CARO
2016. The non-applicability of CARO reporting to consolidated financial
statements also remains the same with only one change which requires
reporting by the auditor of the parent company of adverse comments in CARO
reports of all the companies forming part of its consolidation.

 

ANALYSIS OF
AMENDMENTS IN CARO 2020

There are mainly 30 changes
which consist of four new clauses, three clauses reintroduced
from earlier versions of CARO, 14 new sub-clauses and nine
modifications to existing clauses. The Table below gives
details of all such clauses along with the responsibility of the auditor for
auditing and reporting in brief which is based on the guidance note issued by
ICAI.

 

 

Sr.
No.

Clause
of CARO 2020 (New / Modified / Reintroduced)

New
/ Modified Reporting requirements

Guidance
by ICAI for auditing / reporting on
new requirements

1

3(i)(a)(A)
& (B) – Modified and split into two
sub-clauses

(A)
Whether the company is maintaining proper records showing full particulars
including quantitative details and situation of property, plant &
equipment (PPE).

(B)
Whether the company is maintaining proper records showing full particulars
of Intangible Assets.

(i)
There is effectively no change here except for change in terminology to make
it compliant with revised Schedule III terminology (i.e., from fixed assets
to PPE and
Intangible Assets)

 

(ii)
Right of use assets (‘ROU’) as defined in Ind AS 116 – Leases, Investment
property as per Ind AS 40 and non-current assets held for sale as per Ind
AS 105 are required to be considered for the purpose of reporting under this
clause

(Page
17 & 18 of GN)

2

3(i)(c)
– Modified

Whether
title deeds of immovable properties are held in the name of the company

The
revision in the clause requires the following additional
details in cases where title deed is not in the name of the company:

•
Name of the person as per title deed and whether he is promoter, director,
their relative, or employee of the company

•
Period (range) for which the property is held by above person

•
Reason for not being held in the name of the company (also indicate if any
dispute)

Documents
which are generally referred to for checking the owner in case of immovable
property are registered sale deed / transfer deed / conveyance deed, etc.

 

In
case of mortgaged immovable properties, auditor may obtain confirmation from
Banks / FI with whom the
 same is mortgaged

 

 

 

 

(Page
33 of GN)

Sr.
No.

Clause
of CARO 2020 (New / Modified / Reintroduced)

New
/ Modified Reporting requirements

Guidance
by ICAI for auditing / reporting on
new requirements

3

3(i)(d)
– New

Whether
company has revalued its PPE, ROU, Intangible Assets. If yes, whether such
revaluation is based on valuation by registered valuer. Also, auditor is required
to specify the change in amounts if it is 10% or more of net block of
respective class of PPE or Intangible Assets

It
may be noted that reporting under this clause would be limited to revaluation
model since under cost model revaluation is not permitted. Further, reporting
under this clause will cover both upward and downward revaluation under
revaluation model. Changes to ROU assets due to lease modifications under Ind
AS 116 are not considered as revaluation and hence not required to be reported

 

(Page
37 of GN)

4

3(i)(e)
– New

Whether
any proceedings have been initiated or are pending against the company for
holding any benami property under The Benami Transactions
(Prohibition) Act, 1988 and rules made thereunder. If so, whether the company
has appropriately disclosed the details in Financial Statements

Following
audit procedures are mainly required for purposes of reporting under the said
clause:

•
Management inquiries

•
MRL

•
Review of legal and professional fees ledger

•
Minutes of various committee meetings

 

Following
disclosures are required to be given in financial statements with respect to benami
properties:

•
Nature

•
Carrying value

•
Status of proceedings

•
Consequential impact on financials including liability that may arise in case
proceedings are decided against the company (also, if liability is required
to be provided or shown as contingent liability)

 

The
reporting is not required if the company is the beneficial owner of the benami
property

 

(Page
40 of GN)

5

3(ii)(a)
– Modified

Whether
the coverage and procedure of physical verification of
inventories by management is appropriate in the
opinion of the auditor

 

Whether
discrepancies of 10% or more were noticed in the aggregate for each
class of inventory during its physical verification and, if so, whether they
have been properly dealt with in the books of accounts

This
is reintroduced from legacy reporting

 

The
10% criterion is to be looked at from value perspective only. All
discrepancies of 10% or more in value for each class of inventory are to be
reported irrespective of materiality threshold for the company

 

 

 

(Page
45 of GN)

6

3(ii)(b)
– New

Whether
during any point of time of the year the company has been sanctioned working
capital limits in excess of Rs. 5 crores in aggregate from banks or financial
institutions on the basis of security of the current assets

 

Whether
quarterly returns or statements filed by the company with such banks or
financial institutions are in agreement with the books of accounts of the
company; if not, give details

 

•
Sanctioned limit (fresh / renewed) is to be considered and not utilised
limits

•
Non-fund-based limits like LC, BG, etc., are considered as working capital

•
If utilised limits exceed Rs. 5 crores with sanction below Rs. 5 crores, the
same is not required to be reported

•
Any unsecured sanctioned limit is to be excluded from reporting

•
The auditor is just required to match the inventory value as reported in
quarterly returns / statements submitted to banks / FI with value as per
books of accounts and report disagreement, if any. The auditor is not
required to audit the accuracy of the inventory values reported

•
Quarterly returns / statements to be verified include stock statements, book
debt statements, credit monitoring arrangement reports, ageing analysis of
debtors or other receivables and other financial information to be submitted
to Banks / FI

 

(Page
50 of GN)

Sr.
No.

Clause
of CARO 2020 (New / Modified / Reintroduced)

New
/ Modified Reporting requirements

Guidance
by ICAI for auditing / reporting on
new requirements

7

3(iii)(a)(A)
& (B) – Modified

Whether
company has provided loans or advances in nature of loans or stood guarantee
or provided security to any other entity and, if so, indicate aggregate
amounts of transactions during the year and outstanding as at balance sheet
date for subsidiaries, JV, associates and others

Reporting
under this clause is not applicable to companies whose principal business is
to give loans

The
better way would be to disclose the requisite details in financial statements
and give reference in CARO

 

The
format of reporting is given in GN issued by ICAI on page 60

 

 

(Page
54 of GN)

8

3(iii)(e)
– New

Whether
any loans or advance in nature of loans granted which have fallen due during
the year, have been renewed or extended or fresh loans granted to settle the
overdues. If so, specify aggregate amounts of such fresh / renewed loans
granted and % of such loans to total loans as at balance
sheet date.

Reporting
under this clause is not applicable to companies whose principal business is
to give loans

The
objective of reporting on this clause is to identify instances of
ever-greening of loans / advances in
nature of loans

 

The auditor should obtain list of all parties to whom
loan or advance in nature of loan has been granted and check for dues with
respect to such loans. The auditor would be required to inquire with respect
to uncleared dues on such loans, if any. If the same are renewed or extended,
it would require reporting under this clause. If they are settled through
receipt of fresh loan, the same would be visible in party’s ledger in the
form of inflow first and outflow thereafter.

Format
for reporting is specified on page 68 of GN

 

(Page
55 of GN)

9

3(iii)(f)
– New

Whether
company has granted any loans or advances in nature of loans either repayable
on demand or without specifying any terms or period of repayment, if so,
specify the aggregate amount, % to total loans and aggregate loans granted to
promoters, related parties as defined in section 2(76) of Companies Act, 2013

The auditor should prepare master file containing
party-wise details of various terms and conditions of loans or advances in
nature of loans given and the same should be updated as and when required.
The parties can be tagged as promoter or related party as per definition of
2(69) or 2(76) of the Companies Act, respectively

Format for reporting is specified on page 69 of GN

 

(Page
55 of GN)

10

3(v)
– Modified

In
respect of deposits accepted or amounts which are deemed to be deposits,
whether RBI directives or Companies Act sections 73 to 76 have been complied
with. If not, nature of contraventions to be stated along with compliance of
order, if any, passed by CLB / NCLT / RBI etc.

Deemed
deposits as defined under Rule 2(1)(c) of the Companies (Acceptance of
Deposits) Rules, 2014 defines deposits to include any receipt of money by way
of deposit or loan or in any other form, by a company but does not include
amounts specified therein

 

Examine
form DPT-3 filed by the company

 

(Page
75 of GN)

11

3(vii)(a)&(b)
– Modified

Whether
company is regular in depositing undisputed statutory dues including
GST and if not, the extent of arrears of outstanding dues, or if not
deposited on account of dispute, then the amounts involved and the forum
where the dispute is pending shall be mentioned

The
modification is only to the extent of reporting on GST along with other
statutory dues

 

 

(Page
84 of GN)

12

3(viii)
– New

Whether
any transactions not recorded in the books of accounts have been surrendered
or disclosed as income during the year in tax assessments under the Income
Tax Act, 1961, if so, whether the previously unrecorded income has been
properly recorded in the books of accounts during the year

Reporting
is required only if the company has voluntarily disclosed in its return or
surrendered during search / seizure. Thus, if addition is made by IT
authorities and the company has disputed such additions, reporting under this
clause is not required

Review
all tax assessments completed during the year and subsequent to balance sheet
date but before signing of auditor’s report

Reporting is also required for adequate disclosure in
financial statements or impact as per AS / Ind AS after due consideration to
exceptional items, materiality, prior period errors, etc.

(Page
98 of GN)

Sr.
No.

Clause
of CARO 2020 (New / Modified / Reintroduced)

New
/ Modified Reporting requirements

Guidance
by ICAI for auditing / reporting on
new requirements

13

3(ix)(a)
– Modified

Whether
the company has defaulted in repayment of loans or other borrowings or in the
payment of interest thereon to any lender, if yes, the period and
amount of default to be reported

Preference
share capital would not be considered as borrowings for reporting under this
clause

 

Whether
ICD taken would be considered as borrowings for the purpose of reporting
under this clause will require evaluation

 

(Page
101 of GN)

14

3(ix)(b)
– New

Whether
company is a declared wilful defaulter by any bank or FI or other lender

Reporting
under this clause is restricted to wilful defaulter declared by banks or FI
or any other lender (irrespective of whether such bank / FI has lent to the
company) as the same are governed by RBI Master Circular RBI/2014
-15/73DBR.No.CID.BC.57/20.16.003/2014-15 dated 1st July, 2014 on
wilful defaulters

 

The
GN clarifies that such declaration should be restricted to the relevant
financial year under audit till the date of audit report

 

With
respect to wilful defaults to other lenders, the same would be reported only
if the government authority declares the company as wilful defaulter

 

Auditor
may check information on websites of credit information companies like CIBIL,
CRIF, Equifax and Experian. Auditors may also check RBI websites, CRICIL
database and information available in public domain

 

(Page
106 of GN)

15

3(ix)(d)
– Reintroduced

Whether
funds raised on short-term basis have been utilised for long-term purposes,
if yes, the nature and amount to be indicated

Practical
approach to verify such a possibility is to analyse the cash flow position
containing overall sources and application of funds. Also, certain companies
do follow the Asset Liability Management department which tracks the maturity
lifecycle of different assets and liabilities

 

Review
of bank statements specifically during the period of receipt of short-term
loans / working capital loans and its application thereafter can sometimes
provide direct nexus between receipts and application

 

(Page
114 of GN)

16

3(ix)(e)
– New

Whether
the company has taken any funds from an entity or person on account of or to
meet obligations of its subsidiaries, associates, or JV, if so, details thereof
with nature of such transactions and amount in each case

First
check point would be whether loans or advances are given during the year or
investments (equity or debt) are made in order to meet obligations of
subsidiaries, associates, or JV. Reporting under this clause would cover
funds taken from all entities and not restricted to banks and FIs. The
reference details could be disclosure of related party transactions

Format
for reporting is specified on page 120 of GN

 

(Page
117 of GN)

17

3(ix)(f)
– New

Whether
the company has raised loans during the year on pledge of securities held in
its subsidiaries, JV, associates, if so, give details thereof and also report
if the company has defaulted in repayment of such loans

The
reporting may be cross-referenced to
reporting under 3(ix)(a)

Format
for reporting is specified on page 123-124 of GN

 

(Page
120 of GN)

18

3(xi)
– Modified

Whether
any fraud by the company or any fraud on the company has been noticed or
reported during the year, if yes, the nature and amount involved to be
indicated

The
modification has widened the reporting responsibility of the auditor by
removing the specific requirement of reporting on frauds by the officers or
employees of the company. Thus, all frauds by the company or on the company
should be reported here

The
auditor is not responsible to discover the fraud. His responsibility is
limited to reporting on frauds if he has noticed any during the course of his
audit or if management has identified and reported

Auditor
should review minutes of meetings of various committees, internal auditors
report, etc., to identify if frauds were discussed or reported. Additionally,
the auditor will also have to obtain written representations from management
while reporting under this clause

Reporting
under this clause will not relieve the auditor from complying with section
143(12) of the Companies Act which is specifically covered by new clause
3(xi)(b) as given below

 

(Page
138 of GN)

19

3(xi)(b)
– New

Whether
any report is filed under 143(12) by the auditors in Form ADT-4 as prescribed
in Rule 13 of the Companies (Audit & Auditors) Rules, 2014 with the
Central Government

The
objective of reporting under this clause is to check and report on the
compliance of section 143(12) in terms of reporting of frauds noticed by the
auditors in the company committed by officers or employees of the company to
the Central Government in Form ADT-4 after seeking comments from board /
audit committee (if the amount of fraud exceeds Rs. 1 crore)

 

The
reporting liability under 143(12) also lies with the company secretary
performing secretarial audit, cost accountant doing cost audit and thus
statutory auditor is required to report under this clause reporting by
aforesaid professionals on frauds noticed by them during their audits

 

(Page
144 of GN)

20

3(xi)(c)
– New

Whether
the auditor has considered whistle-blower complaints, if any, received during
the year by the company

The
objective of reporting under this clause is to make the auditor confirm that
he has gone through all whistle-blower complaints and performed / planned his
audit procedure accordingly, thereby addressing financial statements
presentation or disclosure-related concerns raised by whistle-blowers

 

Check
whether requirement of whistle-blower mechanism is mandated by law [SEBI LODR
and section 177(9) of the Companies Act]

 

If
the same is not mandated by law, the auditor may ask from the management all
the whistle-blower complaints received and action taken on the same

 

(Page
147 of GN)

21

3(xiv)(a)
– Reintroduced

Whether
the company has an internal audit system commensurate with the size and
nature of its business

The
auditor should evaluate the internal audit function / system like size of
internal audit team, the scope covered in the internal audit, internal audit
structure, professional compatibility of the team performing internal audits,
reporting responsibility, independence, etc., to comment on the above clause

 

(Page
161 of GN)

22

3(xiv)(b)
– New

Whether
the reports of the Internal Auditors for the period under audit were
considered by the statutory auditor

The
objective of reporting under this clause is just to obtain confirmation from
the statutory auditor that he has gone through the internal audit reports and
considered implications of its observations on the financial statements, if
any. Reporting under this clause will require the auditor to coordinate
closely with the Internal Auditor so that he considers the work done by the
Internal Auditor for his audit purposes, compliance with SA 610 (Revised);
‘Using the Work of Internal Auditors’, is mandatory for the statutory auditor

 

(Page
167 of GN)

23

3(xvi)(b)
– New

Whether
the company has conducted any non-banking finance or housing finance
activities without valid Certificate of Registration (CoR) from RBI

The
auditor is required to first identify whether the company is engaged in
non-banking financial or housing financial activities. If yes, the auditor
should discuss with management with regards to registration requirements of
RBI for such companies and report accordingly

 

(Page
181 of GN)

24

3(xvi)(c)
– New

Whether
the company is Core Investment Company (CIC) as defined by RBI regulations
and whether it continues to fulfil the criteria of CIC. If the company is
exempted or unregistered CIC, whether it continues to fulfil the exemption
criteria

The
auditor is required to identify whether the activities carried on by the
company, assets composition as at previous year-end, etc., satisfy the
conditions for it to be considered as CIC

 

He
should also go through RBI Master Direction – Core Investment Companies
(Reserve Bank) Directions, 2016 which are applicable to all CIC

 

(Page
183 of GN)

25

3(xvi)(d)
– New

Whether
the group has more than one CIC as part of the group, if yes, indicate number
of CIC’s which are part of the group

Companies
in the group are defined in Core Investment Companies (Reserve Bank)
Directions

 

(Page
187 of GN)

26

3(xvii)
– Reintroduced

Whether
the company has incurred cash losses in the financial year and in the
immediately preceding financial year, if so, state the amount of cash losses

The
term cash loss is not defined in the Act, accounting standards and Ind AS.
Thus, for accounting standards compliant companies it can be calculated by
making adjustments of transactions of non-cash nature like depreciation,
impairment, etc., to profit / loss after tax figure

 

Similarly,
for Ind AS companies, profit / loss (excluding OCI) can be adjusted for
non-cash transactions like depreciation, lease amortisation or impairment.
Further, cash profits / cash losses realised and recognised in OCI (not
reclassified to P&L) should be adjusted to above profit / loss to arrive
at cash profit / loss for the company

 

Adjustments
like deferred tax, foreign exchange gain / loss and fair value changes should
also be given effect to since they are non-cash in nature

 

(Page
189 of GN)

27

3(xviii)
– New

Whether
there has been any resignation of the statutory auditors during the year, if
so, whether the auditor has taken into consideration the issues, objections
or concerns raised by the outgoing auditors

The
reporting on this clause is applicable where a new auditor is appointed
during the year to fill a casual vacancy under 140(2) of the Act

 

The
incoming auditor who is required to report on this clause should take into
account the following before reporting on this clause,

•ICAI
code of ethics

•
Reasons stated by the outgoing auditor in Form ADT-3 filed with ROC in
compliance with 140(2) read with Rule 8

•
Implementation guide by ICAI on resignation / withdrawal from engagement to
perform audit of financial statements

•
Compliance with SEBI Circular applicable for auditors of listed companies

 

(Page
191 of GN)

28

3(xix)
– New

On
the basis of the financial ratios, ageing and expected dates of realisation
of financial assets and payments of financial liabilities, other information
accompanying the financial statements, the auditor’s knowledge of the board
of directors and management plans, whether the auditor is of the opinion that
no material uncertainty exists as on the date of audit report that company is
capable of meeting its liabilities existing as at balance sheet date as and
when they fall due within period of one year from balance sheet date

•
Prepare list of liabilities with due dates falling within next one year

•
Check payments subsequent to balance sheet date till the date of issuing
auditors report

•
Obtain plan from management indicating realisable value of assets and
payments of liabilities

•
Ratios to be considered are current ratio, acid-test ratio, cash ratio, asset
turnover ratio, inventory turnover ratios, accounts receivable ratio, etc.

•
Other details which should be obtained from management post-balance sheet
date are MIS, cash flow projections, etc.

 

Adverse
reporting under this clause should have similar reporting in the main report
regarding going concern as specified in SA 570

 

(Page
196 of GN)

29

3(xx)(a)
– New

Whether
in respect of other than ongoing projects, the company has transferred
unspent amount to a fund specified in schedule VII of the Companies Act
within a period of six months of expiry of the F.Y. in compliance with 135(5)
of the Companies Ac.

The
auditor should ask the management to prepare a project-wise report on amounts
spent during the year and considered under CSR activities

 

(Page
204 of GN)

 

Clause
(a) requires unspent amount not relating to any ongoing project to be
transferred to specified fund as per schedule VII of the Act and Clause (b)
requires unspent amount relating to ongoing projects to be transferred to
special bank account opened for CSR activities

 

(Page
209 of GN)

30

3(xx)(b)
– New

Whether
any amount remaining unspent under 135(5) of the Companies Act, pursuant to
any ongoing project has been transferred to special account in compliance
with 135(6) of the Companies Act

 

 

CONCLUSION

The additional reporting
requirements would require additional details from the management and thus it
is very important that an auditor should have a dialogue with the management
immediately for the latter to gear up. It is also important for the auditor to
understand the process followed by the management for collection and processing
of the required information and its control environment which will give him
comfort while complying with the reporting requirements. Lastly, it is
important for the auditor to take suitable management representations wherever
accuracy and completeness of information provided by the management cannot be
confirmed by the auditor to safeguard his position. The auditor would have to
factor in additional time for reporting and the documentation will have to be
robust and fool-proof for future reference and as a safeguard against the
enhanced reporting responsibility. Lastly, reporting under CARO 2020 will no
longer remain a tick-in-the-box procedure or boilerplate reporting.  

 

 

VALUE ADDITION IN INTERNAL AUDIT

BACKGROUND

If one looks for a common definition of ‘value add’, it is the
difference between the price of a product or service and the cost of producing
it. The price is determined by what customers are willing to pay based on their
perceived value. Value is added or created in different ways.

 

Historically, Internal Audit is treated as a ‘cost centre’ rather than a
‘value-added process’. That’s because the definition of ‘value add’ can vary
from one firm / audit department to another. Mostly, it means improving the
business rather than just looking at compliance with policies and procedures.
But what is ‘value add’ to one practitioner may be different to another practitioner
of internal audit. So how does one establish what is ‘value add’? This will be
different in every case and also for each organisation. It has become common
for most practitioners to claim that they deliver ‘value-added’ internal audit
services, and for most stakeholders to speak of availing of ‘value-added’
internal audit services. The question, therefore, is ‘how does an internal
auditor or internal audit team / department add value’ in a particular
assignment or to the organisation?

 

Broadly speaking, adding value would be based on the competencies and
personal qualities of the internal auditor and what is being delivered.

 

James Roth, who has done significant work in this area and published
papers and written books on the subject, in his paper How Do Internal
Auditors Add Value identified four factors that can help internal
auditors determine what will add value to their organisation –

1. A deep knowledge of the
organisation, including its culture, key players and competitive environment.

2. The courage to innovate in ways
stakeholders don’t expect and may not think they want.

3. A broad knowledge of those
practices that the profession, in general, considers value added.

4. The creativity to adapt
innovations to the organisation in ways that yield surprising results and
exceed stakeholders’ expectations.

 

Based on our experience in conducting internal audits in a number of
organisations in India and abroad and speaking to a number of Chief Audit
Executives, including 14 top CAEs in the country being interviewed and a book Best
Practices by Leading Chief Audit Executives – Making a Difference published
with respect to best practices in their respective departments, we are giving
here a few key practices which would go a long way in providing ‘value add’ to
organisations. The internal auditor would then be welcomed and respected by the
top management and treated as a trusted business adviser.

 

IMPROVING CONTROLS OR IMPROVING PERFORMANCE FOR THE ORGANISATION

Normally, internal audit would include examination of financial and
operational information and evaluation of internal controls of significant
processes (ICFR / ICoFR). In terms of presentation to management and the Audit
Committee, the internal auditor would be presenting the risks and controls
evaluated for significant processes and non-conformance thereof with an action
plan to mitigate the non-conformance.

 

The question arises whether in practice the
stakeholders would be happy to get an assurance on controls alone or would they
value improving performance for the organisation. Improving performance would
mean measurable revenue growth or cost savings due to the work carried out by
the internal audit service provider. This is always a point of debate, whether
an internal audit work should be gauged by the cost savings and / or revenue
growth due to work directly carried out by them. From numerous interviews with
CAEs and our practical work in the field with organisations, it is clear that
improving performance is considered a ‘value add’ by stakeholders and is much
appreciated and valued. This does not mean that the internal audit would not be
evaluating internal controls but would mean focus on improving performance to
enhance the value of the internal audit service being delivered.

 

Consider the following cases:

Improving performance –
cost savings in procurement (a pharmaceutical company case)

A medium-sized pharmaceutical company with a yearly turnover of around
Rs. 1,200 crores is facing tough times due to the current pandemic as its
revenue has fallen by 35%. The outsourced partner of the internal audit firm is
approached by the management and helps constitute a team consisting of two
senior procurement officials, a cost accountant, one senior production official
and a senior internal auditor who has been working with the firm and deputed to
this client and having experience in the company processes; together, they go
through all major procurement items to identify areas for cost savings /
rationalisation.

 

A number of questions are raised with the aim of cost savings:

(i)         Are we buying from
authorised vendors, for example, bearings?

(ii)        What would be the
profit margins of vendors from whom we buy imported material – could we work
with them to reduce the cost of procurement of such material?

(iii) Could we substitute some materials being procured to reduce costs
without affecting quality?

(iv) Who are the vendors supplying to our competitors and what material
is being sourced by them? Are their procurement costs cheaper or is their
quality better?

(v)        Could we reduce our EOQ
without affecting costs and our production schedule – improve the working
capital and thereby reduce costs?

 

The team made a presentation on the progress to the top management every
fortnight. In an exercise over two and a half months, by analysing data,
raising the right questions and working on a number of parameters, the team was
able to effectively save Rs. 22 crores in procurement costs without compromising
on quality or service parameters. This was considered as a ‘value add’ for the
team, and especially for the partner of the outsourced chartered accountant
firm.

 

This may be considered as a special assignment but the point being made
is ‘what do the organisation / stakeholders require and is it being delivered
by the internal auditor / internal audit firm?’ In this particular case, the
internal audit was considered ‘value add’ and it would be welcomed and
respected by the stakeholders.

 

Improving performance –
mid-review of expansion project (an engineering company case)

In a new project expansion being executed by a large engineering
organisation, the internal auditor requested that the management allow his team
to carry out a mid-review of the project. Since the internal audit firm was
associated with the organisation for the last few years, the management liked
the idea of a mid-review as the costs for implementing the expansion were quite
high.

 

The internal audit team conducted the review – the estimates, project
plan including time and cost estimates, current time and cost incurred (all
purchase orders for materials and services, materials and services received to
date, consumption, all payments made, etc.), statutory compliances with respect
to procurement and site work, sanctions with respect to bank loans and current
utilisation (including all foreign loans and hedging).

 

The internal audit team highlighted a likely delay in procurement that
could lead to the overall project being delayed, higher costs in a few
procurement areas where similar work carried out in earlier years had been
executed at lower costs, and lapses in statutory compliances. This resulted in
the project being brought back on track in terms of time and cost. The
inspection schedule for outsourced fabricated items was increased, meetings
with vendors commissioning the project were handled at a higher level and some
re-negotiation on the procurement items was undertaken. Statutory compliances
were all competed.

 

Again, this was a value addition because of an independent review by the
internal auditor. Had this been done at the end, it would only have been a
post-mortem and provided ‘learnings’ for the future. In this case, the review
actually resulted in improving performance by having the project being executed
in time with minimal time and little cost overrun.

 

STRATEGIC ALLIANCE WITH OTHER FUNCTIONS

It is important for the internal auditor to forge an alliance with other
functions in the organisation rather than work in isolation. There are other
functions like HSE – Health, Safety & Environment, Risk Management, Legal
& Compliance, Quality, IS or Information Security. All these are also
support functions providing much-needed assurance and governance support to line
functions.

 

Why does the internal audit function have to ‘reinvent’ the wheel? A
strategic alliance with other assurance functions would enable the internal
auditor to

i)   Benefit from work already
being carried out by other function/s and avoid repetition

ii) Have better understanding of
the risks and controls of the process under review

iii)        Make the internal audit
review comprehensive, building and learning from the work carried out by other
functions

iv)        Collaborate to jointly
carry out a review of the technical areas where the other assurance functions
would have better understanding of the process under review.

 

Consider the case where the internal auditor carrying out the review of
the production process first contacted the management representative for ISO
9000 Quality Standard and had a look at the number of non-conformities and
corrective action-taken reports of various issues highlighted by the ISO
auditor for the production process during the entire year.

 

THE INTERNAL AUDIT PROCESS – TRANSPARENCY AND
COMMUNICATION

The entire process from communicating objectives, field work – obtaining
data, analysing data, etc. and communicating final results should be a
transparent exercise. The internal auditor has to be working with auditees /
process owners throughout the life cycle of the internal audit project. There
is nothing to hide as the objectives for the auditee / process owner and the
internal auditor are the same.

 

To bring transparency in the process it will be necessary to communicate
continuously with the auditee team regarding

(a) what are the objectives

(b) what data is required

(c)        what will be achieved at
the end

(d) how can performance of the business be improved due to the internal
audit exercise being carried out for the process under review

(e) what deviations / bottlenecks are being found which can be improved
upon

(f)        what further data or
expert advice is required to form an opinion on the process under review.

 

These are just some aspects of the process but the idea is to
continuously communicate as if the internal auditor and the auditee / process
owner are working together on the project to improve the performance of the
business.

 

Except when the internal auditor suspects
that there are integrity issues which need to be separately reported and / or
investigated, there has to be complete transparency and the working of the
internal auditor needs to be integrated with that of the auditee / process team
under review.

 

An effective internal audit is the sum total
of a proactive auditor and a participative auditee. This
will be possible only when the auditor is experienced in business process, and
is also competent, skilled, professional and transparent in his approach. This
would enable the internal auditor to have a participative auditee (it will also
depend on the maturity of the organisation and its culture) which, in turn,
would lead to an effective internal audit.

 

NEGOTIATING THE ROLE OF INTERNAL AUDIT

It is very important for an internal auditor to negotiate the role of
internal audit. The idea is to work with management in the journey for business
improvement in terms of better technology for business, technological
upgradation, cost savings and other aspects of governance. For this, the internal
auditor has to negotiate his role and grab the opportunities which come his
way.

 

Let us consider the following cases:

(1) The internal auditor requests the management of a large
geographically-spread organisation to put up an exhibit at the annual event to
showcase the role and capabilities of the internal audit function. The
management was taken aback with this request but was pleasantly surprised with
the exhibit and it was much appreciated.

(2) A CAE feels the need to carry out an
energy audit throughout the organisation at its 22 plants in India. He inducts
an engineer with energy audit knowledge and helps with energy audit in many
plants, leading to tremendous savings in coal and improved efficiency in steam
generation.

(3) An internal audit function hires an
engineer with knowledge of transport trailers / trucks and ensures that a
technical audit is done for each trailer / truck in the organisation’s
transportation business segment where the organisation owned a fleet of trucks
/ trailers. This results in tremendous savings due to increase in the life of
tyres and less consumption of diesel and other consumables, etc.

(4) A mid-sized organisation wants to implement a new ERP and the
internal auditor gives one senior team member who has been with the
organisation for many years and has deep knowledge of the processes as the
internal ‘Project Manager’ for the project. The project is successful with most
requirements built into the new ERP to ease availability of data and
decision-making for the process owners.

 

TECHNOLOGY UPGRADATION AND EDUCATION / AWARENESS TO
BUSINESS

One clear area for ‘value addition’ by internal audit is continuous
education and awareness to process owners whenever the internal auditor engages
with others in the organisation. There would be a number of ways this could
happen – promote benchmarking, make others aware of compliances, speak about
best practices in other parts of the organisation, bring good / best practices
from other non-competing organisations to the process under review.

 

Technology is a great enabler for making available data for
decision-making in the way business is carried out and the internal auditor can
help make changes by spreading awareness for adoption of technology by the
organisation.

(I) An internal auditor worked as
a consultant to bring awareness about technology to Legal and Compliance and to
make the entire process of compliance totally automated with alerts for action
to be taken by the process owners for various compliances and breaches being
brought up in real time.

(II) Similarly, in another instance
they worked with Corporate Communications and Investor Relations in a public
listed organisation to install a system to get a feed from social media about
the company’s reputation / news on a real-time basis.

(III)      Another example is an
internal auditor informing the management of a major hotel property and helping
install software which tracks information on day rates for guests with
competing properties and on popular hotel booking sites. Based on this runs an
algorithm to optimise the day rate for walk-in guests being offered. This
helped in increasing the revenue for the property.

 

CONCLUSION

Each and every practice given above for ‘value addition’ by internal
audit cannot be considered in a silo as a separate ‘to do’ but would overlap
with other practices.

 

It is now time to think afresh and work differently. The internal
auditor should be working with business, forging an alliance with other
processes / functions to improve performance, including productivity, for the
organisation and to bring new thought and innovation to every aspect of
business. There is need for the internal auditor to negotiate his role in the
organisation and be a part of the top management team.

 

Business disruption is leading to change which, in turn, is leading to
opportunity for the internal auditor as the process of internal audit is not
limited to any particular process or area unlike many other processes /
functions in the organisation.

 

INTEGRATED REPORTING – A PARADIGM SHIFT IN REPORTING

INTRODUCTION

Over the last few years there has been a paradigm shift in how the
performance of a company is viewed – it is no longer viewed only by how much
profits the company made, how much did it pay shareholders, or how much taxes
did it pay to the government. At business and investor forums, companies are
increasingly being asked questions like ‘Is the company following sustainable
practices?’ ‘Is it following the best ethical practices?’ ‘Is there gender
equality?’ ‘Is it employing child labour?’ ‘What is it doing about climate
change?’

 

At the UN Climate Action Summit in 2019 a
young activist 17 years of age, Greta Thunberg from Sweden (who on 20th September,
2019 led the largest climate strike in history), gave a devastating speech
questioning why world leaders are not considering climate change and are
‘stealing the future’ from the next generation. She said: ‘You have stolen
my dreams and my childhood with your empty words. And yet I’m one of the lucky
ones. People are suffering. People are dying. Entire ecosystems are collapsing.
We are in the beginning of a mass extinction, and all you can talk about is
money and fairy tales of eternal economic growth. How dare you!’

 

Welcome to the brand new world of Integrated
Reporting.

 

WHAT IS INTEGRATED
REPORTING?

Beyond the traditional financial reporting,
there is a growing interest in reporting other matters and this has drawn the
attention of not only activists and companies (mainly goaded by activists), but
also regulators and governments. Various stakeholders have started realising
the need to have a fundamental change in reporting wherein the focus is not
only the financial capital but also on demonstrating the value created by the
company while operating within its social, economic and environmental system.

 

The intended change requires in-depth
understanding of all the building blocks of the value creation process of
business, to enable corporates to develop a reporting model which gives an
insightful picture of its performance and is considered sufficient to assess
the quality and sustainability of their performance.

 

Integrated Reporting is the process founded
on integrated thinking that results in a periodic integrated report by an
organisation about value creation over time and related communication to
stakeholders regarding aspects of value creation.

 

The evolution of Integrated Reporting can be
depicted as under:

 

 

The accumulation of all the above reporting
aspects of an organisation would culminate in what is called an ‘Integrated
Report’.

 

An Integrated Report, besides the financial,
regulatory information and management commentary, also contains reports on
sustainability and the environment to give users and the society a 360-degree
view of the overall impact which a company can have on the society.

 

As can be seen from the above, Chartered
Accountants as well as other professionals in the finance and related fields
who till now considered ‘financial reporting’ as their main job, will now
understand and get involved in much more ‘reporting’, especially since many of
these ‘reports’ would, sooner than later, need independent assertion or
attestations.

 

GLOBAL FOOTPRINTS OF
INTEGRATED REPORTING

International Integrated Reporting Council

Founded in August, 2010, the International
Integrated Reporting Council (IIRC) is a global coalition of regulators,
investors, companies, standard setters, the accounting profession, academia and
NGOs. The coalition promotes communication about value creation as the next
step in the evolution of corporate reporting.

 

The purpose of IIRC is to promote prosperity
for all and to protect our planet. Its mission is to establish integrated
reporting and thinking within mainstream business practice as the norm in the
public and private sectors. The vision that IIRC has is of a world in which
capital allocation and corporate behaviour are aligned to the wider goals of
financial stability and sustainable development through the cycle of integrated
reporting and thinking.

 

IIRC has issued the International Integrated
Reporting Framework (referred to as the <IR> Framework) to accelerate the
adoption of integrated reporting across the world. The framework applies
principles and concepts that are focused on bringing greater cohesion and
efficiency to the reporting process and adopting ‘integrated thinking’ as a way
of breaking down internal silos and reducing duplication. It improves the quality
of information available to providers of financial capital to enable a more
efficient and productive allocation of capital. Its focus on value creation,
and the capital used by business to create value over time contributes towards
a more financially stable global economy. The <IR> Framework was released
following extensive consultation and testing by businesses and investors in all
regions of the world, including the 140 businesses and investors from 26
countries that participated in the IIRC Pilot Programme. The purpose of the
Framework is to establish Guiding Principles and Content Elements that govern
the overall content of an integrated report, and to explain the fundamental
concepts that underpin them.

 

GUIDING PRINCIPLES FOR
PREPARATION OF INTEGRATED REPORT <IR>

As per IIRC, the Integrated Report <IR>
should provide insight into the company’s strategy and how it relates to the
company’s ability to create value in the short, medium and long term and to its
use of and effects on capital. It should depict the combination,
inter-relatedness and dependencies between the factors that affect the
company’s ability to create value over time. Further, it should provide insight
into the nature and quality of the company’s relationships with its key
stakeholders, including how and to what extent the company understands, takes
into account and responds to their legitimate needs and interests. The report
also provides truthful information about the company, whether the same is
positive or negative. The information in the report should be presented:

(a)        On
a basis that is consistent over time;

(b)        In
a way that enables comparison with other organisations to the extent it is
material to the company’s own ability to create value over time.

 

SIX CAPITALS OF INTEGRATED
REPORTING <IR>

 

 

1. Financial Capital:

This describes the pool of funds that is
available to the organisation for use in the production of goods or provision
of services. It can be obtained through financing, such as debt, equity or
grants, or generated through operations or investments.

 

2. Manufactured Capital:

It is seen as human-created,
production-oriented with equipment and tools. It can be available to the
organisation for use in the production of goods or the provision of services,
including buildings, equipment and infrastructure (such as roads, ports,
bridges and waste and water treatment plants).

 

3. Natural Capital:

The company needs to present its activities
which had positive or negative impact on the natural resources. It is basically
an input to the production of goods or the provision of services. It can
include water, land, minerals, forests, biodiversity, ecosystems, etc.

 

4. Human Capital (carrier is the
individual):

This deals with people’s skills and
experience, their capacity and motivations to innovate, including their:

  •         Alignment with and support of the
    organisation’s governance framework and ethical values such as its recognition
    of human rights;
  •         Ability to understand and implement an
    organisation’s strategy;
  •         Loyalties and motivations for improving
    processes, goods and services, including their ability to lead and to
    collaborate.

 

5. Social
Capital:

This deals with institutions and
relationships established within and between each community, group of
stakeholders and other networks to enhance individual and collective
well-being. It would include common values and behaviours, key relationships,
the trust and loyalty that an organisation has developed and strives to build
and protect with customers, suppliers and business partners.

 

6. Intellectual
Capital:

This discusses a key element to a company’s
future earning potential, with a tight link and contingency between investment
in research and development, innovation, human resources and external
relationships. This can be a company’s competitive advantage.

 

RECENT GLOBAL INITIATIVES

In September, 2020 the following five
framework and standard-setting institutions came together to show a commitment
to work towards a Comprehensive Corporate Reporting System:

(i)         Global
Reporting Initiative (GRI)

(ii)        Sustainability
Accounting Standards Board (SASB)

(iii)       CDP
Global

(iv) Climate Disclosure Standard Board (CDSB)

(v)        International
Integrated Reporting Council (IIRC).

 

GRI, SASB, CDP and CDSB set the frameworks / standards for
sustainability disclosure, including climate-related reporting, along with the
Task Force on Climate-related Financial Disclosure (TCFD) recommendations. IIRC
provides the integrated reporting framework that connects sustainability
disclosure to reporting on financial and other capitals.

 

The intent of this collaboration is to
provide:

(a)        Joint
market guidance on how the frameworks and standards can be applied in a
complementary and additive way,

(b)        Joint
vision of how these elements could complement financial generally accepted
accounting principles (Financial GAAP) and serve as a natural starting point
for progress towards a more coherent, comprehensive corporate reporting system,

(c)        Joint
commitment to drive towards this goal, through an ongoing programme of deeper
collaboration between the five institutions and stated willingness to engage
closely with other interested stakeholders.

 

In September, 2020 the International
Financial Reporting Standards (IFRS) Foundation published a consultation paper
on sustainability reporting inviting comments by 31st December, 2020
on:

(I)        Assess
the current situation;

(II)       Examine
the options – i.e., maintain the status quo, facilitate existing
initiatives, create a Sustainable Standards Board and become a standard-setter
working with existing initiatives and building upon their work;

(III)      Reducing
the level of complexity and achieving greater consistency in sustainable
reporting.

 

In October, 2020 the International Auditing and Assurance Standards
Board (IAASB) highlighted areas of focus related to consideration of
climate-related risks when conducting an audit of financial statements in
accordance with the International Standards on Auditing (ISA) by issuing a
document, ‘Consideration of Climate-Related risks in an Audit of Financial
Statements’.

 

If climate change impacts the entity, auditors need to consider whether
the financial statements appropriately reflect this in accordance with the
applicable financial reporting framework (i.e., in the context of risks of
material misstatement related to amounts and disclosures that may be affected
depending on the facts and circumstances of the entity).

 

In November, 2020, IFRS issued a document on ‘Effects of climate-related
matters on financial statements’ – companies are now required to consider
climate-related matters in applying IFRS Standards when the effect of those
matters is material in the context of the financial statements taken as a
whole. The document also contains a tabulated summary of examples illustrating
when IFRS Standards may require companies to consider the effects of
climate-related matters in applying the principles in a number of Standards.

 

Auditors also need to understand how climate-related risks relate to
their responsibilities under the professional standards and the applicable laws
and regulations. (An illustrative audit report where a Key Audit Matter on
‘Potential impact of climate change’ is given in the feature ‘From Published
Accounts’ by the same author on page 75 of this issue.)

 

The importance of Integrated Reporting <IR> can be gauged by the
fact that HRH Prince Charles in 2004 founded the Accounting for Sustainability
Project (A4S). A4S is challenging accountants to save the world by helping
companies meet the United Nations’ Sustainable Development Goals. At present,
A4S has a presence across the Americas, Europe, Middle East, Africa and Asia
Pacific. Its Accounting Bodies Network includes 16 accounting bodies representing
2.4 million accountants in 181 countries, or nearly two-thirds of accountants
globally. Its goal is to inspire action in the global finance industry and
drive a fundamental shift towards resilient business models and a sustainable
economy.

 

‘The risks from environmental, social and economic crises are clear to
see – not just for our planet and society, but also the future resilience of
the global economy,’ said A4S executive Chairman Jessica Fries who led a session titled ‘Can
Accountants Save the World?’ at the 20th World Congress of Accountants, Sydney,
in 2018. She added, ‘Finance leadership and innovation are essential to the
changes needed to tackle these risks and to create the businesses of tomorrow.
The accountancy and finance profession are uniquely placed to create both
sustainable and commercially viable business models’.

 

INTEGRATED REPORTING
<IR> IN INDIA

In 2017, the Securities Exchange Board of
India (SEBI) had issued a circular encouraging the Top 500 companies of India
to consider the use of the Integrated Reporting <IR> framework for annual
reporting. The circular was delivered on the International Organization of
Securities Commissions (IOSCO) principle 16 which states that ‘there should be
full, accurate and timely disclosure of information that is material to
investors’ decisions’.

 

Since then, the companies have started their
integrated reporting journey. In 2019, it was noticed that approximately 100 of
the top 500 companies have reported on Integrated Reporting in their Annual
Reports. Further, SEBI also issued a ‘Consultation Paper on the Format for
Business Responsibility & Sustainability Reporting’ to invite the views of
various stakeholders.

 

In India, several companies included
information on emissions management, water conservation, energy reduction,
human rights and similar topics in the annual report or published / hosted the
same in a separate sustainability report. The transition from corporate social
responsibility to sustainability reporting focused on moving from philanthropic
social impact to stating the impact on natural and human capital. Moving to
Integrated Reporting <IR> would further broaden the report to be
inclusive of all material capitals, connecting them to business risks, its
related decisions and outcomes in the short, medium and long term.

 

Several leading companies in India have
already started issuing Integrated Reports and reporting on the six capitals of
Integrated Reporting listed above. These additional aspects of reporting can
result in an extra 15 to 20 pages of reporting, depending on the use of
graphics, etc. Some of the leading companies that have started issuing
Integrated Reporting are Reliance Industries Ltd., Mahindra & Mahindra
Ltd., HDFC Ltd., ITC Ltd., Tata Steel Ltd., Bharti Airtel Ltd., WIPRO Ltd.,
Larsen & Toubro Ltd., Bharat Petroleum Corporation Ltd., Indian Oil
Corporation Ltd. and so on. Though some disclosures in these reports are of the
‘boilerplate’ type, these would evolve in course of time to carry more
meaningful information.

 

INTEGRATED REPORTING AND
THE ICAI

In February, 2015 the ICAI constituted a
group on Integrated Reporting and in February, 2020 it constituted the
Sustainability Reporting Standards Board (SRSB), respectively. The mission of
SRSB is to take appropriate measures to increase awareness and implement
measures towards responsible business conduct; its terms of reference, inter
alia, include developing audit guidance for Integrated Reporting and to
benchmark global best practices in Sustainability Reporting.

 

ICAI has, to encourage SEBI, also introduced
India’s first award to celebrate the business practice of Integrated Reporting,
internationally acknowledged as the emerging best practice in corporate
reporting.

 

IN CONCLUSION

A recent trend in investing is
‘Environmental, Social and Governance or ESG Investing’. ESG investing refers
to a class of investing that is also known as ‘sustainable investing’. This is
an umbrella term for investments that seek positive returns and long-term
impact on society, environment and the performance of the business. Many
investors are now not only interested in the financial outcomes of investments,
they are also interested in the impact of their investments and the role their
assets can have in promoting global issues such as climate action. Although big
in global investments, ESG funds, which imbibe environment, social
responsibility and corporate governance in their investing process, are
witnessing growing interest in the Indian mutual fund industry, too. As per
reports, there are currently three ESG schemes managing around Rs. 5,000
crores.

 

Trust in a company is achievable through transparent behaviour and is a
key success factor for the business to operate, innovate and grow. Integrated
Reporting <IR> is promoting the need to answer important questions around
long-term value creation and in a world where economic instability and
long-term sustainability threaten the welfare of society. Integrated Reporting
<IR> is not the ultimate goal. It is only the beginning to take the world
towards more sustainability, to make it a better place for the future
generations.

 

PRACTICAL GUIDANCE ON SIGNIFICANT INFLUENCE

There
are numerous situations where, concluding whether an investor exercises
significant influence over the investee and consequently whether the investee
is an associate of the investor, requires considerable judgement to be
exercised. When there is no significant influence, and an entity incorrectly
interprets the relationship to be that of significant influence, it will end up
wrongly consolidating (using the equity method) the entity in the consolidated
financial statements, rather than measuring it in accordance with Ind AS 109 – Financial
Instruments and vice versa.

 

In this
article, we discuss two examples. But before we do that, it is important to
understand the following key provisions in Ind AS 28 – Investments in
Associates and Joint Ventures which is reproduced below.

 

Paragraph
3 defines the following terms:

 

‘An associate is an entity over which the investor has significant
influence.’

 

‘Significant influence is the power to participate in the financial and
operating policy decisions of the investee but is not control or joint control
of those policies.’

 

Paragraph
5:

 

‘If an entity holds, directly or indirectly (e.g.
through subsidiaries), 20 per cent or more of the voting power of the investee,
it is presumed that the entity has significant influence, unless it can be
clearly demonstrated that this is not the case. Conversely, if the entity
holds, directly or indirectly (e.g., through subsidiaries), less than 20 per
cent of the voting power of the investee, it is presumed that the entity does not
have significant influence, unless such influence can be clearly demonstrated.
A substantial or majority ownership by another investor does not necessarily
preclude an entity from having significant influence.’

 

Paragraph
6:

 

‘The existence of significant influence by an entity is usually evidenced
in one or more of the following ways:

a)  representation on the board of
directors or equivalent governing body of the investee;

b)  participation in policy-making
processes, including participation in decisions about dividends or other
distributions;

c)  material transactions between the
entity and its investee;

d)  interchange of managerial
personnel; or

e)  provision of essential technical
information.’

 

Example 1A – Significant influence in a group structure

 

Fact Pattern

 

The
parent has two subsidiaries, Sub 1 and Sub 2. Sub 1 has a 16% ownership
interest in Sub 2. The group structure is as follows:

 

 

 

 

The
parent has appointed two executives of Sub 1 as Directors to the Board of Sub
2. Thanks to the number of Directors on the Board, the two Directors are able
to have an impact on Sub 2’s Board. The parent has the right to remove the two
executives from the Board at any time. Sub 1 has also been directed to manage
Sub 2 in a way that maximises the return for the parent, rather than for Sub 1.
The parent can amend this directive at any time. Whether Sub 1 has significant
influence over Sub 2?

 

Response

 

Ind AS
28:5 indicates that ‘[a] substantial or majority ownership by another investor
does not necessarily preclude an entity from having significant influence’. In
this fact pattern, however, Sub 1 does not have significant influence over Sub
2, because although Sub 1 can participate in policy-making decisions, the
parent can remove Sub 1’s executives from Sub 2’s Board at any time. Therefore,
Sub 1’s apparent position of significant influence over Sub 2 can be removed by
the parent and Sub 1 does not have the power to exercise significant influence
over Sub 2. Since Sub 1 does not have significant influence over Sub 2, Sub 2
is not an associate of Sub 1. It is actually the parent that has 100% control
over Sub 2, directly and indirectly through Sub 1.

 

Example 1B – Board
participation alone does not provide significant influence

 

Fact pattern

 

Internet
Ltd.’s Board is the ultimate decision-making authority and has ten Directors.
The shareholder analysis of Internet Ltd. shows the following shareholders.
Other shares are widely held by the public.

 

Shareholding

Board
representation

Viz Ltd.

38%

4

Fiz Ltd.

36%

4

Ke Ltd.

9%

1

Individual M (Managing Director of Internet Ltd.)
appointed by Viz Ltd.

6%

1

Others – widely held

11%

none

 

100%

10

 

Board
decisions are passed by a 70% majority of voting Directors. Is a 9%
shareholding and representation of one Director on the Board enough to provide
Ke Ltd. with significant influence?

 

Response

 

Whether
Ke Ltd. has significant influence is a matter of judgement. Ke Ltd. has only
one Director out of the ten. The Board is dominated by Viz and Fiz who can make
decisions without the agreement of the other Board members. Under Ind AS 28,
the Board representation is an indicator of significant influence. However, it
does not provide any further guidance on


how to evaluate the representation in the context of the size of the Board,
voting patterns, significant transactions, exchange of managerial personnel and
the like. Ke Ltd. only has 10% of the Board seats and believes this is not
enough to exercise significant influence, given the presence of the two major
investors and the Managing Director on the Board. Although Ke Ltd. participates
in the policy-making processes and decisions, that alone does not enable it to significantly
influence those decisions as suggested under Ind AS 28.

 

Having a
representation on the Board of Directors is an indicator of significant
influence. It is not an automatic confirmation. Additional analysis would be
required and relevant facts and circumstances will need to be considered. Ke
Ltd., in this scenario, holds far less than 20% shareholding threshold
indicated in the standard. It therefore does not have significant influence
over Internet Ltd.

 

CONCLUSION

The
determination of significant influence is a matter of considerable judgement
and needs careful evaluation of all the details, the facts and circumstances of
the case.

PROVISIONING FOR EXPECTED CREDIT LOSSES FOR FINANCIAL INSTITUTIONS AND NBFCs POST-COVID-19

INTRODUCTION

The Covid-19 outbreak which surfaced in
China towards the end of 2019 was declared a global pandemic by the WHO in
March, 2020. It has affected economic and financial markets, and virtually all
industries are facing challenges associated with the economic conditions
resulting from efforts to address it. As the pandemic increases both in magnitude
and duration, entities are experiencing conditions often associated with a
general economic downturn. The continuation of these circumstances could result
in an even broader economic downturn that could have a prolonged negative
impact on an entity’s financial results. In response thereto, the RBI announced
a series of regulatory measures and relief packages dealing with rescheduling
of loans and credit facilities, providing moratorium, asset classification and
provisioning for the entire financial services sector which comprises of banks,
financial institutions and NBFCs.

 

Since the purpose of this article is to
highlight some of the key issues that emanate from the Covid pandemic to be
considered by financial institutions and NBFCs, in particular, in applying the
expected credit loss model (ECL) for provisioning in their Ind AS financial
statements, the discussion of the regulatory aspects will only be limited to
the extent it impacts the ECL. Whilst the focus of this article is for lenders,
much of it would apply to measurement of ECL in industries other than financial
services.

 

For the purpose of this article, it is
assumed that the readers have reasonable working knowledge of the various
technical requirements and guidance under Ind AS on ECL and related matters.

 

OVERVIEW OF THE ECL
MODEL AND ITS INTERPLAY WITH OTHER TECHNICAL AND REGULATORY REQUIREMENTS IN THE
COVID ENVIRONMENT

 

ECL model as per Ind AS 109

Ind AS 109 on
Financial Instruments sets out a framework for determining the amount of
ECL that should be recognised. It requires that lifetime ECLs be
recognised when there is a significant increase in credit risk (SICR) on a
financial instrument. However, it does not set bright lines or a mechanical
approach to determining when lifetime losses are required to be recognised, nor
does it dictate the exact basis on which entities should determine
forward-looking scenarios to consider when estimating ECLs.

 

Ind AS 109 requires entities to measure
expected losses and consider forward-looking information by reflecting ‘an
unbiased and probability-weighted amount that is determined by evaluating a
range of possible outcomes’ and taking into account ‘reasonable
and supportable information that is available without undue cost or effort at
that date about past events, current conditions and forecasts of future
economic conditions’. Whilst it always required entities to consider
multiple scenarios, entities may not have done so because it did not make a
material difference to the outcome in a benign / static economic environment.
However, such an approach may no longer be appropriate in the current Covid
scenario. Further, Ind AS 109 requires the application of judgement and
permits entities to adjust their approach to determining ECLs in different
circumstances. A number of assumptions and linkages underlying the way ECLs
have been implemented to date may no longer hold in the current Covid
environment and therefore entities will have to revisit the ECL approach /
methodology and should not continue to apply their existing ECL methodology
mechanically.

 

PRESENTATION AND
DISCLOSURES

In line with the requirements of Ind AS
107 on Financial Instruments – Disclosures and Ind AS 1 on Presentation
of Financial Statements, entities would be required to provide more
additional information to enable users of financial statements to understand
the overall impact of Covid-19 on their financial position and performance.
This is particularly important for areas in which Ind AS requires that
significant judgement is applied, which might also include other areas of
financial reporting. Similarly, the auditors would also need to consider
whether reporting on Covid-related matters needs to be reported as a key audit
matter in terms of the Auditing Standards.

 

Finally, distinguishing between adjusting
and non-adjusting events requires significant judgement,
particularly in the current environment for those entities where the economic
severity of the pandemic became apparent very shortly after the end of their
reporting period. The Guidance issued by the ICAI in connection therewith
should be referred to.

 

Impact of regulatory measures

The government and the RBI have been
announcing various relief measures / packages to enable entities to tide over
the adverse impact of Covid on their operations and financial position.
However, it may be difficult to initially incorporate the specific effects of
Covid and government support measures on a reasonable and supportable basis. The
changes in economic conditions should be reflected in macro-economic scenarios
applied by entities and in their weightings. If the effects of Covid are
difficult to be reflected in models considering the timing of Covid and
implications on Internal Financial Controls over Financial Reporting (IFCoFR),
post-model overlays or adjustments duly considering the portfolio segmentation
having shared credit risk characteristics and staging criteria (Stages 1, 2 and
3) may need to be considered as a pragmatic approach.

 

Further, entities should carefully assess
the impact of the economic support and relief measures on recognised financial
instruments and their conditions. This includes the assessment of whether such
measures result in modification of the financial assets and whether
modifications lead to their de-recognition. If it is concluded that the
support measures provide temporary relief to borrowers affected by the Covid
outbreak and the net economic value of the loan is not significantly affected,
the modification would be unlikely to be considered as substantial.

 

Finally, measures taken in the context of
the Covid outbreak that permit, require or encourage suspension or delays in
payments, should not be regarded as automatically having a one-to-one impact on
the assessment of whether loans have suffered an SICR. Therefore, a
moratorium under these circumstances should not in itself be considered as an
automatic trigger of SICR. Assessing whether there is an SICR is a holistic
assessment of a number of quantitative and qualitative indicators. Furthermore,
when relief (forbearance) measures are provided to borrowers by issuers, these
measures should be analysed taking into account all the facts and circumstances
in order to distinguish, for example, whether the credit risk on the financial
instrument has significantly increased or whether the borrower is only
experiencing a temporary liquidity constraint and there has not been a
significant increase in credit risk and consequential impact on the ECL to be considered.

 

These and some other specific considerations
arising out of Covid-19 on the assessment of ECL are examined later in this
article.

 

SPECIFIC CONSIDERATIONS


The following are some of the specific
considerations which need to be kept in mind whilst determining the adequacy
and appropriateness of the ECL provisions in the post-Covid scenario.

 

Reassessing the business model

As per Ind AS 109, the classification and
measurement of financial assets is dependent on the contractual cash flows
of the asset and the business model within which the asset is held, which
in turn determines the basis of valuation of the financial assets and
the provisioning thereof. An entity’s business model is determined at a
level that reflects how groups of financial assets are managed together
to achieve a particular business objective. Going forward, entities may need to
revisit their business model to determine whether it (the business model) has
changed due to the Covid implications, as the entity may decide to sell its
‘hold to collect’ portfolio as part of its revised strategy to manage liquidity
and credit risks.

 

Revisiting overall portfolio
segmentation

In accordance with Ind AS 109, financial
instruments should be grouped on the basis of shared credit
risk characteristics. Due to the disruptions in the business
operations, entities might witness an impact on the credit quality of their
portfolio across certain industries, geographies, customer segments, etc., that
may require them to revisit their portfolio segmentation and revise the ECL
assessment as appropriate. This may result in new portfolios being created or
assets moving to an existing portfolio that better reflects the similar credit
risk characteristics of that group of assets.

 

Further, forward-looking information might
need to be tailored for each portfolio. How much weight to give that
information depends on the specific credit risk drivers relevant to the
entities’ portfolios.

 

To illustrate, entities may lend across a
broad customer base resulting in concentration of risk exposure because of the
sectors and geographic areas in which customers are based or work. An entity’s
expectations over future unemployment in a particular sector may only be
relevant to borrowers who work in that sector.

 

At a broader level the portfolios can be
segregated between corporate and retail customer base which can be further
segregated based on the representative shared credit risk characteristics,
as considered relevant. Examples of shared credit risk characteristics may
include, but are not limited to, the following:

(a)   instrument type;

(b)   credit risk ratings;

(c)   collateral type;

(d)   date of initial recognition;

(e)   remaining term to maturity;

(f)    industry;

(g)   geographical location of the borrower; and

(h)   the value and liquidity of collateral
relative to the financial asset if it has an impact on the probability of a
default occurring (for example, loan-to-value ratios).

           

Assessment of SICR vis-à-vis
moratorium

When an entity grants an extension of terms
to a counter-party, the management should assess whether or not this indicates
that there has been a significant increase in credit risk. Measures taken in
the context of the Covid outbreak that permit, require or encourage suspension
or delays in payments should not be regarded as automatically having a
one-to-one impact on the assessment of whether loans have suffered an SICR.
Determining whether a change in the timing of contractual cash flows is an
SICR, or evidence of a credit-impaired financial asset, requires careful
consideration of the specific facts and circumstances.

 

Within the population of customers that
apply for a moratorium, separating those that are in financial difficulty
(borrowers with a solvency issue) from those that are not (borrowers with a
temporary liquidity issue), will be an operational challenge. Consideration
will need to be given to the payment status and history of the borrower
on the date when he applies for a moratorium. Therefore, an assessment will be
needed as to whether the moratorium is providing a short-term liquidity benefit
or addressing a deterioration in the borrower’s ability to meet its obligation
when due which, if it is a significant increase in lifetime Probability of
Default (PD), is an SICR.

 

An illustrative list of factors which can be
considered in making the aforesaid evaluations is as under:

 

1.   ‘Days Past Due’ metrics could reflect
the impact of the payment moratorium where borrowers take advantage of a
payment holiday and so instalments due on or after 1st March, 2020 may
no longer be ‘past due’.

2.   Payment history: Has the customer made
regular payments over, say, the last year on the loan in question and its other
credit obligations?

3.   Collateral: Has the valuation of the
underlying collaterals been significantly depleted?

4.   Leverage: Has the customer seen a
recent increase in leverage or indebtedness?

5.   Repeat forbearance: Has the customer
been granted prior / subsequent (post-balance sheet) forbearance treatments?

6.   Changes to credit risk policy: Do the
previous qualitative indicators of SICR need a reconsideration?

7.   Breach of the covenants of a credit
contract is a possible indication of unlikeliness to pay under the definition
of default. However, a covenant breach does not automatically trigger a
default. Rather, it is important to assess covenant breaches on a case-by-case
basis and determine whether they indicate unwillingness to pay.

8.   Sector in which the customer is
employed or operates, including its representative income profiles.

9.   Reference may also be drawn from various credit
agency reports which detail the sectors which have had a significant
impact, e.g., travel, aviation, tourism, etc.

10. In case of wholesale customers, factors
including current cash position, gearing status, future payments (including
loan repayments, expenses), future cash inflows and likely covenant breaches
can be evaluated.

 

Paragraph B5.5.17 of Ind AS 109 also provides a non-exhaustive list of information that may be
relevant and considered by entities in assessing and evaluating changes in
credit risk.

 

The entity should have a clearly defined
policy based on its portfolio to detail its evaluation of SICR and
how it will be applied across various portfolios and it should be approved by
the Board. (Refer to discussion under Governance process for further
details).

 

Assessing management overlays

This is an important consideration in the
context of the current unprecedented situation. The speed and timing of the
economic impact of Covid would require entities to include Post-Model
Adjustments (PMAs) to cater for the inadequacies of their ECL
models that are not designed to cater for the extreme economic
circumstances and government support measures that currently exist and to
reflect risks and other uncertainties that are not included in the underlying
ECL measurement models. Some of the macro-economic factors which could
be considered for making the assessment include, but are not limited to, GDP
growth rates, bank credit growth, wholesale price index, consumer price index,
Index of Industrial Production, unemployment rate, crude oil price, exchange
rates, etc., depending upon the nature of the portfolio. Considering the
timing, availability of information and uncertainties involved, a pragmatic
approach needs to be considered depending on the facts and circumstances in doing the overlay on Probability of Default (PD)
scenarios at the identified segmented portfolio levels. This would result
in additional downside scenarios in their year-end results, which topped
up the amount of their ECL allowances to specifically address economic
uncertainty.

 

Such PMAs should be well-controlled,
authorised, documented and need to be disclosed in accordance with the
governance framework for ECL as laid down by the entity. It is recommended
that entities disclose an explanation for each material post-model
adjustment or overlay made, along with the reason for the adjustment,
how the amount is determined, the approach used for the estimation and the
amount of each material post-model adjustment.

 

Probability weightage of various
scenarios

Paragraph 5.5.17(a) of Ind AS 109 requires the estimate of ECL to reflect an unbiased and
probability-weighted amount that is determined by evaluating a range of
possible outcomes. In practice, this may not need to be a complex analysis,
and relatively simple modelling may be sufficient without the need for a large
number of detailed simulations of scenarios.

 

However, currently there is little
visibility on how long the pandemic would last and the economic impact could
range from a mild downturn (where growth slows for a quarter or two, and the
economy bounces back immediately) to a severe slowdown (where growth slows for
more than a year followed by a tenuous recovery). Accordingly, ECL computation
needs to be done based on a range of possible scenarios, presenting a varying
degree of the economic and financial crisis and predict corresponding outcomes
such as:

 

(i)   an optimistic scenario, considering a
temporary impact of Covid-19 and a V-shaped recovery,

(ii)  a scenario, considering a severe and extended
impact of Covid-19 and a U-shaped recovery; and

(iii) a pessimistic scenario, with a prolonged severe
downturn, leading to a new low-level normal.

 

An unbiased estimate is one that is neither
overly optimistic nor overly pessimistic. For this purpose, entities will need
to develop an estimate based on the best available data about past events,
current conditions and forecasts of future economic conditions. Adjustments to
expected loss rates in provision matrices and overlays to formal models (where
used) will be needed. Updated facts and circumstances should continue to be
monitored for any new information relevant to assessing the conditions at the
reporting date. The probabilities assigned to these multiple economic scenarios
will often be a significant judgement warranting disclosure, which is a
critical component of ECL reporting, given the level of measurement uncertainty
resulting from Covid.

 

Forward-looking
information

The use of forward-looking information is a
key component of the ECL impairment approach. But this is not straight-forward
and involves judgement. No one can predict the future with certainty so the
incorporation of forward-looking information introduces considerable volatility
into entities’ results.

 

The economic forecasts that entities use to
estimate lifetime losses should not only be consistent with internal
managements’ forward-looking views, but also supportable with sound
quantitative data and methods. It is recommended that lenders consider official
economic forecasts issued by RBI and internal economists in assessing the
severity and duration of the macro-economic deterioration. Economic forecasts
generated by research agencies or professional forecasters could also be used.
However, over-reliance on these sources may become problematic as market prices
for debt and derivatives might reflect factors other than the borrower’s risk
of default (such as market liquidity) and the credit ratings could be a lagging
indicator of credit risk. But so long as the forecasts are defensible and
consistent with the institution’s own views, these could also be used where
relevant for the particular financial instrument or group of financial
instruments, and not at the entity level, to which the impairment requirements
are being applied. Different factors may be relevant to different financial instruments
and, accordingly, the relevance of particular items of information may vary
between financial instruments, depending on the specific drivers of credit
risk. Some examples in respect thereof are as under:

 

(A)  For corporate lending, forward-looking information
includes the future prospects of the industries in which the group’s
counter-parties operate, obtained from economic expert reports, financial
analysts, governmental bodies, relevant think-tanks and other similar
organisations, as well as consideration of various internal and external
sources of actual and forecast economic information.

(B)  For retail lending forward-looking information
includes the same economic forecasts as corporate lending with additional
forecasts of local economic indicators, particularly for regions with a
concentration of certain industries, as well as internally generated
information of customer payment behaviour.

 

As required by paragraph 35G (b) of Ind
AS 107, financial statements should disclose how forward-looking information
has been incorporated into the determination of expected credit losses,
including the use of macro-economic information. Further, paragraph
35G(c) requires disclosure on changes in the estimation techniques or
significant assumptions made during the reporting period and the reasons for
those changes.

 

Events after the reporting period

Ind AS 10 on Events
after the Reporting Period distinguishes between adjusting and non-adjusting
events, with adjusting events being those that provide further evidence of
conditions that existed at the end of the reporting period and therefore need
to be reflected in the measurement of balances in the reporting period. Non-adjusting
events are those that are indicative of
a condition that arose after the end of the reporting period.

 

Entities will need to update their forward-looking
information to reflect expectations at the reporting date. Entities will need
to distinguish between those events that arose after the end of the reporting
period that reflect new events, as opposed to those that were reasonably
expected at the reporting period end and so would have been reasonably assessed
as being included in the forward-looking assessment made at the end of the
reporting period. This assessment might include, for example, assessing the
status and extent of the Covid-19 pandemic in geographies relevant to the
entity’s credit risk exposures at the reporting period end and considering the
path and extent of the increase in infection rates in other areas that were affected
earlier.

 

An entity may consider it reasonable at the
reporting period end to forecast particular macro-economic inputs used in ECL
modelling. If those macro-economic inputs end up not occurring or changing
after the reporting date, this should not be used as evidence to adjust the
entity’s expectation at the period end. Doing so would represent inappropriate
use of hindsight and would not reflect the conditions that existed at the
reporting period end. Distinguishing between adjusting and non-adjusting events
requires significant judgement, particularly in the current environment for
those entities where the economic severity of the pandemic became apparent very
shortly after the end of their reporting period.

 

The severity of the economic impact of Covid
after the end of the reporting period will require consideration even if those
economic impacts are non-adjusting events. When non-adjusting events after the
reporting period are material, an entity is required to disclose the nature of
the event and an estimate of its financial effect, or a statement that such an
estimate cannot be made.

 

Governance process

An entity’s Board of Directors (or
equivalent) and senior management are responsible for ensuring that it has
appropriate credit risk practices, including an effective system of internal
control, to consistently determine adequate allowances in accordance with its
stated policies and procedures, the applicable accounting framework and
relevant supervisory guidance.

 

As per the RBI circular dated 13th
March, 2020 on Implementation of Indian Accounting Standards, for
Non-Banking Financial Companies and Asset Reconstruction Companies, the
RBI expects the Board of Directors to approve sound methodologies for
computation of ECL that address policies, procedures and controls for assessing
and measuring credit risk on all lending exposures, commensurate with the size,
complexity and risk profile specific to the NBFC / ARC. These matters
become more critical in the context of the Covid-19-induced environment.
It would not be out of place for entities to set up a separate sub-committee
of the Board to monitor the impact on various aspects of the business due to
Covid, which could also cover the above referred matters.

 

The following are some of the specific matters
which need to be documented and approved by the Board and / or the Audit
Committee of the Board (ACB):

 

(I)    The parameters and assumptions considered
as well as their sensitivity to the ECL output.

(II)   NBFCs / ARCs are advised to not make
changes in the parameters, assumptions and other aspects of their ECL model for
the purposes of profit smoothening.

(III)  The rationale and justification for any
change in the ECL model.

(IV)  Any adjustments to the model output (i.e.,
a management overlay) which are necessitated due to Covid-19 should be approved
by the ACB together with its rationale and basis.

(V)  ACB should also approve the
classification of accounts that are past due beyond 90 days but not treated as
impaired, together with the rationale for the same.

 

CONCLUSION

Covid-19 is likely to be the new normal and
will continue to pose several challenges which will require quick responses on
a real-time basis, which may make it difficult to incorporate the specific
effects of the regulatory support measures on a reasonable and supportable
basis. However, changes in economic conditions should be reflected in
macro-economic scenarios applied by entities and in their weightings. If the
effects of Covid-19 cannot be reflected in models, post-model overlays or adjustments
will need to be considered. Although the current circumstances are difficult
and create high levels of uncertainty, ECL estimates can still be made if
monitored under the appropriate supervision and governance framework laid down
by the entities, based on reasonable and supportable information supplemented
by adequate disclosures for transparency in the entity’s financial statements.

 

(The author
would like to acknowledge the contribution of CA Rukshad Daruvala and CA
Neville Daruwalla for their inputs in preparing this article.)

 

 

FRAUD ANALYTICS IN INTERNAL AUDIT

BACKGROUND

Even though some organisations are
disinclined to report fraud, it is still necessary to try to prevent and detect
it. There is, however, some confusion over who exactly is responsible for this
task, with many non-auditors having the misconception that it is the duty of
auditors, internal or external, to uncover fraud. From the external auditors’
perspective, their role is to say whether the financial statements fairly
represent the operations of the company. Internal auditors would argue that
revealing fraud is not their ultimate goal – they aim to test the effectiveness
of internal controls. In reality, it’s much more likely that errors rather than
frauds will be found during an audit.

 

Under the
Companies (Auditor’s Report) Order, 2020 – CARO 2020 – the Statutory Auditor is
required to report on fraud and whistle-blower complaints as below:


(a) Has there
been any fraud by the company or any fraud done on the company? Has any such
fraud been noticed or reported at any time of the year? If yes, the nature and
amount involved have to be reported.

(b) Whether
the auditors of the company have filed a report in Form ADT-4 with the Central
Government as prescribed under the Companies (Audit and Auditors) Rules, 2014?

(c) In case of
receipt of whistle-blower complaints, whether the complaints have been
considered by the auditor.

 

While
uncovering fraud may not be an auditor’s main responsibility, there is
certainly a variety of tools, tests and processes that can be utilised to
detect it. And data analytics increases the chances of uncovering fraud.

 

WHAT IS FORENSIC
ACCOUNTING?

Forensic
accounting is a specialty practice area where accounting, auditing and
investigative skills are used to analyse information that is suitable for use
in a court of law.

 

Forensic
accountants are often engaged to quantify damages in instances related to fraud
and embezzlement, as well as on matters involving insurance, personal injury,
business disputes, business interruption, divorce and marital disputes,
construction, environmental damages, cyber-crime, products liability, business
valuation and more.

 

What is
fraud investigation?

Fraud investigation is the process of
resolving allegations of fraud from inception to disposition. Standard tasks
include obtaining evidence, reporting, testifying to findings and assisting in
fraud detection and prevention.

 

Developing an
investigation plan includes:


(i)    Review and gain a basic
understanding of key issues.

(ii)   Define the goals of the
investigation.

(iii)   Identify whom to keep
informed.

(iv)  Determine the terms of
reference and timeline for completion.

(v)   Address the need for law
enforcement assistance.

(vi)  Define team member roles and
assign tasks.

(vii)  Outline the course of
action.

(viii) Prepare the organisation
for the investigation.

 

What is
fraud analytics?

Fraud
analytics is an integral part of fraud investigation. Fraud analytics combines
analytic technology and techniques with human interaction to help detect
potential improper transactions, such as those based on fraud and / or bribery,
either before the transactions are completed or as they occur.

 

The process of
fraud analytics involves gathering and storing relevant data and mining it for
patterns, discrepancies and anomalies. The findings are then translated into
insights that can allow a company to manage potential threats before they occur
as well as develop a proactive fraud and bribery detection environment.

 

KEY REASONS FOR USING DATA ANALYTICS FOR FRAUD DETECTION

Forensic data
analysis tools help organisations to fully realise or realise to a credible
extent early fraud detection, increased business transparency and reduced costs
of their anti-fraud programme.

 

Some of the
key reasons for using forensic data analysis tools are:


(A)  Early fraud detection.

(B)  Ability to detect fraud that
could not be detected earlier.

(C)  Faster response in
investigations.

(D)  Increased business
transparency.

(E)  Getting the business to take
more responsibility for managing the company’s anti-fraud programme.

(F)  Reduced costs of the
anti-fraud programme.

 

Case
study on fraud analytics – ‘Procure to Pay’

‘Procure to
Pay’ is one of the major areas of success with fraud analytics. The main
objective is to check for the validity of items. This encompasses supplier
overpricing, invalid invoices, frauds of various types, accidental duplication
and simply picking up out-of-control expenses.

 

Some of the
illustrative fraud analytics tests for visualisation and / or red flag
detection are:


1.   Analyse purchases or payments
by value bands and identify unusual trends.

2.   Test for splitting,
particularly below threshold authority limits.

3.   Summarise by type of payment
– regular supplier, one-time supplier, etc.

4.   Analyse by period to
determine seasonal fluctuations.

5.   Analyse late shipments for
impact on jobs, projects, or sales orders due.

6.   Reconcile orders received
with the purchase orders to identify shipments not ordered.

7.   Report on purchasing
performance by location.

8.   Summarise item delivery and
quality and compare vendor performance.

9.   Compare accrued payables to
received items to reconcile to general ledger.

10. Check for continued purchases
despite high rate of returns, rejections, or credits.

11. Track scheduled receipt dates
versus actual receipt dates.

12. Identify price increases
higher than acceptable percentages.

13. Capture invoices without a
valid purchase order.

14. Find invoices for more than
one purchase order authorisation.

15. Isolate and extract pricing
and receipt quantity variations by vendor and purchase order.

16. Filter out multiple invoices
just under approval cut-off levels.

17. Detect invoice payments on
weekends or public holidays.

18. Find high value items being
bought from a single vendor.

19. Aging analysis of open orders
beyond a specified number of months.

20. Changes to orders in terms of
quantity and unit price after receipt of material.

21. Orders raised after receipt of
material and / or after receipt of supplier’s bills.

22. Sequential orders raised on
suspect vendors.

23. Backdating of orders.

24. Same material being bought
under different material codes.

25. Same material being bought
from the same vendor on different payment terms and / or delivery terms.

26. Payments to vendors initiated
and approved by the same user.

27. Same vendor having multiple
vendor codes of which one or more code/s have debit balances (on account of
advances) while other code/s are receiving bill-based payments without
adjusting the on-account advances.

28. Duplicate bill payments to a
vendor against the same invoice and order – exact match on invoice.

29. Duplicate bill payments to a
vendor against the same invoice and order – near match on invoice (fuzzy
pattern-based match).

30. Material bought at a higher
price from a vendor when there is an open order within the system for the same
material pending delivery at a lower price.

 

The examples
given in this article are based on use of IDEA Data Analysis Tool. However, a
reader can choose and use any Data Analytical Tool for conducting such fraud
analytics.

 

Case
Study 1 – Using Benford’s Law in IDEA Software to identify Vendor Payment
splitting and / or skimming

 

In this tool Benford’s Law has been
incorporated for easy detection of red flags. Any significant alteration to the
natural flow of numbers is identified in the form of a graph. The graph
containing many specialised views is designed to identify common forms of
fraud.

 

Benford’s Law
lets you compare your data under review for patterns predicted by Benford’s Law
of Digital Analysis. Spot irregularities by analysing digits in numerical data
sets to capture potential fraud (exploratory analytics). Apply the Benford’s
Law – Last 2 Digits Test, to detect skimming and circumvention of vendor
payments just below a threshold approval limit as seen in the ‘Highly
Suspicious’ red bars in the Benford’s screenshot below.

 

 

Case
Study 2 – Apply the Relative Size Factor (RSF) test to capture Vendor Payment
outliers

 

The purpose of
the Relative Size Factor (RSF) test is to identify anomalies where the largest
amount for subsets in a given key is outside the norm for those subsets. This
test compares the top two amounts for each subset and calculates the RSF for
each. The RSF test utilises the largest and the second largest amount to
calculate a ratio based on purchases that are grouped by vendors in order to
identify potential fraudulent activities in invoice payment data, as has often
been suggested in fraud examination literature.

 

 

Case Study 3 – Apply the Fuzzy Duplicate test to
capture duplicate pattern matches

 

The Fuzzy
Duplicate task identifies pattern-based matching (similar) records within
selected character field/s and then groups them based on their degree of
similarity. Identify multiple similar records within selected character fields
to detect data entry errors, multiple data conventions for recording
information and fraud. Generate a potential list of pattern matching duplicates
on the Inventory Description in an Inventory Master Dump.

 

Case
Study 4 – Apply Anti-Bribery and Corruption checks through Search on a General
Ledger narration field

 


A search
provides keyword searching capabilities to find text within fields in a database
without the need to write code / equations to execute the search criteria.
Anti-bribery and corruption checks can be applied through Search on a General
Ledger to look for the narration field containing key words like ‘gift’,
‘donation’, ‘suspense’ and other such text.

 

 

 

CONCLUSION

Incorporating
an anti-fraud programme for internal auditors (even for external / statutory
auditors) is extremely important, irrespective of the requirement of the law as
the top management and stakeholders are moving towards ‘zero tolerance’ of such
incidents. If a process / area has been reviewed / audited and later there are
incidents of fraud detected, then there is always a close scrutiny of the work
carried out by the internal auditor.

 

With the
advent of technology and the data explosion, it is necessary for the internal
auditor to employ data analytics tools and techniques, or ‘Fraud Analytics’,
for:

*
comprehensive coverage of process / area under review,

* storing
evidence using the analytics tool on the steps taken for each test, full
coverage of the period under review or even sample selection,

* devising and
completing various tests for detecting any anomaly or red flags,

* focusing on
transactions / areas which show patterns which deviate from the norms.

DEFINITION OF A BUSINESS (AMENDMENTS TO Ind AS 103)

The definition of business
has been amended (vide MCA notification dated 24th July,
2020) and continues to be intended to assist entities to determine whether a
transaction should be accounted for as ‘a business combination’ or as ‘an asset
acquisition’.

 

The accounting for the
acquisition of an asset and for the acquisition of a business are very different,
hence the classification is very critical. The amendments are applicable to
business combinations for which the acquisition date is on or after the
beginning of the first annual reporting period beginning on or after 1st
April, 2020 and to asset acquisitions that occur on or after the beginning of
that period. In a nutshell, the amendments have made the following broad
changes:


(i) the definition of a
business and the definition of outputs is made narrow.

(ii) clarify the minimum
features that the acquired set of activities and assets must have in order to
be considered a business.

(iii) the evaluation of
whether market participants are able to replace missing inputs or processes and
continue to produce outputs is removed.

(iv) an optional concentration
test that allows a simplified assessment of whether an acquired set of
activities and assets is not a business has been introduced.

 

The amendments replace the
wording in the definition of a business as follows:

Old Definition

New Definition

‘An integrated set of activities and assets
that is capable of being conducted and managed for the purpose of providing a
return in the form of dividends, lower costs or other economic benefits
directly to investors or other owners, members or participants’

‘An integrated set of activities and assets
that is capable of being conducted and managed for the purpose of providing
goods or services to customers, generating investment income (such as
dividends or interest) or generating other income from ordinary activities’

 

 

The changed definition
focuses on providing goods and services to customers, removes the emphasis from
providing a return to shareholders as well as to ‘lower costs or other
economics benefits’, because many asset acquisitions are made with the motive
of lowering costs but may not involve acquiring a substantive process.

 

Under the revised
standard, the following steps are required to determine whether the acquired
set of activities and assets is a business:

Step 1

Consider whether
to apply the concentration test

Does the entity want to apply the
concentration test?

If yes go to Step 2, if no go to Step 4

Step 2

Consider what
assets have been acquired

Has a single identifiable asset or a group
of similar identifiable assets been acquired?

If yes go to Step 3, if no go to Step 4

Step 3

Consider how the
fair value of gross assets acquired is concentrated

Is substantially all of the fair value of
the gross assets acquired concentrated in a single identifiable asset or a
group of similar identifiable assets?

If yes, the concentration test has passed,
transaction is not a business, if no go to step 4

Step 4

Consider whether
the acquired set of activities and assets has outputs

Does the acquired set of activities and
assets have outputs?

Go to step 5

Step 5

Consider if the
acquired process is substantive

  •  If there are no outputs, in what
    circumstances is the acquired process considered substantive?
  •  If there are outputs, in what circumstances
    is the acquired process considered substantive?

If acquired process is substantive,
transaction is a business; if acquired process is not substantive,
transaction is an asset acquisition

 

 

OPTIONAL CONCENTRATION TEST


The optional concentration
test allows the acquirer to carry out a simple evaluation to determine whether
the acquired set of activities and assets is not a business. The optional
concentration test is not an accounting policy choice; therefore, it may be
used for one acquisition and not for another. If the test passes, then the
acquired set of activities and assets is not a business and no further
evaluation is required. If the test fails or the entity chooses not to apply
the test, then the entity needs to assess whether or not the acquired set of
assets and activities meets the definition of a business by making a detailed
assessment.

 

The amended standard does
not prohibit an entity from carrying out the detailed assessment if the entity
has carried out the concentration test and concluded that the acquired set of
activities and assets is not a business. The standard-setter decided that such
a prohibition was unnecessary, because if an entity intended to disregard the
outcome of the concentration test, it could have elected not to apply it.

 

In theory, the
concentration test might sometimes identify a transaction as an asset
acquisition when the detailed assessment would identify it as a business
combination. That outcome would be a false positive. The standard-setter
designed the concentration test to minimise the risk that a false positive
could deprive users of financial statements of useful information. The
concentration test might not identify an asset acquisition that would be
identified by the detailed assessment. That outcome would be a false negative.
An entity is required to carry out the detailed assessment in such a case and
is expected to reach the same conclusion as if it had not applied the
concentration test. Thus, a false negative has no accounting consequences.

 

What is a
single identifiable asset?


A single identifiable
asset includes any asset or group of assets that would be recognised and
measured as a single identifiable asset in a business combination. This will
include assets that are attached or cannot be removed from other assets without
incurring significant cost or loss of value of either asset. Examples of single
identifiable asset include land and buildings, customer lists, trademarks,
outsourcing contracts, plant and machinery, intangible asset (for example, a
coal mine), etc. Land and buildings cannot be removed from each other without
incurring significant cost or loss of value to either of them, unless the
building is inconsequential or very insignificant in value.

 

What is a
group of similar identifiable assets?


Assets are grouped when
they have a similar nature and have similar risk characteristics (i.e., the
risks associated with managing and creating outputs from the assets). The
following are examples of groupings which are not considered to be similar
assets:

(a) a tangible asset and
an intangible asset.

(b) different classes of
tangible assets under Ind AS 16, for example, equipment and building (unless
the equipment is embedded in the building and cannot be removed without
incurring significant cost or loss of value to either the building or the
equipment).

(c) tangible assets that
are recognised under different Standards (e.g. Ind AS 2 ‘Inventories’ and Ind
AS 16 ‘Property, Plant and Equipment’).

(d) a financial asset and
a non-financial asset.

(e) different classes of
financial assets under Ind AS 109 ‘Financial Instruments’ (e.g receivables,
equity investments, etc.).

(f) different classes of
intangibles (e.g. brand, mineral rights, etc.)

(g) assets belonging to
the same class but have significantly different risk characteristics, for
example, different types of mines.

 

In applying the
concentration test, one test is to evaluate whether substantially all of the
fair value of the gross assets acquired is concentrated in a single
identifiable asset or a group of similar identifiable assets? How is the fair
value determined?

 

The fair value of the
gross assets acquired shall include any consideration transferred (plus the
fair value of any NCI and the fair value of any previously held interest) in
excess of the fair value of net identifiable assets acquired. The fair value of
the gross assets acquired may normally be determined as the total obtained by
adding the fair value of the consideration transferred (plus the fair value of
any NCI and the fair value of any previously held interest) to the fair value
of the liabilities assumed (other than deferred tax liabilities), and then
excluding cash and cash equivalents, deferred tax assets and goodwill resulting
from the effects of deferred tax liabilities.

 

The
standard-setter concluded that whether a set of activities and assets includes
a substantive process does not depend on how the set is financed. Consequently,
the concentration test is based on the gross assets acquired, not on net
assets. Thus, the existence of debt (for example, a mortgage loan financing a
building) or other liabilities does not alter the conclusion on whether an acquisition is a business combination. In addition, the gross assets
considered in the concentration test exclude cash and cash equivalents
acquired, deferred tax assets, and goodwill resulting from the effects of
deferred tax liabilities. These exclusions were made because cash acquired, and
the tax base of the assets and liabilities acquired, are independent of whether
the acquired set of activities and assets includes a substantive process.

 

Example – Establishing the
fair value of the gross assets acquired

 

Ze Co holds a 30% interest
in Ox Co. A few years later, Ze acquires control of Ox by acquiring an
additional 45% interest in Ox for INR 270. Ox’s assets and liabilities on the
acquisition date are the following:

 

  •  a building with a fair
    value of INR 720
  •  an identifiable
    intangible asset with a fair value of INR 420
  • cash and cash
    equivalents with a fair value of INR 180
  •  deferred tax assets of
    INR 120
  •  financial liabilities
    with a fair value of INR 900
  •  deferred tax liabilities
    of INR 240 arising from temporary differences associated with the building and
    the intangible asset.

 

Ze determines that at the
acquisition date the fair value of Ox is INR 600, that the fair value of the
NCI in Ox is INR 150 (25% x INR 600) and that the fair value of the previously
held interest is INR 180 (30% x INR 600).

 

Analysis

 

When performing the
optional concentration test, Ze needs to determine the fair value of the gross
assets acquired. Ze determines that the fair value of the gross assets acquired
is INR 1,200, calculated as follows:

 

  •  the total (INR 1,500)
    obtained by adding:

– the consideration paid
(INR 270), plus the fair value of the NCI (INR 150) plus the fair value of the
previously held interest (INR 180); to

– the fair value of the
liabilities assumed (other than deferred tax liabilities) (INR 900); less

 

  • the cash and cash
    equivalents acquired (INR 180); less

 

  • deferred tax assets
    acquired (INR 120).

 

Alternatively, the fair
value of the gross assets acquired (INR 1,200) is also determined by:

 

  •  the fair value of the
    building (INR 720); plus
  •  the fair value of the
    identifiable intangible asset (INR 420); plus
  •  the excess (INR 60) of:

 

– the sum (INR 600) of the
consideration transferred (INR 270), plus the fair value of the NCI (INR 150),
plus the fair value of the previously held interest (INR 180); over

– the fair value of the
net identifiable assets acquired (INR 540 = INR 720 + INR 420 + INR 180 + INR
120 – INR 900).

 

MINIMUM REQUIREMENTS TO QUALIFY AS BUSINESS

What are the
minimum requirements to meet the definition of a business?

 

Elements
of a business

Explanation

Examples

Inputs

An
economic resource that creates outputs or has the ability to contribute to
the creation of outputs when one or more processes are applied to it

 tangible assets

•
right-of-use assets

•
intangible assets

•
intellectual property

•
employees

•
ability to obtain necessary material or rights

Processes

A
system, standard, protocol, convention or rule that when applied to an input
or inputs, creates outputs or has the ability to contribute to the creation
of outputs. These processes typically are documented, but the intellectual
capacity of an organised workforce having the necessary skills and experience
following rules and conventions may provide the necessary processes that are
capable of being applied to inputs to create outputs. (Accounting, billing,
payroll and other administrative systems typically are not processes used to
create outputs.)

•
strategic management processes

•
operational processes

•
resource management processes

Outputs

The
result of inputs and processes applied to those inputs that provide goods or
services to customers, generate investment income (such as dividends or
interest) or generate other income from ordinary activities

•
revenue

 

 

To qualify as a business,
the acquired set of activities and assets must have inputs and substantive
processes that together enable the entity to contribute to the creation of
outputs. However, the standard clarifies that outputs are not necessary for an
integrated set of assets and activities to qualify as a business. A business
need not include all of the inputs or processes that the seller used in
operating that business. However, to be considered a business, an integrated
set of activities and assets must include, at a minimum, an input and a
substantive process that together enable the entity to contribute to the
creation of outputs.

 

According to the
standard-setters, the reference in the old definition to lower costs and other
economic benefits provided directly to investors did not help to distinguish
between an asset and a business. For example, many asset acquisitions may be
made with the motive of lowering costs but may not involve acquiring a
substantive process. Therefore, this wording was excluded from the definition
of outputs and the definition of a business.

 

Ind AS 103 adopts a market
participant’s perspective in determining whether an acquired set of activities
and assets is a business. This means that it is irrelevant whether the seller
operated the set as a business or whether the acquirer intends to operate the
set as a business. An assessment made from a market participant’s perspective
and driven by facts that indicate the current state and condition of what has
been acquired (rather than the acquirer’s intentions) helps to prevent similar
transactions being accounted for differently. Moreover, bringing more subjective
elements into the determination would most likely have increased diversity in
practice.

 

When is an acquired process considered to be substantive?


The amended Standard
requires entities to assess whether the acquired process is substantive. The evaluation
of whether an acquired process is substantive depends on whether the acquired
set of activities and assets has outputs or not. For example, an early-stage
entity may not have any outputs / revenue, and is therefore subjected to a
different analysis of whether the acquired process along with the acquisition
of the development stage entity is substantive or not. Moreover, if an acquired
set of activities and assets was generating revenue at the acquisition date, it
is considered to have outputs at that date, even if subsequently it will no
longer generate revenue from external customers, for example because it will be
integrated by the acquirer.

 

For activities and assets
that do not have outputs at the acquisition date, the acquired process is substantive
only if:

(i) it is critical to the
ability to develop or convert an acquired input or inputs into outputs; and

(ii) the inputs acquired
include both an organised workforce that has the necessary skills, knowledge,
or experience to perform that process (or group of processes) and other inputs
that the organised workforce could develop or convert into outputs. Those other
inputs could include:

(a)    intellectual
property that could be used to develop a good or service;

(b)    other
economic resources that could be developed to create outputs; or

(c)    rights to
obtain access to necessary materials or rights that enable the creation of
future outputs.

 

Examples of the inputs
include technology, in-process research and development projects, real estate
and mineral interests.

 

As can be seen from the
above discussion, for an acquired set of activities and assets to be considered
a business, if the set has no outputs, the set should include not only a
substantive process but also both an organised workforce and other inputs that
the acquired organised workforce could develop or convert into outputs.
Entities will need to evaluate the nature of those inputs to assess whether
that process is substantive.

 

For activities and assets
that have outputs at the acquisition date, the acquired process is substantive
if, when applied to an acquired input or inputs:

(1) it is critical to the
ability to continue producing outputs, and the inputs acquired include an
organised workforce with the necessary skills, knowledge, or experience to
perform that process (or group of processes); or

(2) significantly
contributes to the ability to continue producing outputs and is considered
unique or scarce; or cannot be replaced without significant cost, effort, or delay
in the ability to continue producing outputs.

 

The following additional
points support the above:

(A) an acquired contract
is an input and not a substantive process. Nevertheless, an acquired contract,
for example, a contract for outsourced property management or outsourced asset
management, may give access to an organised workforce. An entity shall assess
whether an organised workforce accessed through such a contract performs a
substantive process that the entity controls, and thus has acquired. Factors to
be considered in making that assessment include the duration of the contract
and its renewal terms.

(B) difficulties in
replacing an acquired organised workforce may indicate that the acquired
organised workforce performs a process that is critical to the ability to
create outputs.

(C) a process (or group of
processes) is not critical if, for example, it is ancillary or minor within the
context of all the processes required to create outputs.

 

As can be seen from the
above discussions, more persuasive evidence is required in determining whether
an acquired process is substantive, when there are no outputs, because the
existence of outputs already provides some evidence that the acquired set of
activities and assets is a business. The presence of an organised workforce
(although itself an input) is an indicator of a substantive process. This is
because the ‘intellectual capacity’ of an organised workforce having the
necessary skills and experience following rules and conventions may provide the
necessary processes (even if not documented) that are capable of being applied
to inputs to create outputs.

 

The standard-setter
concluded that although an organised workforce is an input to a business, it is
not in itself a business. To conclude otherwise would mean that hiring a
skilled employee without acquiring any other inputs could be considered to be
acquiring a business. The standard-setter decided that such an outcome would be
inconsistent with the definition of a business.

 

Prior to the amendments,
Ind AS 103 stated that a business need not include all of the inputs or
processes that the seller used in operating that business, ‘if market
participants are capable of acquiring the business and continuing to produce
outputs, for example, by integrating the business with their own inputs and
processes’. The standard-setter, however, decided to base the assessment on
what has been acquired in its current state and condition, rather than on
whether market participants are capable of replacing any missing elements, for
example, by integrating the acquired activities and assets. Therefore, the
reference to such integration was deleted from Ind AS 103. Instead, the
amendments focus on whether acquired inputs and acquired substantive processes
together significantly contribute to the ability to create outputs.

 

Illustrative
examples

 

Example
–Acquisition of real estate

 

Base facts

 

Ze
Co purchases a portfolio of 8 single-family homes along with in-place lease
contracts for each of them. The fair value of the consideration paid is equal
to the aggregate fair value of the 8 single-family homes acquired. Each
single-family home includes the land, building and lease-hold improvements.
Each home is of a different carpet size and interiors. The 8 single-family
homes are in the same area and the class of customers (e.g., tenants) are
similar. The risks in relation to the homes acquired and leasing them out are
largely similar. No employees, other assets, processes or other activities are
received in this transaction.

 

Scenario 1 – Application of optional concentration test

 

Analysis

 

Ze elects to apply the
optional concentration test set and concludes that:

 

  •  each single-family home
    is considered a single identifiable asset because:

 

  •  the building and
    lease-hold improvements are attached to the land and cannot be removed without
    incurring significant cost; and
  •  the building and the
    associated leases are considered a single identifiable asset, because they
    would be recognised and measured as a single identifiable asset in a business
    combination.

 

  •  the group of 8
    single-family homes is a group of similar identifiable assets because they are
    all single-family homes, are similar in nature and the risks associated with
    operations and creating outputs are not significantly different. This is
    consistent with the fact that the types of homes and classes of customers are
    not significantly different.

 

Ze concludes that the
acquired set of activities and assets is not a business because substantially
all of the fair value of the gross assets acquired is concentrated in a group
of similar identifiable assets.

 

Scenario 2 –Corporate
office park

 

Facts

 

Assume the same base case,
except that Ze also purchases a multi-tenant corporate office park with four
15-storey office buildings with in-place leases. The additional set of
activities and assets acquired includes the land, buildings, leases and
contracts for outsourced cleaning, security and maintenance. However, no
employees, other assets, other processes or other activities are transferred.
The aggregate fair value associated with the office park is similar to the
aggregate fair value associated with the 8 single-family homes. The processes
performed through the contracts for outsourced cleaning and security are minor
within the context of all the processes required to create outputs.

 

Analysis

 

Ze elects to apply the
optional concentration test and concludes that the single-family homes and the
office park are not similar identifiable assets, because the risks associated
with operating the assets, obtaining tenants and managing tenants are
significantly different. This is consistent with the fact that the two classes
of customers are significantly different. As a result, the concentration test
fails because the fair value of the corporate office park and the 8
single-family homes is similar. Thus, Ze proceeds to evaluate whether the
acquisition is a business in the normal way.

 

The set of activities and
assets has outputs because it generates revenue through the in-place leases. Ze
needs to evaluate if there is an acquired process that is substantive. For
activities and assets that have outputs at the acquisition date, the acquired
process is substantive if, when applied to an acquired input or inputs:

  •  it is critical to the
    ability to continue producing outputs, and the inputs acquired include an
    organised workforce with the necessary skills, knowledge, or experience to
    perform that process (or group of processes); or
  •  significantly
    contributes to the ability to continue producing outputs and is considered
    unique or scarce; or cannot be replaced without significant cost, effort, or
    delay in the ability to continue producing outputs.

 

Ze concludes that the
above criterion is not met because:

 

  •  the set does not include
    an organised workforce;

 

  •  the only processes
    acquired (processes performed by the outsourced cleaning, security and
    maintenance personnel) are ancillary or minor and, therefore, are not critical
    to the ability to continue producing outputs.

 

  • the processes do not
    significantly contribute to the ability to continue producing outputs.

 

  •  the processes are not
    unique or scarce and can be replaced without significant cost, effort, or delay
    in the ability to continue producing outputs.

 

Consequently, Ze concludes
that the acquired set of activities and assets is not a business. Rather, it is
an asset acquisition.

 

Scenario 3 –Corporate
office park

 

Facts

 

Consider the same facts as
in Scenario 2, except that the acquired set of activities and assets also
includes the employees responsible for leasing, tenant management, and managing
and supervising all operational processes.

 

Analysis

 

Ze elects not to apply the
optional concentration test and proceeds to evaluate whether there is a
business in the normal way. The acquired set of activities and assets has
outputs because it generates revenue through the in-place leases. Consequently,
Ze carries out the same analysis as in Scenario 2.

 

The acquired set includes
an organised workforce with the necessary skills, knowledge or experience to
perform processes (i.e. leasing, tenant management, and managing and
supervising the operational processes) that are substantive because they are
critical to the ability to continue producing outputs when applied to the
acquired inputs (i.e. the land, buildings and in-place leases). Additionally,
those substantive processes and inputs together significantly contribute to the
ability to create output. Therefore, Ze concludes that the acquired set of
activities and assets is a business.

 

In the author’s view,
these amendments may result in more acquisitions being accounted for as asset
acquisitions as the definition of business has narrowed. Further, the
accounting for disposal transactions will also be impacted as Ind AS 110 Consolidated
Financial Statements will be applicable in case of the recognition of
proceeds from the sale of a business, while Ind AS 115 Revenue from
Contracts with Customers will be applied for the recognition of proceeds
from the sale of an asset.

DATA-DRIVEN INTERNAL AUDIT – II PRACTICAL CASE STUDIES

 

BACKGROUND

Internal auditors are effective in their
delivery of professional services only by conducting value-added services.
Important value drivers for management are:

– cost savings / optimisation,

– prevention or detection of frauds,

– compliance with procedures and regulations.

 

These can only be achieved in today’s day and
age by adoption of technology for all stages in the life-cycle of the internal
audit. It may necessitate getting the data from multiple sources, analysing
huge quanta of data, comprehensively quantifying the findings and presentation
of data in intelligent form to various stakeholders for action to be taken for
improvement/s.

 

Let’s add the fact that we are moving to
remote auditing, again a necessity in today’s circumstances and which would
most probably become the new normal in times to come. Remote auditing is
already being practised by many organisations where internal auditors carry out
internal auditing for global, geographically-spread entities from their
internal audit teams based out of India.

 

In our earlier article (Pages 11-13; BCAJ,
August, 2020), we have discussed the necessity of adopting a data-driven
internal audit approach for efficient and effective internal audit, basically
explaining ‘why’. Now, we are offering the methodology to be adopted for making
it happen, in other words, ‘how’ to do it.

 

STAGES IN DATA-DRIVEN INTERNAL AUDIT

Using what you know

(1) DETERMINE WHETHER DATA ANALYTICS IS APPROPRIATE
FOR THE AUDIT

The potential benefits of using Data
Analytics can be judged from the audit objectives and the expected problems, as
well as from the data volume, the number of records and the number of fields.
Special consideration should be given to the usefulness of additional analysis
over what is currently provided by the system and whether any special factors
apply, such as fraud detection and investigation, Value for Money audits (in
obtaining performance statistics) and special projects.

 

(2) CONSIDER AUDIT OBJECTIVES AND WHERE DATA
ANALYTICS CAN BE USED

Data Analytics can be used in different areas
with different goals and objectives. Data Analytics is generally used to
validate the accuracy and the integrity of data, to display data in different
ways and to generate analysis that would otherwise not be available. It can
also be helpful in identifying unusual or strange items, testing the validity
of items by cross-checking them against other information, or re-performing
calculations.

 

Although Data Analytics allows you to
increase your coverage by investigating a large number of items and potentially covering 100% of transactions, you may still want to extract
and analyse a portion of the database by using the sampling tasks within. You
could examine a subset of the population (a sample), to predict the financial
result of errors, or to assess how frequently a particular event or attribute occurs
in the population as a whole.

 

The quality of the data, your knowledge of
the database and your experience will contribute to the success of Data
Analytics processes. With time you will be able to increase or widen the scope
of investigations (for example, conducting tests which cannot be done manually)
to produce complex and useful analyses, or to find anomalies that you never thought
were feasible.

 

It is also not unusual that far more
exceptional items and queries are identified when using Data Analytics than other methods and that these may require follow-up time. However, the use
of Data Analytics may replace other tests and save time overall. Clearly, the
cost of using the Data Analytics Tool must be balanced against the benefits.

 

Case Study 1 – General Ledger – What is our
Audit Objective?

Management override and posting of fictitious
journals to the General Ledger is a common way of committing fraud; and one of
the key audit procedures is to test the appropriateness of journal entries
recorded in the General Ledger.

 

The objectives may include testing for risk
or unusual transactions such as:

  • Journals with no description,
  •  Journals not balancing,
  • Journals containing keywords,
  •  Journals posted by unauthorised users,
  •  Journals posted just below approval limits,
  • Journals posted to suspense or contra
    accounts.

 

Case Study 2 – Accounts Receivable – What is
our Audit Objective?

Accounts Receivable is one of the largest
assets of a business; therefore, there is a need to audit and gain assurance
that the amounts stated are accurate and reasonable.

 

The objectives may include:

  • Identify large and / or unusual credit
    notes raised in the review period,
  • Capture customers with significant write-offs
    during the year,
  • Isolate customers with balances over their
    credit limit,
  •  Filter out related party transactions
    and balances,
  •  Generate duplicates and gaps in the
    sales invoice numbers,
  •  Match after-date collections to year-end
    open items / balances.

 

Preparing data for analysis

(3) DETERMINE DATA REQUIRED AND ARRANGE DOWNLOAD
WITH PREPARATION

Data download is the most technical stage in the
process, often requiring assistance and co-operation from Information
Technology (IT). Before downloading or analysing the data, it is necessary to
identify the required data. Data may be required from more than one file or
database. It is important at this stage that the user understands the
availability and the details of the databases. You may also have to examine the
data dictionary to determine the file structure and the relationships between
databases and tables.

 

In determining what data is required, it may
be easier to request and import all fields. However, in some cases this may
result in large file sizes and it may be time-consuming to define all the
fields while importing the files. Therefore, it may be better to be selective,
ignoring blank fields, long descriptive fields and information that is not
needed. At the same time, key information should not be omitted.

 

Case Study 1 – General Ledger – Planning –
What Data is Required?

The Auditor needs to obtain a full General
Ledger transactions history for the audit year after all the year-end
(period-end) postings have been completed by the client. To carry out a
completeness test on the General Ledger transactions, the ‘Final’ Closing Trial
Balances at the current and previous year-ends are required. Where possible,
obtain a system-generated report as a PDF file, or observe the export of the
Trial Balance, this will give assurance over the integrity and completeness of
the Trial Balance figures from the Accounting Software or ERP system.

 

General ledger initial check for preparing
the data

Field Statistics can be used to verify the
completeness and accuracy of data like incorrect totals, unusual trends,
missing values and incorrect date periods in the General Ledger. This pre-check
in the data preparation stage allows the Auditor a greater chance of
identifying any issues that will cause invalid test results. Comparing
difference in totals obtained from the client for the Transaction Totals in the
General Ledger with the Field Statistics should be clarified with the client
before proceeding further with the Analytic tests.

 

Case Study 2 – Accounts Receivable – Planning
– What Data is Required?

The Auditor should requisition the ‘AR
Customer-wise open items at the year-end’ data. This data provides more details
than a simple list of balances because often an Auditor wants to test a sample
of unpaid invoices rather than testing the whole customer balance. Further, the
Auditor should obtain the ‘Accounts Receivable Transactions’ during the year to
analyse customer receipts in the year, to test for likely recoverability. Apart
from this, more detailed Data Analytics can be performed on the sales invoices
and credit notes, as well as cut-off analysis.

 

Accounts receivable initial check for
preparing the data

Field Statistics can be used to verify the completeness and accuracy of
data like incorrect totals, unusual trends, missing values and incorrect date
periods in the Accounts Receivable (AR) ledger. This pre-check in the data
preparation stage offers the Auditor a better chance of identifying any issues
that could cause invalid test results. Comparing difference in totals obtained
from the client for the AR Debit Credit Totals with the Field Statistics should
be clarified with the client before proceeding further with the Analytic tests.

 

Validating data

(4) USE ANALYTIC TASKS

Case Study 1 – General Ledger – Highlighting
Key Words within Journal Entry Descriptions

Objective – To isolate and extract any manual journal entries using key words or
unusual journal descriptions. These can include, but not be limited to,
‘adjustment, cancel, missing, suspense’.

 

Technique – Apply a search command on the manual journal entries which have been
posted with the defined unusual descriptions by using a text search command.

 

 

Interpretation of Results – Records shown when using the above
criteria would display records which have description narratives that include
key terms such as ‘adjustment’, ‘cancel’, ‘suspense’ and ‘missing’, and may
require further investigation.

 

When determining which manual journal entries
to select for testing, and also what description should be tested, it is
helpful to know that financial statements can be misstated through a variety of
fraudulent journal entries and adjustments, including:

  • Writing off liabilities to income,
  • Adjustments to reserves and allowances
    (understated or overstated),
  •  False sales reversed after year-end and
    out-of-period revenue recorded to inflate revenue.

 

Therefore, when defining the narratives to
search for, you will need to tailor the said search to the type of manual
journal entry that the Auditor is aiming to test.

 

Case Study 2 – Accounts Receivable –
Detecting suppression of Sales

Objective – To test for gaps in invoicing sequences which may indicate unrecorded
sales and / or deleted invoices.

 

Technique – Gap Detection is used to detect gaps in data. These could be gaps
within purely numeric or alpha-numeric sequential reference numbers, or these
could be gaps within a sequence of dates. Perform a Gap Detection on the field
‘Invoice Number’.

 

 

Interpretation of Results – Any gaps in invoicing sequences require
further investigation to ensure that revenue has been correctly allocated, as
well as to check for improper revenue recognition which can be accomplished by
manipulating income records, causing material misstatement.

 

Discovering patterns, outliers, trends using
pre-built analytic intelligence

The Discover task provides insights through
patterns, duplicates, trends and outliers by mapping data to high-risk elements
using the Data Analytical Tool’s predefined Analytic Intelligence.

 

  • Identify trends, patterns, segmental
    performance and outliers automatically.
  • Intuitive auto-generation of dashboards that
    can then be further refined with IDEA’s inbuilt Analytic Intelligence.

 

(5) REVIEW AND HOUSEKEEPING

As with any software application, all work
done in Data Analytic Tools must be reviewed. Review procedures are often
compliance-based, verifying that the documentation is complete and that
reconciliations have been carried out. The actual history logs from each analytical
activity should also be reviewed.

 

 

Backup of all the project folders must be
done meticulously and regularly.

 

Clear operating instructions with full
details on how to obtain files, convert them and download them should be
documented for each project and kept easily accessible for the Audit Teams who
will take up the project in the ensuing review period. If necessary, logic
diagrams with appropriate explanatory comments should be placed in the Audit
working-paper file so that a different auditor could pick up the project in the
following year.

 

CONCLUSION

By embedding data analytics in every stage of the audit process and
mining the vast (and growing) repositories of data available (both internal and
external), Auditors can deliver unprecedented real-time insight, as well as
enhanced levels of assurance to management and audit committees.

 

Businesses are faced with unprecedented
complexity, volatility and uncertainty. Key stakeholders can’t wait for
Auditor’s analysis of historical data. They must be alerted to issues at once
and be assured of repetitive monitoring of key risks. Data Analytics empowers
Audit to deliver, as well as to serve the business more proactively in audit
planning, scoping and risk assessments, and by monitoring key risk indicators
closely and concurrently. Auditor’s use of data analytics in every phase of the
audit can help management and the audit committee make the right decision at
the right time.

 

GOVERNANCE & INTERNAL CONTROLS: THE TOUCHSTONE OF SUSTAINABLE BUSINESS – PART I

‘Barings Bank
collapsed by rogue trader’, screamed media headlines in February, 1995,
shocking the world. Is this even possible? How can one person bring down a
two-century-old reputed bank and a banker to the Queen of England? But it did
happen. And not isolated, though – closer home, the country opened 2009 reading
the confession of the Satyam Chairman, Mr. Ramalinga Raju, saying ‘It was like
riding a tiger, not knowing how to get off without being eaten’. Mr Raju
admitted to inflating profits with fictitious positions in the balance sheet,
including inflated (non-existent) cash and bank balances, overstated debtors,
understated liabilities and accrued interest which was non-existent1.
He confessed to manipulating the books for several years which attained
unmanageable proportions to the tune of Rs. 14,162 crores through these devious
methods. Ironically, Satyam had just received the Golden Peacock Global Award
for Excellence in Corporate Governance in September, 2008! But this was revoked
soon after Mr. Raju’s confession.

 

Quite a few major
debacles have followed since – Enron, Tyco, Lehman Brothers, Kingfisher,
Café  Coffee Day, PMC Bank… Regrettably,
we are witnessing this not just in business ventures, but scams, or at least
alleged ones, are also surfacing in diverse spheres such as government spends,
sports arena and so on. That we live in a VUCA world dogged with volatility,
uncertainty, complexity and ambiguity only compounds the
issue.

 

Why do these occur?
Many factors could propel such events or behaviour including arrogance, power (nasha)
and greed. But what I would like to share here is my learning on two
fundamental drivers to a sustainable business – Governance and Internal
Controls. Broadly speaking, the former is all about ethos, culture, mind-set
and a way of life embedded in individuals, leaders and enterprises. Internal
Controls encompass the practices, processes and procedures which serve to
auto-generate and instil self-correcting operating mechanisms, thereby
functioning as a secure preventive measure. While effective internal controls
are integral to running operations, good governance is the edifice on which
great organisations are built. Leaders, therefore, while ensuring adequate
controls need to exhibit personal integrity and uphold high governance
standards to establish a sustainable business.

In recent times, a
lot has been written on these subjects and regulatory frameworks and awareness
levels have improved considerably. Yet, we witness cases of deceit cropping up
in numbers and magnitude which are discomforting. And at the core seems to be
intent and character. Given the ingenuity of the human race, if there is
a chosen intent to defraud, person/s acting unilaterally and / or in collusion will
find a way to do it. This ends up in a curative process and the learning from
each episode then gets calibrated in the system for improvements.
Investigations post the Barings Bank debacle revealed that a trader, Mr.
Nicholas Leeson’s greed and inadequate operational risk controls at Barings
made the bank collapse under a $1.4 billion debt. In Satyam’s case, Mr. Raju
wanted to divert funds to real estate which eventually fell through. It was, inter
alia, found that the cash and bank verification procedures were lacking. It
is customary now for auditors to seek balance certification from banks. The
Companies Act, 20132 has made corporate fraud a criminal offence and
lays out the responsibilities on fraud reporting. The Act also provides for a
rigorous framework for related party transactions. A Serious Fraud
Investigation Office (SFIO) which was set up under the Act has a statutory
status and now has the power to arrest as well. The SFIO has been actively
investigating cases relating to corporate fraud. The Securities and Exchange
Board of India published detailed disclosure requirements in 2015, applicable
to all listed companies3. This sets out stringent guidelines relating
to reporting / disclosure of material events and actual and suspected fraud.
The Institute of Chartered Accountants of India4 came out with a
Guidance Note on Reporting on Fraud.

HOW
IT PLAYS OUT: ENRON, A CLASSIC CASE

Enron was a company
headquartered in Houston, Texas which was dealing in commodities, energy and
services and ranked as America’s fifth largest company. In 2001, the company
filed for bankruptcy leading to shareholders losing $74 billion, thousands of
employees and investors losing their retirement accounts and many employees
losing their jobs. The CEO, Mr. Jeffrey Skilling, and the former CEO, Mr,
Kenneth Lay, kept huge debts off balance sheets. An internal whistle-blower, Ms
Sherron Watkins, helped to bring them to book as high stock prices stoked
external suspicions. How unfortunate! This company was named by Fortune
Magazine as ‘America’s Most Innovative Company’ six years in a row prior to
the scandal and lost its sheen overnight. A Committee entrusted to examine the
role of the auditors, Arthur Andersen, assessed that the firm did not fulfil
its professional responsibilities in connection with its audits of Enron’s
financial statements. Moreover, in 2002, Andersen was convicted of obstruction
of justice for shredding documents related to its audit of Enron. The Supreme
Court in 2005, however, reversed Andersen’s conviction but serious damage had
been done which practically wrecked the firm. Consequent to this scandal, new
regulations were designed to strengthen the accuracy of financial reporting for
publicly-traded companies, the most important being the Sarbanes-Oxley Act
(2002) which imposed criminal penalties for destruction, falsification or
fabricating financial records.

 

Having good
governance as the DNA complemented by sound internal controls are, hence, the
hallmarks of world-class enterprises. Let us examine each of them. This is
covered in two parts – Part I: Governance, and Part II: Internal Controls.

 

GOVERNANCE

Governance or
Corporate Governance comprises the suite of principles and processes by which
an enterprise is controlled, directed or governed in a manner balancing the
interests of the stakeholders, creating long-term sustainable value.
Stakeholders include customers, investors, workforce, suppliers, funders, the
government and the society at large. It is based on policies such as commitment
to conducting business with all integrity and fairness, being transparent by making
all the necessary disclosures and decisions, complying with the laws of the
land and discharging responsibility towards all the stakeholders.

 

Corporate Governance provides the structure for a company to achieve its
aspirations and hence encompasses every aspect of management, from operations
and internal controls to performance measurement and corporate disclosure. Most
companies strive to establish a high standard of Corporate Governance. For many
investors, it is not enough for a company to be just profitable; it also needs
to demonstrate good corporate citizenship through ethical behaviour, respect
for the environment and sound Corporate Governance practices. It is about
balancing individual and social purpose, as well as economic and sustainability
goals.

 

Clearly, there is a
level of confidence that is attached to a company practising good Corporate
Governance. Foreign investors accord weightage to this aspect, too. It is not
surprising, therefore, that the markets have demonstrated a positive approach
towards companies reputed for upholding good governance standards.

 

INSTILL
GOVERNANCE

Some people
consider that governance is an innate quality – you either have it or you
don’t! While this is true in some ways, great corporations also have a systematic
way of nurturing and reinforcing good Corporate Governance. Here, I draw upon
my experience associated over decades with the Unilever and Tata Groups to
highlight some codified best-in-class practices – Unilever Code of Business
Principles (CoBP5) and Tata Code of Conduct (TCoC6).

 

Both CoBP and TCoC
bring out clearly the way these world-class enterprises conduct their
businesses as well as expect their business collaborators to respect and behave
in dealings with their companies. It is expressly communicated that violations
to the Code are unacceptable. They go a step further to clarify that no grudge
will be held against any employee who may even give up a business benefit for
the sake of upholding the Code and not compromising it.

 

Instilling this culture
is a continuous process and also requires review and updation to reflect the
changing environment. Some of the building blocks to make this a living
document are:

 

(i)            
The Code Document: Publishing a written Code is an important step which helps as a good
reference point for all the enterprise stakeholders to guide their behaviour.
CoBP which was launched in 1995 now has 14 clauses in the Code supported by 24
policies. TCoC was first formalised in 1998 and the amended version of 2015
comprises detailed guidelines for all stakeholders. These Codes address varied
aspects from ethics to compliance to diversity to environment.

 

(ii)  Putting
to Work: A practice manual is quite useful wherein
live situations are enumerated explaining how one applies the Code in
day-to-day working, including Musts / Must nots and Q&A. Case
studies are shared. A fascinating format used is through performing skits.
These skits are done innovatively in town hall meetings or annual family day
functions through short engaging stories which convey the essence of the Code.
An impactful variation is the use of contests with several groups competing for
prizes with creative skits bringing out the ethos through interesting
sequences.

 

(iii)  Monitoring and Review: These entities have robust mechanisms to ensure that the Code is
communicated, explained and implemented. Apart from imparting training, some
simple steps such as a written annual confirmation from every employee, an
appropriate clause in contracts with business associates, feedback surveys, a
strong whistle-blowing mechanism, etc. facilitate to monitor the Code in
action.

 

(iv) Completing the Loop: An important
component is to Walk the Talk. A policy should spell out the
consequences for breach of the Code and the process followed to investigate any
allegation of Code violation. Once established, it is vital to implement the
outcome in an objective manner. Finally, sharing of such instances including
action taken is critical not only to demonstrate seriousness but also to raise
awareness levels within the organisation. However, communication is handled
sensitively given the personal ramifications of each case.

 

VALUE SYSTEMS AND BOARD ENGAGEMENT

Governance also
comprises not only voicing core beliefs but also making them integral to the
ways of doing business. The aspect of beliefs and value systems is tested right
upfront at the time of recruitment, assessing business collaborations, or in
acquiring businesses. In acquisitions, finding the right pedigree and therefore
cultural fit becomes the first filter even before business
considerations are put to play. I can quote Safety and Sustainability as great
examples of mettles of governance. These beliefs are embedded into the core of
the strategy rather than appearing on the periphery. Some simple but effective
actions of institutionalising behaviour are listed in the box below.

 

  •     Employment terms spelling
    out that Safety is a condition of employment.  This drives home that Safety is paramount.
  •     Wearing seat belts even
    while seated in the rear of a vehicle.   
  •     Holding on to the handrail
    and refraining from using a mobile phone, while climbing up or down the stairs
    is made into a conscious habit. 
  •     Building Sustainability as
    a mind-set and weaving it into all strategies and decisions made. Here a
    shining example is to consciously go for green buildings as a policy even if
    construction costs work out to be a tad higher.
  •     Keeping these as focus
    Internal Audit themes
  •     Compelling every employee
    particularly in locations such as factories to come  up with suggestions
    pertaining to Safety
  •     Recognising identification
    of near-misses reporting
  •     Encouraging innovation
    towards green manufacturing processes and products
  •     Prohibiting highway travel
    at night and restricting number of persons travelling on the same flight

 

Beyond operations,
I had the privilege of experiencing governance at a Board level. Many years
ago, we had introduced a practice of Board evaluation in a rather structured
manner. All Board members including independent directors were asked to share
their perceptions on a simple two-page questionnaire annually, with due ratings
followed by comments. As the Managing Director, I, too, filled in one and here
I put forth the management viewpoint on the functioning of the Board. I had the
privilege along with the Company Secretary to tabulate the forms both for the
rating as well as other comments. The summary showed the average rating score
against each question as well as comments on what went well and where we could
do better as a Board. We followed a ritual of a Board dinner post every Annual
General Meeting. But prior to the dinner, we had a chat session for about an
hour debating on progress from the previous year and the outcome of the
evaluation to decide on what to focus on going forward.  Actions such as expediting the Board meeting
agenda papers and minutes, field familiarisation for directors, exposure of key
personnel with the Board, etc. came out of such interactions. I found this
entire process delightful and this created a good bonhomie, too, amongst the
Directors. Of course, some of these actions and the Board evaluation processes
have become mandatory in recent years.

 

ESTABLISHING GOOD GOVERNANCE IS NON- NEGOTIABLE

The topic of
governance is wide and encompasses many other aspects – for instance, insider
trading, competitive intelligence, peer dynamics, compensation structures,
workforce conduct, etc. Every element has not been dealt with in this article.
There are legislative pronouncements, too, covering these. One can study the
Codes referred to above to comprehend the various ramifications of this
critical subject. Other companies, such as Johnson & Johnson, Google, Ford
Motor Company, IKEA, Starbucks, Toyota, etc., have their Codes available
publicly on their websites.

 

In sum,
establishing good governance is non-negotiable for any entity striving to
create sustained value while balancing and meeting the interests of multiple
stakeholders. A one-size-fits-all approach, however, may not work with
the modalities and structure varied to suit every enterprise given its ethos
and culture.

 

Do the right thing is what we see as the belief of great institutions. Even if it
means, in many situations, not just sticking to regulations but going beyond
the rule book and what is mandated! And… that is the test of good governance.

This is the second article in the series by V. Shankar
(The first in this series appeared in our issue of January, 2020)

 

_______________________________________

1.  7 January 2009: Satyam Chairman, Mr.
Ramalinga Raju’s letter to his Board of Directors

2.  The Companies Act, 2013: Sections 143,
211, 447

3.  Securities and Exchange Board of India (Listing
Obligations and Disclosure Requirements) Regulations, 2015

4.    The Institute of Chartered Accountants of
India: ICAI Guidance Note on Reporting on Fraud Under Section 143(12), 2016

5. Unilever.com: About | Who we are | Our Values & Principles |
Code of Business

Principles and related Code policies

6. Tata.com: About Us| Values & Purpose | Tata Code
of Conduct)

LEARNINGS FOR AUDIT FIRMS IN THE ERA OF PCAOB AND NFRA

INTRODUCTION

Audit firms have
always been subject to regulatory review by both the ICAI as well as the
regulators. Whilst initially they only underwent scrutiny by the ICAI in terms
of the disciplinary mechanism, over a period of time ICAI introduced the
concept of review of individual audits undertaken by the firms, as also the
firm itself through the FRRB, Peer Review and QRB mechanism.
Recently, the QRB Reviews have been substituted through oversight and
regulation by the NFRA for firms involved in auditing a certain class of
entities, whereas the QRB will be involved in other matters.

 

Accordingly,
it would be pertinent to note the background and role played by the NFRA and
its implications on the future of audit firms.

 

NFRA

After the
Satyam scandal took place in 2009, the Standing Committee on Finance proposed
the concept of establishing a National Financial Reporting Authority (NFRA) for
the first time in its 21st Report. The Companies Act, 2013
subsequently gave the regulatory framework for its composition and constitution.
The Union Cabinet approved the proposal for its establishment on 1st
March, 2018. The establishment of NFRA as an independent regulator is an
important milestone for the auditing profession and will improve the
transparency and reliability of financial statements and information presented
by listed companies and large unlisted companies in India.

 

The NFRA
was  constituted on 1st
October, 2018 by the Government of India u/s 132(1) of the Companies Act, 2013.
As per the said section, NFRA is responsible for recommending accounting and
auditing policies and standards in the country, undertaking investigations and
imposing sanctions against defaulting auditors and audit firms in the form of
monetary penalties and debarment from practice for up to ten years.

 

APPLICABILITY

As per Rule 3
of the NFRA Rules, 2018, the Authority shall have power to monitor and enforce
compliance with accounting standards and auditing standards and oversee the
quality of service u/s 132(2) or undertake investigation u/s 132(4) in respect
of auditors of the following class of companies and bodies corporate, namely:

 

(a) Companies whose securities are listed on any
stock exchange in India or outside India;

(b) Unlisted public companies having paid-up
capital of not less than Rs. 500 crores or having annual turnover of not less
than Rs. 1,000 crores, or having, in aggregate, outstanding loans, debentures
and deposits of not less than Rs. 500 crores as on the 31st of March
of the immediately preceding financial year;

(c) Insurance companies, banking companies,
companies engaged in the generation or supply of electricity, companies
governed by any special Act for the time being in force or bodies corporate
incorporated by an Act in accordance with clauses (b), (c), (d), (e) and (f) of
sub-section (4) of section 1 of the Act;

(d) Any body corporate or company or person, or any
class of bodies corporate or companies or persons, on a reference made to the
Authority by the Central Government in public interest; and

(e) A body corporate incorporated or registered
outside India, which is a subsidiary or associate company of any company or
body corporate incorporated or registered in India as referred to in clauses
(a) to (d) above, if the income or net worth of such subsidiary or associate
company exceeds 20% of the consolidated income or consolidated net worth of
such company or body corporate, as the case may be, referred to in clauses (a)
to (d).

 

Thus, the
NFRA has stepped into the shoes of the QRB to concentrate on audit firms involved
in entities which are perceived as public interest entities. Currently
all private limited companies even if they satisfy the thresholds as per clause
(b) above are not covered. Consequently, the QRB will henceforth be
involved in the review of audits firms involved in undertaking audits other
than those covered above.

 

The concept
of establishing the NFRA has been greatly influenced by the establishment and
functioning of the PCAOB in the USA and hence it would not be out of place at
this stage to briefly discuss its role.

 

PCAOB

The Public
Company Accounting Oversight Board (‘PCAOB’) is a private-sector, non-profit
corporation created by the US Sarbanes-Oxley Act of 2002 (‘SOX’) to oversee
accounting professionals who provide independent audit reports for publicly
traded companies only, unlike NFRA which covers large unlisted public entities,
too. The annual budget of PCAOB for the year 2019 is $273.7 million for a
market cap of $9.8 trillion. The PCAOB’s responsibilities include the
following:

 

(i)   registering public accounting firms;

(ii) establishing auditing, quality control, ethics,
independence and other standards relating to public company audits;

(iii) conducting inspections, investigations and
disciplinary proceedings of registered accounting firms; and

(iv) enforcing compliance with SOX.

 

Registered
accounting firms that issue audit reports for more than 100 issuers (primarily
public companies) are required to be inspected annually. This is usually around
ten firms. Registered firms that issue audit reports for 100 or fewer issuers
are generally inspected at least once every three years. Many of these firms
are international non-U.S. firms who are involved in the audit of
publicly-traded companies on the US Stock Exchanges. Consequently, some
Indian audit firms who are involved in issuing audit reports are required to be
registered with PCAOB and hence be subject to PCAOB inspections.

 

INSPECTION REPORTS

The PCAOB periodically issues inspection reports
of registered public accounting firms. While a large part of these reports are
made public (called ‘Part I’), portions of the inspection reports that deal
with criticisms of, or potential defects in, the audit firm’s quality control
systems are not made public if the firm addresses those matters to the Board’s
satisfaction within 12 months of the report date.

 

Those portions are made public (called ‘Part II’)
only if (1) the Board determines that a firm’s efforts to address the
criticisms or potential defects were not satisfactory, or (2) the firm makes no
submission evidencing any such efforts.

 

IL&FS OUTBURST

After having understood the role of NFRA and to a
certain extent PCAOB, it would be pertinent at this stage to examine the public
outbursts against the closely-held financial sector giant ILFS which piled up
huge debts amounting to around Rs. 90,000 crores by September, 2018. The
problems initially surfaced with defaults in the repayment of the most liquid
and known safest form of debt, viz., commercial paper, followed by a domino
effect which threatened and called into question the stability of the entire
NBFC sector. This understandably led to a public outburst on various aspects
and called into question the role of the government, the RBI and the auditors,
amongst others. The following were some of the key matters which triggered the public outburst:

 

(1) What was the RBI doing all these years as a
part of its inspection process, considering that there were reports of breach
of NOF, group exposure and capital adequacy norms in case of one of the group
entities?

(2) How did the Credit Rating Agencies fail to see
through the high leverage and the potential defaults without any warnings and
suddenly downgraded the rating from stable to default?

(3) The impact of the defaults on the mutual funds
which had heavily invested in the debt instruments and the consequential impact
on the common investors;

(4) The bailing out by the government through
investments by LIC and SBI and other similar profitable PSUs (‘family jewels’)
thereby potentially jeopardising the savings of millions of investors and
policy-holders;

(5) As is always the case, the role of the auditors
was also called into question on many fronts like adherence to independence
requirements, maintaining professional scepticism, failure to comply with
regulatory requirements, provide early warning signals, etc.

 

It would be
pertinent at this point to dwell on NFRA and assess its role and duties in
conducting Audit Quality Review (AQR) of CA firms. The first such
AQR was completed in December, 2019 in respect of the audit undertaken by a
firm of one of the IL&FS group entities, which is an NBFC, being the first
such within that group which is in the public domain and which has been used as
a basis for the discussion hereunder.

 

AQR PROCESS

This is one of the important tools provided to the
NFRA to regulate and monitor audit firms as covered in the Rules referred to
earlier, which was conducted by the Quality Review Board. The QRB Review and
AQR can also be considered as equivalent to the PCAOB reviews conducted in the
case of the US-listed entities referred to earlier.

Scope
and regulatory force

The scope and
the regulatory force for the AQR are provided in Rule 8 of the NFRA Rules,
2018. The said Rules provide that the NFRA may, for the purpose of
enforcing compliance with the Auditing Standards, undertake the following
measures which would broadly constitute the scope for the AQR:

(A) Review working papers and other documents and
communications related to the audit;

(B) Evaluate the sufficiency of the quality control
system followed by the auditor; and

(C) Perform such other testing of the audit,
supervisory and quality control procedures of the auditor as may be considered
necessary or appropriate.

 

Though Section 133 of the Companies Act, 2013 requires
the NFRA to inter alia monitor and enforce compliance with both the
Accounting and the Auditing Standards, the main focus of the AQR, which
we will discuss in the subsequent section, is on compliance with the auditing
and quality control standards.

 

Steps
involved in undertaking the AQR

The AQR which
is undertaken is not a one-way traffic but follows an elaborate process of
seeking information from the audit firm, followed by the draft findings against
which the replies of the audit firm are sought before the final report is
issued. The following are the various steps which are broadly undertaken before
the final report is issued and the same are included in a separate Annexure to
the report so that there is no ambiguity:

(a) Formal letter sent by NFRA to the engagement
partner (EP) asking for the audit file of the client selected for review.

(b) Subsequent letter sent to the EP asking for the
list of related parties and the details of the audit and non-audit revenue of
the selected client under affidavit.

(c) NFRA’s letter sent to the EP containing a
questionnaire sent via email and the replies against the same by the audit
firm.

(d) NFRA’s letter to the EP conveying its prima
facie observations against the various issues in the questionnaire referred
to in (c) above and the reply there against.

(e) Issuance of the Draft AQR Report (DAQR).

(f) Presentation made by the EP and the other team
members to the NFRA in pursuance of the observations in the DAQR.

(g) Written replies furnished by the EP to NFRA in
response to the observations in the DAQR.

(h) Issuance of the final AQR Report by NFRA.

 

Summary
of the NFRA’s conclusions in the AQR

The culmination of the above process resulted in
several findings, recommendations and conclusions covering a wide spectrum of
issues which were analysed under the following broad categories as tabulated
hereunder. Whilst a detailed discussion thereof is beyond the scope of this
article, the main findings as discussed here would not only provide an insight
into the thinking of the NFRA but also serve as an eye-opener to the audit
firms, especially the small and medium-sized ones, to enable them to ramp up
their audit quality keeping in mind the current circumstances.

 

Area

Key Findings / Observations
and Conclusions

 

 

Compliance with independence requirements

The NFRA has come down heavily on the independence requirements
violated by the audit firm, as evidenced by the following matters:

a) The audit firm had grossly violated the provisions of section
144 of the Companies Act, 2013 by providing various prohibited services
and also not taking the approval of the Audit Committee, including in
respect of services provided by associated / connected firms / companies
to both the company and its holding or subsidiary companies. The total
fees for such non-audit engagements in excess of the corresponding audit fees
has, in the words of the NFRA used in the Report, ‘undoubtedly fatally
compromised the windependence in mind required by the Audit Firm’

b) The approval of the Board of Directors for such
services is not permissible where the company has an Audit Committee and the
same would amount to an override of controls

c) There was a clear violation of the RBI Master
Directions since the EP was involved in the audit for a period of five
years as against the mandatory rotation after a period of three
years

d) The Senior Audit Engagement team comprising of the Audit
Director and Audit Senior Manager were involved in the audit for a period
in excess of seven years which is against the spirit of the staff
rotation and familiarity threat principles enshrined in SQC-1. The
contention of the audit firm that such requirements were applicable only to
the EP and the Engagement Quality Control Review (EQCR) Partner
was not acceptable to the NFRA since the EQCR is an entirely independent
exercise. This clearly compromised on the audit firm’s independence both in
letter and in appearance

 

 

Role of the EP

The reference by NFRA to the role of the EP is both interesting
as well as insightful, as reflected through the following key observations:

a) The practice of the audit firm in designating two partners
as EPs is clearly a violation of SQC-1 as well as SA-220 – Quality control
for an Audit of Financial Statements, which clearly mandates that member
firms should have only one EP, which aspect was also clearly laid down even
in the audit firm’s Internal Quality Manual

b) The time spent by the signing partner (who is
considered by the NFRA as the EP) and the evidence of the review of
documentation by him during the course of the audit, clearly shows
that almost all the important work of audit, i.e., independence evaluation,
risk assessment, audit plan, audit procedures, audit evidence, communications
with management or those charged with governance (TCWG) was not adequately
directed / supervised / reviewed
by the EP

 

 

Communication with TCWG

Since an ongoing two-way communication between the audit firm
and TCWG is an important element in the audit process, the following
observations by the NFRA in this regard merit attention:

a)The audit firm was not able to produce a single document
minuting the discussions held with TCWG

b) The assertion of the audit firm that they have
exercised their professional judgement in making their written communications
cannot be taken as a justification that nothing was required to be
communicated. This also runs contrary to the fact that the RBI
inspections and subsequent correspondence had revealed serious
non-compliances relating to NOFs, CRAR, NPAs and Group entity exposures,
amongst others, which are significant and require to be communicated under
SA-250 on Consideration of Laws and Regulations in an Audit of Financial
Statements and SA-260 on Communication to Those Charged with Governance

c) As per the minutes of the meetings of the Board of
Directors and the Audit Committee, there was also nothing on record to
demonstrate that the audit firm representatives had attended any meetings at
which the above matters were discussed, except the meeting at which the
accounts were approved and adopted. Further, even at the said meeting the
contention of the audit firm that there were no serious non-compliances with
laws and regulations does not hold water, considering the correspondence
referred to above and the non- disclosure in the
financial statements

 

 

Evaluation of Risk of Material Misstatement
(ROMM) Matters

Assessment of ROMMs being an important component in the entire
audit process has naturally received due attention by NFRA and the following
are some of the important observations in respect thereof:

a) The reference in the audit work papers to
compliance with International Auditing Standards is a clear
non-compliance with section 143(9) of the Companies Act, 2013. The Report
further states that ‘the Companies Act refers only to SAs prescribed by
that statute and to no other. Hence, any reference to any SAs other than so
prescribed is clearly non-compliant with the Companies Act. NFRA, as a body
constituted under the Companies Act, 2013,

obligated to consider only what is compliant with
that Act.’

b) The audit firm failed to appropriately deal with
identification, categorisation and minimisation of engagement risk,
especially looking at the size, nature and economic significance of the
auditee company. The risk of misstatement due to fraud was also ruled out by
the audit firm, especially with regard to revenue recognition which is a
presumed fraud risk as per SA-240. This led to inadequate audit responses.
Some specific instances to highlight the same are discussed in points
(d) to (f) below

c) There were significant contradictions in the assessment of
ROMM which lead to the conclusion that the assessment had been carried out in
so casual a manner as to result in a complete sham

d) There is no reference in the audit file to the fact that
the audit firm has noted the SI – NBFC character of the entity whilst
undertaking a risk assessment and the consequential risk classification as
normal which is reflective of an inadequate understanding of the
financial and business sectors of the economy. The NFRA has further
remarked that ‘the RBI, as the chief regulator of financial and
monetary matters, makes this determination, which
needs to be

respected and not treated
cavalierly.’

e) There were several inadequacies found in the testing and
evaluation of NPAs, including the requirement of early recognition of
financial distress and the resolution thereof and the classification of
Special Mention

Accounts in terms of the RBI guidelines

f) The audit firm should have maintained professional
scepticism throughout the audit by recognising the possibility that a
material misstatement due to fraud could exist as per SA-240, notwithstanding
the auditor’s past experience of the honesty and integrity of the entity’s
management and TCWG, by performing specific and adequate procedures to
address the following matters, amongst others:

(i) Suppression of defaults due to regular
‘ever-greening’ of loans,

(ii) Manual overriding of controls for a substantial
portion of loans sanctioned during the year as evidenced by the statement /
analysis in the audit file and the corresponding observations in respect
thereof in the

RBI Inspection Report,

(iii) 
Procedures to test the completeness and accuracy of the listing of
NPAs,

(iv) Testing of journal entries, especially those
pertaining to items posted after the closing date, significant period end
adjustments and estimates, inter-company transactions, etc.

Testing / disclosure of specific matters arising
out of RBI Inspection Reports

a) The audit firm did not question the management and challenge
the inflation of profit by a material amount through inclusion of the value
of a derivative asset which was entirely unjustified. The Report mentions
that ‘the actions of the auditor in not having done so, and having
accepted the stand of the management without question, shows clearly a gross
dereliction of duty and negligence on the part of the audit firm’

b) The audit firm accepted the stand of the management
about not disclosing the fact that the Net Owned Funds (NOF) and the Capital
to Risk Assets Ratio (CRAR) of the entity as on 31st March, 2018
were both negative, based on the RBI Inspection Report and related
communications and that this situation could lead to cancellation of the NBFC
license of the entity. The audit firm also certified the accounts as showing
positive NOF and CRAR, accepting the explanations of the management which
were clearly contrary to law. The explanation of the audit firm seems to
imply that this communication of the RBI was not available to them. This
explanation was held to be unacceptable for the reason that this clearly
showed the complete lack of due diligence and professional scepticism on the
part of the audit firm. Had proper inquiries been made both with TCWG and the
RBI, it is certain that this communication would have been formally made
available to the audit firm

c) Consequent to the above matter, the audit firm did not
adequately question the going concern assumption on the basis of which
the management had prepared the financial statements

 

 

Learnings
and challenges for audit firms

A careful
evaluation of the findings arising out of the above report provides several
learnings as well as challenges, especially for the small and medium-sized
firms, considering that the observations have been made in respect of an
international firm which is supposed to have robust processes. The challenges
before the SMPs are broadly analysed under the following headings:

 

Adverse
publicity / reputational risk:

Unlike the
earlier QRB Review Reports, the NFRA shares its findings and publishes the
reports on its website and hence the same are available in the public domain,
which immediately leads to bad publicity and adverse reputational risk for both
the audit firm and the client / entity concerned. This is in line with the authority
provided to it in terms of Rule 8(5) of the NFRA Rules. It may,
however, be noted that Rule 8(6) of the NFRA Rules provides that no confidential
or proprietary information should be so published unless there are
reasons to do so in the public interest which are recorded in writing. However,
what constitutes confidential or proprietary information has not been defined.

 

One of the
ways in which this can be achieved is by dividing its report into two parts as
is done by the PCAOB as discussed earlier.

 

EMPHASIS ON AUDIT INDEPENDENCE AND AUDIT ADMINISTRATION /
COMMUNICATION

There is now
a growing expectation of independence both in letter and in spirit.
Whilst prima facie the requirements under the statute may appear to have
been complied with, independence of the mind in the eyes of the external
stakeholders / users of the audit report is also important. This may be a challenge
to smaller firms who have a limited number of audits and staff to perform the
same, making them vulnerable to the familiarity threat. Accordingly, in
future audit firms would have to keep in mind these aspects before they accept
fresh audit engagements since the ICAI / QRB has the power to regulate all
entities. Further, the general tendency of being an all-weather friend and
trusted adviser would need to be carefully calibrated with the regulatory
guidelines. Finally, a lot of emphasis would have to be placed on the extent
of the role played by the EP as against the tendency to rely on the work done
at the junior level due to both time and technical constraints (e.g. the EP
being a tax specialist). In this context, the observation of the NFRA of the audit
firm designating two EPs may not help since the concept of shared
responsibility did not cut ice with the NFRA. To mitigate these
problems, small and medium-sized firms would do well to undertake external
consultation on a more formalised and frequent basis since it is
also recognised as an important element in the overall quality control process
in terms of SQC-1.

 

IMPORTANCE OF FRAUD AND RISK ASSESSMENT

The
importance of these two aspects cannot be overemphasised. The current
environment of regulatory overdrive makes audit firms vulnerable to greater
scrutiny on these aspects. Several specific observations by NFRA on granular
aspects of fraud and risk assessment in the audit report like ever-greening of
loans, valuation of derivatives, testing of related party and inter-company
transactions, manual override of controls, etc. makes it imperative for audit
firms to exercise greater degree of professional scepticism since their
professional judgements would come under greater scrutiny. To mitigate these
problems, audit firms, especially the small and medium-sized ones, should have
regular training and orientation programmes, both external and internal, so
that apart from sharpening the technical skills the necessary soft skills are
also developed. Such training costs should not be considered as a cost but as
an investment.

 

COMPLIANCE WITH AND ATTENTION TO REGULATORY MATTERS

The NFRA Report has sent out a clear message that
audit firms ignoring regulatory matters do so at their own risk. Further, NFRA
has taken a strict view on certain matters like risk classification in case of
Systemically Important (SI) – NBFCs as greater than normal, which is
questionable. Another area flagged by them involves inadequate
communication and dialogue with the management and TCWG on regulatory matters.
Accordingly, it is important for audit firms to rigorously follow the
requirements laid down under SA-250 and SA-260 even though the primary
responsibility for compliance with laws and regulations rests with the management
and TCWG.

 

Robust
documentation of the audit engagement and firm level policies

The oft-used
phrase what is not documented is not done and also the fact that
audit documentation should be self-explanatory and be able to stand on its own,
has been clearly in evidence in the NFRA’s findings in several places,
e.g. reference to International Standards on Audit (this provides a subtle
message to the firms with an international affiliation that compliance with
international requirements is no substitute for compliance with the local
regulations, guidelines and pronouncements), non-availability of minutes of
meetings of discussions / communication with the management on important
matters, no specific documentation evidencing performance of key audit procedures
in respect of certain transactions having greater risk and fraud potential and
so on.

 

One of the
most important learnings for audit firms involved in the audit of covered
entities is to streamline and standardise routine audit documentation
by laying down clear policies, checklists and other documentation for execution
of audit engagements in general and keeping in mind the specific documentation
requirements as laid down in the various Standards on Auditing, as also on the
various elements of the system of quality control, as under, as laid down in
SQC-1:

 

(I)   Leadership responsibilities for quality within
the firm;

(II)   Ethical requirements (including independence
requirements);

(III)  Acceptance and continuance of client
relationships and specific engagements;

(IV) Human Resource policies covering recruitment,
training, performance evaluation, compensation, career development, assignment
of engagement teams, etc.;

(V)  Engagement performance, including
consultation, engagement quality review, engagement documentation retention and
ownership, etc.

 

Whilst
framing policies in respect of the above and any other related matters, care
should be taken to avoid mechanically copying the requirements laid down in the
Standards. The policies should be framed keeping in mind, among other things,
the size of the firm, the nature and complexity of the clients served and the
competence of the personnel to implement the same.

 

How
small and medium-sized firms can prepare for NFRA review

One of the
most important elements is to have an audit manual in place covering the
policies and procedures, with all templates, formats, and checklists in place
to ensure compliance with the applicable Auditing Standards. The structure and
significant content of the audit manual could be as follows:

 

  • INTRODUCTION AND FUNDAMENTAL PRINCIPLES:

This chapter
introduces the fundamental principles related to reasonable assurance,
objective of an audit, audit evidence, documentation, financial reporting
framework, quality control, ethics, professional scepticism, technical
standards.

  •   PRE-ENGAGEMENT
    ACTIVITIES:

In this chapter the
manual deals with the basic engagement information, engagement evaluation:
client acceptance / continuance, independence declarations, staff assessment
and audit budget, planning meetings, terms of the engagement.

  •   PLANNING THE AUDIT:

This chapter covers
the audit approach, gathering knowledge of the business, laws and regulations
and understanding the accounting systems and internal controls, fraud risk
discussions and indicators, related parties.

  •  RISK ASSESSMENT PROCEDURES:

This chapter will
help auditors comply with the standards of auditing related to the
identification and mitigation of risk of material misstatement, fraud risk and
going concern risk at the initial stage of audit.

  • PLANNING MATERIALITY:

Planning
materiality is one of the most critical elements of an audit as it determines
the coverage of the audit. Planning materiality should be determined at the
planning stage and should be updated if required during the execution phase.

  •   AUDIT PROGRAMMES:

A well-designed
audit programme ensures compliance of auditing standards and quality standards
while performing the audit and also acts as a guiding checklist for the
engagement team.

  • TEST OF CONTROLS AND SUBSTANTIVE TESTS:

This chapter guides
the team in determining the reliance on the test of controls vis-a-vis the test
of details, resulting in a balanced approach between the two to ensure an
efficient and effective audit.

  •   PERFORMING THE AUDIT:

This chapter is the
heart of the audit documentation. It deals with documentation of the execution
of the entire audit, determining the audit sampling, audit sampling procedures,
consideration of applicable laws and regulations, inquires with management and those
charged with governance, external confirmation procedures, analytical
procedures, procedures to audit accounting estimates and fair value
measurements, identification of related parties, going concern considerations,
considering the work of internal audit or experts, physical verification
procedures, etc.

  •  FINALISATION: AUDIT CONCLUSIONS AND
    REPORTING:

The auditor needs
to ensure the adequacy of presentation and disclosure, subsequent event and
going concern consideration, final analytical review, evaluation of audit test
results, issue of the auditor’s report, communicate with those charged with
governance and coverage of management representations.

 

 

 

CONCLUSION

What is
not documented is not done has been the age-old mantra! Audit documentation helps the auditors to prove to the user of the
financial statements, usually the authorities, that a proper audit was
conducted. The data that has been recorded can help in ensuring and encouraging
that the quality of the audit is maintained. It also provides an assurance that
the audit that was performed was in accordance with the applicable auditing
standards.  

 

 

PANEL DISCUSSION ON UTILITY OF FINANCIAL STATEMENTS AND RELEVANCE OF AUDIT AT THE 10TH Ind AS RSC

A panel discussion on the ‘Utility
of Financial Statements and Relevance of Audit’ was the highlight of the 10th
Ind AS Residential Study Course (RSC) held at the Alila Diwa
Hyatt in Goa from 5th to 8th March, 2020.

 

The panellists represented
various stakeholder groups related to financial statements: Mr Raj Mullick,
Senior Executive Vice-President at Reliance Industries Ltd. from the preparers’
side; Mr. Nilesh Vikamsey, Past President of the ICAI representing the auditor
fraternity; Mr. Jigar Shah, CEO, Kimeng Securities India Pvt. Ltd. and
also an analyst; and Mr. Prashant Jain, Chief Investment Officer of HDFC
AMC (a fund manager). The discussion was moderated by Mr. Sandeep Shah,
CA. This report on the panel discussion is for the readers of the BCAJ
who would benefit immensely considering the present situation relating to audit
of financial statements.

 

INITIAL
REMARKS

Preparers’ Perspective:

Mr. Raj Mullick began by
indicating that the utility of the financial statements lay at two extreme
ends; whilst they provide a lot of value to certain classes of users such as
analysts, government authorities and bankers, they are often relegated to the
dustbin by certain other users, including some shareholders. However, generally
financial statements are relevant to various stakeholders like shareholders,
government authorities, bankers, analysts, suppliers and customers, each of
whom looks at specific aspects as per their requirements and serve as an
important communication tool on various matters like vision, mission and
strategy of the entity, its leadership, dividend policy and CSR activities,
amongst others.

 

He highlighted that there are
several challenges which could hamper their utility, including the sheer size
of the content, the use of several technical jargons like MAT, Deferred Tax,
OCI, ESOP, etc. Some of these challenges could be overcome by disclosure of
sufficient qualitative and quantitative information covering impact analysis of
future events and other explanatory and proactive disclosures so as to meet the
varying needs of lenders, analysts and also credit rating agencies.

 

On the role of the finance team
in making the financial statements more relevant and reliable, he highlighted
various steps which could be taken as under:

(a) Working closely with the CEO;

(b) Establishing appropriate accounting policies;

(c) Reflecting the nature of the business in the financial statements;
and

(d) Disclosing critical estimates and judgements.

 

Finally, Mr. Mullick
stated that the role of the auditors is of paramount importance since they
provide an assurance on the completeness of the financial statements and their
compliance with the generally-accepted accounting principles. He also
emphasised that by performing systematic, in-depth reviews of corporate
controls, the auditors help ensure that a company avoids coming under
regulatory scrutiny. He cautioned that going forward, for auditors to be
relevant they need to go much beyond numbers and be more tech-savvy and exhibit
a better understanding of the business.

 

Auditors’ Perspective:

Mr. Nilesh Vikamsey began by
stating that for (this) audience the relevance of the financial statements and
the utility of audit is a no-brainer in spite of some recent
‘accidents’. He indicated that financial statements are relevant to the
following sets of users:

(i) Shareholders, managements, potential investors and promoters;

(ii) Lenders, analysts, rating companies and potential lenders;

(iii) Government and tax authorities;

(iv) Regulators like SEBI, MCA
and RBI.

 

He lamented
the fact that in the past even when the auditors had qualified the financial
statements of a particular company on several counts, including on ‘going
concern’ issues, large funding was provided to it mainly on the security of its
brand, which raised a doubt as to whether the intended users took the financial
statements seriously.

According to him, the financial
statements reflect on matters involving governance, risks, estimates,
contingencies, etc. which may not always be a focus point of the various users,
and hence their relevance and utility could get diluted. Besides, the credit
and market risk disclosures need improvement from the current boiler plate /
template-ised disclosures.

 

Another area where there was
enough ammunition provided by the financial statements was the red flags (which
may not be always acted upon by the users), on issues such as:

(1)   Rising debt-equity ratio;

(2)   Capitalising revenue expenditure;

(3)   Rising fixed assets without corresponding increase in production
and / or sales;

(4)   Large ‘other expenses’ in the P&L account;

(5)   Rising accounts receivable and inventory compared with sales;

(6)   Higher or lower ‘other income’ as compared to ‘revenue from operations’.

 

Mr. Vikamsey also
touched upon disclosure initiatives at the international level to address
issues around which accounting policies need to be disclosed, defining
materiality, better organised entity-specific disclosures on performance,
working capital management, etc., improving the structure and content of
financial statements with new sub-totals (EIBDTA) and notes on management
performance measures.

 

He pointed out that in spite of
the recent aberrations due partly to the greed of some members and which needed
to be tempered, the role of auditors will always remain relevant. However, they
would need to embrace greater digitisation which would result in sampling
getting replaced with AI and routine operations like reconciliation being
automated. Going forward, the auditors would need to adopt a middle path
between scepticism and investigation. Various reporting initiatives like
KAMS, ICFR CARO, LFAR, etc. provide useful insights to analysts, investors and
regulators. Moreover, independent directors need to see greater value in the
audit process and need to don the auditor’s hat to keep pushing the management.

 

Analysts’ Perspective:

Mr. Jigar Shah stressed
that the utility and relevance of the financial statements can be improved by
building ‘additional, relevant, non-conventional’ disclosures,
especially around predicting future events, diversity and ESG (Environment,
Social and Corporate Governance) which would be a win-win situation for all
stakeholders. Earnings may not always necessarily represent the bottom line and
may not have a correlation to the market capitalisation of the entity due to
various reasons like contingent liabilities, whistle-blower complaints, etc.

 

On the question of asset
impairment, he observed that it is generally done only in times of an extreme
business cycle, or when the business is about to be sold. He emphasised a more
regular and vigorous assessment of asset impairment due to various
technological changes like 5G, IOT and other matters like climate change and
sustainability which could have an impact on industries like automobiles
(emission norms, electric vehicles), cement (penalties for flouting pollution
norms), real estate (climate change and global warming resulting in destruction
of real estate in coastal cities due to floods), general insurance (impact of
climate change on underwriting models) and IT (impact due to water crisis in
cities like Bangalore and Chennai).

 

Another area where he felt that
more granular disclosures were needed was with regard to intangibles in certain
specific industries like pharma, banks / finance companies, consumer goods
companies and so on on matters like expenses on brands, digital initiatives,
customer acquisition, technology development (because as per the current
accounting standards, any expenses on self-generated intangibles need to be
expenses off and may not always be completely disclosed).

 

On audit quality and its
relevance, Mr. Jigar Shah felt that the same is largely maintained and
it would not be proper to paint everyone with the same brush. The role of audit
is also likely to increase in the coming days due to various additional
reporting requirements under CARO. He also felt that auditors should not resign
immediately but must report.

 

Fund Managers’ / Investors’
Perspective:

Mr. Prashant Jain started by
stating that as an investor there are two mistakes which need to be guarded
against: the first is to avoid investments in entities whose value is likely to
fall, and the other is to miss investing in entities whose value is likely to
rise. Whilst the financial statements generally provide clues to the first
situation if one reads the notes and other information in detail and identifies
any aggressive accounting policies and other red flags, the same may not be
true in the case of the latter. In his view the balance sheet and the cash
flows are more important and relevant from their long-term value perspective
than the Profit and Loss statement which is more temporary in nature. He
recalled that one of his earliest learnings from a senior fund manager was that
the bottom line is sanity, the top line is vanity but cash
is reality!

 

It would be wrong to link
failures entirely to the financial statements, except in situations like severe
ALM mismatches or aggressive accounting policies since they could arise due to
various other reasons like government policies, competitor actions, failed
acquisitions and incorrect capital allocation, amongst others.

 

Mr. Jain felt that
there could be better quality disclosures on certain matters such as:

(A) Impact on the financial statements due to non-routine matters like
significant changes in oil prices, foreign exchange volatility in case an
entity has operations in several geographies;

(B) The reasons for recording huge amounts as goodwill in tune with the
underlying performance of the group companies;

(C) The impact on the financial statements due to long-term leases where
there is a lower profitability in the initial years, and in situations where
the entity keeps on entering into new leases continuously.

 

PANEL DISCUSSION

After the above observations,
moderator Sandeep Shah put forth various questions arising out of them
and on certain other matters, resulting in a healthy discussion amongst the
panellists. A summary of the views of the panellists on various matters is
provided here:

 

(i) Whether rigorous examination by auditors
is undertaken: The primary responsibility for the preparation of the
financial statements is that of the management and the auditors generally
conduct a rigorous examination thereof. However, the quality of disclosures
could improve and greater scepticism on their part is warranted in view of the
recent failures;


(ii) Whether audit is a commodity: There
were differing views on this. The views in support thereof arose primarily from
the growth expectations and undercutting of fees due to rotation, especially
amongst the larger firms. However, firms are now evaluating their risk
profiling of clients and increasingly resorting to resignations within the
regulatory framework. On the other hand, since in certain cases the auditors
grow with the companies, there is no commoditisation and it is up to the entity
whether it wants to do so;


(iii) Competitiveness of audit fees: On the
question whether the fees paid to the auditors are reasonable vis-a-vis
the complexity involved, it was felt that there was scope for improvement since
the lower fees are partly due to the lower rate of growth in the compensation
levels of the white-collar employees in the past 20 years compared to the
blue-collar employees, such as drivers;


(iv) Audit quality and related disclosures: The
quality of the audit firms is primarily driven by the partners and the staff
both in terms of their brand value and technical competence. However, adequate
disclosures are not made in respect of the credibility of the team members
except for the name of the signing partner. It was felt that a rating of the
audit firms is the need of the hour. The AQI proposed in the MCA consultation
paper could also be a step in that direction, though the ICAI has not made much
progress in the matter. Many small firms are quite meticulous in undertaking
their assignments. In sum, it was noted that in many cases, at the time of
acquisition the acquirer insists on firms of a certain standing to ensure quality;


(v) Role of auditors in evaluation of business and industry impact: It is not
the responsibility of the auditors to evaluate the future impact on the
entity’s business since they are not industry experts, except that they may
only highlight the risks. It was suggested that the management may, as part of
the annual report, give specific disclosures about the possible pricing and
financial implications due to the impact of technology changes on their
business in the foreseeable future;


(vi) Role of technology and digitisation on the audit function: This will
result in a revised set of skills on the part of the auditors around data
inputs / querying which would be very dynamic in nature;


(vii) Relevance and utility of the MD&A: There
were mixed reactions on its utility. Whilst, on the one hand, it serves as a
useful communication tool especially for the larger companies, on the other it
always tends to be optimistic and a report card of the present without
providing a meaningful analysis of the future plans of the business.
Accordingly, it was felt that it does not merit more than a passing interest;


(viii) Relevance of investor presentations: Since
they generally tend to be more detailed than the MD&A, they are more
relevant to the analysts due to their interactive nature which helps them in
updating their valuation models. However, the forward-looking statements made
therein are quite often not substantive and tend to be optimistic and biased;
hence they should be read in conjunction with the detailed notes in the
financial statements, because the devil lies in the details;


(ix) Transition to Ind AS – whether beneficial: Whilst
there is no doubt that Ind AS provides better quality of disclosures, it was
felt that the earlier format of the balance sheet was more reader-friendly
since it provides the sum total of the various line items at a glance as
against the ‘Current’ and ‘Non-Current’ classification of all line items under
Ind AS, which could be summarised. Further, the concept of ‘Mark to Market’ presents
challenges in analysing the financial position and results in a meaningful
manner;


(x) Earnings management: The greatest challenge therein
lies in managing the expectation mismatch. In certain situations, it could be
used as a legitimate tool by the management by cutting certain discretionary
costs like advertising or delaying capital expenditure; in other situations, it
may not be justified, especially if it is achieved through aggressive and
questionable accounting policies. It was, however, agreed that over a period of
time the same would be mitigated through a natural process of reconciliation
and tie-up with the market forces coupled with greater regulatory scrutiny;


(xi) Sufficiency of the current financial statements framework to all
industries: Whilst it was largely felt that the current financial statements
framework is sufficient for most industries, in certain industries such as
media, real estate, airlines, multiplexes, pharma, etc., it may not always
provide meaningful and relevant information like the extent of land parcels
(real estate), products, USFDA inspections (pharma), impact of long-term leases
(airlines, multiplexes) and IPR (media);


(xii) Usefulness of joint audit: It does provide value and add to
the quality of the audit, especially in the case of larger entities; the
experience has been generally good in countries which have mandated it.
However, care needs to be exercised that whilst allocating the work no
significant areas are left out. For the smaller companies it may result in
increased cost;


(xiii) Incentives for auditors: The main incentive and
motivating factor for an auditor is being a member of the ICAI. However,
considering his role as a solution provider, one of the motivating factors
would be that his recommendations are accepted. There can be no greater feather
in the cap than when the financial statements certified by him get an award
from the ICAI for the best-presented accounts.

 

CONCLUSION

There
was unanimity that the discussion provided a 360-degree view of various matters
from the perspectives of a preparer, auditor, investor and analyst. However,
concerns remain on overregulation and the existence of a trust
deficit which would in the coming days play a greater role in determining
the efficacy of the financial statements and the role of the auditors.

DISCONTINUED OPERATIONS

BACKGROUND

Ind AS 105 Non-current
assets held for sale and discontinued operations requires discontinued
operations to be presented separately in the profit and loss account, so that
the users of financial statements can separate the profits or losses from
continuing and discontinued operations. Such a segregated presentation helps
users of financial statements to determine the maintainable profits or losses
that arise from continuing operations.

 

Ind AS 105 (paragraph 32) defines
a discontinued operation as a component of an entity that either has been
disposed of, or is classified as held for sale, and

(a)   represents a separate major line of business or geographical area
of operations,

(b)  is part of a single co-ordinated plan to dispose of a separate
major line of business or geographical area of operations, or

(c)   is a subsidiary acquired exclusively with a view to resale.

 

Paragraph 33 of Ind AS 105
requires an entity to disclose:

(a)   a single amount in the statement of profit and loss comprising the
total of:

(i)    the post-tax profit or loss of discontinued operations; and

(ii)   the post-tax gain or loss recognised on the measurement to fair
value less costs to sell or on the disposal of the assets or disposal group(s)
constituting the discontinued operation.

(b)   an analysis of the single amount in (a) into:

(i)    the revenue, expenses and pre-tax profit or loss of discontinued
operations;

(ii)   the related income tax expense;

(iii) the gain or loss recognised on the measurement to fair value less
costs to sell or on the disposal of the assets or disposal group(s)
constituting the discontinued operation; and

(iv) the related income tax expense.

A common question that is
generally raised is with respect to a parent transferring an operation to a
subsidiary and whether in the parent’s separate financial statements the
disposal of the operation will be presented as a discontinuing operation. In
the consolidated financial statements, since the business remains within the
group, there is no discontinued operation which is required to be presented separately. Consider the detailed fact pattern below:

 

FACT PATTERN

A Ltd. (‘the Company’ or ‘the
parent’) enters into an arrangement whereby it will transfer an operation that
qualifies as an operation (as defined earlier) under Ind AS 105 to a
newly-set-up company (NewCo). The transfer is a slump sale and is set out in a
Business Transfer Agreement (BTA). NewCo is a wholly-owned subsidiary of the
company when it is set up.

 

The transfer is done with a
pre-requisite that an investor will concurrently invest in NewCo. to the extent
of 30%. The company has not lost control due to the said infusion, because it
still holds majority (70%) ownership. The investor will have significant
influence over NewCo.

 

There is no impairment on the
assets transferred.

 

Should the transferred operation
be classified as discontinued operations in the Separate Financial Statements
of A Ltd.?

 

ANALYSIS

There is no guidance with respect
to this specific issue either under Ind AS 105 or other Ind AS’s. In the stated
fact pattern, there are two possible views for the classification of the
transferred operation.

 

View 1: The
transferred operation is a discontinued operation in the parent’s separate
financial statements

In the fact pattern, an investor
will be investing to the extent of 30% shareholding in NewCo. There will be no
loss of control for the parent, because the parent still owns a majority stake
in NewCo. Nonetheless, running the operations by the company on its own as
against transferring it to a subsidiary, in which a potential investor has
significant influence, are two different things. Essentially, in the separate
financial statements of the parent the business is getting converted into an
investment in a subsidiary in which an independent investor will play a
significant role.

 

Earlier, the parent was running
the operations. After the transfer, the parent will have to manage the
investment in the subsidiary. The relevant decisions at the separate financial
statement level will be whether to retain the investment or dispose of the
investment, whether the investment should be further diluted, the proposal with
respect to dividends, etc. The parent and the subsidiary are two separate
entities with independent boards and subjected to a regulatory framework. This
suggests that the appropriate classification of the transferred operation
should be discontinued operation.

 

Accordingly, the transferred
operations should be classified as a discontinued operation.


View 2: The
transferred operation is not a discontinued operation in the parent’s separate
financial statements

The transfer
of operations to NewCo is simply a change in the geography of the operations,
because the operations continue to remain with the group. The transferred
operations are still controlled by A Ltd. In substance, A Ltd. continues to
control the operations though there will be significant influence exercised by
the independent investor in NewCo. There is a very thin line between managing
the investment in a subsidiary vs. running the operations represented by that
investment. Consequently, the transferred operations are not discontinued
operations in the separate financial statements of the parent.

 

The author believes that both the above views are
acceptable. However, View 1 may be preferred keeping in mind the concept
of ‘substance over form’. View 1 also represents faithfully the fact
that the profit and loss in the separate financial statements will not include
the results of the operation going forward. A segregated presentation will help
users of financial statements to determine the maintainable profits or losses
that arise from continuing operations in the separate financial statements. 

FINANCIAL REPORTING AND AUDITING CONSIDERATIONS ON ACCOUNT OF COVID-19

Most countries, businesses and
companies are expected to be impacted by the Covid-19 pandemic and the
increased economic uncertainty may have major financial reporting consequences.
Supply-chains,distribution-chains, cash-flows, demand, price variations,
facility access, workforce availability, debt obligations, contract
cancellations, are experiencing turbulence. 
Such a holistic and cumulative impact on different spheres of business
operations carries a definite, and acute consequence on the financial reporting
by the entity.

 

The role of preparers of
financial statements, audit committees, auditors and regulators become critical
in this situation. Distilling the impact through the requirements of existing
accounting and auditing requirements frameworks and communicating it
effectively will enable financial markets to base their decisions on such
robust and dependable inputs.

 

Auditors’ role will require
special attention in relation to appropriate treatment of the financial impacts
and disclosures thereof. The Institute of Chartered Accountants of India has
issued an ‘Accounting & Auditing Advisory on Impact of Coronavirus on
Financial Reporting and the Auditors Consideration’ to help its members in
effectively discharging their obligations.

 

There will be issues to consider
for this year’s reporting as well as in future years. Every entity would need
to consider the financial impact on itself and the areas of the financial
statements that will be affected along with determining the required
disclosures. Financial reporting areas that are likely to require close
consideration include the following:

 

(1)  Impairment of assets

Impairment of assets becomes the
foremost financial reporting consideration, given that testing of impairment is
predominantly based on the earnings realisation from a group of assets.

 

The assumptions such as
the fall in demand, impact of lockdown, fall in commodity prices, decrease in
market interest rates, manufacturing plant shutdowns, shop closures, reduced
selling prices for goods and services, cost of capital, etc. may have a
meaningful impact on the impairment testing performed by entities. Whilst most
entities would perform impairment testing on an annual basis, the current
Covid-19 situation would qualify for being an ‘indicator’, thereby requiring
entities to test for impairment even in the interim.

 

(2)  Going concern

Financial statements are prepared
on a going concern basis unless management intends either to liquidate the
entity or to cease trading, or has no realistic alternative but to do so.

 

With business models being
challenged especially in the travel, hospitality, leisure and entertainment
segments, companies may need to consider the implications on the assessment of
going concern and whether these circumstances will result in prolonged
operational disruption which will significantly erode the financial position of
the entity or otherwise result in failure.

 

It is the
responsibility of management to make an assessment as to whether the entity is
a going concern or otherwise. The unprecedented and uncertain nature of the
pandemic makes it imperative for an entity to evaluate various scenarios that
are possible and assess their impact on the assumption of going concern.
Inability to satisfy the assumptions of going concern would lead to deviation
from historical cost-based accounting and other impacts.

 

Management should also expect an informed
and sometimes contrarian dialogue with auditors on the aspect of going concern.

 

(3)  Valuation of inventory

With social distancing norms in
place, entities may not have been able to carry out their annual physical
inventory count fully or even partially on the cut off date. Due to the
lockdowns, auditors and companies may need to rely on additional alternate
procedures to gain comfort on the position and valuation as on 31st March,
2020.

Companies would need to assess
whether, on their reporting date, an adjustment is required to the carrying
value of their inventory to bring them to their net realisable value in
accordance with the principles of Ind AS 2 –Inventories and AS 2 – Valuation
of Inventories.

 

Given the pandemic, net
realisable value calculation will likely require more detailed methods and
assumptions, e.g. write-down of stock due to lesser expected price realisation,
reduced movement in inventory, expiry of perishable products, lower commodity
prices, or inventory obsolescence. The usability of raw materials and work in
progress may also require close consideration.

 

A typical question arises in
relation to allocation of overheads to the valuation of inventory. If an entity
ceases production or reduces production for a period of time, significant
portions of unallocated fixed production overheads (e.g., rent, depreciation of
assets, some fixed labour, etc.) will need to be expensed rather than
capitalised, even if some reduced quantity of inventory continues to be
produced.

 

(4)  Lease and onerous contracts

The implications of force
majeure provisions on contracts and leases remain to be tested. It is
possible that there may be changes in the terms of lease arrangements or
lessors may grant concession to lessees with respect to lease payments,
rent-free holidays, additional days in subsequent period, etc. Such revised
terms or concessions shall be considered while accounting for leases which may
lead to the application of accounting relating to the modification of leases.
However, generally anticipated revisions are not taken into account.

 

Some entities may encounter
situations wherein certain contracts may become onerous to perform. Ind AS 27
defines an onerous contract as a contract in which the unavoidable costs of
meeting the obligations under the contract exceed the economic benefits
expected to be received under it. Price erosions, long-term commitment, salvage
discount, commitment of additional performance are certain triggers to evaluate
whether a contract has turned onerous. As soon as a contract is assessed to be
onerous, a company applying Ind AS 37 records a provision in its financial
statements for the loss it expects to make on the contract.

 

(5)  Expected credit loss (ECL)

ECL is an expectation-based
probability weighted amount determined by evaluating a range of possible
outcomes. It enables entities to make adequate provisions for non-realisation
of financial assets including trade receivables.

 

Ind AS 109 – Financial
Instruments requires an entity, amongst other matters, to also evaluate the
likelihood of the occurrence of an event if this would significantly affect the
estimation of expected losses of financial assets. In assessing the expected
credit loss, management should consider reasonable and supportable information
at the reporting date. Covid-19 impact would require to be factored in the ECL
probability model of entities.

 

Expected credit losses may
increase due to an increase in the probability of default for financial assets.
Additionally, the effects of the coronavirus may trigger a significant increase
in credit risk, and therefore the recognition of a lifetime ECL provision on
many financial assets.

 

Event-based provisioning in
relation to specific instances, like a customer turning insolvent or a specific
financial investment getting affected, would continue to be factored in
irrespective of the ECL.

 

(6)  Revenue recognition and borrowing costs

Ind AS 15 – Revenue from
Contracts with Customers often requires a company to make estimates and
judgements determining the timing and amount of revenue to be recognised.
Covid-19 may result in a likely increase in sales returns, decrease in volume
discounts, higher price discounts, etc. Entities may need to account for
returns and refund liabilities towards the customers whilst recognising the
revenue.

 

Ind AS 115 requires an entity to
defer a component of revenue to be recognised when the contract includes
variable consideration. This may result in some entities recognising a contract
liability rather than revenue, if significant uncertainty exists surrounding
whether the entity will realise the entire consideration.

 

Separately, the guidance on
borrowing costs requires an entity to suspend the capitalisation of borrowing
costs to an asset under construction for such extended periods that the actual
construction of the asset is suspended.

 

(7)  Government grant

Governments may support entities
with monetary and non-monetary measures, but such benefits may be one-time
events or spread over time.

 

Entities may need to establish an
accounting policy regarding government assistance which needs to be appropriate
and in line with the requirements of Ind AS 20 – Accounting for Government
Grants and Disclosure of Government Assistance. It is essential to distinguish
between government assistance and government grants and ensure that grants are
recognised only when the recognition criterion in Ind AS 20 is met. Some of the
government assistance may involve deferral of tax payments or other tax
allowances. The accounting treatment of tax allowances may need to be accounted
for under Ind AS 12 –  Income Taxes
rather than Ind AS 20.

 

The current relaxation by the
Reserve Bank of India allowing a moratorium on loan instalments may not qualify
as a government grant.

 

(8)  Deferred tax

Ind AS 12 – Income Taxes
requires that the measurement of deferred tax liabilities and deferred tax
assets shall reflect the tax consequences that would follow from the manner in
which the entity expects, at the end of the reporting period, to recover or
settle the carrying amount of its assets and liabilities.

 

Covid-19 could affect future
profits and / or may also reduce the amount of deferred tax assets or create
additional deductible temporary differences due to various factors (e.g. asset
impairment, non-utilisation of available losses, change in projections).
Entities having deferred tax assets on account of accumulated tax losses would
need to reassess their measurement with a newer set of business projections.

 

Entities may have considered the
assumption of ‘indefinite reinvestment’ and not recognised deferred tax on
accumulated undistributed earnings of subsidiaries. Such assumptions may need
to be revisited to determine if they remain appropriate given the entity’s
current cash flow projections.

 

(9)  Fair value and hedge accounting

Ind AS 113 – Fair Value
Measurement recognises the fact that observable inputs being considered for
deriving fair value may be either of (i) observable market price (quoted price
in an active market – Level 1) or (ii) application of valuation techniques
(Level 2 and Level 3).

 

With 1,500 companies trading at
their 52-week low on the Bombay Stock Exchange, the fair value measurement
considered by entities may need a re-look across all three methods of observable
inputs.

While volatility in the financial
markets may suggest that the prices are aberrations and do not reflect fair
value, it would not be appropriate for an entity to disregard market prices at
the measurement date, unless those prices are from transactions that are not
orderly.

 

The financial assumptions in a
valuation model like discounting rate, weighted average cost of capital, etc.
that are considered in a Level-3 valuation would need a reassessment.

 

Hedge effectiveness assessment is
required to be performed at the inception and on an on-going basis at each
reporting date or in case of a significant change in circumstances, whichever
occurs first. The current volatility in the markets may result in an entity
requiring to either re-balance the hedge where applicable, or discontinuing
hedge accounting if an economic relationship no longer exists, or the
relationship is dominated by credit risk. Certain opportunistic and speculative
transactions may also take place.

 

When a hedging relationship is
discontinued because a forecast transaction is no longer highly probable, a
company needs to determine whether the transaction is still expected to occur.
If the transaction is:

(i) still expected to occur, then gains or losses on the hedging
instrument previously accumulated in the cash flow reserve would generally
remain there until the future cash flows occur; or

(ii) no longer expected to occur, then the accumulated gains or losses
on the hedging instrument need to be immediately reclassified to profit or
loss.

 

(10) Disclosures and management guidance

Transparent disclosures should be
made on the effects and risks of this outbreak on the entity. The Securities
and Exchange Commission instructed publicly traded companies to provide
‘robust’ disclosures on the impact of Covid-19 on their operations and results.
Entities would need to disclose the impact of Covid-19 on their performance,
including qualitative aspects of the business.

 

Difficult times also warrant
accuracy in guidance; in an uncommon move, leading Indian bell-wether companies
like Wipro and Infosys have refrained from giving any annual guidance to
their shareholders for F.Y. 2020-21, citing the uncertain impact of Covid-19.

 

The relevance of an audit effort
on the financial statements is further emphasised in uncertain times like
these. Some of the common questions that auditors could encounter would
include:

 

(A) Have the risk considerations relevant to an entity changed, thereby
requiring an amendment to the audit approach?

Standards on auditing require an
auditor to identify and assess the risk of material misstatements and
materiality in planning and performing an audit. This assessment may have been
made during the earlier half of the financial year 2019-20 and the audit
procedures tailored on the basis of such earlier assessment. Due to Covid-19
and its far-reaching implications, the risk considerations relevant to an
entity may change significantly, thereby requiring an auditor to revisit the
audit plan, materiality and the approach to testing.

 

The perfect storm that Covid-19
offers has the potential to usurp good and healthy business models and push
profitable companies into a survival challenge. It would be important for
auditors to revisit the audit plan and the risk considerations once again given
the exposure an entity would have to Covid-19.

 

(B) Have the audit procedures been compromised on account of
restrictions, lockdowns and social distancing?

Auditors may face a challenge in
performing routine audit procedures during times of lockdown, social
distancing, travel restrictions, lesser access to management teams, etc.
Typically, audit procedures that have either a physical work-stream or
dependency on a third party are likely to get impacted. These could include
physical verification of inventory, cash on hand reviews, seeking external
balance confirmations, requiring comfort from component auditors, etc.

 

SA 501 requires the auditor to
observe some physical inventory counts on an alternative date if the attendance
of physical counting cannot be performed at the year-end date, or perform
alternative audit procedures where attendance of physical inventory counts is
impracticable. The standard also requires an auditor to perform roll-back procedures
to derive the desired comfort on inventory level on a reporting date.

 

Audit procedures should be
simulated to understand the potential impacts on such procedures to be
performed and alternate procedures identified to supplement or otherwise replace
such an audit procedure.


(C) How does an auditor provide comfort on the operating effectiveness
of internal financial controls given the altered way of working, such as work
from home, no wet signatures, cloud dependency, etc.?

Standards on auditing require an
auditor to assess the design and implementation along with the operating
effectiveness of internal controls over financial reporting. The sudden impact
of Covid-19 and the precautionary measures taken by governments across the
world have resulted in newer work models of work from home, no wet signatures,
cloud dependency, etc.

 

Auditors would need to evaluate
the impact of such differentiated working models on the internal control
framework and the desired reliance by the auditor on their operating
effectiveness. If the level of expected controls reliance changes, it is
important to document this and any other resulting changes to the planned audit
response.

 

(D) Is Covid-19 an adjusting event or a non-adjusting event?

According to Ind AS 10 – Events
after the reporting date, events occurring after the reporting period are
categorised into two, viz. (a) Adjusting events, i.e. those that require
adjustments to the amounts recognised in the financial statements for the
reporting period, and (b) Non-adjusting events, i.e. those that do not require
adjustments to the amounts recognised in the financial statements for the
reporting period.

 

Entities and auditors would need
to ascertain the impact of Covid-19 as either an adjusting or non-adjusting
event given the peculiarity that the effects of Covid-19 and lockdown were
prevalent in March, 2020 itself. Entities impacted by the Covid-19 pandemic
will need to assess how these events have, and may in future impact their
operations. Managements will need to consider the facts and apply critical
judgement in assessing what specific events and, more importantly, the timing
of those events, provide evidence of conditions that existed at the end of the
reporting period in order to determine if an adjustment is required. If it is
concluded as non-adjusting, the entity will need to determine if disclosure of
the event is required.

 

(E) Does Covid-19 require added consideration to emphasis of matter and
in relation to going concern uncertainty?

If the auditor considers it
necessary to draw users’ attention to a matter presented or disclosed in the
financial statements that in the auditor’s judgement is of such importance that
it is fundamental to users’ understanding of the financial statements, the
auditor shall include an ‘Emphasis of Matter’ paragraph in the Auditor’s
Report. SA 706 also cites instances that may warrant an emphasis of matter
observation by the auditor. One such instance is ‘A major catastrophe
that has had, or continues to have, a significant effect on the entity’s
financial position.’ Depending on the circumstances of the entity, the
auditor may consider appropriate reporting as emphasis of matter.

 

When
preparing financial statements, management is required to make an assessment of
an entity’s ability to continue as a going concern. In line with SA 570
(Revised), the auditor’s responsibilities are to obtain sufficient appropriate
audit evidence regarding, and conclude on, the appropriateness of management’s
use of the going concern basis of accounting in the preparation of the
financial statements, and to conclude, based on the audit evidence obtained,
whether a material uncertainty exists about the entity’s ability to continue as
a going concern.

 

Depending
on the circumstances, the auditor would need to consider whether to include a
separate section ‘Material Uncertainty Related to Going Concern’ in the
auditor’s report.

 

COVID AND FAIR VALUE MEASUREMENT

Fair value measurements are
required or permitted under Ind AS for many financial instruments and
non-financial assets and liabilities. They are required for quoted and unquoted
investments in shares, bonds, receivables, payables, derivatives, etc. As also
in certain situations for non-financial items, such as in determining
impairment of property, plant, equipment or goodwill. This article attempts to
discuss whether the current markets post the Covid outbreak can be considered
as not being orderly and therefore ignored for determining the fair values for
the year ending 31st March, 2020 financial statements.

 

Before we attempt to address the
moot question, whether markets as on 31st March, 2020 were orderly
or not, let us first look at the various provisions of Ind AS 113 Fair Value
Measurement.

(i)
Paragraph 2 of Ind AS 113 states that ‘Fair value is a market-based
measurement, not an entity-specific measurement. For some assets and
liabilities, observable market transactions or market information might be
available. For other assets and liabilities, observable market transactions and
market information might not be available. However, the objective of a fair
value measurement in both cases is the same – to estimate the price at which an
orderly transaction to sell the asset or to transfer the liability would take place
between market participants at the measurement date under current market
conditions (i.e., an exit price at the measurement date from the
perspective of a market participant that holds the asset or owes the
liability).’

(ii) Paragraph 3 of Ind AS 113
states that ‘When a price for an identical asset or liability is not
observable, an entity measures fair value using another valuation technique
that maximises the use of relevant observable inputs and minimises the use of
unobservable inputs. Because fair value is a market-based measurement, it is
measured using the assumptions that market participants would use when pricing
the asset or liability, including assumptions about risk. As a result, an
entity’s intention to hold an asset or to settle or otherwise fulfil a
liability is not relevant when measuring fair value.’

(iii) Paragraph 61 of Ind AS 113
states as follows ‘An entity shall use valuation techniques that are
appropriate in the circumstances and for which sufficient data are available to
measure fair value, maximising the use of relevant observable inputs and
minimising the use of unobservable inputs.’

(iv) Ind AS 113 defines orderly
transaction as ‘A transaction that assumes exposure to the market for a
period before the measurement date to allow for marketing activities that are
usual and customary for transactions involving such assets or liabilities; it
is not a forced transaction (e.g. a forced liquidation or distress sale.).’

 

IDENTIFYING TRANSACTIONS THAT ARE NOT
ORDERLY

Ind AS 113.B38 states that ‘If
an entity concludes that there has been a significant decrease in the volume or
level of activity for the asset or liability in relation to normal market
activity for the asset or liability (or similar assets or liabilities), further
analysis of the transactions or quoted prices is needed. A decrease in the
volume or level of activity on its own may not indicate that a transaction
price or quoted price does not represent fair value or that a transaction in
that market is not orderly.’

 

Ind AS 113.B43 provides guidance
for determination of whether a transaction is orderly (or is not orderly).
Whether there has been a significant decrease in the volume or level of
activity requires comparison to normal market activity level. B43 lists down
the following circumstances that may indicate that a transaction is not
orderly:

(a) There was not adequate
exposure to the market for a period before the measurement date to allow for
marketing activities that are usual and customary for transactions involving
such assets or liabilities under current market conditions.

(b) There was a usual and
customary marketing period, but the seller marketed the asset or liability to a
single market participant.

(c) The seller is in or near
bankruptcy or receivership (i.e., the seller is distressed).

(d) The seller was required to
sell to meet regulatory or legal requirements (i.e., the seller was forced).

(e) The transaction price is an
outlier when compared with other recent transactions for the same or a similar
asset or liability.

 

OBSERVATIONS AND CONCLUSIONS

Fair value is a measurement of a
date-specific exit price estimate based on assumptions (including those about
risks) that market participants would make under current market conditions.
The fair value measurement objective is to determine an exit price at the
measurement date from the perspective of a market participant. Fair value of
the asset or liability reflects conditions as of the measurement date and not
a future date. It would not be appropriate for an entity to disregard
market prices at the measurement date, unless those prices are from
transactions that are not orderly. The concept of an orderly transaction is
intended to distinguish a fair value measurement from the price in a distressed
sale or forced liquidation. The intent is to convey the current value of
the asset or liability at the measurement date, not its potential value at a
future date.

 

The current situation may make it
challenging to estimate the price that would be obtained due to highly volatile
markets and / or a lack of an active market existing for certain instruments
(e.g. derivatives that are not traded on an exchange). However, the objective
of ‘fair value’ will continue to be to determine a price at which an orderly transaction
would take place between market participants under conditions that existed at
the measurement date. It would not be appropriate to adjust or disregard
observable transactions unless those transactions are determined to be not
orderly. There is a high bar to conclude that a transaction price is not
orderly under Ind AS 113.B43, which provides a list of factors to consider if a
transaction is not orderly. The author believes that there is an implicit
rebuttable presumption that observable transactions between unrelated parties
are orderly. In almost all instances, such transactions are considered orderly.
Therefore, the evidence necessary to conclude an observable transaction between
unrelated parties is not orderly should be incontrovertible. Accordingly,
the fair value of an investment in an active market (e.g. BSE, NSE, etc.) would
continue to be calculated as the product of the quoted price for the individual
instrument times the quantity held (commonly referred to as ‘P times Q’), even
in times of significant market volatility. Volatility may raise questions
as to whether current pricing is reflective of fair value. However, the
standard does not permit current market evidence to be dismissed on the basis
of volatility alone.

 

Some may argue that in the
current environment there is an element of forced selling and that fair value
measurement is not intended to reflect prices in a forced or distressed sale.
Nevertheless, the presence of distressed or forced sellers in a market may
influence the price that could be obtained by a non-distressed seller in an
orderly transaction.

 

Fair value measurement would
consider how the Covid outbreak and any actions taken by governments at the
reporting date would have impacted market participants’ valuation assumptions.
Current market conditions may appear to be a ‘distress sale’, however, if such
conditions exist broadly in the market, then those factors should be
incorporated into a fair value measurement. It would be incorrect to adjust a
measure for expected ‘rebounds’ in value. For financial instruments with level
1 prices (those that are quoted on an active market), even if there is a
significant decline in activity on that market, this does not mean that the
price has become unobservable or that it was 
under a distress sale or a forced liquidation.

 

Whilst determining a valuation
for other than level 1 category of instruments (i.e., those that are quoted in
an active market), preparers of financial statements may have to use valuation
techniques. This may be the case for several unquoted shares or derivatives or
bonds, etc. Preparers using valuation techniques may have to consider the
impact of Covid-19 on various assumptions including discount rates,
credit-spread / counter-party credit risk, etc. In doing so, the aim will
be to maximise observable inputs and minimise unobservable inputs. The
observable inputs will reflect current market conditions at the balance sheet
date and should not be ignored.

 

The
ICAI guidance ‘Impact of Corona Virus on Financial Reporting and the
Auditors Consideration’ states that ‘It may not be always appropriate to
conclude that all transactions in such a market are not orderly. Preparers
should be guided by the application guidance in Ind AS 113 that indicates
circumstances in which the transaction is not considered an orderly
transaction.’ Though the ICAI guidance does not provide any detailed
guidance, it makes no exception to complying with the requirements of the
Standards. For Indian GAAP, similar considerations will apply in respect of
financial assets within the scope of AS 13 Accounting for Investments.

UNCERTAINTY OVER INCOME TAX TREATMENTS

Ind
AS 12 Uncertainty over Income Tax Treatments (Appendix C) is effective
for the financial years beginning 1st April, 2019. An ‘uncertain tax
treatment’ is a tax treatment for which there is uncertainty over whether the
relevant taxation authority will accept the tax treatment under tax law. For
example, an entity’s decision not to submit any income tax filing in a tax
jurisdiction, or not to include particular income in taxable profit, is an
uncertain tax treatment if its acceptability is uncertain under tax law.

 

Uncertain
tax treatments generally occur where there is uncertainty as to the meaning of
the law, or to the applicability of the law to a particular transaction, or
both. For example, the tax legislation may allow the deduction of research and
development expenditure, but there may be disagreement as to whether a specific
item of expenditure falls within the definition of eligible research and
development costs in the legislation. In some cases, it may not be clear how
tax law applies to a particular transaction, if at all.

 

One
of the questions that was not clear in Appendix C was with respect to the presentation
of uncertain tax liabilities / assets. Whether, in its statement of financial
position, an entity is required to present uncertain tax liabilities as current
(or deferred) tax liabilities or, instead, within another line item such as
provisions? A similar question could arise regarding uncertain tax assets.

 

The
presentation of uncertainty over income tax treatments is very sensitive as it
may lead the Income-tax authorities to draw conclusions on the entities’
conclusion over the outcome of the uncertainty, or may provide information that
may lead to an investigation. Therefore, given a choice, entities would like to
combine uncertain tax provisions with another line item such as provisions.

 

AUTHOR’S RESPONSE


The
following points are relevant to respond to the question:


(i)
uncertain tax liabilities or assets
recognised applying Appendix C are liabilities (or assets) for current tax as
defined in Ind AS 12 Income Taxes, or deferred tax liabilities, or
assets as defined in Ind AS 12; and


(ii)
       neither Ind AS 12 nor Appendix C
contain requirements on the presentation of uncertain tax liabilities or
assets. Therefore, the presentation requirements in Ind AS 1 Presentation of
Financial Statements apply. Paragraph 54 of Ind AS 1 states that ‘the
statement of financial position shall include line items that present:… (n)
liabilities and assets for current tax, as defined in Ind AS 12; (o) deferred
tax liabilities and deferred tax assets, as defined in Ind AS 12…’

 

Therefore,
applying Ind AS 1, an entity is required to present uncertain tax liabilities
as current tax liabilities (paragraph 54[n]) or deferred tax liabilities
(paragraph 54[o]); and uncertain tax assets as current tax assets (paragraph
54[n]), or deferred tax assets (paragraph 54[o]).

 

Similarly,
Ind AS Schedule III to the Companies Act 2013 requires separate
presentation of current tax asset, current tax liability, deferred tax asset
and deferred tax liability. Additionally, General Instruction No. 2 for
preparation of financial statements of a company required to comply with Ind AS
clarifies that the requirements of Ind AS will prevail over Schedule III, if
there are any inconsistencies.

 

In
particular, one should note that:


(a)
       when there is uncertainty over
income tax treatments, Appendix C specifies how an entity reflects any effects
of that uncertainty in calculating current or deferred tax in accordance with
Ind AS 12. Paragraph 4 of Appendix C states (emphasis added):


‘This
Appendix clarifies how to apply the recognition and measurement requirements in
Ind AS 12 when there is uncertainty over
income tax treatments. In such a circumstance, an entity shall recognise and
measure its current or deferred tax asset or liability applying the
requirements in Ind AS 12 based on taxable profit (tax loss), tax bases,
unused tax losses, unused tax credits and tax rates determined applying this
Appendix.’


(b)
       An entity therefore applies
Appendix C in determining taxable profit (tax loss), tax bases, unused tax
losses, unused tax credits and tax rates when there is uncertainty over income
tax treatments. These amounts are in turn used to determine current / deferred
tax applying Ind AS 12, which in turn flow through to be current / deferred tax
liabilities if the amounts relate to the current or prior periods but are
unpaid / unreversed.

 

(c)
       Appendix C requires an entity to
reflect the effect of uncertainty in determining taxable profit, tax rates,
etc. when it concludes that it is not probable that the taxation authority will
accept an uncertain tax treatment (paragraph 11 of Appendix C). Consequently,
the taxable profit on which current tax, as defined in Ind AS 12, is calculated
is the taxable profit that reflects any uncertainty applying Appendix C. The
definition of current tax in paragraph 5 of Ind AS 12 does not limit the
taxable profit (tax loss) used in determining current tax to the amount
reported in an entity’s income tax filings. Instead, the definition refers to
(emphasis added) ‘the amount of income taxes payable (recoverable) in respect
of the taxable profit (tax loss) for the period’.

 

(d)
       Paragraph 54 of Ind AS 1 states:


‘The
statement of financial position shall include line items that present the
following amounts:…


(l)
provisions;…

 

(n)
liabilities and assets for current tax, as defined in Ind AS 12 Income Taxes;

(o)
deferred tax liabilities and deferred tax assets, as defined in Ind AS 12;…’

 

Particularly,
requirements in paragraphs 54(n) and 54(o) of Ind AS 1 will preclude an entity
from presenting some elements of income tax within another line in the
statement of financial position, such as provisions. In particular, paragraph
29 of Ind AS 1 states ‘…an entity shall present separately items of a
dissimilar nature or function unless they are immaterial’. Paragraph 57 of
Ind AS 1 states that ‘…paragraph 54 simply lists items that are sufficiently
different in nature or function to warrant separate presentation in the
statement of financial position.’ Consequently, liabilities for current
(or deferred) tax as defined in Ind AS 12 are sufficiently different in nature
or function from other line items listed in paragraph 54 to warrant presenting
such liabilities separately in their own line item (if material).

 

CONCLUSION

When
there is uncertainty over income tax treatments, paragraph 4 of Appendix C
requires an entity to ‘recognise and measure its current or deferred tax asset
or liability applying the requirements in Ind AS 12 based on taxable profit
(tax loss), tax bases, unused tax losses, unused tax credits and tax rates determined
applying Appendix C’. Paragraph 5 of Ind AS 12 Income Taxes defines:


(1)
       current tax as the amount of income
taxes payable (recoverable) in respect of the taxable profit (tax loss) for a
period; and


(2)
       deferred tax liabilities (or
assets) as the amounts of income taxes payable (recoverable) in future periods
in respect of taxable (deductible) temporary differences and, in the case of
deferred tax assets, the carry forward of unused tax losses and credits.

 

Consequently,
uncertain tax liabilities or assets recognised applying Appendix C are
liabilities (or assets) for current tax as defined in Ind AS 12, or deferred
tax liabilities or assets as defined in Ind AS 12.

 

Neither
Ind AS 12 nor Appendix C contains requirements on the presentation of uncertain
tax liabilities or assets. Therefore, the presentation requirements in Ind AS 1
apply. Paragraph 54 of Ind AS 1 states that ‘the statement of financial
position shall include line items that present:… (n) liabilities and assets for
current tax, as defined in Ind AS 12; (o) deferred tax liabilities and deferred
tax assets, as defined in Ind AS 12…’.

 

Paragraph
57 of Ind AS 1 states that paragraph 54 ‘lists items that are sufficiently
different in nature or function to warrant separate presentation in the
statement of financial position’. Paragraph 29 requires an entity to ‘present
separately items of a dissimilar nature or function unless they are
immaterial’.

 

Similarly,
Ind AS Schedule III to the Companies Act 2013 requires separate
presentation of current tax asset, current tax liability, deferred tax asset
and deferred tax liability. Additionally, General Instruction No. 2 for
preparation of financial statements of a company required to comply with Ind AS
clarifies that the requirements of Ind AS will prevail over Schedule III if
there are any inconsistencies.

 

Accordingly, applying
Ind AS 1, an entity is required to present uncertain tax liabilities as current
tax liabilities (paragraph 54[n]) or deferred tax liabilities (paragraph
54[o]); and uncertain tax assets as current tax assets (paragraph 54[n]) or
deferred tax assets (paragraph 54[o]).  

 

REVERSE FACTORING OR SUPPLIER FINANCING

BACKGROUND

Banks may
offer services to buyers of goods or services in order to facilitate payment of
their trade payables arising from purchases from suppliers. In a reverse
factoring arrangement, a bank agrees to pay amounts an entity owes to its
suppliers and the entity agrees to pay the bank at a date later than when the
suppliers are paid. Reverse factoring arrangements can vary significantly in
both form and substance. When the original liability to a supplier has been
extinguished or there is a change in terms, the following issues arise:

(a)  Whether the resulting new liability to the
bank should be presented as bank borrowing or ‘trade payables.’ A point to note
is that bank borrowing is required to be separately presented from trade
payables under Ind AS Schedule III requirements. Needless to say that
presentation as bank borrowing may have a significant impact on the gearing
ratios and debt covenants.

(b)
Additionally, the entity is also required to consider various disclosure
requirements. Consequently, this issue is very important.

 

Whether the
resulting new liability to the bank should be presented as bank borrowing or
‘trade payables’?

 

REQUIREMENTS OF Ind AS
STANDARDS

Before we
embark on answering these questions, let us consider the various requirements
under Ind AS standards:

1. Paragraph
54 of Ind AS 1 – Presentation of Financial Statements: ‘The
balance sheet shall include line items that present the following amounts:
(a)………….. (k) trade and other payables; (l) provisions; (m) financial
liabilities excluding amounts shown under (k) and (l)……….’

 

2. Paragraph
57 of Ind AS 1: ‘This Standard does not prescribe the order or format in which
an entity presents items. Paragraph 54 simply lists items that are sufficiently
different in nature or function to warrant separate presentation in the balance
sheet. In addition:

(a) line
items are included when the size, nature or function of an item or aggregation
of similar items is such that separate presentation is relevant to an
understanding of the entity’s financial position; and (b)…’

 

3. Paragraph
70 of Ind AS 1 explains that ‘some current liabilities, such as trade payables…
are part of the working capital used in the entity’s normal operating cycle’.

 

4. Paragraph
29 of Ind AS 1 states that ‘…An entity shall present separately items of a
dissimilar nature or function unless they are immaterial …’

 

5. Paragraph
11(a) of Ind AS 37 – Provisions, Contingent Liabilities and
Contingent Assets states that ‘trade payables are liabilities to pay for
goods or services that have been received or supplied and have been invoiced or
formally agreed with the supplier’.

 

6. Paragraph
3.3.1 of Ind AS 109 – Financial Instruments states: ‘An entity
shall remove a financial liability (or part of a financial liability) from its
balance sheet when, and only when, it is extinguished – i.e., when the
obligation specified in the contract is discharged or cancelled or expires.’

 

ANALYSIS

Based on the
various requirements of Ind AS standards presented above, an entity presents a
financial liability as a trade payable only when it:

(i)
represents a liability to pay for goods or services;

(ii) is
invoiced or formally agreed with the supplier; and

(iii) is
part of the working capital used in the entity’s normal operating cycle.

 

Other
payables are included within trade payables only when those other payables have
a similar nature and function to trade payables; for example, when other
payables are part of the working capital used in the entity’s normal operating
cycle.

 

A point to
note is that bank borrowing is required to be separately presented from trade
payables under Ind AS Schedule III requirements. In assessing whether to
present reverse factoring arrangements as trade payables (whether included with
other payables or not) or bank borrowing, requires further analysis. An entity
will have to assess whether to derecognise a trade payable to a supplier and
recognise a new financial liability to a bank as bank borrowings. Such an
assessment is made in accordance with Ind AS 109 – Financial Instruments.

 

Under Ind AS
109 if the arrangement results in derecognition of the original liability (e.g.
if the purchaser is legally released from its original obligation to the
supplier), an entity in such a case will have to pay the bank rather than the
supplier. Consequently, in such a case, presentation as a bank borrowing may be
more appropriate. Derecognition can also occur and presentation as bank
borrowing will also be appropriate if the purchaser is not legally released
from the original obligation but the terms of the obligation are amended in a
way that is considered a substantial modification. For example, the payment of
trade payable may not entail transfer of any collateral. However, if collateral
is provided in a supplier financing arrangement, this would mean that the
original agreement to pay to the creditor has been substantially modified. In
such cases, too, presentation of the reverse factoring as a bank borrowing
rather than trade payable may be more appropriate. Even if the original
liability is not derecognised, other factors may indicate that the substance
and nature of the arrangements indicate that the liability should no longer be
presented as a trade payable and a bank borrowing presentation may be more
appropriate.

 

Analysis of
supply-chain finance is a complex and judgemental exercise. Obtaining an
understanding of the following factors would help in making the decision on the
presentation:

• What are
the roles, responsibilities and relationships of each party (i.e. the entity,
the bank and the supplier) involved in the reverse factoring?

• What are
the discounts or other incentives received by the entity that would not have
otherwise been received without the bank’s involvement?

• Whether
there is any extension of the date by the bank by which payment is due from the
entity beyond the invoice’s original due date?

• Is the
supplier’s participation in the reverse factoring arrangement optional?

• Do the
terms of the reverse factoring arrangement preclude the company from
negotiating returns of damaged goods to the supplier?

• Is the
buyer released from its original obligation to the supplier?

• Is the
buyer obligated to maintain cash balances or are there credit facilities with
the bank outside of the reverse factoring arrangement that the bank can draw
upon in the event of non-collection of the invoice from the buyer?

• Does the
buyer have a separate credit line for these arrangements?

• Whether
additional security is provided as part of the arrangement that would not be
provided without the arrangement?

• Whether
the terms of liabilities that are part of the arrangement are substantially
different from the terms of the entity’s trade payables that are not part of
the arrangement?

 

Some reverse
factoring arrangements require that a buyer will pay the invoice regardless of
any disputes that might arise over the goods (for example, the goods are found
to be damaged or defective). In the event of a dispute, a buyer who agrees to
such a condition would use other means, such as adjustments on future purchases
from the supplier, to recover the losses. These provisions provide greater
certainty of payment to the bank and may reflect that the arrangement in
substance is a financing to the buyer. However, for a buyer who buys regularly
from a supplier to routinely apply credits for returns against payments on
future invoices, this condition might not be viewed as a significant change to
existing practice. Additionally, this provision may not constitute a
significant change to the terms of the original trade payable if failure by the
buyer to pay on the invoice due date does not entitle the bank to any recourse
or remuneration beyond what is stipulated in the terms of the invoice.

 

In some
reverse factoring arrangements, the buyer may be required to maintain
collateral or other credit facilities with the bank. These requirements may
indicate a financing arrangement in substance, particularly if a buyer’s
failure to maintain an appropriate cash balance would trigger
cross-collateralisation events on the buyer’s other debt instruments held by
the bank. For the liability to be considered a trade payable, the bank
generally can collect the amount owed by the buyer only through its rights as
owner of the receivable it purchased from the supplier. Some examples are
provided below which help in understanding the above requirements.

 

Example 1 –
Financing of advances to suppliers made by the buyer

A buyer
makes an advance payment to a supplier for goods to be delivered to the buyer
six months later. For this purpose, the buyer obtains a credit from the bank
based on its own credit rating and credit facility. The supplier is not
involved in the buyer obtaining the credit facility from the bankers. Here, as
far as the buyer is concerned, the buyer obtains credit from a bank and makes
an advance payment to the supplier. The buyer may directly make the advance to
the supplier, or the bank may do so on behalf of the buyer. In this example, it
is not appropriate for the buyer to present the borrowing from the bank and the
advance to the supplier on a net basis. It is also not appropriate for the
buyer to present the borrowing from the bank as trade payable, because no goods
have been received at the date of borrowing.

 

Example 2:
Bank negotiates with supplier directly on buyer’s behalf

A supplier
approaches a bank for discounting an invoice representing supply of goods to a
buyer. The bank agrees to pay the supplier before the legal due date to obtain
an early payment discount. However, the buyer is not legally relieved from the
obligation under its trade payable. The way the mechanism works is that the
supplier agrees to receive the amount from the buyer net of the early payment
discount at the contractual due date and to pay the bank this same amount only
if it receives the payment from the buyer. If the supplier fails to pay the
bank, the buyer agrees to pay the bank. The bank charges a fee to the buyer,
which is lower than the early payment discount. This effectively results in the
bank and the supplier sharing the benefit of the early payment discount. In
this example, since the buyer is not legally relieved of his obligation to pay
the supplier (or to the bank on behalf of the supplier), the buyer continues to
recognise the trade payable to the supplier. Furthermore, the buyer does not
provide any collateral to the bank, nor is the arrangement substantially
different from the terms of the entity’s trade payable. The buyer will
recognise the liability as trade payable. Additionally, the buyer also
recognises a guarantee obligation, initially measured at fair value, for its
promise to pay the bank if the bank does not receive a payment from the
supplier.

 

Example 3:
Receivables purchase agreement

In a reverse
factoring arrangement, a bank acquires the rights under the trade receivable
from the supplier. However, the buyer is not legally released from the payable.
The buyer may be involved to some extent in such an arrangement. For example,
the buyer agrees that he is no longer eligible to offset the payable against
credit notes received from the supplier, or the buyer may be restricted from
making direct payments to the supplier. In this fact pattern, the buyer would
need to consider whether the change to the terms of the trade payable is
significant or not.

 

If there is
a substantial change, the transfer is accounted for as an extinguishment –
which means, the previous liability should be derecognised and replaced with a
new liability to the bank. The impact of any additional restrictions imposed by
the reverse factoring agreement on the buyer’s rights will need to be properly
evaluated. One possibility is that because the buyer selects each payable at
its sole discretion, it will only select those payables where the effect of any
such restriction is not significant. On the other hand, it may be the case that
the buyer, bank and supplier have agreed initially on a minimum amount of
payables / receivables being refinanced by the bank. In such a case, the buyer
has no further discretion to avoid the change in his rights, even when the
change is significant.

 

Example 4:
Trade structure / supply chain finance / reverse factoring

• Steel
Limited (SL) purchases raw material and other supplies from various suppliers.

• SL has
negotiated 180 days’ extended credit term with all suppliers, which fact will
be stated in the invoice.

• To address
the working capital issues of suppliers, SL’s bankers have agreed to buy bills
endorsed by SL.

• The
suppliers decide whether they need to transfer bills to SL’s bankers as well as
timing and other terms of transfer. The suppliers can also get their bill
discounted from other bankers. However, it may not be cost effective.

• If a
supplier decides to get bill discounted from SL’s banker, the banker will
consider SL’s credit risk to decide the amount payable on transfer.

• Transfer
does not release SL from its liability toward the supplier. Rather, SL
continues to be liable to pay the amount to the supplier.

• If SL
defaults in payment of dues, the banker can use the court process against SL
for payment but only through the involvement of the supplier.

• SL does
not receive any additional benefit except extended credit period as originally
agreed with the supplier.

• SL does
not have a separate credit line with the bank for these arrangements, nor
provides any collateral.

 

Response

From the
facts it is clear that:

• SL is not released from its obligation towards the supplier.

• Nor is
there a change in the terms of payable.

• Nor has SL
received any discounts or rebates that would not have otherwise been received.

• There is no
extension of the payment date beyond the invoice’s original due date.

• The
supplier’s participation in the reverse factoring arrangement is completely
optional.

• SL does
not have a separate credit line with the bank for these arrangements, nor does
it provide any collateral.

• These
factors indicate that SL should continue to classify its liability as trade
payable.

 

Example 5:
Trade structure / supply chain finance / reverse factoring

• SL
purchases raw material and other supplies from various suppliers.

• SL has
negotiated 180 days’ extended credit term with all suppliers.

• Within one
month of purchase, SL can select suppliers who need to get their bill
discounted from SL’s bank. The selected suppliers will transfer their bills to
the bank for immediate cash.

• Assume
that the bill amount is Rs. 100; the bank will deduct Rs. 10 as discounting
charge and pay the remaining amount (Rs. 90) to the supplier.

• Through an
agreement signed between SL and the bank, SL:

• Commits itself to pay to the bank the specified
invoice on its due date.

• Pays a service fee for ‘services’ to the
bank.

• Pays finance cost to the bank (as per a
credit line with the bank).

• In
summary, SL will pay to the bank:

• Nominal amount of the invoice (Rs. 100).

• Less discount for immediate payment
included in the payment conditions between the buyer and SL (Rs.
10).

• Plus, the service and finance
commission payable to the Bank (Rs. 5).

 

Response

• The
supplier appears to have relinquished its obligation to pay to the bank. It
appears that SL has now the obligation for payment to the bank.

• The
substance of the transaction is that SL is paying in advance to the supplier
for getting the benefit of cash discount.

• For this
purpose, it is drawing a credit line from the bank and paying the related
interest expense.

• The
supplier’s participation in the arrangement is decided by SL.

• These
facts indicate that the supplier payable should be reclassified from trade
payable to a bank borrowing.

 

What are the
various disclosure requirements applicable in a reverse factoring arrangement?

 

REQUIREMENTS OF Ind AS
STANDARDS

1. Paragraph
6 of Ind AS 7 – Statement of Cash Flows defines: (a) operating activities as
the principal revenue-producing activities of the entity and other activities
that are not investing or financing activities; and (b) financing activities as
activities that result in changes in the size and composition of the
contributed equity and borrowings of the entity.

 

2. Paragraph 43 of Ind AS 7 states: ‘Investing and financing transactions
that do not require the use of cash or cash equivalents shall be excluded from
a statement of cash flows. Such transactions shall be disclosed elsewhere in
the financial statements in a way that provides all the relevant information
about those investing and financing activities.’

 

3. Paragraph
44 of Ind AS 7 states: ‘Many investing and financing activities do not have a
direct impact on current cash flows although they do affect the capital and
asset structure of an entity. The exclusion of non-cash transactions from the
statement of cash flows is consistent with the objective of a statement of cash
flows as these items do not involve cash flows in the current period.’

 

4. Paragraph
44A of Ind AS 7 states: ‘An entity shall provide disclosures that enable users
of financial statements to evaluate changes in liabilities arising from
financing activities, including both changes arising from cash flows and
non-cash changes.’

 

5. Paragraph 122 of Ind AS 1 – Presentation of Financial Statements states: ‘An entity shall disclose,
along with its significant accounting policies or other notes, the judgements,
apart from those involving estimations, that management has made in the process
of applying the entity’s accounting policies and that have the most significant
effect on the amounts recognised in the financial statements.’

 

6. Paragraph
112 of Ind AS 1 states: ‘The notes shall: …. (c) provide information that is
not presented elsewhere in the financial statements, but is relevant to an
understanding of any of them.’

 

ANALYSIS

The analysis
below is consistent with the IFRIC tentative agenda decision in June, 2020, ‘Supply
Chain Financing Arrangements – Reverse Factoring – Agenda Paper 2.’

 

Cash flow
statement

An entity
that has entered into a reverse factoring arrangement determines whether to
classify cash flows under the arrangement as cash flows from operating
activities or cash flows from financing activities. If the entity considers the
related liability to be a trade or other payable that is part of the working
capital used in the entity’s principal revenue-producing activities, then the
entity presents cash outflows to settle the liability as arising from operating
activities in its statement of cash flows. In contrast, if the entity considers
the related liability as borrowings of the entity, then the entity presents
cash outflows to settle the liability as arising from financing activities in
its statement of cash flows.

 

Investing
and financing transactions that do not require the use of cash or cash
equivalents are excluded from an entity’s statement of cash flows (paragraph 43
of Ind AS 7). Consequently, if cash inflow and cash outflow occur for an entity
when an invoice is factored as part of a reverse factoring arrangement, then
the entity presents those cash flows in its statement of cash flows. If no cash
flows are involved in a financing transaction of an entity, then the entity
discloses the transaction elsewhere in the financial statements in a way that
provides all the relevant information about the financing activity (paragraph
43 of Ind AS 7).

 

NOTES TO FINANCIAL
STATEMENTS

Paragraph 44A of Ind AS 7 requires an entity to provide ‘disclosures that
enable users of financial statements to evaluate changes in liabilities arising
from financing activities, including both changes arising from cash flows and
non-cash changes’. Such a disclosure is required for liabilities that are part
of a reverse factoring arrangement if the cash flows for those liabilities
were, or future cash flows will be, classified as cash flows from financing
activities.

 

Ind AS 107 –
Financial Instruments: Disclosures defines liquidity risk as ‘the risk
that an entity will encounter difficulty in meeting obligations associated with
financial liabilities that are settled by delivering cash or another financial
asset’. Reverse factoring arrangements often give rise to liquidity risk
because:

(a) the
entity has concentrated a portion of its liabilities with one financial
institution rather than a diverse
group of suppliers. The entity may also obtain other sources of funding from
the financial institution providing the reverse factoring arrangement. If the
entity were to encounter any difficulty in meeting its obligations, such a
concentration would increase the risk that the entity may have to pay a
significant amount, at one time, to one counter party.

(b) some
suppliers may have become accustomed to, or reliant on, earlier payment of
their trade receivables under the reverse factoring arrangement. If the
financial institution were to withdraw the reverse factoring arrangement, those
suppliers could demand shorter credit terms. Shorter credit terms could affect
the entity’s ability to settle liabilities, particularly if the entity were
already in financial distress.

 

Paragraphs 33-35 of Ind AS 107 require an entity to disclose how exposures
to risk arising from
financial instruments including liquidity risk arise, the entity’s objectives,
policies and processes for managing the risk, summary quantitative data about
the entity’s exposure to liquidity risk at the end of the reporting period
(including further information if this data is unrepresentative of the entity’s
exposure to liquidity risk during the period), and concentrations of risk.
Paragraphs 39 and B11F of Ind AS 107 specify further requirements and factors
an entity might consider in providing liquidity risk disclosures.

 

An entity
applies judgement in determining whether to provide additional disclosures in
the notes about the effect of reverse factoring arrangements on its financial
position, financial performance and cash flows. An entity needs to consider the
following:

(i)
assessing how to present liabilities and cash flows related to reverse
factoring arrangements may involve judgement. An entity discloses judgements
that management has made in this respect if they are among the judgements made
that have the most significant effect on the amounts recognised in the
financial statements (paragraph 122 of Ind AS 1).

(ii) reverse
factoring arrangements may have a material effect on an entity’s financial
statements. An entity provides information about reverse factoring arrangements
in its financial statements to the extent that such information is relevant to
an understanding of any of those financial statements (paragraph 112 of Ind AS
1).

DATA-DRIVEN INTERNAL AUDIT – I

BACKGROUND

The basics of Internal Audit remain the same
– add value and manage risk; but it cannot operate in isolation, and just as
technology continues to revolutionise the way we do business in the 21st
century, Internal Audit is not immune from disruption.

 

The business environment is changing rapidly
in the face of the data revolution. IDC predicts that worldwide data will
increase by 61% and reach 175 zetta bytes by 2025. What is new is the ubiquity
and volume of data. From big data to data science to predictive analytics, data
is everywhere.

 

Management today makes use of tools and
technologies like ERP, analytics, visualisation, artificial intelligence, etc.,
and converts available data into information for better, more informed
decisions impacting the business. Should the Internal Auditor be left behind?

 

Internal Audit is one of the professions
where developments affecting data (data availability, data sources, data
analysis, etc.) are particularly important and impactful.

 

The opening lines of the popular science
fiction serial of the 1970s, ‘Star Trek – Space, The Final Frontier’,
are: These are the voyages of the Star Ship Enterprise. Its five-year mission
– to explore strange new worlds, to seek out new life and new civilizations, to
boldly go where no man has gone before. Those words are etched in our
minds.

 

To draw a parallel to that, the future of
Internal Audit is to explore and apply new tools and technologies. Not just for
the sake of ‘me too’ but to be relevant and –

  •  do more (continuously add value) with less
    resources;
  •  be in tune with audit tools and
    technology, similar to those being adopted by businesses (increasingly,
    management is now working with 4th and 5th generation
    tools and technologies and auditors cannot use 1st or 2nd
    generation tools and technologies any more);
  •  continuously upgrade skills in the face of
    this data revolution.

 

TOWARDS A DATA-DRIVEN FUTURE – SURVEY

CaseWare IDEA Inc., Canada conducted a
survey in late 2019 wherein about 400 Internal Audit professionals from junior
auditors to the C-Suite level were surveyed and responses were gathered from
around the world on their approach to audit through the lens of technology.

 

To offer an unbiased assessment of the state
of Internal Audit in 2020, this survey was tool agnostic.

 

Who was surveyed?

 

 

Geographic distribution of the survey


Geographic Distribution

The survey was promoted globally across multiple channels. Although a plurality (42%) of respondents operate out of North America, the survey results reflects the views of audit professionals from all major global geographic regions, including Asia Pacific (20%), Latin America (17%), Europe (11%), Africa (8%), and the Middle East (2%).

 

 Topics covered in
the survey

Feedback was
sought from the respondents on the following areas:

  • Current and
    planned elements of Internal Audit approaches;
  • Most
    significant Internal Audit challenges;
  • Compliance
    demands;
  •  Data
    analytics in Internal Audit;
  •  Artificial
    Intelligence and Machine Learning in Internal Audit activities;
  •  Cloud
    Technology in Internal Audit;
  •  Training and
    adoption of audit technology;
  •  Priorities
    for 2020, and much more.

 

Findings
of the survey

The survey
findings suggested that individuals and leadership within the Internal Audit
profession are aware of the unique opportunities that are being offered by new
technologies and data analytics, but they are struggling to:

 

  •  Embrace and
    adopt these new technologies
  •  Train
    internal audit staff on technology tools
  •  Move from
    traditional, manual processes to data-driven auditing processes.

 

Compliance
demands – a perennial challenge for Internal Audit – continue to rank as one of
the top priorities for auditors and data ethics is taken seriously by most
respondents.

 

The year ahead
for Internal Audit will be marked by:

  •  The adoption
    of data analysis technology,
  •  The
    optimisation of existing audit technology,
  •  Training
    auditors on audit technology.

 

Many of these
challenges and priorities are interconnected and together they represent a
global movement towards data-driven audit.

 

Top
challenges – an overview

In the survey,
audit professionals were asked to address their biggest audit challenges
currently, and the answers reflect the views of respondents as they stood at
the close of 2019. When asked to name their top Internal Audit challenges,
three clear priorities emerged as the top challenges faced by auditors,
regardless of role or geographic location.

 

Leading the
charge was the need to move from traditional, manual processes to data-driven
audit, a priority which 62% of respondents named as a top audit challenge.
Close behind were the need to adopt new technology (57%) and addressing the
skills shortage (47%).

 

Need for
adoption of data-driven audit

Data-driven
audit uses technology, big data, data analytics, and even predictive analytics,
to make auditing a data-centric, risk-sensitive, technology-enabled, continuous
activity.

 

Data-driven
auditing is an approach marked by:

  •  The use of
    data analytics technology;
  •  A decreased
    reliance on manual tools and processes (e.g., traditional spreadsheets and
    sampling);
  •  Results-based
    decision-making that enables both the auditor and the client to find more value
    in an audit;
  •  Using these
    approaches to enable management to minimise risk.

 

Data-driven
audit shirks conventional, manual approaches to auditing to realise a future of
data-based decision-making.

 

BENEFITS OF DATA ANALYTICS – KEY POINTS

Clients,
customers and investors alike have little tolerance when controls fail to
reveal erroneous data used in operational decisions and financial reporting.
Undetected errors in systems and data can also yield opportunities for fraud
and abuse. The best tool that can be used to determine the reliability and
integrity of information systems is data analysis software.

 

Audit results
gleaned from competent data analysis activities by Internal Audit can shine a
light on the issues lying within the organisation’s data. When properly used by
trained audit staff, data analysis software can be incorporated into audit
plans to provide both assurance and consulting service opportunities to the
organisation’s information systems and thus become the true cornerstone of an
effective audit function.

 

Some of the key
benefits of the use of data analytics are:

  •  In-depth
    review of process-generated data rather than traditional sample checks which
    are ineffective and inefficient;
  •  Ability to
    reveal surprises and insights which the client management never knew about – true
    value add    ;
  •  Possibility
    to go beyond controls and focus on cost saving and revenue maximisation;
  •  Concurrent
    use of data analytics in audit significantly reduces compliance costs;
  •  Framework to
    automate complex Management Control ‘MIS’ reports through Automatic Routines –
    ‘Macros’.

 

DATA ANALYTICS MATURITY DECISION
FOR INTERNAL AUDIT

Different
types of data analytics

Organisations
need to consider different types of data analytics:

  •  Descriptive
    analytics     interprets historical data;
  •  Predictive
    analytics     predicts future outcomes based on historical data;
  •  Diagnostic
    analytic    s examines the data and asks ‘why?’
  •  Prescriptive
    analytics     identifies the best course of action based on the analysis of
    data.

 

The data
analytics maturity scale

Whatever the
benefits of automating data analytics, the organisation needs to determine at
the strategic level how data analytics might best contribute to its audit
goals.

This strategic
activity can benefit from considering data analytics in terms of ‘maturity’
stages below:

Traditional
Auditing: Data
analytics may be used but is mainly descriptive and applied during the planning
phase.

  •  Ad Hoc
    Integrated Analytics: This may include both descriptive and diagnostic
    analytics at the planning and execution phases (e.g., identifying outliers),
    but is carried out in an ad hoc rather than systematic manner.
  •  Continuous
    Risk Assessment and Auditing:     This may include all types or categories of
    data analytics in a pre-defined automated set. This set provides ongoing data
    to auditors.
  •  Integrated
    Continuous Auditing and Continuous Monitoring:     A full set of automated
    analytics is deployed and permits continuous monitoring by management, as well
    as a continuous data flow to the audit shop. The systems are largely seamless
    and integrated.
  •  Continuous
    Assurance of Enterprise Risk Management:     A full set of automated analytics
    is deployed, as with level 4. In addition, there is a further emphasis on
    aligning continuous data analysis with strategic enterprise goals. The internal
    audit plan is ‘dynamic’ in response to risk fluctuation.

 

CONCLUSION

The road for
internal auditing in 2020 and beyond would be:

  •  Upgrade
    skill-sets and become aware; explore and apply available and emerging tools and
    techniques;
  •  Adopt a
    data-driven approach to auditing, using tools and technologies like audit apps,
    data analytics, machine learning, artificial intelligence, etc.;
  •  To add value
    to the organisation and be a trusted business adviser to management.

 

The second
part of this article will cover practical cases with steps for using analytics
and conducting data-driven audits.

 

 

ACCOUNTING RELIEF FOR RENT CONCESSIONS ON LEASES

On 28th May, 2020,
the International Accounting Standards Board (the IASB) finalised an amendment
to IFRS 16 Leases titled ‘Covid-19-Related Rent Concessions –
Amendment to IFRS 16’. The Institute of Chartered Accountants of India
(ICAI) has already issued an Exposure Draft mirroring the IFRS 16 amendment.
This will become a standard in India when it is notified by the Ministry of
Corporate Affairs (MCA).

 

The modified standard
provides lessees with an exemption from assessing whether a Covid-19-related
rent concession is a lease modification. The amendments require lessees that
have elected to apply the exemption to account for Covid-19-related rent
concessions as if they were not lease modifications. It may be noted that
accounting for lease modification can be very cumbersome and time consuming for
many lessees that have significant leases on their balance sheet. If the
modification accounting applies, a lessee does not recognise the benefits of
the rent concession in profit or loss straight away. Instead, the lessee will
recalculate its lease liability using a revised discount rate and adjust its
right-of-use assets. If the modification accounting does not apply, the profit
or loss impact of the rent concession would generally be more immediate.

 

The practical expedient in
many cases will be accounted for as a variable lease payment. If accounted for
as a variable lease payment, the concession is accounted for in profit or loss
in the period in which the event or condition that triggers those payments
occurs.

 

It may be noted that the
practical expedient is a choice and it is not mandatory to apply. The practical
expedient is not available to lessors. The practical expedient applies only to
rent concessions that meet all the following conditions (paragraphs 46A and
46B):

 

Condition 1
– The rent concession occurs as a direct consequence of the Covid-19 pandemic.

 

Condition 2
– The change in lease payments results in revised consideration for the lease
that is substantially the same as, or less than, the consideration for the
lease immediately preceding the change.

 

Condition 3
– Any reduction in lease payments affects only payments originally due on or
before 30th June, 2021.

 

Condition 4
– There is no substantive change to other terms and conditions of the lease.

 

Let’s take a few scenarios to
assess the applicability of the practical expedient.

 

ISSUE

Base fact
pattern

  •  Lessor leases commercial space to lessee,
  • Lease term is four years and rental is fixed at Rs. 4,000 p.m.

 

Whether practical expedient
is available in the following scenarios?

Scenario

Facts

Can practical
expedient be applied?

1

  •  Year 2020: Rent is reduced
    to Rs. 3,000 p.m. for May-July, 2020 due to business disruption as a result
    of Covid-19

 

  •  No change in subsequent years and no other change in


lease contract

Yes, as rent concession is as a direct
consequence of the Covid-19 pandemic and all the other three conditions are
also met

2

  •  Year
    2020: Rent is reduced to Rs. 3,000 p.m. for


May-July, 2020

 

  •   Year 2021: Rent for
    Aug.-Oct., 2021 is increased by Rs. 1,000 p.m. from the original rent. B will
    pay Rs. 5,000 p.m. for


Aug.-Oct., 2021

Yes, because reduction in lease payments affects
only payments originally due on or before 30th June, 2021.
Additionally, the increase in lease rental is beyond 30th June,
2021 and is in proportion to the concession provided. For Condition 3,
amendment acknowledges that a rent concession would meet this condition if it
results in reduced lease payments on or before 30th June, 2021 and
increased lease payments that extend beyond 30th June, 2021

3

  •  Lessor agreed for a six-month rent holiday from May – Oct., 2020, i.e.,
    concession of Rs. 24,000

 

  • However, in the month of March, 2021, the lessee pays this amount along with interest of Rs. 3,000, which totals to Rs. 27,000

 

Here, though there is a rent holiday, but those
rents are paid subsequently, along with interest. IASB has noted in their
basis of conclusion that if the cash flows have increased to compensate the
time value of money, it would appear to be appropriate for entities to assess
that Condition 2 is met. Other increases in consideration, such as penalties
that are included in the deferral, would cause this criterion to be not
satisfied

4

  • Year 2020 & 2021: Rent is reduced to Rs. 3,000 p.m. for May, 2020 – Dec.,
    2021

 

  • Year
    2022 & 2023: Rent for Jan. 2022 – Aug. 2023 is increased by Rs. 1,000
    p.m. from original rent. B will pay     Rs. 5,000 p.m. for Jan., 2022 – Aug., 2023

 

No. In this scenario, the rent reduction is as a
direct consequence of Covid. However, the reduction of Rs. 1,000 affects the
payments originally due for the period even beyond 30th June,
2021. The timeline prescribed in the amendment is purely rule-based. It would
not be appropriate to interpret it in such a way that rental concession can
be applied to the rent covering the period up to 30th June, 2021
and for rent changes beyond 30th June, 2021 the normal accounting
of lease modification can be applied. One should consider the changes in the
lease rentals in their entirety. It is not acceptable that rent concessions
are accounted such that one portion satisfies the criterion (i.e. May, 2020 –
June, 2021, i.e., 30th June is the date beyond which rent
concessions completely disqualify the entity from applying the accounting
relief) and the remaining portion, i.e., July, 2021 to August, 2023 does not
satisfy the criterion

5

  • Year 2020: Rent is reduced to Rs. 3,000 p.m. for


May-July, 2020

 

  • Year 2021: Rent for Aug.-Oct., 2021 is increased by Rs. 4,000 p.m. from original rent. B will pay Rs. 8,000 p.m. for
    Aug.-Oct., 2021

No, because the reduction is of Rs. 1,000 in 2020
but in 2021 the rent increased by Rs. 4,000 from original rent which is not
in proportion to the concession provided

6

  • Lessor offers to reduce the monthly rent on the condition that its space is
    reduced from 8,000 sq. ft. to 5,000 sq. ft.

No, it would be a substantive change to other
terms and conditions, and therefore the practical expedient would be unavailable
for that rent concession

7

  • Rent holiday for May-July, 2020

 

  • At the end of the lease term, it gets extended for three months on the terms
    and conditions contained in the original lease agreement

 

Yes, because the lease extension is not considered
as a substantive change to other terms and conditions of the lease. This
point has been clarified in basis for conclusion of the standard

 

 

 

Comparison
between applying the practical expedient and lease modification

Example –
rent abatement

Entity A leases retail space
from Entity B. As at 31st May, 2020, Entity B grants Entity A a
one-month rent abatement, where rent of Rs. 1 million that would otherwise be
due on 1st June, 2020 is unconditionally waived. The rent concession
satisfies the criteria to apply the practical expedient. The rent concession is
a lease modification because it is a change in consideration for a lease that
is not part of the original terms and conditions of the lease. The rent
concession meets the definition of a lease modification and it would be
accounted for as such if the practical expedient is not elected by Entity A.

           

 

Practical expedient not applied – lease
modification accounting (Ind AS 16.39 – 43)

Practical expedient is applied – variable lease
payment accounting [Ind AS 16.38(b)]

Effect on
lease liability

Reduced to
reflect the revised consideration

Reduced to
reflect the revised consideration

Effect on
discount rate

The total
revised, remaining consideration is re-measured using an updated discount rate
as at the effective date of the lease modification

No change
in discount rate

Effect on
right-of-use asset

The
offsetting adjustment is recorded against the carrying value of the
right-of-use asset

No effect

Effect on
profit or loss

None as at
the time of modification; but will result in modified finance expense and
depreciation in subsequent periods

The
offsetting adjustment is recorded in profit or loss

 

As is
visible from the above example, the practical expedient provides relief to the
lessee in the following ways:

(a) The lessee does not have to assess each rent
concession to determine whether it meets the definition of a lease
modification;

(b) It also simplifies the
calculations that are prepared by the lessee, since it does not require a revised
discount rate;

(c) The rent concession is accounted in profit or
loss in the period in which the event or condition that triggers the revised
consideration occurs, rather than being reflected in future periods as revised
finance expense and depreciation of the right-of-use asset.

 

CONCLUSION

The author believes that the
practical expedient is a welcome relief for lessees that have a large number of
leases, for example, airline, telecom, retail and other entities. However,
applying practical expedient may not be as simple as it appears and there could
be numerous complexities in determining what scenarios can be subjected to a
practical expedient, as well as the accounting of the practical expedient.

 

If the lessee applies the
practical expedient, it shall disclose if it has applied the expedient to all
lease contracts or the nature of the contracts to which it has applied the
expedient. The lessee should also disclose the P&L impact of applying the
practical expedient.

 

ACCOUNTING FOR OWN EMPLOYEE TRAINING COSTS INCURRED ON CUSTOMER CONTRACTS

This article seeks to provide guidance on
the most appropriate accounting under Ind AS 115 Revenue from Contracts with
Customers to account for own employee training costs incurred on customer
contracts.

 

FACT PATTERN

Consider the following fact pattern:

 

1. Ez Co enters
into a contract with a customer, Ti Co, that is within the scope of Ind AS 115.
The contract is for the supply of outsourced services. Ez’s employees take
calls from Ti’s customers and provide them with online assistance for
electronic products purchased from Ti.

2. To be able to
provide the services to Ti, Ez incurs training costs for its employees so that
they understand Ti’s equipments and processes. Applying Ind AS 115, Ez does not
identify the training as a performance obligation.

3. The contract
permits Ez to recharge to Ti the costs of training (i) Ez’s employees at the
beginning of the contract, and (ii) new employees that Ez hires as a result of
any expansion of Ti’s operations. Ez is unable to recharge costs associated
with training replacement employees (i.e., new employees of Ez recruited to
replace those that leave Ez’s employment).

 

Whether Ez should
recognise an asset for the training costs incurred to fulfil a contract with
the customer (Ti)?

 

RESPONSE

Training costs
should not be capitalised as a cost to fulfil a contract, regardless of whether
they are explicitly rechargeable in Ez’s contract with its customer.

 

ANALYSIS

Paragraphs 95-96 of
Ind AS 115 state:

 

95  If the costs incurred in fulfilling a contract
with a customer are not within the scope of another Standard (for example, Ind
AS 2 Inventories, Ind AS 16 Property, Plant
and Equipment or Ind AS 38 Intangible Assets), an entity shall
recognise an asset from the costs incurred to fulfil a contract only if those
costs meet all of the following criteria:

(a)  The costs relate directly to a contract or to an
anticipated contract that the entity can specifically identify (for example,
costs relating to services to be provided under renewal of an existing contract
or costs of designing an asset to be transferred under a specific contract that
has not yet been approved);

(b)  the costs generate or enhance resources of the
entity that will be used in satisfying (or in continuing to satisfy)
performance obligations in the future; and

(c)  the costs are expected to be recovered.

 

96  For costs incurred in fulfilling a contract
with a customer that are within the scope of another Standard, an entity shall
account for those costs in accordance with those other Standards.

 

In this context,
training costs are specifically addressed in Ind AS 38. Ind AS 38.69 requires
that (extract):

‘In some cases,
expenditure is incurred to provide future economic benefits to an entity, but
no intangible asset or other asset is acquired or created that can be
recognised. … Other examples of expenditure that are recognised as an expense
when it is incurred include:

a)   …

b)   Expenditure on training activities

c)   …

d)   …’

 

Paragraph 3 of Ind AS 38 states (extract) – ‘If another Standard
prescribes the accounting for a specific type of intangible asset, an entity applies
that Standard instead of this Standard. For example, this Standard does not
apply to:

(a)….

…….

(i)   assets arising from contracts with customers
that are recognised in accordance with Ind AS 115, Revenue
from Contracts with Customers’.

 

It may be noted
that Ind AS 115 does not apply specifically to training costs. Consequently,
Ind AS 38 will apply. As a result, training costs that are incurred in respect
of a contract with a customer cannot be recognised as an asset and must be
expensed as incurred. A prohibition on capitalising employee training costs is
consistent with the requirement that an asset must be controlled. Since an
employer does not control its employees, it follows that training costs that
enhance the knowledge and performance of employees cannot be capitalised (see
paragraph 15 of Ind AS 38). This is also consistent with the requirements of
paragraph B 37 of Ind AS 103 Business Combinations, which prohibits the
recognition of an asset for an acquired assembled workforce because it is not
an identifiable asset.

 

The training costs
meet the following requirements of paragraph 95 Ind AS 115:

  •     relate specifically to a
    contract that Ez can identify (Ind AS 115.95[a]);
  •     enhance the resources of Ez
    that will be used in satisfying performance obligations in the future (Ind AS
    115.95[b]); and
  •     are expected to be
    recovered (Ind AS 115.95[c]).

 

A key difference
between Ind AS 115.95 and the criteria in Ind AS 38 is that, under Ind AS
115.95, the entity does not need to control the resource. It is not necessary to demonstrate that the employees are controlled
by Ez; instead, it is sufficient that Ez’s resources (the employees) have been
enhanced by the training.

 

Paragraph 95 of Ind
AS 115 requires an entity to recognise an asset from the costs incurred to
fulfil a contract with a customer not within the scope of another Ind AS
Standard only if those costs meet all the three criteria specified in paragraph
95. Consequently, before assessing the criteria in paragraph 95, an entity
first considers whether training costs incurred to fulfil a contract are within
the scope of another Standard.

 

Paragraph 5 of Ind
AS 38 states that ‘this Standard applies to, among other things, expenditure
on advertising, training, start-up, research and development activities’.

 

Accordingly, in the
fact pattern described, the entity applies Ind AS 38 in accounting for the
training costs incurred to fulfil the contract with the customer. Since an
employer does not control its employees, it follows that training costs that
enhance the knowledge and performance of employees cannot be capitalised.  

 

GOVERNANCE & INTERNAL CONTROLS: THE TOUCHSTONE OF SUSTAINABLE BUSINESS – PART II

On 12th March, 2020 BCAS made an announcement
deferring my talk scheduled a week hence. The previous
day, WHO had labelled the novel coronavirus disease
or Covid-19 as a pandemic. As a consequence, several
precautions snowballed into locking down half the world’s
population as the deadly virus quickly infected over four
million people in 210 countries and claimed tens of
thousands of lives. Our Prime Minister asked for 22nd
March to be observed as Janata Bandh following which
we are into Lockdown 3.0 (and now 4.0 till 31st May,
2020). Some have termed this outbreak as a Black Swan
event and the biggest challenge humanity has faced
since World War II, seriously impacting lives, earnings,
economies and businesses with a whopping toll on the
markets. We still have to see a flattening of the curve
and estimates are that this will trigger a global recession
for an extended period. The trillion-dollar question…
who could have anticipated this and, more importantly,
prepared for it?

Over the last few decades we have been witness to
quite some events of tremendous gravity such as Ebola,
SARS, Bird Flu, the 2008 meltdown, the 2011 Earthquake
and Tsunami, Brexit… With these abnormal occurrences
occurring with discomforting regularity, is this the new
normal?

But what have all these got to do with internal controls (IC)?
Sound internal controls which encompass identifying and
managing risks both internal and external, are a sine qua
non for running a sustainable business. Conventionally
though, internal controls were more of the order of internal
checks and internal audit (IA). Segregation of duties,
maker-checker procedures, vouching transactions,
physical verification of cash, stocks and so on received
a lot of prominence. And internal audit was seen as a
routine albeit necessary activity, coasting alongside the
main operations in business. Within corporations, too, this
function was never the sought-after role for accounting
and finance professionals. Not so any longer. The everchanging
world in which things are turning more complex
by the day, is only making this entire process difficult and
tricky as we reflect on the Covid-19 pandemic.

INTERNAL CONTROLS

Controls function to keep things on course and internal
controls in any business or enterprise provide the
assurance that there would be no rude surprises. The
Committee of Sponsoring Organisations1 (COSO) has
defined IC as ‘a process, effected by an entity’s board of
directors, management and other personnel, designed to
provide reasonable assurance regarding the achievement
of objectives relating to operations, reporting and
compliance’. As per SIA 120 issued by the Institute of
Chartered Accountants of India2, ICs are essentially risk
mitigation steps taken to strengthen the organisation’s
systems and processes, as well as help to prevent and
detect errors and irregularities. In SA 3153 it is defined
as ‘the process designed, implemented and maintained
by those charged with governance, management and
other personnel to provide reasonable assurance about
the achievement of an entity’s objectives with regard
to reliability of financial reporting, effectiveness and
efficiency of operations, safeguarding of assets and
compliance with applicable laws and regulations’. IC
therefore encompasses entity level, financial as well as
operational controls (Figure 1).

1. COSO Committee of Sponsoring Organisations of the Treadway Commission:
Internal Control – Integrated Framework, May, 2013
2 Standard on Internal Audit (SIA) 120 issued by the Institute of Chartered
Accountants of India
3 Standard on Auditing (SA) 315 ‘Identifying and Assessing the Risks of Material
Misstatement Through Understanding the Entity and its Environment’, issued
by ICAI effective 1st April, 2008

A number of regulatory requirements are in place in the
realm of IC. The Companies Act, 20134 requires the
statutory auditor to report on ‘whether the company has
adequate internal financial controls system in place and
the operating effectiveness of such controls’. It requires
the Board to develop and implement a risk management
policy and identify risks that may threaten the existence
of the company. It imposes overall responsibility on
the Board of Directors with regard to Internal Financial
Controls. The Directors’ Responsibility Statement has to
state that ‘the Directors, in the case of a listed company,
had laid down internal financial controls to be followed by
the company and that such internal financial controls are
adequate and were operating effectively.’ And they have
also devised a proper system to ensure compliance with
the applicable laws and that such systems are operating
effectively. SEBI5 Regulations stipulate the preparation of
a compliance report of all laws applicable to a company
and the review of the same by the Board of Directors
periodically, as well as to take steps (by the company) to
rectify instances of non-compliance and to send reports
on compliance to the stock exchanges quarterly.
Furthermore, listed companies have additional
responsibilities on Internal Controls for Financial Reporting.
A Compliance Certificate is mandated to be signed by the
CEO and CFO to indicate that ‘they accept responsibility for
establishing and maintaining internal controls for financial
reporting and that they have evaluated the effectiveness of
the internal control systems of the listed entity pertaining to
financial reporting and they have disclosed to the auditors
and the audit committee, deficiencies in the design or
operation of such internal controls, if any, of which they are
aware and the steps they have taken or propose to take
to rectify these deficiencies’. The Institute of Chartered
Accountants of India has formulated Standards on Internal
Audit which are a set of minimum requirements that need
to be complied with. Hence, the overall responsibility
for designing, assessing adequacy and maintaining the
operating effectiveness of Internal Financial Controls rests
with the Board and the management (Figure 2).

THE CONTROL S HIERARCHY

Internal Controls is a vast topic in its own right. What we
will examine in this article are the following aspects:
(i) IC in action,
(ii) M anaging Risks, and
(iii) E xcellence in Business

4 The Companies Act, 2013: Sections 134, 143, 149
5 Securities and Exchange Board of India (SEBI) (Listing Obligations and Disclosure
Requirements) Regulations, 2015

Given the enlightened readers’ expert knowledge on the
above, I will dwell on anecdotes from my experience having
been on both sides of the table (auditor as well as auditee)
which could provide perspectives for due consideration.

Internal Controls in action
First, some ground realities:
* IC is commonly perceived as a specialist domain of
auditors whereas fundamentally it is the lookout of every
person in the workforce. Every manager must realise that
s/he has the core responsibility of running operations
consciously abiding by the control parameters. As the
primary owner, every person in charge must provide
assurance that their work domain is under control through
a control self-assessment mechanism;
* IA is perceived as a statutory duty and often deprived
of the credit it deserves. The irony is that this function is
not appreciated when all is well and the first issue to be
frowned upon when something goes amiss!
* O perations get priority and IA, instead of being seen
as a guide and ally to business, is perceived to be an
adversary.

In well-run enterprises there is realisation and
understanding of the importance of IC in running and
growing a sustainable business. Here are some good
practices I have experienced which build and nurture a
healthy control culture in the enterprise.

(i) In Hindustan Unilever (HLL then) there was an
unwritten practice that accountants had to go through a stint in IA. Speaking for myself, I can candidly state that my
appreciation of enterprise-wide business processes grew
during my tenure in Unilever Corporate Audit. I bagged
my first business role to run the Seeds Business in HLL
on the strength of the exposure to various businesses and
functions while in IA. A stint in IA is invaluable in opening
up the mind to the various facets of business;

(ii) U nilever Corporate Audit always reported to the
Board of Unilever and this chain of command percolated
down. In India, we were a resource for the region. IA,
therefore, had the desired independence. Not only did it
give us working exposure in several geographies, we often
worked in teams with members from different countries.
Apart from learning best practices from different parts of
the world, I found the attitude to audit and culture quite
varied. When we came up with issues, in many countries
it would be accepted and debated purely at a professional
level, whereas in some it would be taken as a personal
assault by the auditee! Managing such conflicts by open
communication and objective fieldwork / analytics is a
valuable experience in honing leadership skills;

(iii) IA used to take on deputation team members from
other functions such as Manufacturing, Sales, QA, etc.
This provided a two-pronged advantage. As a primary
owner of controls, such functional members became the
spokespersons for demystifying IA within the organisation.
Equally, these members brought in their domain expertise
to raise the quality within IA, in particular on operational
controls. Involving and engaging team members in
different ways helps in building the control culture;

(iv) A udit always began with a meeting with the Chairman
/ MD / Business Head as the case may be. Not only
did this give a perspective to the business but it also
highlighted for the IA team the priorities and areas where
the business looked for support from IA. This would also
demonstrate the senior leadership’s commitment to IA.
Soon thereafter, we would convert this into a Letter of
Audit Scope outlining the focus areas of the particular
audit. In a sense, it was like giving out the question paper
before the exam! Open communication with the auditee
and a constructive attitude is the core of a productive
outcome.

Managing Risks

At the core of Board functioning in a company is the task
of managing risks. With change and uncertainty being
the order of the day, regulations require listed companies
to have a separate Risk Management Committee at the Board level which is often chaired by an Independent
Director. While identifying and managing financial and
operational risks can be delegated to the management,
the Board focuses on strategic or environmental risks.
A major risk which we find emerging is that of disruptions.
While the other risks which are identified or anticipated can
be reasonably managed, businesses today feel challenged
due to disruptions coming from various quarters. These
could be in the form of Regulatory disruption (e.g. FDI in
multi-brand retail), Market disruption (e- and m-commerce
congruence), Competitive disruption (Jio in the telecom
space), Change in consumer buying behaviour (leasing
or renting vs. buying) or Disruptors in the service space
(Airbnb or Uber). What businesses need to be planning
for is not just combating competition from traditional
competitors, but that coming from the outside as well.

The purport of these external risks become clear, as
pointed out by the World Economic Forum6, as global risks
– an unsettled world, risks to economic stability and social
cohesion, climate threats and accelerated biodiversity
loss, consequences of digital fragmentation, health
systems under new pressures. As for Covid-19, there
were research papers published post the SARS event
warning about such an eventuality. Stretching it further,
even films such as Contagion portrayed this. It is feared
that a number of MSMEs and startups may get seriously
throttled due to this disruption. How seriously do Boards
and managements take the cue from such pointers going
forward and, more important, prepare for such disruptions
is going to be the key in sustaining businesses.

As we learn to work differently during lockdowns, there is
a growing reliance on remote working and heightened use
of technology. Webinars, video chats, video conferences,
e-platforms and Apps have become daily routines and
add another dimension to cyber security, data protection
and data privacy.

In Rallis India Limited, it had been the practice for many
years to have an off-site meeting of the Board devoted
to discussing strategy and long-term plans. It is now
imperative that companies use such fora at a Board and
senior leadership level not only to debate annual and
long-term plans, but also scenario planning simulating
various major risks. These are necessary to strengthen
IC by crafting exhaustive disaster recovery plans not
only for operations or digital disruptions, but also for force majeure events occurring in different magnitudes
across the extended supply chain both within and
externally.

6 World Economic Forum: The Global Risks Report, 2020

Excellence in Business

In the Tata Group, in addition to instilling the Tata Code
of Conduct, all companies adopt the Tata Business
Excellence Model7 (TBEM). Based on the Malcolm
Balridge model of the USA, TBEM encourages Tata
Companies to strive for excellence in every possible
manner. Instituted by Chairman Emeritus Mr. Ratan Tata
in honour of Bharat Ratna Late J.R.D. Tata who embodied
excellence, TBEM is the glue amongst Tata Companies
to share best practices and provide a potent platform
for leadership development. Last year marked the 25th
year of its highest award called the JRD-Quality Value
Award, which was bestowed on companies that reached
a high threshold of business excellence. Rallis won the
JRD-QV Award in 2011 and I benefited hugely having
been an integral part of the TBEM process. This gave
me tremendous perspectives on managing businesses,
especially in the following areas:

(a) T BEM is a wall-to-wall model touching every aspect
of business from leadership to strategy to customer
to results. A trained team comprising members from
different backgrounds and businesses comes together
for an assessment over many man-months. While
assessment is done against a framework, this is not
in the nature of an audit. Evidence and records do not
get as much importance as interactions with people. It
is not uncommon for a team to interact with a thousand
persons connected with the company being assessed,
both workforce as well as other stakeholders. Therefore,
the smell of the company would give a perspective on
governance matters as well. Excellence assessments
is a great discipline for organisations to get an external
assurance on both governance and internal controls;

(b) U nique to TBEM is the practice of having Mentors for
every assessment. I have been privileged to be a longstanding
Mentor. The Mentor essentially assesses the
strategy of the company and also plays the crucial role of
being a bridge between the company and the assessing
team. The Mentor finally presents the assessment finding
to the Chairmen both at the company and at the Group
level. Over the years this has given me exposure to various
industries ranging from steel to battery to insurance to
coffee and retail, not to speak of connecting with scores of people within the Group and beyond. A great tool for
leadership development;

(c) T BEM uses the lens of continuous improvement
to assess businesses. Deep within lies the twin benefit
of this not only sharpening controls but also constantly
improving the effectiveness and efficiency of business
processes. The DNA of excellence in an organisation
leads every individual to keep questioning and enriching
jobs. Excellence is a journey, not a destination and a way
of doing business.

7 www.tatabex.com – About us – Tata Business Excellence Model

Bringing these together

All the three components, viz., risk management, internal
audit and business excellence acting in unison are
crucial to building and nurturing a sustainable business.
In many organisations, however, the degree of maturity
and the level of execution of each of these vary and are
rarely found to be harmoniously in motion. Embedded in
this lies the fact that each of these is driven by different
frameworks, parameters, regulations, formats, reporting systems, teams and so on. A softer aspect is that most
of this is perceived as a theoretical exercise and the
operating management having to fill in tedious forms
while running the business!

Here is an approach (Figure 3) which integrates all
of these driving similar goals and therefore avoiding
repeated exercises involving the operating teams.

The Enterprise Risk Management exercise carried out
across the organisation involving internal and external
stakeholders culminates in the identification of the
environmental, strategic, operational and financial risks
of the business. The Enterprise Process Management
model crafts all the business processes into three
levels which can be aligned and integrated with the
mitigation plans for the risks. These L1, L2 and L3
processes keep getting updated and improved annually
to drive continuous improvement as well as to enhance
controls.

The internal audit self-control checklists as well as audit
plans would be dovetailed with these mitigation plans and
processes. Such an approach will not only ensure that operations are run within the defined control framework
keeping risks within the appetite of the business, but
also strive continuously for excellence as processes
keep improving its efficiencies and effectiveness. This
integrated framework will then flow through populating the
various formats required and help the operating teams
to also address different reviews in a cohesive manner.
Above all, this brings in the desired objective of the entire
workforce viewing and putting into action the entire gamut
of the internal control framework enabling them to register
a superior performance in business.

The Late J.R.D. Tata’s quote sums this up well: ‘One
must forever strive for excellence, or even perfection, in
any task however small, and never be satisfied with the
second best.’

Driving excellence, all businesses will necessarily need
to uphold the highest standards of governance and
internal controls for long-term sustainable value creation,
committed to all stakeholders.

(This article is a sequel to Part 1 published on Page 15 in
BCAJ, March, 2020)

INTERNAL AUDIT ANALYTICS AND AI

INTRODUCTION

Artificial Intelligence (AI) is set to be the key driver of
transformation, disruption and competitive advantage in
today’s fast-changing economy. We have made an attempt
in this article to showcase how quickly that change is
coming, the steps that Internal Auditors need to take to get
going on the AI highway and where our Internal Audits can
expect the greatest returns backed by investments in AI.

1.0 Artificial Intelligence Defined

While there are many definitions of Artificial Intelligence
/ Machine Intelligence, the easiest to comprehend is
about creating machines to do the things that people are
traditionally better at doing. It is the automation of activity
associated with human thinking:
(A) Decision-Making,
(B) Problem-Solving, and
(C) Learning.
A more formal definition would be, ‘AI is the branch of
computer science concerned with the automation of
intelligent behaviour. Intelligence is the computational
ability to achieve goals in the world’.

1.1 Common AI Terms and Concepts

Machine Learning (ML): This is a subset of AI. Machine
Learning algorithms build a mathematical model based
on sample data, known as ‘training data’, in order to
make predictions or decisions without being explicitly
programmed to perform the task.
* Unsupervised ML – Can process information without
human feedback nor prior data exposure;
* Supervised ML – Uses experience with other datasets
and human evaluations to refine learning.

Natural Language Processing (NLP): A sub-field of
linguistics, computer science, information engineering
and artificial intelligence concerned with the interactions
between computers and human (natural) languages, in
particular how to programme computers to process and
analyse large amounts of natural language data. NLP
uses ML to ‘learn’ languages from studying large amounts
of written text. Its abilities include:

(i) Semantics – What is the meaning of words in
context?
(ii) Machine Translation – Translate from one language
to another;
(iii) Name entity recognition – Map words to proper
names, people, places, etc.;
(iv) Natural Language Generation – Create readable
human language from computer databases;
(v) Natural Language Understanding – Convert text
into correct meaning based on past experience;
(vi) Question Answering – Given a human-language
question, determine its answer;
(vii) Sentiment Analysis – Determine the degree of
positivity, neutrality or negativity in a written sentence;
(viii) Automatic Summarisation – Produce a concise
human-readable summary of a large chunk of text.

Neural Network (or Artificial Neural Network): This
is a circuit of neurons with states between -1 and 1,
representing past learning from desirable and undesirable
paths, with some similarities to human biological brains.

Deep Learning: Part of the broader family of ML methods
based on artificial neural networks with representation
learning; learning can be supervised, semi-supervised
or unsupervised. Deep Learning has been successfully
applied to many industries:
(a) Speech recognition,
(b) Image recognition and restoration,
(c) Natural Language Processing,
(d) Drug discovery and medical image analysis,
(e) Marketing / Customer relationship management.

Leading Deep Learning frameworks are PyTorch
(Facebook), TensorFlow (Google), Apache MXNet,
Chainer, Microsoft Cognitive Toolkit, Gluon, Horovod and
Keras.

1.2 AI Concepts – Context Level (Figure 1)
1.3 Artificial Intelligence Challenges

Many challenges remain for AI which need to be managed
effectively:

(1) What if we do not have good training data?
(2) The world is biased, so our data is also biased;
(3) OK with deep, narrow applications, but not with wide ones;
(4) The physical world remains a challenge for computers;
(5) Dealing with unpredictable human behaviour in the wild.

2.0 Global Developments

There has always been excitement surrounding AI. A
combination of faster computers and smarter techniques
has made AI the must-have technology of any business.
At a global scale, the main business drivers for AI are:
(i) Higher productivity, faster work,
(ii) More consistent, higher quality work,
(iii) Seeing what humans cannot see,
(iv) Predicting what humans cannot predict,
(v) Labour augmentation.

2.1 Global Progress on AI – A few examples

2.2 The Internal Audit Perspective

Robotic Process Automation (RPA) is a key business driver for AI in audit in the sense that it has the potential to achieve significant cost savings on deployment. The goal of RPA is to use computer software to automate knowledge workers’ tasks that are repetitive and timeconsuming.

The key features of RPA are:
* Use of existing systems,
* Automation of automation,
* Can mimic human behaviour,
* Non-invasive.

The tasks which are apt for RPA are tasks which are definable, standardised, rule-based, repetitive and ones involving machine-readable inputs.

Sample listing of tasks for RPA:

2.3 Case Study of Application of RPA for Accounts Payable process (Figure 2; See following page)

2.4 AI Audit Framework for Data-Driven Audits (Figure 3; See following page)

3.0 Internal Audit AI in Practice – Case Study RPA Case Study from India:

A leading automobile manufacturer had the following

environment and challenges:

(a) Millions of vendor invoices received as PDF files;

(b) Requirement for invoice automation, repository build,

duplicate pre-check;

(c) Manual efforts were fraught with errors;

(d) PDF to structured data conversion was inconsistent;

(e) Conclusion: A Generic RPA tool was needed.

The solution proposed entailed:

(1) Both audit analytics and RPA being positioned as one solution,

(2) Live feed to the PDF files from diverse vendors,

(3) Extract Transform Load jobs were scheduled for the PDF files,

(4) Duplicate pre-check metrics were built and scheduled,

(5) Potential exceptions were managed through a convenient and collaborative secure email notification management system plus dashboards,

(6) Benefit – 85% reduction in effort and 10x improvement in turnaround time.

4.0 How you can get started on using AI in your

Internal Audits

You can get started on your AI journey in Internal Audit by bringing your analytics directly into the engagement. With AI in Audit the efficiency, quality and value of decisionmaking gets significantly enhanced by analysing all data pan enterprise as one.

Some of the steps you can take to get along in your Audit AI journey are listed below:

(I) Integrate your audit process / lifecycle;

(II) Collaborate with clients on a single platform;

(III) Make every audit a data-driven audit;

(IV) Use data analytics through all phases of projects;

(V) Use RPA where manual work is an obstacle;

(VI) Use Audit Apps where process is well-defined;

(VII) Augment audits with statistical models and Machine Learning;

(VIII) Evolve to continuous monitoring and Deep Learning.

(Adapted from a lecture / presentation by Mr. Jeffery Sorensen, Industry Strategist, CaseWareIDEA Analytics, Canada, with his permission)

COVID-19 AND PRESENTATION OF ‘EXCEPTIONAL ITEMS’

This article
provides guidance on the presentation and disclosure of exceptional items in
the financial statements arising due to Covid-19. Firstly, it is important to
look at the requirements of various authoritative guidances which are given
below:

 

(1)  Schedule III to the Companies Act, 2013
specifically requires a line item for ‘exceptional items’ on the face of the
statement of Profit and Loss (P&L).

(2)  The Securities and Exchange Board of India
Circular dated 5th July, 2016 requires that listed entities shall
follow the Schedule III to the Companies Act, 2013 format for purposes of
presenting the financial results.

(3)  The term ‘exceptional items’ is neither
defined in Schedule III nor in any Ind AS.

(4) Paragraphs 9, 85, 86, 97 and 98 of Ind AS 1 Presentation
of Financial Statements are set out below:

 

9    ‘The objective of financial statements is to
provide information about the financial position, financial performance and
cash flows of an entity that is useful to a wide range of users in making economic
decisions… This information, along with other information in the notes,
assists users of financial statements in predicting the entity’s future
cash flows and, in particular, their timing and certainty.’

85   An entity shall present additional line items
(including by disaggregating the line items listed in paragraph 82), headings
and subtotals in the statement of profit and loss, when such presentation is
relevant to an understanding of the entity’s financial performance.

86   Because the effects of an entity’s various
activities, transactions and other events differ in frequency, potential for
gain or loss and predictability, disclosing the components of financial
performance assists users in understanding the financial performance achieved
and in making projections of future financial performance. An entity includes
additional line items in the statement of profit and loss, and it amends the
descriptions used and the ordering of items when this is necessary to explain
the elements of financial performance. An entity considers factors including
materiality and the nature and function of the items of income and expense. For
example, a financial institution may amend the descriptions to provide
information that is relevant to the operations of a financial institution. An
entity does not offset income and expense items unless the criteria in
paragraph 32 are met.

97   When items of income or expense are material,
an entity shall disclose their nature and amount separately.

     

98   Circumstances that would give rise to the
separate disclosure of items of income and expense include:

(a) write-downs of inventories to net realisable
value or of property, plant and equipment to recoverable amount, as well as
reversals of such write-downs;

(b) restructurings of the activities of an entity
and reversals of any provisions for the costs of restructuring;

(c)   disposals of items of property, plant and
equipment;

(d) disposals of investments;

(e) discontinued operations;

(f)   litigation settlements; and

(g) other reversals of provisions.

 

(5) In December, 2019 IASB issued
an Exposure Draft General Presentation and Disclosures (ED) that, once
finalised, would replace IAS 1 and eventually Ind AS 1. The deadline for
submitting comments is 30th September, 2020. The ED proposes
introducing a definition of ‘unusual income and expenses’ and requiring all
entities to disclose unusual income and expenses in a single note.

 

(6) As per the ED: ‘Unusual income and expenses
are income and expenses with limited predictive value. Income and
expenses have limited predictive value when it is reasonable to expect that
income or expenses that are similar in type and amount will not arise for
several future annual reporting periods.’

 

(7) Paragraph B67-B75 of the application guidance
to the ED provides further explanation of the nature of ‘unusual’ items. In
particular, the following extracts may be noted:

 

‘In
determining whether income or expenses are unusual, an entity shall consider
both the type of the income or expense and its amount. For example, an
impairment loss resulting from a fire at an entity’s factory is normally an
unusual type of expense and hence would be classified as an unusual expense
because in the absence of other indicators of impairment, another similar
expense would not reasonably be expected to recur for several future annual
reporting periods.

 

Income and expenses that are not unusual by type may be unusual in
amount. Whether an item of income or expense is unusual in amount is determined
by the range of outcomes reasonably expected to arise for that income or
expense in several future annual reporting periods. For example, an entity that
incurs regular litigation costs that are all of a similar amount would not
generally classify those litigation expenses as unusual. However, if in one
reporting period that entity incurred higher litigation costs than reasonably
expected because of a particular action, it would classify the costs from that
action as unusual if litigation costs in several future annual reporting
periods were not expected to be of a similar amount. The higher litigation
costs are outside the range of reasonably expected outcomes and not predictive
of future litigation costs.’

 

(8) The ED also supports the conceptual concerns
raised by certain stakeholders about the presentation of exceptional items as a
separate line item in the P&L statement rather than in the notes. The
following may be particularly noted:

 

The Board
proposes that information about unusual income and expenses should be disclosed
in the notes rather than presented in the statement(s) of financial
performance. The Board concluded that disclosure in the notes would enable
entities to provide a more complete description and analysis of such income and
expenses. Disclosure in the notes also provides users of financial statements
with a single location to find information about such income and expenses and
addresses some stakeholders’ concerns that unusual income and expenses may be
given more prominence than other information in the statement(s) of financial
performance.

 

Some
stakeholders suggested that, given the importance some users of financial
statements attach to the disclosure of unusual income and expenses, operating
profit before unusual income and expenses should be added to the list of
subtotals specified by IFRS Standards and the requirements relating to analysis
of operating expenses by function or by nature adjusted accordingly. In their
view, no longer being able to present an operating profit subtotal before
unusual items would be a significant step back from current practice. The Board
has not proposed adding this subtotal because, in some cases, presentation of
an operating profit before unusual income and expenses subtotal could result in
a presentation that mixes natural and functional line items. Users have told
the Board that they do not find mixed presentation useful and want to see all
operating expenses analysed by one characteristic (nature or function).

 

AUTHOR’S ANALYSIS AND CONCLUSIONS

The two
fundamental questions that need to be answered are as follows:

(i)   What items are included as exceptional items?

(ii)   Whether an exceptional item is presented as a
separate line item in the P&L or only described in the notes?

 

Before we start
addressing the above questions, the following points may be kept in mind:

(a) Exceptional items may arise from Covid or
non-Covid factors or a combination of both. For example, the fall in oil prices
may be due to Covid as well as trade wars between oil-producing countries.

(b) The separate presentation of exceptional item
in the P&L is required by both SEBI and Schedule III.

(c)   The two factors / tests that dominate whether
an item is exceptional are the size of the item (‘materiality test’) and the
predictive value (‘predictability test’). For example, by presenting a non-recurring
item as exceptional, investors can exclude those exceptional items in making
future projections of the performance. This aspect is also clear in the IASB’s
ED. At this point in time, the pandemic should be considered to be unusual and
non-recurring and will meet the test in the ED.

 

(d) Whilst Schedule III and SEBI require separate
presentation of exceptional items, there are a few anomalies which are listed
below:

(i)   The presentation of exceptional item as a
separate line item results in a mixed presentation. For example, presentation
of losses on inventory due to marking them down to net realisable value as
exceptional item results in cost of sales division into two separate line
items.

(ii)   An item of expense or loss may be caused by
both exceptional and non-exceptional factors. Segregating between what is
exceptional and what is not exceptional may be challenging. For example,
consider that the value of investment in an equity mutual fund at December-end
was Rs. 100. Prior to the outbreak / lockdown the value had gone up to Rs. 110.
On 31st  March, 2020 the value
had fallen to Rs. 85. Consequently, a net loss of Rs. 15 is included in the
P&L for the last quarter. This theoretically may be represented in two
ways, (a) Rs. 15 is an exceptional item, or (b) Rs. 25 is an exceptional item
and Rs. 10 is income from normal gains. Putting it simply, determining what is
exceptional can be very arbitrary in this case, because it involves determining
an arbitrary cut-off date. It also results in a mixed presentation when one
item is segregated into two different components. In this given case, the
author believes that Rs. 15 should be considered as an exceptional item and the
segregation was done to merely illustrate the point.

 

(e)   Given the specific
requirement of SEBI and Schedule III, it may not be incorrect to disclose a
material and non-recurring item as exceptional on the face of the P&L.
However, a better option would be not to present an exceptional item in the
P&L because it results in a mixed presentation and arbitrariness in
segregating an item as exceptional and not exceptional. Rather, exceptional
items may be more elaborately described in the notes to accounts.

 

Table
1

 

Expenditure

Author’s evaluation of exceptional and
non-exceptional

Impairment

For many enterprises, impairment is
non-recurring. Therefore, the same may be presented as exceptional items if
those are material, irrespective of whether they are caused due to Covid or
non-Covid factors

Incremental costs
due to Covid

If the costs are incremental to costs incurred
prior to the Covid outbreak and not expected to recur once the crisis has
subsided and operations return to normal, and clearly separable from normal
operations, they may be presented as an exceptional item. Temporary premium
payments to compensate employees for performing their normal duties at
increased personal risk, charges for cleaning and disinfecting facilities
more thoroughly and / or more frequently, termination fees or penalties for
terminated contracts or compliance with contractual provisions invoked
directly due to the events of the pandemic, may be both incrementally
incurred as a result of the coronavirus outbreak and separable from normal
operations. On the other hand, payments to employees for idle time, rent and
other recurring expense (e.g., security, utilities insurance and maintenance)
related to temporarily idle facilities, excess capacity costs expensed in the
period due to lower production, paying employees for increased hours required
to perform their normal duties and paying more for routine inventory costs
(e.g., shipping costs) will generally not be incremental and separable and
should not be presented as exceptional items

Provision for
doubtful debts

Provisions for doubtful debts are determined using
the expected credit loss method (ECL). The forward-looking projections in the
ECL model may be adjusted to reflect the post-Covid economic situation.
Generally, it will be difficult to segregate the overall ECL between those
that are Covid-caused and others. Besides, a higher ECL may be expected, on a
go forward basis, because Ind AS 109 specifically requires the ECL model to
be adjusted for forward-looking information. Consequently, it is difficult to
argue that a higher ECL provision will be a non-recurring feature. Therefore,
the provisions should not be identified as an exceptional item

Suspension of capitalisation of borrowing cost
due to Covid lockdown

There can be two views on this matter. Due to
suspension, the borrowing costs incurred during construction of an asset may
be expensed rather than capitalised. Consequently, the expense will impact
the P&L all at once. Had the interest expenditure been capitalised, had
there been no Covid, the expense would have been reflected by way of future
depreciation charge. As a result, since the expenditure is in any case
incurred, there is no exceptional item. The alternative view is that because
of the lockdown the interest expenditure is impacting the P&L all at
once. Since such expenditure is non-recurring the same may be presented as an
exceptional item

Litigation costs

Is the litigation caused due to Covid? For
example, there is clear evidence that the contract delay was due to Covid and
the customer is litigating on the same? Legal costs incurred to defend the
entity’s position may be presented as an exceptional item. Similarly, advice
from counsel on force majeure clauses in contracts may be considered
to be exceptional. These items may be presented as an exceptional item

Write-off / write-down
of inventories

If this meets the materiality test and the
predictability test, it may be presented as an exceptional item

Losses due to fall in NAV of investments made in
mutual
funds (MF)

If this meets the materiality test and the
predictability test, it may be presented as an exceptional item

Restructuring costs

Costs incurred on downscaling of operations if
caused due to Covid may be presented as an exceptional item

Onerous contracts

If this meets the materiality test and the
predictability test, it may be presented as an exceptional item

Severance pay for premature termination of
employment

Normal salary cost paid for lockdown period will
generally not pass the tests because salary is a recurring cost. However,
severance pay may be non-recurring in nature, whether caused due to Covid or
otherwise, and hence may be presented as an exceptional item

 

 

For the
purposes of providing additional guidance, the following indicative list of
expenditures is evaluated from the perspective of whether those are
exceptional, from the prism of the principles described above. The assumption
is that the items discussed in Table 1 (on the previous page) are
material to the specific entity.

 

The fundamental challenge in
identifying an exceptional item is that it results in arbitrariness due to
segregating an item into two separate components and a mixed presentation. Therefore,
it is suggested that the items discussed above which are identified as
exceptional items may be presented as such with an elaborate description in the
notes to the accounts.

 

It is not uncommon for
entities to supplement the EPS figures required by Ind AS 33 by voluntarily
presenting additional amounts per share, for example, profits before and after
exceptional items. For additional earnings per share amounts, the standard
requires:

(I)    that the denominator used should be that
required by Ind AS 33;

(II)   that basic and diluted amounts be disclosed
with equal prominence and presented in the notes;

(III) an indication of the basis on which the
numerator is determined, including whether amounts per share are before or
after tax; and

(IV) if the numerator is not reported as a line item
in the statement of comprehensive income or separate statement of P&L, a
reconciliation to be provided between it and a line item that is reported in
the statement of comprehensive income [Ind AS 33.74].

 

Alternative EPS figures may
be presented on the face of the P&L as well as in the notes.  

 

PRACTICAL GUIDANCE – DETERMINATION OF LEASE TERM FOR LESSEE

Determining the lease term under Ind AS 116 Leases can be a very
complex and judgemental exercise. For purposes of evaluating the lease term,
one needs to understand the interaction between the non-cancellable period in a
lease, the enforceable period of the lease and the lease term. Lease term is
determined at the inception of the contract. An entity shall revise the lease
term if there is a change in the non-cancellable period of a lease.

 

Note: The determination of lease term under Ind AS 116 is very crucial
because it impacts the determination of (1) whether a lease is a short-term
lease – if it is a short-term lease, practical expediency is available not to
apply the detailed recognition requirements of the standard applicable to a
non-short-term lease, (2) the lease term also determines the amount of the
right of use asset (ROU) and the lease liability on the balance sheet.
Subsequent depreciation and finance charges are also impacted by the amount
capitalised on account of the ROU asset and the lease liability.

 

The concepts are described in detail below under three broad steps.

 

STEP
1 – DETERMINE THE ENFORCEABLE PERIOD

A contract is defined as ‘An agreement between two or more parties that
creates enforceable rights and obligations.’

 

(Para B34) In determining the lease term and assessing the length of the
non-cancellable period of a lease, an entity shall apply the definition of a
contract and determine the period for which the contract is enforceable. A
lease is no longer enforceable when both the lessee and the lessor have the right to terminate the lease without permission from the other
party with no more than an insignificant penalty.

IFRIC observed (see IFRIC update June, 2019, Agenda Paper 3, Lease
term and useful life of leasehold improvements IFRS 16 Leases and IAS 16
Property, Plant and Equipment) that, in applying paragraph B34 (above) of
IFRS 16 and determining the enforceable period of the lease, an entity
considers:

(a) the economics of the contract. For example, if either party has an
economic incentive not to terminate the lease and thus would incur a
penalty on termination that is more than insignificant, the contract is
enforceable beyond the date on which the contract can be terminated; and

(b) whether each of the parties has the right to terminate the
lease without permission from the other party with no more than an
insignificant penalty. If only one party has such a right, the contract is
enforceable beyond the date on which the contract can be terminated by that
party.

 

Therefore, when either party has the right to terminate the contract
with no more than insignificant penalty, there is no longer an enforceable
contract. However, when one or both parties would incur a more than
insignificant penalty by exercising its right to terminate, the contract
continues to be enforceable. The penalties should be interpreted broadly to
include more than simply cash payments in the contract. The wider
interpretation considers economic disincentives. If an entity concludes that
the contract is enforceable beyond the notice period of a cancellable lease (or
the initial period of a renewable lease), it then applies paragraphs 19 and
B37-B40 of IFRS 16 to assess whether the lessee is reasonably certain not to
exercise the option to terminate the lease.

 

Author’s note: These
clarifications should equally apply to Ind AS, as IFRIC deliberations and
conclusions are global and robust.

 

Example – Enforceable
period

A lease contract of a retail outlet in a shopping mall allows for the
lease to continue until either party gives notice to terminate the contract.
The contract will continue indefinitely (but not beyond ten years) until the
lessee or the lessor elects to terminate it and includes stated consideration
required during any renewed periods (referred to as ‘cancellable leases’).  Neither the lessor nor the lessee will incur
any contractual cash payment or penalty upon exercising the termination right.
The lessee constructs leasehold improvements, which cannot be moved to another
premise. Upon termination of the lease, these leasehold improvements will need
to be abandoned, or dismantled. Can the lease term go beyond the date at which
both parties can terminate the lease (inclusive of any notice period)?

 

In the fact pattern above, while the lease can be terminated early by
either party after serving the notice period, the enforceable rights in the
contract (including the pricing and terms and conditions) contemplate the
contract can continue beyond the stated termination date (but not beyond ten
years), inclusive of the notice period. There is an agreement which meets the
definition of a contract (i.e., an agreement between two or more parties that
creates enforceable rights and obligations). However, the mere existence of
mutual termination options does not mean that the contract is automatically
unenforceable at a point in time when a potential termination could take
effect. Ind AS 116.B34 provides explicit guidance on when a contract is no
longer enforceable – ‘a lease is no longer enforceable when the lessee and
the lessor each has the right to terminate the lease without permission from
the other party with no more than an insignificant penalty.’ The penalties
should be interpreted broadly to include more than simply cash payments in the
contract. The wider interpretation considers economic disincentives.

 

In the above example, the enforceable period is ten years, i.e., if
either party has an economic incentive not to terminate the lease and
thus would incur a penalty on termination that is more than insignificant, the
contract is enforceable beyond the date on which the contract can be
terminated.

 

The fact pattern includes an automatic renewal up to a period of ten
years. The agreement could have been drafted as a one-year contract with a
fixed nine-year renewal period (setting out detailed terms and conditions of
renewal), which either party could have terminated. In either of these fact
patterns, if there is more than an insignificant penalty for either of the
parties for the period of ten years, the enforceable period will be ten years.
This assessment should be carried out at the inception of the contract.

 

STEP
2 – DETERMINE THE LEASE TERM

Extract of Ind AS 116:

18 An entity shall determine
the lease term as the non-cancellable period of a lease, together with both:

(a) periods covered by an option to extend the lease if the lessee is
reasonably certain to exercise that option; and

(b) periods covered by an option to terminate the lease if the lessee is
reasonably certain not to
exercise that option.

19 In assessing whether a
lessee is reasonably certain to exercise an option to extend a lease, or not to
exercise an option to terminate a lease, an entity shall consider all relevant
facts and circumstances that create an economic incentive for the lessee to
exercise the option to extend the lease, or not to exercise the option to
terminate the lease, as described in paragraphs B37–B40.

B34 In determining
the lease term and assessing the length of the non-cancellable period of a
lease, an entity shall apply the definition of a contract and determine the
period for which the contract is enforceable. A lease is no longer enforceable
when the lessee and the lessor each has the right to terminate the lease
without permission from the other party with no more than an insignificant
penalty.

B35 If only a
lessee has the right to terminate a lease, that right is considered to be an
option to terminate the lease available to the lessee that an entity considers
when determining the lease term. If only a lessor has the right to terminate a
lease, the non-cancellable period of the lease includes the period covered by
the option to terminate the lease.

B37… entity
considers all relevant facts and circumstances that create an economic
incentive for the lessee to exercise, or not to exercise, the option (Ind AS
116.19, Ind AS 116.B37-B40):

* contractual terms and conditions for the optional periods compared
with market rates

* significant leasehold improvements

* costs relating to the termination of the lease

* the importance of that underlying asset to the lessee’s operations

* conditionality associated with exercising the option

 

To determine the lease term, the parties would apply Ind AS 116.18-19
and B37-40 (i.e., the reasonably certain threshold). ‘Reasonably certain’ is a
high threshold and the assessment requires judgement. It also acknowledges the
guidance in Ind AS 116.B35 which indicates that the lessor termination options
are generally disregarded. If only a lessor has the right to terminate a lease,
that is disregarded to determine the lease term, because the lessee does not
have an unconditional right to avoid its obligation to continue with the lease.

 

Example – Lease term

Incremental facts to the previous example are that the mandatory
non-cancellable period is one year and notice period is two months. In this
example, it is possible that the lease term may exceed the one year and two
months period. The lease term is one year and two months plus the period
covered by the termination option that it is reasonably certain the lessee will
not exercise such termination option. However, the lease term cannot be no
longer than the period the contract is enforceable, i.e. ten years. The lease
term therefore, will fall between one year two months and ten years.

 

STEP
3 – CONSIDER INTERACTION BETWEEN ENFORCEABLE PERIOD AND LEASE TERM

Consider the following lease contract:

# Lock-in period is one year

# Contract is for ten years and will be auto renewed for a year for next
nine years after lock-in period of one year

# The terms and conditions of the auto renewal are clearly spelt out in
the contract

# Either party can cancel the contract by giving two months’ notice
after lock-in period without paying any monetary penalty.

 

In the above example, the non-cancellable period is
one year. The enforceable period is dependent upon whether either party is
incurring more than an insignificant penalty. If neither party is incurring
more than an insignificant penalty, the enforceable period is one year
(non-cancellable period) and two months (notice period). However, if either
party is incurring more than an insignificant penalty, the enforceable period
is ten years (total contract period). The enforceable period could have been
greater than ten years if the contract had a further renewal clause and the
terms and conditions of the auto renewal are clearly spelt out in the contract.
The lease term will fall between the non-cancellable period and the enforceable
period. It cannot be greater than the enforceable period. For example, if the
lessee has made significant investment by way of leasehold improvement, and the
life of the improvement is eight years, the lease term may be eight years,
subject to other facts. If, however, the life of leasehold improvements is ten
years, then there may be significant disincentive for the lessee to walk away
from the lease earlier than ten years, and the lease term may be ten years,
subject to evaluation of other facts.

 

The above thought process is captured in the table below.

 

ILLUSTRATIVE
EXAMPLES

Query

3Z Co (lessee) enters into arrangements for lease of warehouses for a
period of one year. The lease agreement does not provide any purchase option in
respect of the leased asset, but 3Z has a right to renew for one additional
year. Consider two scenarios: (a) right of renewal does not require permission
of the lessor; (b) right of renewal requires permission of the lessor. Whether
the recognition exemption for short-term leases is available to 3Z?

 

Response

Whether the short-term lease exemption applies depends on what the lease
term is and if that term is one year or less. First, one should determine the
enforceable period. If either party has an economic incentive not to terminate
the lease and thus would incur a penalty on termination that is more than
insignificant, the contract is enforceable beyond the date on which the
contract can be terminated. Assuming that there is economic disincentive for
one of the parties (either lessee or lessor), the enforceable period is two
years in both the scenarios.

 

The next step is to determine the lease term. In assessing whether a
lessee is reasonably certain to exercise an option to extend a lease, or not to
exercise an option to terminate a lease, an entity shall consider all relevant
facts and circumstances that create an economic incentive for the lessee to exercise
the option to extend the lease, or not to exercise the option to terminate the
lease. If only the lessor has the right to terminate a lease, that is
disregarded to determine the lease term, because the lessee does not have an
unconditional right to avoid its obligation to continue with the lease.
Consequently, in both the scenarios the lease term could range between one and
two years. If the lease term is greater than one year, the lease would not
qualify for short-term exemption.

 

Query

Scenario 1

Lessee entered into a lease arrangement with lessor for an overhead line
facility with Indian Railways across their railway track for a period of ten
years. Lessee paid in advance the rentals for the entire period of ten years.
The arrangement does not grant lessee with tenancy or right or interest in the
land. Based on past experience, the lessor will renew the contract for another
ten years at the end of the contract period. The following are some of the
principal terms of agreement:

 

(i)    Either
party can terminate the contract by giving one month’s notice and no monetary
penalty will apply.

(ii)   Lessor
reserves full rights on the land below the overhead line facility.

(iii) If
lessor gives termination notice, lessee at its own cost shall remove the overhead
line and shall restore the railway land to its original condition. Lessor has
given notice to lessees to shift transmission lines from railway land only in a
few rare and unusual cases.

(iv) Lessee
is reasonably certain to continue the lease till the validity of transmission
licence, i.e. 30 years since shifting of transmission lines will affect its
business adversely.

(v)   There
are no renewal options beyond ten years and a new agreement will need to be
entered into between the lessor and the lessee, and the terms and conditions
with respect to the new agreement will have to be agreed upon by both parties
at that point in time.

 

Will the lease qualify as a short-term lease?

 

Scenario 2

Consider the same fact pattern as above, with some
changes. Beyond the ten-year period, the contract includes an automatic renewal
option whereby the contract will automatically continue for an additional term
of 20 years, unless either party terminates the contract. What will be the
lease term in this fact pattern?

 

Response

Scenario 1

If one or both parties would incur a more than
insignificant penalty by exercising its right to terminate – the contract
continues to be enforceable over the ten-year period. The penalties should be
interpreted broadly to include more than simply cash payments in the contract.
The wider interpretation considers economic disincentives. The following
factors prima facie suggest that at the commencement date, the lessee is
not likely to have an economic incentive to exercise the termination option:

(a)   Lessee
expects to operate the transmission line beyond ten years.

(b)   It is
unlikely that the lessee will be able to locate an alternative location that
fulfils its requirements. Such open spaces will generally be available only
with Indian Railways. If at all an alternative location is available, it may
involve a considerable increase in the length of the transmission line and may
therefore involve considerable additional cost.

(c)   If at
all relocation is possible, the relocation may entail significant additional
costs and the benefit of obtaining alternative location at lower lease rentals
may not be worth it.

(d) In case
premature termination by the lessee results in the lessor forfeiting a significant
part of the advance lease rental payment, this would be an additional factor
providing economic incentive to the lessee to not terminate the lease
prematurely.

 

The enforceable period will therefore be ten years,
irrespective of whether the lessor will incur more than an insignificant
penalty or not by terminating the contract. The next step is to determine the
lease term. An entity shall determine the lease term as the non-cancellable
period of a lease, together with the periods covered by an option to extend the
lease if the lessee is reasonably certain to exercise that option.
Interestingly, under Ind AS 116, the legal enforceability of the option from
the perspective of the lessor is not relevant. In other words, the lessor may
refuse to extend the lease and may cancel the lease during the ten-year period,
or at least has the ability to cancel the lease at any time during the ten-year
period. However, in determining the lease term, the lessor’s rights are not
relevant. Consequently, based on the facts in the given case, the lease term
will be ten years and will not qualify for short-term exemption.

 

Scenario 2

In the second scenario, the same assessment as in
Scenario 1 is relevant. However, in this scenario the contract will be
automatically renewed for another 20 years unless either of the party walks
away from the contract. As mentioned above, in determining the lease term, the
lessor’s rights are not relevant. An entity will consider the factors described
in B37. From the available information it appears that the lessee will continue
for 30 years, beyond which there are no additional renewal or automatic renewal
clauses. The lease term could therefore be 30 years, subject to further
analysis of detailed facts.

 

Query

A part of the transmission line of El Co passes through private land
(not owned by Indian Railways). El enters into a lease agreement with the
private land owner for a period of 12 months for overhead facility. The
following are some of the principal terms of agreement:

(i)    There
are no renewal or automatic renewal clauses and the lease can be renewed or
cancelled with the mutual consent of both the parties.

(ii)   Either
party shall be at liberty to put an end to the arrangement by giving one-month
previous notice in writing to that effect and in the event of such a notice
neither of the party shall have any claim for any compensation whatsoever.

 

It is likely that the contract will be renewed for another one year at
the expiry of its current term. The lease agreement does not provide any
purchase option in respect of the leased asset to the lessee. The lessee is
reasonably certain to continue the lease till the validity of transmission
licence, i.e. 30 years, since shifting of transmission lines will affect its
business adversely. Whether the short-term lease exemption will apply?

 

Response

The lease agreement to allow overhead transmission lines is for a period
of 12 months. The agreement does not grant a renewal, auto-renewal or extension
or purchase option to the lessee. Accordingly, the lease qualifies as a
‘short-term lease’, notwithstanding the fact that upon expiry of each 12-month
period there is high degree of certainty that the lease will be renewed for a
further period of 12 months by mutual consent between the lessor and the lessee
at that point in time. The lessee can, therefore, avail the exemption of not
applying the lessee accounting model of the standard to the lease and instead
account for the lease as per paragraph 6 of Ind AS 116. As per paragraph 6, the
lessee recognises the lease payments as an expense on a straight-line basis
over the lease term or another systematic basis.  

 

           

 

 

ACCOUNTING FOR CRYPTOCURRENCY

In June, 2019 the IFRIC decided on
the interesting issue of accounting for cryptocurrency. The IFRIC applies to
cryptocurrency that has the following characteristics:

 

i.   a
digital or virtual currency recorded on a distributed ledger that uses
cryptography for security;

ii.   not
issued by a jurisdictional authority or other party; and

iii.  does not give rise to a contract between the holder and another
party.

 

Ind AS 38 Intangible Assets
applies in accounting for all intangible assets except:

 

a. those that are within the scope
of another Standard;

b. financial assets, as defined in
Ind AS 32 Financial Instruments: Presentation;

c. the recognition and measurement
of exploration and evaluation assets; and

d. expenditure on the development and extraction of minerals, oil, natural
gas and similar non-regenerative resources.

 

A financial asset is any asset that
is: (a) cash; (b) an equity instrument of another entity; (c) a contractual
right to receive cash or another financial asset from another entity; (d) a
contractual right to exchange financial assets or financial liabilities with
another entity under particular conditions; or (e) a particular contract that
will or may be settled in the entity’s own equity instruments.

 

Cash is a financial asset because
it represents the medium of exchange and is therefore the basis on which all
transactions are measured and recognised in financial statements. A deposit of
cash with a bank or similar financial institution is a financial asset because
it represents the contractual right of the depositor to obtain cash from the
institution or to draw a cheque or similar instrument against the balance in
favour of a creditor in payment of a financial liability. Consequently, cash is
expected to be used as a medium of exchange (i.e. used in exchange for goods or
services) and as the monetary unit in pricing goods or services to such an
extent that it would be the basis on which all transactions are measured and
recognised in financial statements.

 

Though some cryptocurrencies can be
used in exchange for goods or services, they are not used to such an extent
that it would be the basis on which all transactions are measured and
recognised in financial statements. Consequently, in the present times
cryptocurrency is not cash. Neither is a cryptocurrency an equity
instrument of another entity. It does not give rise to a contractual right for
the holder and it is not a contract that will or may be settled in the holder’s
own equity instruments.

 

Ind AS 2 Inventories applies
to inventories of intangible assets. Paragraph 6 of that Standard defines
inventories as assets:

 

1.  held
for sale in the ordinary course of business;

2.  in
the process of production for such sale; or

3.  in
the form of materials or supplies to be consumed in the production process or
in the rendering of services.

 

If an entity holds cryptocurrencies
for sale in the ordinary course of business, the general requirements of Ind AS
2 apply to that holding. However, a broker-trader of cryptocurrencies, who buys
or sells commodities for others or on their own account, will measure their
inventories at fair value less cost to sell [Ind AS 2.3(b)].

 

IFRIC CONCLUSION

Paragraph 8 of Ind AS 38 defines an
intangible asset as ‘an identifiable non-monetary asset without physical substance’.
Paragraph 12 of Ind AS 38 states that an asset is identifiable if it is
separable or arises from contractual or other legal rights. An asset is
separable if it ‘is capable of being separated or divided from the entity and
sold, transferred, licensed, rented or exchanged, either individually or
together with a related contract, identifiable asset or liability’. Paragraph
16 of Ind AS 21 The Effects of Changes in Foreign Exchange Rates states
that ‘the essential feature of a non-monetary item is the absence of a right to
receive (or an obligation to deliver) a fixed or determinable number of units
of currency’. IFRIC concluded that a holding of cryptocurrency meets the
definition of an intangible asset in Ind AS 38 because (a) it is capable of being
separated from the holder and sold or transferred individually; and (b) it does
not give the holder a right to receive a fixed or determinable number of units
of currency. IFRIC also concluded that Ind AS 2 applies to cryptocurrencies
when they are held for sale in the ordinary course of business. If Ind AS 2 is
not applicable, an entity applies Ind AS 38 to holdings of cryptocurrencies.

 

In addition to other disclosures
required by Ind AS Standards, an entity is required to disclose any additional
information that is relevant to an understanding of its financial statements
(paragraph 112 of Ind AS 1 Presentation of Financial Statements). An
entity provides the disclosures required by (i) paragraphs 36–39 of Ind AS 2
for cryptocurrencies held for sale in the ordinary course of business; and
(ii) paragraphs 118–128 of Ind AS 38 for holdings of cryptocurrencies to which
it applies Ind AS 38. If an entity measures holdings of cryptocurrencies at
fair value, paragraphs 91–99 of Ind AS 113 Fair Value Measurement
specify applicable disclosure requirements.

 

Applying paragraph 122 of Ind AS 1,
an entity discloses judgements that its management has made regarding its
accounting for holdings of cryptocurrencies if those are part of the judgements
that had the most significant effect on the amounts recognised in the financial
statements. Paragraph 21 of Ind AS 10 Events after the Reporting Period
requires an entity to disclose details of any material non-adjusting events,
including information about the nature of the event and an estimate of its
financial effect (or a statement that such an estimate cannot be made). For
example, an entity holding cryptocurrencies would consider whether changes in
the fair value of those holdings after the reporting period are of such significance
that non-disclosure could influence the economic decisions that users of
financial statements make on the basis of the financial statements.  

 

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ACCOUNTING OF E-WASTE OBLIGATION

The E-waste (Management) Rules, 2016 (“Rules”), as amended,
impose e-waste obligations on manufacturers of electrical and electronic goods
who have placed any goods in the market in the current financial year. The
collection, storage, transportation, segregation, refurbishment, dismantling,
recycling and disposal of e-waste shall be in accordance with the guidelines
published by the Central Pollution Control Board.

 

The purpose of this article is not to dive deep into the
legislation, but to explain the accounting consequences with a simplified
example.

 

Consider a refrigerator manufacturer that has been in
manufacturing for many years; it has the following e-waste obligations under
the Rules:

Obligation for financial year

(the measurement period)

Quantum of
e-waste obligation

Expected cost (Rs. million)

2018-19

10% of
refrigerators sold in 2008-09

50

2019-20

20% of
refrigerators sold in 2009-10

110

2020-21

30% of
refrigerators sold in 2010-11

200

2021-22

40% of
refrigerators sold in 2011-12

310

2022-23

50% of
refrigerators sold in 2012-13

415

2023-24

60% of
refrigerators sold in 2013-14

550

2024-25

70% of
refrigerators sold in 2014-15

690

2025-26

70% of
refrigerators sold in 2015-16

750

2026-27

70% of
refrigerators sold in 2016-17

850

2027-28

70% of
refrigerators sold in 2017-18

990

 

 

4,915

 

If the manufacturer participated in the market in the current
financial year (2018-19), its obligation is determined with reference to 10% of
the refrigerators sold in the preceding 10th year (2008-09) and the
cost is estimated at Rs. 50 million. As can be seen from the above table, the
liability increases substantially over the years due to volume increases (i.e.,
the number of refrigerators sold each year keeps increasing) and the percentage
applied under the Rules also increases steeply. The question that arises is, is
a provision of Rs. 4,915 million required for the year end 2018-19?

 

The main argument for supporting a provision of Rs. 50
million is that the obligating event is the participation in the market for the
financial year 2018-19 (the measurement period), and the cost of fulfilling the
obligation is determined by reference to the year 2008-09 under the Rules. On
this basis, the cost of obligation is Rs. 50 million, and should be provided
for, unless it has already been expended and charged to P&L.

 

The main argument for supporting a provision of Rs. 4,915
million is that the obligating event is all the sales made in the past, rather
than participation in the market for the current financial year. A provision of
Rs. 4,915 million will ensure that cost related to all previous years’ sales
are provided for. Accordingly, any costs including future costs for sales
already made are recognised. Consequently, the sales and the accompanying cost
of those sales are matched and recognised in the same period, thereby ensuring
that matching principles are followed.

 

Appendix B, Liabilities arising from Participating in a
Specific Market – Waste Electrical and Electronic Equipment of Ind AS 37 Provisions,
Contingent Liabilities and Contingent Assets deals with the accounting and
is discussed below. At a global level this issue was discussed and led to
issuance of IFRIC 6 Liabilities arising from Participating in a Specific
Market – Waste Electrical and Electronic Equipment, on the basis of which
Appendix B was developed.

 

What constitutes the obligating event in accordance with
paragraph 14(a) of Ind AS 37 for the recognition of a provision for waste
management costs:

  • the manufacture or sale of the
    historical household equipment?
  • participation in the market
    during the measurement period?
  • the incurrence of costs in the
    performance of waste management activities?

 

Paragraph 17 of Ind AS 37 specifies that an obligating
event is a past event that leads to a present obligation that an entity has no
realistic alternative to settling. Paragraph 19 of Ind AS 37 states that
provisions are recognised only for “obligations arising from past events
existing independently of an entity’s future actions”.

 

Participation in the market during the measurement period is
the obligating event in accordance with paragraph 14(a) of Ind AS 37. As a consequence, a liability for waste
management costs for historical household equipment does not arise as the
products are manufactured or sold. Since the obligation for historical
household equipment is linked to participation in the market during the
measurement period, rather than to production or sale of the items to be
disposed of, there is no obligation unless and until a market share exists
during the measurement period.

 

The International Financial Reporting Interpretations
Committee (IFRIC) considered an argument that manufacturing or selling products
constitutes a past event that gives rise to a constructive obligation.
Supporters of this argument emphasise the definition of a constructive
obligation in paragraph 10 of IAS 37 and point out that in determining whether
past actions of an entity give rise to an obligation, it is necessary to
consider whether a change in practice is a realistic alternative. These
respondents believed that when it would be necessary for an entity to take some
unrealistic action in order to avoid the obligation then a constructive
obligation exists and should be accounted for.

 

The IFRIC rejected this
argument, concluding that a stated intention to participate in a market during
a future measurement period does not create a constructive obligation for
future waste management costs. IFRIC felt that in accordance with paragraph 19
of Ind AS 37, a provision can be recognised only in respect of an obligation
that arises independently of the entity’s future actions. If an entity has no
market share in a measurement period, it has no obligation for the waste
management costs relating to the products of that type which it had previously
manufactured or sold and which otherwise would have created an obligation in
that measurement period. This differentiates waste management costs, for
example, from warranties, which represent a legal obligation even if the entity
exits the market. Consequently, no obligation exists for the future waste
management costs until the entity participates in the market during the
measurement period.

 

Some constituents asked
the IFRIC to consider the effect of the following possible national
legislation: the waste management costs for which a producer is responsible
because of its participation in the market during a specified period (for
example, 20X6) are not based on the market share of the producer during that period but on the producer’s
participation in the market during a previous period (for example, 20X5). The
IFRIC noted that this affects only the measurement of the liability and that
the obligating event is still participation in the market during 20X6.

 

The IFRIC considered whether its conclusion is undermined by
the principle that the entity will continue to operate as a going concern. If
the entity will continue to operate in the future, it treats the costs of doing
so as future costs. For these future costs, paragraph 18 of Ind AS 37
emphasises that financial statements deal with the financial position of an
entity at the end of its reporting period and not its possible position in the
future. Therefore, no provision is recognised for costs that need to be
incurred to operate in the future.

 

On the basis of the above discussions, under Appendix B of
Ind AS 37, a provision of only Rs. 50 million is required in 2018-19 (unless
the amount is already expended), which should be charged to the P&L.

SETTING UP THE INTERNAL AUDIT FUNCTION

Internal Audit is an important function within an
organisation. In the present context of increasing emphasis on good governance,
the need for well-defined risks and controls framework, the focus on prevention
rather than detection and desire for a strong compliance culture, there is an
urgent need to ensure that the Internal Audit function has been set up with due
thought process.

 

This article highlights some of the key areas that require
attention while setting up the Internal Audit function in an organisation.
For organisations that already have such a function, there may be a need to
revisit the manner in which it has been set up and make suitable changes to
ensure that the Internal Audit function is engineered to perform effectively.

 

The management of the company while setting up the Internal
Audit function has to take a few key decisions:

 

  • Organisational placement: Who will IA
    report to?
  • Structure: Will IA be an in-house
    function, a totally outsourced function or a co-sourced function?
  • Team composition and location: What
    skill sets will be required for the IA team? How should the team be selected /
    sourced?
  • Scope: How will the scope of IA be
    determined? What will be kept out of the scope?
  • Budget and resources: What is a
    reasonable budget and what resources need to be made available to IA?

 

ORGANISATIONAL PLACEMENT

The audit committee of the
Board (“ACB”) is required to take primary responsibility for ensuring an effective
Internal Audit function. In an ideal situation, internal auditors functionally
report to the ACB and administratively to the CEO. In organisations that do not
require to have an ACB, the responsibility for setting up and overseeing the
Internal Audit function rests with the Board or an equivalent Governing Body,
in case of non-corporate bodies.

 

In reality, in a large
number of cases, the Internal Audit function reports to the CFO, both
administratively and functionally. Even where it does not report to the CFO,
the CFO wields strong influence on the Internal Audit function. The word
“audit” is so strongly associated with the financial reporting process that it
is often wrongly presumed that anything to do with audit, including internal
audit, must have a dotted or a solid line to the CFO.

 

In the absence of a clear understanding of the important role
assigned to the Internal Audit function in the corporate governance framework,
the function is more often than not organisationally misplaced, thereby undermining
its very role.

 

There are also organisations where Internal Audit technically
reports to the ACB, but for all practical purposes that is only on paper. In
these cases, the Audit Committee plays virtually no role in ensuring the
effectiveness of the Internal Audit function, often spending minimal time on
Internal Audit matters. All decisions, such as appointment of internal
auditors, scope determination, access rights and budget for Internal Audit are
taken unilaterally by the CEO or the CFO.

 

It has been my experience that an effective Internal Audit
function has two levels of reporting lines:

 

  • For operational audits, the first level of
    reporting may be to the CEO or a committee comprising of senior executive
    management. However, the key issues arising or areas of difference of opinions
    from such audits need to be presented to the ACB periodically.
  • For organisation-wide audits dealing with
    governance matters (such as effectiveness of whistle-blower mechanism, related
    party process audit and compliance function review) or for audits of functions
    directly headed by the CEO, the reporting has to be to the ACB.

     

For Internal Audit function to play a meaningful role in
an organisation, the first step is to ensure correct organisational placement and
to provide meaningful access to those charged with governance, in this case the
ACB

 

IA Structure: In-house, Outsourced or Co-sourced? Or, is
there a fourth option?

 

                 

A decision that requires deliberation by the management is
the structure of the Internal Audit Department. For a long time, discussions on
the structure have been limited to the three obvious options – that the
Internal Audit function be entirely an in-house function, or the entire
function be outsourced to an external agency, or the Internal Audit function be
partly in-house and partly outsourced.

 

What drives this decision? For some industries, the
regulators have mandated the structure. e.g., a bank is not allowed to
outsource its Internal Audit function, whereas an insurance company above a
certain size is mandatorily required to engage an external agency to perform
its internal and concurrent audit. For large corporate conglomerates and
multinational companies, there is often a Central Internal Audit team headed by
a “Group Head – Internal Audit”. This central team is supported either by a
team large enough to perform all internal audits across all group entities or
is supported by one or more professional firms, each one assigned to perform
internal audit of specific entities of the group or specific areas within
select entities. Increasingly, it is observed that large listed companies or
corporate conglomerates assign the position of “Chief Internal Auditor” to an
in-house person and the management, along with the Chief Internal Auditor,
determines the structure of the IA function.

 

Ideally, the management of the company, with guidance from
the members of the ACB, and in consultation with the Chief Internal Auditor,
should decide upon the structure of Internal Audit function in a manner that:

  • Ensures transparency and fair reporting on the
    status of risks and controls, and on the effectiveness of risk management
    processes and governance processes;
  • Encourages good talent and specialised skills,
    as required, to be available to the Internal Audit function;
  • Ensures that Internal Audit function remains a
    relevant and focused function within the organisation, providing early alerts
    and timely warnings where needed;
  • Accelerates the use of technology for making
    the Internal Audit function efficient and time-sensitive;
  • Allows the organisation to optimise the costs,
    e.g., by appointing local audit firms for remote / decentralised units, while
    retaining the centralised function audits in-house.

 

Unfortunately, in many cases, the structure of the Internal
Audit function is selected in a casual manner based on past practices, without
much deliberation and with the primary objective of cost optimisation. This
needs to change significantly – so that the determination of the structure of
Internal Audit function is a conscious decision backed by serious thinking.

 

In the present dynamic
times, there is the emergence of a fourth option – multi-sourced internal audit
where, in addition to selecting one of the three basic structures described
above, specialist skills are brought in as team members on a need basis,
typically for areas very specific to the industry, or new emerging areas such
as blockchain, cyber security, data privacy, social media audits, etc. With a
fast increasing gig economy on the one hand and a fast changing world on the
other, Internal Audit function cannot be served well with static skills – hence
the emerging trend of seeking the support of specialists to supplement the
internal audit team, for select areas / activities. An effective Internal
Audit function can be designed based on a fine play between in-house talent,
outsourced support on a regular, recurring basis and specialised skills sourced
on a need basis.

 

Decisions for taking support through outsourcing must be
based on strategic thinking as to what is driving the outsourcing decisions –
(a) is it the need to have additional people, (b) the inability to recruit the
right talent, (c) the need for having people in the right geography, (d) the
need for specialised skills that are not available in-house, (e) the need to
bring in lateral experience of the outsourced firm, or (f) the need to optimise
cost as outsourced resources are cheaper than adding team members in-house? If
the structure is strategically decided and the rationale for outsourcing is
clearly understood, the selection of outsourcing partners would be far better
and more effective.

 

To summarise, while setting up the Internal Audit
Function, its structure must be determined based on serious, strategic thinking
and the decision must be revisited periodically to ensure that the structure
continues to be relevant.

 

TEAM COMPOSITION AND LOCATION

Once the decision about the structure of the Internal Audit
function is taken, next is the selection of the team leader, the team members
and / or the outsourcing partners. A good mix of competencies and qualities
needs to be brought together for an effective internal audit. The team leader
should have a clear vision, strong people skills, deep understanding of risks
and controls and of the business being audited, breadth of knowledge about the
external economic and competitive environment, and much more. The past practice
of appointing a “minister without a portfolio” as the Head of Internal Audit
must stop – the Head of Internal Audit must be committed and passionate about
the function and be able to inspire the team to think out of the box and
deliver beyond expectations.

 

 

Careful determination of the size, mix and composition of the
IA team and the identification of competencies and qualities required goes a
long way in selecting the right outsourcing partners. Gone are the days when
internal audit teams would comprise largely of chartered accountants. The
present-day IA team needs to come from different academic and experience
backgrounds – a good IA team for a large company or a corporate group would
include, in addition to finance and accounting persons, specialists in the
industry being audited, some functional specialists such as IT specialists,
engineers, legal and tax specialists and forensic experts.

In case of a multi-locational organisation it is important to
decide the location where the members of the IA team are to be stationed and to
ensure adequate infrastructure at such locations. With advance of technology, it
is not the mere physical location but the decision as to centralisation /
decentralisation of Internal Audit function that becomes relevant.

 

The management may devise suitable policies to encourage flow
of talent into the Internal Audit function – many organisations follow the
policy of placing new entrants first for a stint in internal audit and then
rotate them out based on demonstrated capabilities and interest. Similarly, at
the time of considering promotions from mid-management to senior level, organisations
give due weightage to those who have spent time as part of the internal audit
team for a certain tenure. These considerations, at an early stage, make the
internal audit teams vibrant, with a good mix of young entrants and experienced
functional experts.

 

IA SCOPE DETERMINATION

There has been a lot of
talk about “risk-based internal audit”, where the risk assessment of the
organisation should form the primary basis for scope determination. This is all
very well for organisations that have gone through a rigorous process of risk
assessment and make efforts to keep the same updated to reflect dynamic risks.
For such organisations, the internal audit scope would be determined by the
management in consultation with the internal auditors, based on the identified
risks and their severity after considering the impact of mitigating controls.

 

Many organisations,
however, do not have a mature Risk Management Function and their documented
Risk Management Framework is sketchy and not reflective of the real risks
comprehensively. In such cases, the determination of scope becomes an intuitive
exercise, driven by the areas covered in the past 2-3 years and by the areas
and risks that are apparent and significant. Many finer areas that merit
inclusion in the audit scope remain outside the purview. For internal audit
scope to be meaningful, there is a need for the Risk Management framework of
the organisation to be comprehensive and updated on a dynamic basis. An
internal audit scope designed based on a well-defined Risk Management framework
and after seeking inputs from senior executive management, audit committee
members and statutory auditors tends to be comprehensive and relevant.If
there is one area that needs to be overhauled, it is the manner of fixing the
scope of internal audit – in most cases, there is little creativity, hardly any
dynamism and no clear link between key risks and audit areas included in the
scope.

 

For a meaningful internal audit, the scope must reflect
the dynamic reality and the real concern areas of the organisation, it must
cover adequate ground for proving reasonable assurance on the effectiveness of
controls, and it must have flexibility to modify / enhance the scope to
accommodate newly-identified risks / activities that require attention.

 

IA BUDGET AND RESOURCES

Internal audit is an important management function that
requires a plan, a budget and a commitment for resources, just like any other
function. Management may do well to establish a comprehensive budget detailing
the various heads under which the IA function will need to spend and the
resources and infrastructural support that it would require.

 

The budget and resource planning needs to include:

  •  People cost for the in-house team;
  • Outsourcing cost for the audits proposed to be
    outsourced;
  • Specialist cost;
  • Training needs for skill upgradation of the IA
    team;
  • Technology tools and equipment;
  • Allocation for proper space and infrastructure
    – access to work stations, meeting rooms, video conferencing and communication facilities,
    etc.;
  • Provision of support for development of IT
    utilities and reports required for audit, administrative support, etc.

 

In this dynamic environment, very often the internal audit
budgets are static and the kind of resources allotted are outdated. The
investment made in training and upgrading the skills and knowledge of the IA
team leaves much to be desired and all this inevitably leads to an impoverished
IA function trying hard to “live within the budget”.

 

An effective IA function needs to be empowered with a
healthy budget for efficient execution and skill enhancement, the latest IT
tools and infrastructure and adequate resources for partnering with appropriate
outsourcing agencies and specialists. Expectations from internal audit need to
be aligned to the budget and resources provided for internal audit.

 

CONCLUDING REMARKS

Internal audit is one of the pillars of corporate governance
– lack of planning or mindless cost-cutting in building this pillar can bring
down the superstructure of corporate governance. The tone at the top where the
function is respected as a value adder and not merely as a statutory obligation
will help sustain a great Internal Audit function.

 

Many of the thoughts
expressed in this article may appear to be academic or theoretical – but these
are fundamental to the establishment of a robust Internal Audit function in any
organisation. Just as “well begun is half done”, in the case of Internal Audit
function – “Ill-begun is almost totally lost.”

 

In the present times, when Internal Audit function is
expected to perform audit at the speed of risk, ensuring that the foundation on
which the Internal Audit function is standing is strong and periodically
reinforced to stand the test of time is critical.

RELATED PARTY TRANSACTIONS: LESSONS FROM CASE STUDIES

This is a sequel to the article published
in the BCAJ of August, 2019: ‘De-layering Related Party Transactions through
Internal Audit’ by CA Ashutosh Pednekar

 

This article (a sequel) gives practical
approaches to identification of Related Parties (RPs), examining the legitimacy
of Related Party Transactions (RPTs) and such other matters that internal
auditors could integrate in their audits. Conflict of interest and RPTs have
become a very important part of audits of companies. The author offers case
studies that could inform the reader about some principles, techniques and
tools to uncover the substance of transactions where RPs are involved

 

The way an organisation deals with its
related parties speaks volumes about the culture and integrity of the
decision-makers, i.e., the management. To an Internal Auditor, reviewing the
dealings of a company with its related parties can provide an understanding of
its culture and beliefs, its core values and transparency.

 

There are various pronouncements and
regulations promulgated for guiding and monitoring identification and
disclosures of RPs and RPTs. There are governance mechanisms that place an
onerous responsibility on the Audit Committee of ensuring that all RPTs are at
arm’s length pricing. Taxation laws and transfer pricing audit requirements
further reduce the possibility of arbitrariness in the commercial terms agreed
for RPTs. What, then, can the Internal Auditor’s review of RPs and RPTs
contribute that is not already covered by the various disclosure, approval and
reporting protocols?

 

CASE 1: WHO IS A
RELATED PARTY? SUBSTANCE OVER FORM?

 

Background

Ms Smart is the Internal Auditor of a large
listed company. As part of the internal audit, she came across a transaction
where the company had awarded a three-year exclusive contract to a PR agency
called Connexions under which 70% of the contract value was paid upfront and
the balance 30% was to be paid in three equal instalments – the agreement also
stated that in case of premature termination of the agreement by the company,
Connexions would not be required to refund any amount already paid to it. There
were no past commercial transactions between the company and Connexions.

 

An
unusual transaction

Ms Smart found this transaction unusual and
uncharacteristic of the company. The terms of the contract seemed one-sided,
favouring the PR agency. Hence, she inquired about the vendor and found that
the agency was owned by three partners, one of whom was a woman whose name
appeared somewhat familiar.

 

A
smart search

Ms Smart engaged with social media platforms
like LinkedIn and Facebook to find out more about the partners / owners of the
PR agency. And she found that the woman partner was none other than the fiancée
of the Managing Director’s son. She also came across news items and YouTube
videos showing the lavish engagement ceremony of the MD’s son with the woman in
question.

 

Is
a fiancée a related party? In matters of doubt, err on the safe side

Ms Smart felt that while the PR Agency was
not strictly an RP under any regulations, the substance of the transaction made
it an RPT. She brought this to the notice of the Audit Committee and explained
why the transaction might need approval akin to the approval required for an
RPT to ensure good governance and transparency.

 

Next, Ms Smart
explained that the regulations define the ambit and the intent of the law. In
case of RPTs, the intent is to prevent the abuse of minority shareholders or
other stakeholders by decisions taken by the controlling shareholders favouring
their RPs. In cases where a counter party does not strictly meet the definition
of an RP, but for all practical purposes is perceived as an RP, it is better to
treat the transaction with such a party as an RPT.

Audit
Committee verdict

The Audit
Committee agreed to take a wider view of the policy related to RPs, and advised
the management to report transactions with potential RPs to the Audit
Committee. In the present case, based on the facts presented, the Audit
Committee found the transaction to be not at arm’s length and not transparent
and, hence, advised that necessary steps be taken to revise the contract.

 

CASE 2: EXAMINING THE
NEED / LEGITIMACY OF AN RPT

 

Internal
Audit mandate for review of RPTs

Ms Sceptic, the Internal Auditor of a
company dealing in industrial products, was asked by the Audit Committee to
undertake a special review of related party transactions of a listed entity.

 

Internal
Audit findings

Ms Sceptic went through the policy and the
entire process of identification and approval of RPTs. She was satisfied with
the contents of the policy and the process adopted for establishing fair price
for RPTs.

 

But in her
detailed review of reported RPTs she came across the following two transactions
that caught her attention:

(i) Purchase of three paintings from the
spouse of one of the Independent Directors, from an exhibition held at a
well-known art gallery. The total sum paid for these paintings was Rs.
84,00,000. The value of the paintings was as per the valuation certificate and
was in line with the price of other paintings sold at the exhibition. In the
same month, the company had paid interest on late payment of GST and TDS due to
a liquidity crunch that it had been facing for some months.

(ii) Brokerage, amounting to Rs. 40,00,000
(being 1% of property value, this being the norm in the broking industry) on a
large property purchase transaction was credited to Amanda Services in which a
director’s daughter is a partner. Amanda Services has an impressive website
projecting the entity as a real estate broking firm. The brokerage remained
unpaid for three months after the transaction of purchase of property was
concluded.

 

On inquiry, Ms Sceptic found that the
brokerage could not be paid as Amanda Services did not have a GST registration.
She also found that the GST registration was applied for almost two months
after the property purchase transaction was concluded. This suggested that
Amanda Services may not be an established player in the real estate broking
business.

In both the above cases, due disclosures
were made and approvals were in place. Arm’s length pricing was also
established. However, it appeared that in the first case the need to purchase
the paintings was not established, whereas in the second case there was a
reason to doubt as to whether Amanda Services had indeed provided broking
services for the property transaction.

 

The
conclusion

Ms Sceptic presented her findings, with
corroborative details, to the Audit Committee, clearly pointing out that before
determining the reasonableness of pricing, it is important to establish the
legitimacy of the need and the actual delivery of services. The Audit Committee
acknowledged that the review of RPs and RPTs must include validation of the
underlying legitimacy of the RPTs.

 

CASE 3: PROVISION OF FREE
FACILITIES

 

Background

Ms Curious is the Chief Internal Auditor of
a listed company where the promoters are from a single family and hold about
40% of the equity shares. The company operates out of its corporate office in a
metro city and rents five floors of the said building.

 

On a day when the internal audit was going
on, Ms Curious was told that there was no place for the Internal Audit team to
sit (this is not a surprise) for a few days as certain branch managers were
visiting and they needed to be provided working space. Hence, it was suggested
that the internal audit be rescheduled and the team assigned to a branch or a
depot audit for a few days.

 

Chance
discovery

Ms Curious, being curious by nature and keen
to complete the internal audit on hand expeditiously, walked around the five
floors trying to find space for her team to occupy temporarily. She came across
a part of the office with a  glass door
leading to an enclosed smaller office space. She found a group of about 15
people working there whom she had not interacted with before but had seen
around in the company cafeteria at lunch time. This appeared strange, as the
Internal Audit scope had covered all key areas of the company over the past few
years since she was appointed as the Chief Internal Auditor.

 

Research
and analysis – from doubt to a confirmed finding

On exchanging courtesies, she learned that
these people were employees of the family office of the promoters, managing
entities dealing with personal investments of the promoter family. She also
found that the family office had been occupying the space for several years.

 

What
next? Communicating with those charged with governance

Ms Curious ran a search to find out if any
recovery was being made towards the rent or utilities from any related party.
She also looked up the disclosures for remuneration of directors and related
party transactions to see if there was any approval / disclosure for use of corporate
office premises for the private use of the promoters, free of cost. When her
search did not yield any positive results, it became clear to her that this was
an inappropriate action by the promoters that had perhaps not been disclosed to
the Audit Committee members and, hence, never been subjected to any scrutiny or
debate.

 

She considered various options to bring this
issue to the notice of the management. After mulling over the options, she
sought a meeting with the Audit Committee Chairman, expressed her concern,
handed over a confidential note giving details and requested him to take it up
with the management and the other Audit Committee members.

 

CASE 4: ALLOWING RP TO
TERMINATE AN ONEROUS COMMITMENT

 

Background

Ms No Nonsense is the internal auditor of a
corporate conglomerate comprising of a flagship listed company known as XYZ
Limited (XYZ), several subsidiaries and associate entities. The listed company
held large office premises in excess of its requirements.

 

XYZ had leased out some of its office
premises to an associate company in which it held 49% stake and the promoter
family held 51%. The lease was given on rent and other terms that were
established to be at arm’s length. Offices in the same building were also
leased out to an unrelated party at the same time, on the same rates and terms.
Both the leases were for a period of nine years, with a lock-in period of five
years and an escalation clause increasing the rent by 8% at the end of two
years.

 

Two years after entering into these leases, the
real estate market nosedived and rental rates came down drastically.
Consequently, both the parties requested premature termination of the lease.
XYZ did not permit the unrelated party to terminate the lease without paying
the liquidated charges stated in the lease agreement and issued legal notices
to that effect. However, for the RP, XYZ allowed the foreclosure without
charging the dues as per the agreement. The MD approved the foreclosure
decision but requested the Audit Committee for approval, this being an RPT.

 

The
Internal Auditor – Putting things in perspective

Ms No Nonsense, the Internal Auditor, was
required to review the RPTs on a quarterly basis and report to the Audit
Committee on the same. In the present case, she apprised the Audit Committee
that the RPT transaction (of waiver of escalation clause and permitting a
foreclosure of the lease without any penalties) was not in the interest of XYZ
and the treatment given to the RP was significantly favourable compared to an
exactly similar transaction undertaken with an unrelated counter party. In her
opinion, this RPT was a case of favouring the RP against the interest of XYZ
Limited.

 

 

Constraints
of the Audit Committee

When the Audit Committee is asked to approve
RPTs, at times the information given is incomplete and misleading. Comparable
transactions with unrelated parties are not always presented to the AC. Thus
approvals given by it may be based on incomplete facts. Besides, the attention
given at the time of entering into an RPT is much more compared to the
attention given to terminations, rollovers or extensions. Having an objective
review prior to giving approval may help the Audit Committee to grant approval
based on full facts and details.

 

 

LESSONS FROM THE CASE
STUDIES

The case studies presented above contain
several important lessons, both for the Internal Auditors and the Audit
Committee. A summary of these lessons is presented hereunder:

 

(a) Going
beyond the confines of definitions: In identifying an RP and an RPT,
one needs to go beyond the confines of the regulatory definitions and apply the
‘substance over form’ principle by looking at the spirit of the regulations.

 

(b) Unmasking: Special attention may be paid to unravel:

(1) Arrangements for providing free usage of
assets, facilities and resources to RPs;

(2) Unusual, uncharacteristic arrangements
that do not reflect usual contractual acumen, as RPTs may be masked therein;

(3) Terminations and modifications of
approved RP transactions / contracts on terms favourable to the RP.

 

(c) Questioning
purpose and legitimacy: Review of RPTs needs to go beyond the
disclosures and reporting protocols and must extend to questioning the
legitimacy and the purpose of entering into such transactions.

 

(d) Going beyond the obvious: Internal Auditors may periodically consider special audits like an
asset usage review, people deployment review, etc., to identify potential
redundancies and misuse, including violation of regulations pertaining to RPs.

 

(e) Engaging
with the AC: The Audit Committee must create opportunities for direct,
periodic interactions between the auditors and the Audit Committee members in
the normal course. Internal Auditors need to maintain a line of communication
open with the Audit Committee members, to be able to escalate issues directly
relating to governance matters. Reporting on issues related to RPs and RPTs is
sensitive and requires tactful communication.

 

SHOULD INTERNAL AUDIT
SCOPE INCLUDE REVIEW OF RPTS?

The cases discussed above are very simple
and straightforward. As organisations become larger and the complexity, volume
and value of RPTs increase, it becomes difficult for the Audit Committee to
ensure that:

 

(I) All RPs and RPTs have been duly
identified;

(II) Adequate
processes and technology-based initiatives have been employed for
identification of all RPs and RPTs;

(III) Dealings not resulting in financial
transactions are also reported to the Audit Committee;

(IV) The facts and details required for a
fair assessment of the necessity for RPTs and the arm’s length pricing thereof
have been presented to them;

(V) Entities that are not strictly RPs but
are likely to be perceived as such are also subjected to similar scrutiny as
RPTs; and

(VI) The tendency of the executive
management to circumvent due scrutiny of RPTs is identified and escalated in a
timely manner.

 

With onerous responsibilities cast on the
Audit Committee with respect to related party dealings and disclosures, it has
become imperative for the Audit Committee to put the RP-related processes and
transactions through the objective scrutiny of specialist professionals.
Internal Auditors, with their curiosity, scepticism, smartness and
no-nonsense approach, are well suited to give due assurance to the Audit
Committee and, where required, give early alerts with respect to cases of
abuse, inappropriateness, misuse or fraudulent conduct.

 

By extending the Internal Audit scope to
RPTs, the Internal Auditors are empowered to gain necessary access to such transactions
and through this, gain relevant insights into the culture and ethics of the
Management. Such insights make the overall Internal Audit more meaningful and
conversations with the Audit Committee more relevant.

To conclude, Internal Audit of processes
pertaining to Related Parties and Transactions is not just a compliance review
– it is an audit of integrity and culture, of the tone at the top, of
convergence between stated values and demonstrated actions. When looked at in
this light, this audit assumes great importance: it calls for great maturity,
sensitivity and experience from the Internal Auditors.

 

If
you have integrity, nothing else matters. If you don’t have integrity, nothing
else matters.

– Alan K. Simpson

KEY AUDIT MATTERS IN THE AUDITOR’S REPORT

It is always dissatisfaction with the status quo that drives
change, and the quantum of change is often proportionate to the magnitude of
dissatisfaction. So it was with the auditor’s report that auditors the world
over had been issuing with consistency. When the powerful investor-lender
lobby, who are the prime stakeholders in corporate enterprises, and therefore
the most crucial users of auditor’s reports, said that “the auditor’s opinion
on the financial statements is valued, but that the report could be more
informative”, they were making a polite understatement. In reality, they were
pretty upset about the fact that auditors were not telling them very much about
the most important matters they dealt with during the audit, how they responded
to them, and how they had concluded on them in forming their opinion. They were
unhappy that the entire process of audit was rather opaque and mysterious and
sought greater transparency. Their dissatisfaction got exacerbated each time
one more large corporation went under and they lost money. 

 

Standard setters across the world were under acute pressure from this
powerful lobby, supported by regulators, to change the situation. That was the
genesis of the effort to revise reporting standards by the two leading standard
setters in the world: the IAASB1 and the PCAOB. In the meanwhile, an
initiative for change was taken independently by the UK as early as in 2012-13
followed closely by the Netherlands, both countries bringing out revised
reporting standards by 2014. When the IAASB announced 2016 as the effective date
for its revised ISAs, there were several countries that early-adopted them,
including Germany, Switzerland, Hong Kong, South Africa, New Zealand and
Poland. In fact, Zimbabwe conducted a “dry run” of the revised reporting
standards a full year ahead of the IAASB effective date. The PCAOB in the US
started its effort even earlier, in 2008. The new proposed standard was exposed
for outreach of various stakeholders several times, comments were invited and
examined, roundtables were held and finally, in 2016, a reproposed standard was
announced with staggered effective dates2. India framed its revised
reporting standards, based almost wholly on ISAs, with 2017 as the effective
date. But that date was later revised to accounting periods beginning 1st
April, 2018.

___________________________________________________

 

1   IAASB or
International Auditing & Assurance Standards Board is a constituent of the
International Federation of Accountants. The PCAOB or Public Companies
Accounting Oversight Board is the audit oversight body created under the
Securities & Exchange Commission of the United States.

 

 

The auditor’s report of a large enterprise is the “finished product”
signed and delivered after months of sustained efforts put in by a large number
of audit professionals and partners in planning and performing an audit. It
addresses the final outcome of that process for users of financial statements.
Yet, over the years, the auditor’s report largely became so standardised (or
“boilerplate”) that there was no significant difference to be seen between the
auditor’s report of one enterprise as compared to that of another, particularly
where the opinion was “clean”, even though the two entities’ businesses and
economic situations would be completely different. Users of audited financial
statements wanted to see more distinctiveness in the auditor’s report so that
each such report told its own story and had its own character. To achieve this,
the standard setters introduced the concept of disclosing Key Audit Matters
(KAMs) in the auditor’s report.

 

INTENDED
BENEFITS

Communicating KAMs3  in
the auditor’s report does not change the auditor’s responsibilities in any way.
Nor does it change the responsibilities of either the management or those
charged with governance (TCWG). Rather, it is intended to highlight matters of
the most significance in the audit that was performed “through the eyes of the
auditor”. KAMs may also be perceived by users to enhance audit quality, and
improve the confidence that they have in the audit and the related financial
statements. The communication of KAMs could help to alleviate the information
asymmetry that exists between company managements and investors, which could
result in more efficient capital allocation and could even lower the average
cost of capital.

 

Throughout the standard-setting
process, both by IAASB and by PCAOB, the multitude of stakeholders who
responded, ranging from investors, lenders, regulators, oversight authorities,
national standard setters, preparers of financial statements and accounting
firms have expressed their support to the introduction of KAMs in auditors’
reports of listed entities and felt that it would protect the interests of
investors and further the public interest in the preparation of informative,
accurate and independent auditors’ reports. 

 

2   For large
accelerated filers FYs ending on or after 30/6/2019; Others – 15/12/2020

3         Under
the related PCAOB Standard, KAMs are called Critical Audit Matters (CAMs). An
effort has been made to give key comparative positions under the
related PCAOB standard in the footnotes, for the general appreciation of the
reader.

 

It is believed that having KAMs in the auditor’s report will:

  •    Increase transparency
  •     Focus users of the financial statements on
    areas of financial statements that are subject to significant risks,
    consequence and judgement
  •    Provide users with a basis to further engage
    with managements and TCWG
  •     Enhance communications between the auditor
    and TCWG on the most significant matters in the audit
  •     Increase the attention given by both,
    managements and auditors, to disclosures in the financial statements,
    particularly for the most significant matters
  •     Renew the auditor’s focus on matters to be
    communicated, indirectly resulting in an increase in professional scepticism
    and improvement in audit quality. 

 

CHANGES MADE IN
STANDARDS


Apart from the introduction of the concept of communicating KAMs
contained in a new Standard, SA 701 Communicating Key Audit Matters in the
Independent Auditor’s Report, some other changes have also been made,
mainly in SA 260(R) Communication with Those Charged With Governance; SA
570(R) Going Concern; SA 700(R) Forming an Opinion and Reporting on
Financial Statements; SA 705(R) Modifications to the Opinion in the
Independent Auditor’s Report; SA 706(R) Emphasis of Matter Paragraphs
and Other Matter Paragraphs in the Independent Auditor’s Report; and SA
720(R) The Auditor’s Responsibilities Related to Other Information.
Besides this, consequential amendments have also been made to SAs 210, 220,
230, 510, 540, 600 and 710.

 

WHAT IS A KEY
AUDIT MATTER?


KAM is defined in the Standard as: Those matters that, in the
auditor’s professional judgement, were of most significance in the audit of the
financial statements of the current period. Key audit matters are selected from
matters communicated with those charged with governance.4

_______________________________________

4   A
CAM under the PCAOB Standard, on the other hand, is any matter arising from the
audit of the FS that was communicated or required to be communicated to the
audit committee and that (1) relates to accounts or disclosures that are
material to the FS, and (2) involved especially challenging, subjective, or complex
auditor judgement. CAMs are not a substitute for the auditor’s departure from
an unqualified opinion.

 

Perhaps the most challenging part of disclosing KAMs is how to determine
the matters that constitute KAMs. The Standard has struck a delicate balance
between prescription and auditor judgement over here. The definition itself
clearly states that the matters to be disclosed should be those that “in the
auditor’s professional judgement” were of the most significance. It then
requires that such matters should be selected by the auditor “from matters
communicated with TCWG”. Apart from this, it also underlines three areas that
are the most likely sources of matters that would be discussed with TCWG, among
others.

 

Several auditing standards specify matters that the auditor should take
up with TCWG, in addition to SA 260(R) Communication with Those Charged with
Governance, and 265 Communicating Deficiencies in Internal Control to Those
Charged with Governance. From these, the auditor first picks out matters
“that required significant auditor attention.” Then he applies his professional
judgement to further filter down matters and selects those that were “of the
most significance” in the audit of the current period as KAMs.

 

The auditor would
therefore be well advised to be armed with a ready-referencer checklist of
matters that the various standards prescribe for communication with TCWG to
first ensure that he complies with that requirement. It may be noted that there
is a subtle difference between SA 260 and SA 265 that is to be found in their
respective titles. Whereas SA 260 requires the auditor to communicate “with”
TCWG, SA 265 requires him to communicate “to” TCWG. To put it colloquially, SA
260 is two-way traffic (a discussion) but SA 265 is largely one-way traffic.
The definition of KAM talks about matters that were communicated “with” TCWG.
Significant deficiencies in internal control that are communicated to TCWG may
not always fall within the concept of KAM, although the auditor might have had
to modify his audit approach due to them, increasing his audit effort.

 

MATTERS TO BE
CONSIDERED BY THE AUDITOR IN DETERMINING KAMS5

The auditor is required to explicitly consider:

  •     Areas of higher assessed risks of material
    misstatement, or significant risks.
  •     Significant auditor judgements relating to
    areas of significant management judgement, including accounting estimates
    having high estimation uncertainty.
  •     The effect of significant events or
    transactions that occurred during the year. 

______________________________________________

5   For
determining CAMs under the PCAOB Standard, the following points are provided:
(a) the auditor’s assessment of the risks of misstatement, including
significant risks; (b) the degree of auditor judgement related to areas in the
FS that involve the application of significant judgement or estimation by
management, including estimates with significant measurement uncertainty; (c)
the nature and timing of significant unusual transactions and the extent of audit
effort and judgement related to these transactions; (d) the degree of auditor
subjectivity in applying audit procedures to address the matter or in
evaluating the results of those procedures; (e) the nature and extent of audit
effort required to address the matter, including the extent of specialised
skill or knowledge needed or the nature of consultations outside the engagement
team regarding the matter; and (f) the nature of audit evidence obtained
regarding the matter.

 

 

This requirement articulates the thought process the auditor should go
through to consider these drivers of “areas of significant auditor attention”
while noting that KAMs are always selected from matters communicated to TCWG.
It should not, however, be assumed that KAMs could only result from a
consideration of these three specific indicators, nor that all the three
indicators must exist to determine KAMs. Furthermore, the standard requires the
auditor to filter down to “matters of most significance” from out of the “areas of significant auditor
attention”. 

 

If one examines the three indicators mentioned above, one would see that
these are matters of most concern to the users of the audited financial
statements because any of them could turn out to be the cause of material
infirmity in the balance sheet of an entity or a source of management fraud.
Identification of matters drawn from them as KAM would enlighten users about
their nature, magnitude and how the auditor dealt with them. It would also
enable users, such as investors or analysts, to directly question the
management and TCWG about those matters. 

 

The importance given in the Standard to matters discussed with TCWG has
a double purpose: (a) investors and lenders want to have insights into matters
taken up in interactions between the auditor and TCWG, including those that
were keeping the auditor up at nights, consistent with the audit committee’s
role representing the interest of shareholders; and (b) to stimulate discussion
between the auditor and TCWG that, it was perceived, was not happening as much
as it should. Obviously, matters that comprise communications with TCWG would
be matters that are material to the audit of the financial statements, and
selecting the ones that are of the most significance out of these would limit
KAMs to only crucial issues that were hitherto not getting disclosed in the
auditor’s report, and which investors and lenders wanted to focus on in
understanding the financial statements of companies they had put their money
into.

 

Significant
risks


To determine a risk as significant the auditor considers:

(a)    Whether it is a fraud risk;

(b)    Whether the risk relates to
major changes in developments that impact the entity or its business;

(c)    Whether the risk arises from
complexity of transactions;

(d)    Whether there are
significant related party transactions;

(e)    Whether measurements of
amounts included in the financial statements involve a high level of
subjectivity or measurement uncertainty; and

(f)     Whether the risk involves
significant events or transactions that are outside the normal course of
business of the entity, or appear to be unusual in nature.

 

Significant
judgements


The second point of consideration is significant auditor judgements
relating to areas of significant management judgement, including accounting
estimates having high estimation uncertainty. Accounting estimates involving
the outcome of litigation, fair value estimates for derivative financial
instruments that are not publicly traded, and fair value accounting estimates
for which a highly specialised entity-developed model is used, or for which
there are assumptions or inputs that cannot be observed in the marketplace,
generally involve a high level of estimation uncertainty. However, estimation
uncertainty may exist even where the valuation method and data are well
defined. Estimates involving judgements are generally made in the following
areas and often involve making assumptions about matters that are uncertain at
the time of estimation:

(a)    Allowance for doubtful
accounts;

(b)    Inventory obsolescence;

(c)    Warranty obligations;

(d)    Depreciation method used or
useful life of assets;

(e)    Provision against carrying
amounts of investments;

(f)     Outcome of long-term
contracts;

(g)    Financial obligations or
costs arising from litigation;

(h)    Complex financial
instruments that are not traded in an open market;

(i)     Share-based payments;

(j)     Property or equipment held
for disposal;

(k)    Goodwill, intangible assets
or liabilities acquired in a business combination;

(l)     Transactions involving non-monetary
exchange.

 

Estimates involving
judgements are likely to be susceptible to intentional or unintentional
management bias. This susceptibility increases with subjectivity and is often
difficult to detect at the individual account balance level. Intentional
management bias often foreshadows fraud.

 

Significant
events and transactions

The auditor would
need to exercise professional judgement to determine if a significant event or
transaction that he encounters in an audit poses a risk of material misstatement
or not, since such events or transactions could be of many assorted types. Some
such events are listed below:

(a)    Operations in economically unstable regions,
volatile markets, or those subject to complex regulation;

(b)    Cash flow crunch, non-availability of funds,
liquidity and going concern issues, or loss of customers;

(c)    Changes in the industry where the entity
operates, or in the supply chain;

(d)    Forays into new products, services, lines of
business, or new locations;

(e)    Failed products, service
lines, ventures, business segments or entities;

(f)     Complex alliances, joint
ventures, or significant transactions with related parties;

(g)    Use of off-balance sheet
finance, special purpose entities, and other complex financial arrangements;

(h)    Distress related to
personnel like non-availability of required skills, high attrition, frequent
changes in key executives;

(i)     Unremediated internal
control weaknesses;

(j)     Inconsistencies between
entity’s IT and business strategies, changes in IT environment, installation of
new IT systems and controls having a bearing on revenue recognition or
financial reporting;  

(k)    Inquiries into the entity’s
business by regulators or government bodies;

(l)     Past misstatements, history
of errors, or significant period-end journal entries;

(m)   Significant non-routine or
non-systematic transactions, including inter-company transactions, and large
revenue transactions at or near period-end;

(n)    Transactions recorded based
on management intent, e.g. debt financing, intended sale of assets,
classification of marketable securities;

(o)    Application of new
accounting pronouncements;

(p)    Pending litigation and
contingent liabilities.

 

Matters to be
communicated with TCWG

SA 260, Communication with Those Charged With Governance,
includes many matters that should be communicated by the auditor. For the
purposes of KAMs reporting, however, all of those (e.g. the auditor’s
responsibility in relation to the audit; auditor independence) may not be
relevant. What would be relevant are communications of the significant risks
identified by the auditor and his significant findings.

 

Significant
risks


Communication with TCWG of significant risks (including fraud risks)
identified by the auditor helps them understand those matters, why they require
special audit consideration, and helps them in fulfilling their oversight
responsibility better. However, care should be taken when discussing the
planned scope and timing of the audit procedures so as to not compromise the
effectiveness of the audit, especially when some or all of TCWG are also part
of management. Such communication may include:

(a)   How the auditor plans to
address the risks;

(b)   The auditor’s approach to
internal control;

(c)   The application of the
concept of materiality;

(d)   The nature and extent of
specialised skills or knowledge needed to perform the audit, including the use
of auditor’s experts;

(e)   The auditor’s preliminary
views about matters that are likely to be KAMs;

(f)    Interaction and working
together with the entity’s internal audit function.

 

On his part, the auditor also benefits from a discussion with TCWG by
understanding:

(a)   The appropriate persons
within TCWG with whom to communicate;

(b)   The allocation of
responsibility between management and TCWG;

(c)   The entity’s objectives,
strategies and the related business risks;

(d)   Matters that TCWG consider
warrant particular auditor attention and areas where they request him to
perform increased audit procedures;

(e)   Significant communication
with regulators;

(f)    Other matters that TCWG
consider may influence the audit;

(g)   The attitudes, awareness and
actions of TCWG concerning (i) the importance of internal control and how they
oversee the effectiveness of internal control, and (ii) the detection and
possibility of fraud;

(h)   The actions of TCWG in
response to changes taking place in the accounting, IT, legal, economic and
regulatory environment;

(i)    Responses of TCWG to
previous communication with the auditor.

 

Significant
findings


These include:

(a)    The auditor’s views about
qualitative aspects of the entity’s accounting practices such as the
appropriateness of accounting policies, determination of accounting estimates,
and adequacy of financial statement disclosures;

(b)    Significant difficulties
encountered by the auditor during the audit;

(c)    Significant matters arising
during the audit that were or are being discussed with management;

(d)    Written representations that
the auditor desires;

(e)    The form and content of the
auditor’s report (now also including matters that the auditor expects to
include as KAMs);

(f)     Other significant matters
arising during the audit that the auditor feels are relevant to TCWG.

 

Other matters:

Beyond SA 260, there are several other standards that specifically
require the auditor’s communication with TCWG that have a bearing on KAMs
reporting:

(a)    SA 240, pertaining to the
auditor’s responsibilities relating to fraud;

(b)    SA 250, pertaining to
consideration of laws and regulations;

(c)    SA 265, pertaining to
communicating internal control deficiencies;

(d)    SA 450, pertaining to
evaluation of misstatements;

(e)    SA 505, pertaining to
external confirmations;

(f)     SA 510, pertaining to
initial audit engagements;

(g)    SA 550, pertaining to
related parties;

(h)    SA 560, pertaining to subsequent
events; and

(i)     SA 570, pertaining to going
concern.

 

ORIGINAL
INFORMATION AND SENSITIVE MATTERS


During the
formation of the Standard, concerns were voiced that the auditor might provide
“original information” when reporting KAMs. Original information is any
information about the entity that has not otherwise been made publicly
available by the entity. The Standard has addressed this in paragraphs A35-A38
by emphasising that the auditor should take care not to provide any original
information in KAMs, but if it becomes necessary to do so, he should encourage
management to include new or additional disclosures in the financial statements
or elsewhere in the annual report so that it no longer remains original
information.

 

Similar apprehension was voiced with regard to the auditor disclosing
“sensitive matters” when reporting KAMs. Sensitive matters could be possible
illegal acts or possible fraud, significant deficiencies in internal control,
breaches of independence, complex tax strategies or disputes, problems with
management or TCWG, quality of risk management structures, regulatory
investigations, a contingent liability that did not meet the requirements for
disclosure, other litigation or commercial disputes, evaluation of identified
or uncorrected misstatements, etc. The Standard has addressed this in paragraph
14(b), with more detailed application guidance in paragraphs A53-A56, by
stating that in extremely rare circumstances, where the entity has not publicly
disclosed information about it, the auditor may determine that a matter should
not be communicated in the auditor’s report because the adverse consequences of
doing so would reasonably be expected to outweigh the public interest benefits
of such communication.

 

COMMUNICATING
KAMS


To introduce KAMs to the user, and to dispel the danger that
communication of KAMs might be misunderstood by some users to be a separate
opinion by the auditor on those specific matters, the Standard makes the
following introductory statements6:

 

  •     Key audit matters are those matters that,
    in the auditor’s professional judgement, were of most significance in the audit
    of the financial statements of the current period; and
  •      These matters were addressed in the context
    of the audit of the financial statements as a whole, and in forming the
    auditor’s opinion thereon, and the auditor does not provide a separate opinion
    on these matters.

 

Each KAM should then describe (i) why the matter was considered to be
one of most significance in the audit, and was therefore determined to be a
KAM, and (ii) how the matter was addressed in the audit. It would be advisable
for the auditor to include in the description of a KAM a reference to a Note to
the Financial Statements where management has described the matter in detail
from its point of view7. And, if there is no such disclosure, he
should encourage management to include it. Doing so will also take care of the
danger of the auditor unwittingly providing any original information.  

_________________________________________

6   The introductory statement
in case of CAMs under the PCAOB Standard is: The critical audit matters
communicated below are matters arising from the current period audit of the FS
that were communicated or required to be communicated to the audit committee
and that: (1) relate to accounts or disclosures that are material to the
financial statements and (2) involved our especially challenging, subjective,
or complex judgements. The communication of critical audit matters does not
alter in any way our opinion on the financial statements, taken as a whole, and
we are not, by communicating the critical audit matters below, providing
separate opinions on the critical audit matters or on the accounts or
disclosures to which they relate.

7   The
following needs to be done to communicate CAMs under the PCAOB Standard: (a)
identify the CAM; (b) describe the principal considerations that led the
auditor to determine that the matter is a CAM; (c) describe how the CAM was
addressed in the audit [in doing so, describe: (i) the auditor’s response or
approach that was most relevant to the matter; (ii)  a brief overview of the audit procedures
performed; (iii) an indication of the outcome of the audit procedures; and (iv)
key observations with respect to the matter, or some combination of these
elements]; (d) refer to the relevant financial statement accounts or
disclosures that relate to the CAM.

 

To dispel any misunderstanding that may arise in the minds of users as
to the import of disclosing KAMs by the auditor, and to clearly make users
understand the significance of a KAM in the context of the audit, and the
relationship between KAMs and other elements of the report, it is necessary for
the auditor to use language that:

  •       Does not imply that the matter was not appropriately
    resolved by the auditor in forming his opinion;

  •       Relates the matter directly to the
    specific circumstances of the entity, while avoiding generic or standardised
    language;
  •       Takes into account how the matter is
    addressed in the related disclosures in the financial statements, if any; and
  •       Does not contain or imply discrete
    opinions on separate elements of the financial statements.

 

The Standard intends that description of a KAM should be relatively
clear, concise, understandable, entity-specific and should not be viewed as
competing with the management’s disclosures or providing original information
about the entity. Also, that there should be a balance between the requirement
to explain why the auditor considered each matter to be of the most significance
in the audit and the flexibility allowed in describing its effect on the audit.
The Standard has left the nature and extent of the auditor’s response and
conclusion on the matter to his judgement by using the words “how the matter
was addressed in the audit”. Nevertheless, the Standard provides guidance that
the auditor may describe:

  •       Aspects of the auditor’s response or
    approach that were most relevant to the matter or specific to the assessed risk
    of material misstatement;
  •       A brief overview of procedures performed;
  •       An indication of the outcome of the
    auditor’s procedures; or
  •       Key observations with respect to the
    matter;

– or some combination of these elements.

 

While matters that give rise to a modified opinion that are reported
under SA 705(R) or going concern matters that are reported under SA 570(R) are,
by definition, KAMs, as they are already prominently mentioned elsewhere in the
auditor’s report, they are not required to be again described in detail under
the KAMs section. Only a reference may be made in the KAMs section to the
related Basis for Qualified/ Adverse Opinion, or the Material Uncertainty
Related to Going Concern sections of the auditor’s report.

 

Where the auditor determines, based on facts and circumstances of the entity
and the audit, that there is no KAM to be disclosed, he shall nevertheless
include a statement under the KAMs section that there is no KAM to communicate.
It is an expectation in the Standard that in every audit of a listed entity
there would be at least one matter that qualifies as KAM, and therefore the
auditor should be very circumspect in asserting that there is no KAM to report.
However, there could be situations where the auditor determines that a KAM,
though there, is not to be communicated (i) because law or regulation prohibits
such communication, (ii) that the matter belongs to the category of extremely
rare circumstances where the consequences of communication outweigh the public
interest benefits of communication, or (iii) that the only matters to be
communicated as KAMs are disclosed elsewhere in the report in the basis for
modified opinion or going concern sections.

 

SA 705.29, Considerations When the Auditor Disclaims an Opinion on
the Financial Statements states that when the auditor disclaims an opinion
on the financial statements, the auditor’s report shall not include a KAMs
section.

 

The auditor is required to communicate with TCWG (i) the matters that he
has determined to be KAMs, or (ii) that he has determined that there are no KAMs.

 

APPLICABILITY


The Standard is mandatorily applicable to listed entities8.
Yet, the Standard allows for voluntary application by the auditor to audits of
financial statements of other entities also. SA 700(R).A35-A38 deals with two
situations where KAMs may be communicated: (i) where law or regulations
requires such communication, and (ii) where the auditor decides to communicate
KAMs for unlisted entities, particularly in case of unlisted public interest
entities (PIEs). PIEs are large entities that have a large number and a wide
range of stakeholders, for example, banks, insurance companies, employee
benefit funds, charitable institutions, etc.

 

Even where law or regulation is silent, voluntary communication of KAMs
in the auditor’s report by auditors of PIEs is to be encouraged, given the fact
that most of them are very large in size, have many stakeholders, and deal with
huge amounts of public money and may often also have large government
shareholding.

 

The ICAI Implementation Guide to SA 701
pointedly mentions that: “The auditor’s report is a deliverable by the auditors
and hence the decision to communicate key audit matters is to be taken by
auditors only.” In cases of unlisted entities where the auditor would like to
keep his option open for communicating KAMs, ISA 210.A249 (2018
Handbook) Agreeing the Terms of Audit Engagements, states that the
engagement letter may make reference to “the requirement for the auditor to
communicate key audit matters in the auditor’s report in accordance with ISA
701.” This is also reiterated in SA 700.A37.  

 

 

8   PCAOB Standards apply only to listed
entities and hence there is no ambiguity w.r.t. CAMs communication.

 

 

DOCUMENTATION


While the overarching requirements of SA 230, Documentation, of
documenting significant professional judgements made in reaching conclusions on
significant matters arising during the audit appropriately address the
documentation of significant judgements made in determining KAMs, SA 701
nevertheless includes specific documentation requirements in respect of the
following:

  •       Matters that required significant auditor
    attention and the rationale for the auditor’s determination as to whether or
    not each of these matters is a KAM;
  •       Where applicable, the rationale for the
    auditor’s determination that there are no key audit matters to communicate in
    the auditor’s report or that the only key audit matters to communicate are
    those matters addressed by paragraph 1510 ;
  •       Where applicable, the rationale for the
    auditor’s determination not to communicate in the auditor’s report a matter
    determined to be a key audit matter.

 

This is so that a more specific documentation requirement 11 would
address the concerns of regulators and audit oversight authorities (like NFRA)
for their ability to appropriately inspect or enforce compliance with the
Standard.  

 

ILLUSTRATIVE KAMs

A)      Introductory paragraph

  •       Key Audit Matters

Key audit matters are those matters
that, in our professional judgement, were of most significance in our audit of
the financial statements of the current period. These matters were addressed in
the context of our audit of the financial statements as a whole, and in forming
our opinion thereon, and we do not provide a separate opinion on these matters.

 

 

9   The related Indian Standard
on Auditing, SA 210, has not been correspondingly revised by ICAI as of the
date of this article.

10  Matters given in the basis
for modified opinion or the going concern sections of the auditor’s report

11       The
corresponding documentation requirement for CAMs under the PCAOB Standard is:
For each matter arising from the audit of the financial statements that: (a)
was communicated or required to be communicated to the audit committee, and (b)
relates to accounts or disclosures that are material to the financial
statements; the auditor must document whether or not the matter was determined
to be a critical audit matter (i.e., involved especially challenging,
subjective, or complex auditor judgement) and the basis for such determination.
[Note: Consistent with the requirements of AS 1215, Audit Documentation, the
audit documentation should be in sufficient detail to enable an experienced
auditor, having no previous connection with the engagement, to understand the
determinations made to comply with the provisions of this Standard.]

 

B)      Why the matter was considered to be one of
most significance in the audit and therefore determined to be a KAM?

 

  •       Goodwill

Under Indian Accounting Standards (Ind AS), the Group is required to
annually test the amount of goodwill for impairment. This annual impairment
test was significant to our audit because the balance of XX as of March 31,
20X1 is material to the financial statements. In addition, management’s
assessment process is complex and highly judgemental and is based on
assumptions, specifically [describe certain assumptions], which are
affected by expected future market or economic conditions, particularly those
in [name of country or geographic area].

 

  •       Valuation of Financial Instruments

The Company’s investments in structured financial instruments represent
[x %] of the total amount of its financial instruments. Due to their
unique structure and terms, the valuations of these instruments are based on
entity-developed internal models and not on quoted prices in active markets.
Therefore, there is significant measurement uncertainty involved in this
valuation. As a result, the valuation of these instruments was significant to
our audit.

 

  •       Effects of New Accounting Standards

As of April 1, 20XX, Ind ASs 110 (Consolidated Financial Statements),
111 (Joint Arrangements) and 112 (Disclosure of Interests in Other Entities)
became effective. Ind AS 110 requires the Group to assess for all entities
whether it has: power over the investee, exposure or rights to variable returns
from its involvement with the investee, and the ability to use its power over
the investee to affect the amount of the investor’s returns. The complex
structure, servicing and ownership of each vessel requires the Group to assess
and interpret the substance of a significant number of contractual agreements.

 

  •       Valuation of Defined Benefit Pension
    Assets and Liabilities

The Group has recognised a pension surplus of [monetary value] as
of March 31, 20X1. The assumptions that underpin the valuation of the defined
benefit pension assets and liabilities are important, and also subjective
judgements as the surplus/deficit balance is volatile and affects the Group’s
distributable reserves. Management has obtained advice from actuarial
specialists in order to calculate this surplus, and uncertainty arises as a
result of estimates made based on the Group’s expectations about long-term
trends and market conditions. As a result, the actual surplus or deficit
realised by the Group may be significantly different to that recognised on the
balance sheet since small changes to the assumptions used in the calculation
materially affect the valuation.

 

  •       Revenue Recognition

The amount of revenue and profit recognised in the year on the sale of [name
of product] and aftermarket services is dependent on the appropriate
assessment of whether or not each long-term aftermarket contract for services
is linked to or separate from the contract for sale of [name of product].
As the commercial arrangements can be complex, significant judgement is applied
in selecting the accounting basis in each case. In our view, revenue
recognition is significant to our audit as the Group might inappropriately
account for sales of [name of product] and long-term service agreements
as a single arrangement for accounting purposes and this would usually lead to
revenue and profit being recognised too early because the margin in the
long-term service agreement is usually higher than the margin in the [name
of product] sale agreement.

 

  •       Going Concern Assessment

As disclosed in Note 2, the Group is subject to a number of regulatory
capital requirements, which are a key determinant of the Group’s ability to
continue as a going concern. We identified that the most significant assumption
in assessing the Group’s and [significant component’s] ability to
continue as a going concern was the expected future profitability of the [significant
component], as the key determinant of the forecasted capital position. The
calculations supporting the assessment require management to make highly
subjective judgements. The calculations are based on estimates of future
performance, and are fundamental to assessing the suitability of the basis
adopted for the preparation of the financial statements. We have therefore
spent significant audit effort, including the time of senior members of our
audit team, in assessing the appropriateness of this assumption.

 

C)      How the matter was addressed in the audit?

  •       Goodwill

Our audit procedures included, among others, using a valuation expert to
assist us in evaluating the assumptions and methodologies used by the Group, in
particular those relating to the forecasted revenue growth and profit margins
for [name of business line]. We also focused on the adequacy of the
Group’s disclosures about those assumptions to which the outcome of the
impairment test is most sensitive, that is, those that have the most
significant effect on the determination of the recoverable amount of goodwill.

 

  •       Revenue Recognition

Our audit procedures to address the risk of material misstatement
relating to revenue recognition, which was considered to be a significant risk,
included:

•    Testing of controls, assisted
by our own IT specialists, including, among others, those over input of
individual advertising campaigns’ terms and pricing; comparison of those terms
and pricing data against the related overarching contracts with advertising
agencies; and linkage to viewer data; and

•    Detailed analysis of revenue
and the timing of its recognition based on expectations derived from our
industry knowledge and external market data, following up variances from our
expectations.

 

  •       Disposal of a Component

We have involved our valuation, financial instruments and tax
specialists in addressing this matter and focused our work on:

•       Assessing the
appropriateness of the fair values assigned to each element of the
consideration received by referring to third-party data as applicable;

•       Evaluating management’s
assessment of embedded derivatives within the sale and purchase agreement; and

•       Critically assessing the
fair value of [name of component] and the related allocation of the
purchase price to the assets and liabilities acquired by evaluating the key
assumptions used.

 

We also evaluated the presentation and disclosure of the transactions
within the consolidated financial statements.

 

  •       Restructuring Provision and
    Organisational Changes

In our audit we addressed the appropriateness and timely recognition of
costs and provisions in accordance with Ind AS 37 – Provisions, Contingent
Liabilities and Contingent Assets. These recognition criteria are detailed and
depend upon local communication and country-specific labour circumstances.
Recognition criteria can be an agreement with the unions, a personal
notification or a settlement agreement. The component audit teams have
performed detailed audit procedures on the recognition and measurement of the
restructuring provisions related to their respective components. The Group
audit team has identified the completeness and accuracy of the restructuring
provisions as a significant risk in the audit, has reviewed the procedures
performed by the component audit teams and discussed with the component teams
the recognition criteria. The restructuring provisions at the head office were
audited by the Group audit team. We found the criteria and assumptions used by
management in the determination of the restructuring provisions recognised in
the financial statements to be appropriate.

 

Decision framework to guide the auditor in
exercising his professional judgement





  •       Restructuring Provision and Disposition
    of a Mine

Our audit procedures included, among others: examining the
correspondence between the Group and the [name of government] and
discussing with management the status of negotiations; examining announcements
made by management to assess whether these currently commit the Group to
redundancy costs; analysing internal and third-party studies on the social
impact of closure and the related costs; recalculating the provision for
closure and rehabilitation costs for the mine in the context of the accelerated
closure plans; and reassessing long-term supply agreements for the existence of
any onerous contracts in the context of the Group’s revised requirements of the
accelerated closure plans. We assessed the potential risk of management bias
and the adequacy of the Group’s disclosures.

 

We found the assumptions and resulting estimates to be balanced and that
the Group’s disclosures appropriately describe the significant degree of
inherent imprecision in the estimates and the potential impact on future
periods of revisions to these estimates. We found no errors in calculations.

 

D)      How the auditor may refer to the related
disclosures in the description of a KAM?

 

  •       Valuation of Financial Instruments

The Company’s disclosures about its structured financial instruments are
included in Note 5.

 

  •       Goodwill

The Company’s disclosures about goodwill are included in Note 3, which
specifically explains that small changes in the key assumptions used could give
rise to an impairment of the goodwill balance in the future.  

 

DE-LAYERING RELATED PARTY TRANSACTIONS THROUGH INTERNAL AUDIT

Virtually every
business has transactions with related parties. They are a business necessity.
Businesses have related entities and they transact in a regular and routine
manner. These could be genuine transactions executed in the same manner as any
other transaction with a non-related party. However, of late the phrase Related
Party Transaction (RPT) has taken on a kind of negative connotation. Is it
justified? Perhaps not. Is it true? Perhaps not. Is it due to a few events –
real as well as alleged – where the blame for a business failure / business
loss is placed on related party transaction/s? Perhaps.

 

Firstly, it is not
correct to paint all RPTs with the same brush. Further, to ensure that an RPT
is genuine and fulfils business needs, laws and regulations are already in
place. The Companies Act requires approval of RPTs by the Board of Directors
and confirmation that they are at arm’s length. Similarly, SEBI (Listing
Obligations and Disclosure Requirements) Regulations prescribe a comprehensive
mechanism for the manner of dealing with related party transactions, from
approval to monitoring. The Income-tax Act requires a justification of the
transaction to ensure that there is no disallowance while computing taxable
income, as well as to ensure that there is no adjustment in a transfer pricing
assessment. Accounting standards – both Indian and international – necessitate
disclosures of RPTs. All in all, there are sufficient checks and balances in
various regulations that businesses have to adhere to vis-à-vis RPTs.

 

A scrutiny
mechanism is in place to achieve / assess compliance with the requirements.
This scrutiny takes place at various levels and in diverse manners. Each
scrutiniser’s objective is different and that impacts the manner and detailing
of scrutiny. The various genres of scrutinisers and their objectives can be
summarised as under:

 

Management – they have primary responsibility to assert that the RPT is
necessary, genuine, at arm’s length pricing and at par with any other business
transaction. They are also responsible for seeking the required approvals, from
the Board of Directors / Audit Committee of the Board, as the case may be,
before entering into RPTs;

Board of
Directors – assertions of internal control over
financial reporting and adequacy of internal financial controls rests finally
with the Board of Directors. Apart from according approvals to
management-recommended RPTs, the Board also has governance responsibility to
ensure the adequacy of IFC and ICFR. As part of this responsibility, the Board
scrutinises the RPTs before blessing them;

Statutory
Auditor – true and fair opinion is the deliverable
of the statutory auditor. In arriving at this opinion, he / she needs to
scrutinise the RPTs, ensuring due authorisations are in place. He / she also
signs off the proper disclosures in tandem with accounting and other reporting
standards;

Tax authorities – they scrutinise with the intention of determining whether any
adjustment is required while computing taxable income or determining adjustment
for transfer pricing. The focus of such a scrutiny is pricing and not so much
the due authorisation of the RPT;

Other regulators – this scrutiny includes the process of approvals and disclosures;

Shareholders – a body that has in the recent years heightened its scrutiny by
ensuring the appropriateness of the RPT as well as its pricing. There have been
occasions where Board-approved RPTs have been scrutinised and inquired into by
shareholders.

 

What about scrutiny
by internal auditors? Does the internal audit fraternity consider RPT as a
major element to be audited? There are varied experiences across industries and
sectors. For RPTs to be covered by internal audit, it would be appropriate to
consider the following factors:

 

Is it part of the
internal audit charter or policy document? Many large and mature organisations
have a formal IA Charter / Policy. We need to determine whether such a document
has a reference to auditing RPTs;

 

Does the management
have a desire of including RPTs within the ambit of internal audit? It may so
happen that managements themselves identify RPTs to be an element to be
audited;

Whether the
internal auditor has determined RPTs to be a significant business component or
/ and a significant control parameter? In both these situations the internal
auditor will need to discuss with the management and convince them of the need
of auditing RPTs;

 

Lastly, the view of
the Audit Committee of the Board (ACB) is also to be considered. They may
desire all or certain RPTs to be covered by internal audit. They may desire
that the process of RPTs be audited because under governance norms, the buck
stops at the ACB.

 

Based on the
outcome of the above processes, it is advisable for the internal auditor to
perform a risk assessment of the processes around the RPT. On such an
assessment the audit universe for the RPTs can be determined and agreed upon
with the auditee management.

 

THE AUDIT PROCESS

First, one needs to start with identifying related parties and examining
transactions with them. Usual source points will be the entity’s mechanism of
identifying the related parties. Are the declarations of Directors sufficient?
Or does the internal auditor need to prod beyond them? In my view, the
internal auditor will need to do an assessment of the governance process of the
company and then arrive at his / her own conclusion on the robustness and
adequacy of the same. If reliance can be placed on the governance process
it would be easy for the internal auditor to depend on the process of
identifying the related parties. The internal auditor could also look at the
various declarations that the company would have filed with, say, MCA or with
tax authorities (for transfer pricing or GST), as also declarations made to
customs authorities during cross-border transactions. Another important source
of information would be the one submitted to bankers and lenders on who are the
related parties. The internal auditor can inquire about the group structure of
the entity, both at its parent / holding company level, as well as the
subsidiaries (including step-down subsidiaries), associates and joint ventures,
both in India and overseas.

 

A major risk of
audit is not identifying all the related parties and, on the basis of the above
information, the internal auditor needs to determine whether reliance can be
placed upon the information furnished. In case the auditor determines that
complete reliance is not possible, he / she will need to scrutinise further.
There will be a need to scrutinise the ledgers of the entity and identify the
possibility of the entity missing out on identifying a related party. The
auditor’s eyes and ears should be open to spotting whether there are entities
who would qualify as related parties – entities with similar sounding names or
pattern of names, entities structured as trusts, overseas entities, and so on.
This scrutiny will also give comfort to the internal auditor on the
completeness of the identification of the related parties and the transactions
with them. Needless to say, in today’s terminology the word scrutiny is
substituted by data mining. With the ERP systems deployed across organisations
and the tools available to internal auditors, data mining, if done correctly,
throws up significant information.

 

The second
part of the audit process involves the pricing of the RPT. And pricing is the
culmination of a business process that involves recommendation and approval by
the persons who have the authority to do so. As an internal auditor the focus
will be on the mechanism of the company to ensure that the transaction is
priced appropriately. The following sources of information and inquiry will
help the audit process:

 

Does the entity
have a pricing policy for RPTs?

Is it clear and
unambiguous?

Is it applied
uniformly and consistently?

Does the policy
permit deviations? If so, how are the deviations authorised?

 

Assess the number
of instances of deviations – how many, for which related party, for any product
or service? Data mining on the deviations will certainly throw out signals for
the internal auditor to follow and assess the genuineness of the same;

 

Business groups,
and multi-national groups in particular, usually have a group pricing policy.
This policy lays down the criteria of how a product or service is priced. This
policy can also have differentiating factors based on geographies or even on
product offerings;

 

The views taken by
tax authorities are another important source of information. Though such views
may be taken with a completely different objective, but they definitely give a
perspective from an internal audit point of view;

 

Consider the nature
of the transactions. Are they within ordinary course of business, or are they
not in the ordinary course of business? Depending upon this, there would be
different processes followed by the company which the auditor needs to be aware
of. A transaction within the ordinary course will have a different approval
process or would be carried with omnibus approvals of the Audit Committee or
the Board. A transaction not within the ordinary course would require a
specific approval. These processes would be defined in the various policy
documents or would be indicative of the practices followed. It may be noted
that for transactions not in the ordinary course of business, the auditor would
need to examine whether the processes followed remain consistent or not. Any
inconsistency in processes also needs to be examined further.

 

All these sources
of information, when properly applied, will give reasonable comfort to the
auditors on the appropriateness of the pricing of the RPT.

 

The most important
part of the audit process is the deployment of professional scepticism
by the internal auditor. In fact, this needs to be deployed by the auditor all
through the audit process. This will help the internal auditor to de-layer the
RPTs and determine their genuineness or otherwise, as well as their
appropriateness or otherwise. Businesses enter into RPTs consistently and
across financial years. Transactions with some related parties are more
frequent than with others. They could also be more voluminous than others. In
such an environment, the auditor will need to dig deeper into his skills,
remain sceptical and inquire into the various decision-making processes of the
auditee vis-à-vis related party transactions. Such inquiries with various
levels of management, corroborated by further supporting evidence, will help
the auditor opine on the appropriateness of the RPTs.

 

With so much glare
on the rightfulness or perceived wrongfulness of RPTs, internal auditors need
to walk that extra mile and de-layer RPTs to come to a proper opinion on their
reasonableness. The following checklist is just a pointer on how to handle this
de-layering and may not be considered as exhaustive:

 

CHECKLIST FOR HANDLING DE-LAYERING OF RPTS

 

Sr.
No.

Particulars

Basic points

1

Internal approval
by

2

Nature of
transaction

3

Whether the same is
in ordinary course of business? Basis for deciding ordinary course of
business:

•

MOA, AOA for nature
of transactions

•

Frequency of such
transactions entered

4

Whether transacted
on an arm’s length basis

Agreement specific

5

Tenure of agreement

6

Whether the Related
Party Transaction would affect the independence of an independent Director?

7

Rationale for
entering into the RPT

8

Is there any
non-monetary consideration given?

9

Terms of payment

10

Any other expenses

11

Interest

Points related to
arm’s length pricing

12

Documenting the
arm’s length price

13

Whether the same
pricing is used as that for other vendors?

14

Whether the terms
of the RPT are fair and on arm’s length basis to the company and would apply
on the same basis if the transaction did not involve a related party? (such
as advance payment / received, pricing, supply and other terms)

15

Has a vendor / customer
rating been done for the related party like it is done for any non-related
party, and if so, how well do they compare?

16

Is this activity
with related party needed for the company to generate revenue or achieve its
purpose or objective?

17

How are the above
terms different for a related party from a transaction entered into with a
non-related party?

18

How is the pricing
arrived at? Are there any terms which are not mentioned in the contract for
arriving at price?

Company specific

19

Relation with
related party

20

Commencement of
business with related party

21

Other services
provided by / to same related party (estimated)

22

Whether the service
is provided on a regular basis or non-regular?

23

Whether the same
service is provided by vendor on sole basis or with other vendors (may be
related or not)?

24

Whether this
activity is very uniform when it happens?

25

How far is the
financial scale of this activity compared to the relevant common denominator?
(the denominator being total sales if selling to a related party, or total
purchase if buying from a related party, or total financial expenses if
paying interest on loans to a related entity

26

Secured / unsecured

27

Whether the price
charged / paid by the company can be considered at arm’s length pricing?

 

REPORTING

The internal auditor will need to report his / her opinion
on the appropriateness of RPTs and the adequacy of compliance with laws,
regulations as well as internal policies and procedures. On the basis of the
above audit processes, the internal auditor will need to indicate in the report
at a minimum the following:

 

Existence of due
approvals for the RPT;

Reasonability of
arm’s length pricing;

Execution of the
transaction in accordance with the approvals and the pricing; and

Deviations and
exceptions, if any.

Of course, all
other principles of reporting – materiality, brevity and preciseness – remain
fundamental.

 

Based on the scope
and objective of the internal audit, a report on RPT could be a distinct audit
area or it could be bundled into another audit area, e.g. if one is auditing a
P2P process all the above facets around an RPT can be examined; similarly for
any other area under audit.

CONCLUSION

In my view one of the key result areas of the internal
audit function is that when placing reliance on its reports, the top management
derives comfort on the existence of controls. It has been the experience that
comfort of existence of controls enables the Board and top management to take
appropriate risk-driven business decisions. Auditing RPTs fulfils a significant
management control function. It is time that the management (Audit Committee /
Board) extends the internal audit scope to specifically cover the audit of the
process of identification of related parties, fair pricing of RPTs, their
approval and full and fair disclosures and reporting. Inclusion of this area in
Internal Audit scope is necessary to empower the Internal Auditors to gain
access, ask relevant questions and undertake a deep-dive to ensure that the
process adopted is adequate and that the organisation is complying with the
regulations relating to related parties, not just in form, but also in spirit.

The BCAJ will
carry a sequel to this article where practical examples based on Internal Audit
of Related Party Transactions will be covered.  

 

 

BANNING THE AUDITORS

1.
    BACKGROUND

 

1.1     This article deals with some of the complex
issues relating to the auditor’s role and responsibilities relating to
financial reporting in the context of fraud and business failures and the
provisions of the Companies’ Act, 2013 that pertain to the removal and barring
of auditors, including firms for failure to report material misstatements
arising out of the above.

 

The integrity of
financial statements is important because millions of stakeholders rely on them
for decision-making. Unreliable financial reporting has serious implications;
they lead to financial losses, loss of jobs and, most importantly, they shatter
investor confidence. The law is settled: it is the primary responsibility of
management to maintain proper books of accounts and  build an effective governance framework,
including internal financial controls. However, external auditors provide the
most critical link between the company and its stakeholders. They are appointed
by the members, vested with powers specified under law and they report directly
to the members. They have access to the company’s records, systems and
processes, all the key members of management who are charged with governance:
the board, the audit committee, and all relevant management; they evaluate all
significant and other accounting policies; in essence, they do all the work
that is necessary for expressing the opinion of “true and fair” on the
financial statements.

 

1.2     The Ministry of Corporate Affairs (MCA)
recently launched prosecution against several auditor firms (‘current and
former’) for their alleged role in “perpetuating the fraud” in a leading
financial services and infrastructure company, a matter that has been widely reported
in the media. The MCA moved the National Company Law Tribunal (NCLT) for
debarment of these audit firms and their audit partners. It sought interim
attachment of their properties, including bank accounts and lockers.

 

1.3 In this context,
the ICAI Regulations provide for various actions against an individual member
for professional misconduct arising from not discharging professional
responsibilities in the manner as required. In the matter of disciplinary
action in the Satyam case, the Institute of Chartered Accountants of India
(ICAI), in an e-mailed statement, had told PTI that it has no powers to take
disciplinary action against chartered accountant firms and that a request that
was sent to the government in this regard in 2010 was yet to be acted upon… status
quo remains even as on date. This article examines some of the complex
issues relating to the banning of auditors, this being a complex and
exceptional event. The aspects relating to the legality and powers, etc., of
the various regulatory bodies in this specific context is clearly beyond the
scope of this article.

 

1.4 The present law
for the removal of auditors is contained in sections 140(5) and 143(12) of the
Companies’ Act 2013, which sections we shall examine in detail because of the
wide import of these sections and the manner in which these are currently being
interpreted in terms of what actions can be (and need to be) taken against
individual engagement team members, the practice and the firm. We shall also
examine the impact that these developments will have on several contentious
issues such as, for example, the detection and reporting on fraud and business
failures during the course of audit and the consequences of failure to not
report on these matters specifically, on the engagement partner and team
members and the firm… and the profession. The MCA claims that invoking section
140(5) of the Company’s Act in the case would allow debarring an audit firm for
at least five years; the validity of these claims is being evaluated by the
NCLT.

 

1.5 The asymmetry
between the auditor’s role in the detection and reporting for risks of fraud
and business failures and stakeholders’ expectations is widening. In this
environment, regulators and shareholders seeking action against auditors for
not adequately addressing the risks that lead to these failures… trying to
find audit failures behind every business failure needs to be addressed.
Stakeholders, particularly the Regulators and shareholders, expect the auditors
to be vigilant and address the risk of business failures and fraudulent
practices through better audit procedures and communication. Auditors are no
longer perceived as “assurers” but as professionals, who by virtue of the role
they play and the position in which they are placed, considered as a critical
line of defense and are considered responsible in addressing the twin risks of
business failure and fraudulent conduct of managements. The aspect of audit
failures is also a harsh reality and regulators in other countries… particularly
the UK and US are concerned about these audit failures, looking at serious
action and reforms in the auditing market.

 

2.
BUSINESS FAILURES AND FRAUD: THE AUDITOR’S RESPONSIBILITIES AND STAKEHOLDER EXPECTATIONS

 

2.1 The recent
example of business failures of large companies has clearly brought into focus
what the responsibilities of auditors are to address the related potential and
inherent risks and “red flags,”    in
their audit approach, audit tests and communications with those charged with
governance and where required under law, escalating to the regulatory
authorities cases of fraudulent conduct. Business failures happen due to
diverse reasons: economic downturns, market disruptions, liquidity crises, poor
governance, and even significant acts of fraudulent conduct by management are
factors that can individually or jointly cause businesses to fail. Hundreds of
companies in India have lined up for insolvency under the IBC; loss to
stakeholders run in several thousands of crores of rupees. Similarly, the NPA
crisis in the commercial banking sector is estimated to have caused losses that
run upward of Rs. 7 trillion…  the
economy is yet to recover from credit not flowing adequately as a result; NBFCs
as a sector have also come under severe stress, with the risk of mega failures
looming large.

 

2.2 Regulators and
other stakeholders not only rely on audited statements but also take financial
decisions that impact wealth, savings, investments and taxes. Business failures
and more particularly, those arising due to fraudulent conduct, result in
significant losses to lenders, investors and shareholders. The role of the
Board, the audit committee, management and auditors are invariably subject to
scrutiny and investigation. The provisions of the law provide for penalties,
imprisonment in case business failures are also on account of governance and
fraudulent conduct. Specifically, section 140(5) of the Companies Act, 2013
provides for removal of the auditor(s) if it is established that the auditor
has either acted in a fraudulent manner or abetted fraud by the company or its
officers. The NCLT’s order also renders the auditor and the firm ineligible for
appointment as auditors of any company for a period of five years. (We shall
deal with the debarring of auditors and firms later).

 

2.3 Since the
collapse of Enron, there have been several other large failures in the US, the
UK and India. In the UK recently, where there has been a spate of business
failures, regulatory authorities have commented on the failure of audit to
demonstrate adequate scepticism, challenge managements and constantly shifting
blame from one to another. The conclusions were unmistakable: the public and
key stakeholders had become disillusioned with the reliability of audits and
distrustful of the performance of directors. While the Competition Commission,
the Financial Reporting Council and others acknowledged the fact that there
exists an ‘expectations gap’ between what an audit does and what are the
stakeholders’ expectations from audit, the truth was that audits too often fell
short on quality and expectations.

 

2.4 In India, ever
since Satyam, various stakeholders have urged on the need for reform in the
audit market by way of stricter regulations and penalties and the amendments to
the Companies Act, 2013, the formation of the NFRA and the increasing role of the
SFIO are all steps in that direction.

 

3.
PROVISIONS UNDER THE COMPANIES’ ACT, 2013 FOR REMOVAL (INCLUDING DEBARRING)  AND RESIGNATION OF AUDITORS

 

3.1 Section 140(1)
provides for removal of auditors before the expiry of their term only by
special resolution and approval of the Central Government. There is also a
requirement for the auditor to be heard and to make representation to the CAG
indicating the reasons and provide facts that may be relevant.

 

3.2 Let us examine the provisions of
Section 140(5)

 

i. The
provisions of Section 140(5) provide that the NCLT can, suo moto or based on an application from the Central Government
or a concerned person, direct change of auditors (that is, remove the auditors)
if it is satisfied that the auditor has acted in a fraudulent manner or abetted
or colluded in any fraud by the company or its directors and officers.

 

ii. The NCLT
passes final order for removal of the auditor (including the firm) and also rendering the auditor (including the
firm) ineligible for appointment as auditor of any company for a period of five
years, including being liable for action and punishment for fraud u/s 447 of
the Act.

 

3.3 Let us
examine some of the key and relevant implications (of i. and ii. above):

 

3.3.1 Section
140(5) does not define under what circumstances can the NCLT hold that the
auditor acted in a fraudulent manner or abetted / colluded in any fraud by the
company or its officials. The words, ‘directly or indirectly’ appear to
qualify and may be interpreted to mean both direct participation or “tacit”
approval to fraudulent behavior by the auditor and fraud by the management.
Situations that can potentially come under the realm of “indirect fraudulent
behavior” or “indirectly abetting or colluding management fraud” could possibly
include:

 

– absolute, gross
negligence or turning a blind eye to what appears apparent to any reasonable
person (in position as auditor) or what the SEC describes as “reckless conduct”
by the auditor. The serious risk is that gross negligence in evaluating key
inherent risks and absence of internal controls, choosing not to pursue serious
irregularities that came to the auditor’s attention during audit and raised by
audit staff could be perceived as “tacit approval” of fraudulent conduct;

-where it is
established that the auditor was aware of serious and material irregularities
but chose not to discuss, escalate or report to those charged with governance
and to the shareholders and government and instead chose to rely on sham
representations from management;

– agreeing not to
report to shareholders serious risk of defaults in the settlement of material
obligations that could impact the sustainability of the business;

– agreeing to not
deal with serious lapses in governance, internal controls, material frauds
detected by management including non-compliance with certain laws and
regulations;

– serious conflicts
of interest that result in loss of independence as auditor to express an
opinion of true and fair.

 

3.3.2
Debarring the firm

 

To debar a firm would
mean the “direct or indirect” involvement of every partner in the
firm to the fraudulent behavior or the act of conniving to abet or collude with
management. Debarring a firm is not unique to India; the SEC also provides for
suspending license to practice where “reckless behavior” is clearly established
at a firm-wide level. Three illustrative instances are provided to highlight
circumstances under which a firm could run the risk of being debarred:

 

Where the leadership
of the practice comprising of (say) the senior partners, was not only actively
involved on the engagement including managing audit quality, discussions with
management but agreeing to act in a manner clearly demonstrative of “utter
disregard” to discharge professional obligations on the engagement…

say, for example,
agreeing with management to suppress material facts that reveal involvement of
management in serious fraud. In such cases, it would therefore not be necessary
for the NCLT to hold that ‘every partner’ was involved because ‘the firm is
clearly perceived to act in disregard for professional obligations.’

 

Where the rendering
of non-audit services are significant; even in normal circumstances, auditors
will do well to review all non-audit services that they render to remain free
of the charge of “conflict of interest” and “independence” as these could make
them vulnerable to the risk of complicity in case of failure to detect serious
frauds and other irregularities. In this context, the rendering of non-audit
services that fall under ‘prohibited services’ as defined in section 144 of the
Act can put to risk the entire practice getting debarred in case of charges of
fraudulent behavior, connivance, etc.

 

Absence of firm-wide
audit methodology, ethics, risk and independence policy because regulators may
perceive the risk of audit failure as systemic and ‘waiting to happen”’any
time.

 

3.3.3
Complexities relating to a firm-wide ban:

 

Except as stated in
circumstances in 3.3.2 above, it is only under certain unique circumstances
that an entire firm could be charged with fraudulent behavior or in abetting
and colluding with management. A firm-wide ban means that all partners and
employees (including non-professional employees) are being accused and charged
under the section for fraudulent conduct or for complicity. Where the NCLT
Order has the effect of banning an entire firm for a period of five years, it
has to be established that the entire firm comprising the firm leadership, the
audit partners (not only from the engagement team but also from other teams and
other locations) and the tax and advisory partners in that firm
had all connived with or abetted in the fraudulent activities in the company.
Without a detailed investigation into the affairs of the firm, and its risk
management policies, every correspondence, every mail box, the risk management
policies, the audit methodology… the list is endless! How can an authority
establish beyond all reasonable doubt that the entire firm was involved in
abetting or conniving with management, especially when over a hundred partners
typically work in these large firms in different disciplines and departments
remains a challenge! The provisions appear arbitrary and rigid… this can
only cause serious harm to the entire process of reforms that the Regulators
are working towards.

 

3.3.4 Learning
from global best practices: How SEC, PCAOB, deal with major audit failures and
suspension of licenses:

 

i. The SEC/PCAOB
Regulations provide for Removal, Suspension, or Debarment of Accounting Firms
or Offices of firms. The rules identify factors the Regulators consider in
determining the appropriate penalty and remedy. Under current regulations
governing practice, the Regulator can remove, suspend, or debar a firm by
naming each member of the firm or office in the order of suspension or
debarment. The Regulations provide that, in considering whether to take action
against a firm and the severity of the sanction against a firm, the Regulator
may assess the gravity, extent of involvement of firm personnel, including the
leadership, scope, or repetition of the act or failure to act; the adequacy of
and adherence to applicable policies, practices, or procedures for the firm’s
conduct of its business and the performance of audit services; the selection,
training, supervision, and conduct of members or employees of the firm involved
in the performance of audit services; the extent to which managing partners or
senior officers of the firm participated, directly or indirectly through
oversight or review, in the act or failure to act; and the extent to which the
firm has, since the occurrence of the act or failure to act, implemented
corrective internal controls to prevent its recurrence. Section 140(5) contains
no such mitigating provisions. None of the regulatory agencies in India,
barring the ICAI have any mechanism or laid down procedure to examine these
aspects. The results can only be arbitrary and harm the profession.

 

ii. There is no
exhaustive list of factors and circumstances may present other facts that the
Regulator will take into account in determining whether to take an action
against a firm. The Regulators anticipate that there may be circumstances in
which it will not be appropriate to remove, suspend, or debar an entire firm,
but that action should be taken against a particular office or specific offices
of the firm. The Regulator would hold hearings on removals, suspensions, and
debarments under rules that are consistent with the relevant Rules of Practice
and Procedure including, provide among other things, for written notice to the
respondent of the intended action and the opportunity for a public hearing
before an appropriate judge. Reckless and ‘disreputable conduct’ including
mainly, aiding and abetting violations, of specified laws and the reckless
provision of false or misleading information, or reckless participation in the
provision of false or misleading information also may lead to removal,
suspension, or debarment of firms. The most important point is, except in a
case where the continuance of a firm could cause irreparable damage to the
Regulatory environment because of extreme and reckless behaviour, it was felt
that an immediate suspension would not stand up to any legal scrutiny.

 

iii. The provisions
of Section 140(5) appear limited in scope in terms of dealing with the removal
of auditors for fraudulent conduct and connivance and not with past cases of
audit failures. The Companies Act also appears clearly ill-equipped to
prescribe elaborate procedures for determining professional misconduct of the nature
described in Section 140(5). An independent agency will need to be set up
on the lines of the PCAOB to inspect firms (public interest entity audits may
be taken up) on quality, risk and independence. That agency will frame
regulations on various aspects of audit so that there is a comprehensive and
professional basis for evaluating firms on risk, independence and quality…
Section 140(5) cannot be used as a ‘lone wolf’ provision to penalise and debar
auditors. The Regulators cannot step in only to penalise auditors; they have a
more constructive role to play for the development and sustenance of the
profession.

 

iv. The US and the
UK have framed regulations on similar lines that deal specifically with removal
and debarring of auditors. But, these are all based on a comprehensive
framework and procedures to proactively deal with audit risk and quality.
Section 140(5) needs to be backed by a similar structure before enacting laws
for removal and debarring of auditors. The PCAOB and its equivalent in the UK
have been therefore effective in identifying audit failures and disciplinary
actions taken by regulators against firms including the Big Four act as a
deterrent for reckless audit. Firms and partners are penalised and there is a
specific plan that is laid down by the regulator for the audit firm to
implement. These form the basis for the regulator to conclude whether auditors
indulge in repeated wrongful behaviour… to conclude whether the firm needs to
be considered for debarment. Matters are referred to a judicial authority to
decide on the case. These processes and procedures are designed to ensure that
the regulators and auditors work together and play an important role in the
improvement of the financial markets and the financial reporting process.

 

v. The current
scenario where several investigative agencies investigate and interrogate
auditors on the same issues is gross and counter-productive because they have
otherwise no role to play in the development of the profession. The SEC and the
PCAOB in the US and the FRC in the UK are known to be extremely methodical in
their approach but, their credibility arises on account of their deep knowledge
of all aspects of the financial reporting process and also, their role in
developing auditing standards, building audit quality and risk management.

 

3.3.5 Section
447 and the “intent to deceive”

 

 i. Section 447 of the Act defines ‘Fraud’ to
include any act, omission, concealment of any fact or abuse of position
committed by any person by himself or by connivance with an ‘intent to deceive.’ This imposes a challenge
because the auditor does not have the benefit of scrutinising and identifying
fraudulent financial transactions in the books because ‘intent to defraud’
would in most cases reflect in the financial books at some future date.

 

ii. The start point
for an auditor would be a detailed evaluation of the key inherent risks, based
on a deep understanding of the business, the overall control environment and
the company’s history of internal control failures, manifestation of business
risks and incidence of frauds.

 

iii. Detailed
consultation with those charged with governance is necessary; the primary
responsibility for maintaining internal financial controls and books of
accounts that are free of material misstatements is that of management. The
auditor will need to discuss the risk of fraud with the audit committee and the
internal auditors because they are best placed to discuss “red flags” in
the system.

 

iv. In all this, it
is extremely important for the auditor to remain compliant with the mandatory
accounting standards and the standards on auditing.

 

3.3.6 Business
failure and fraudulent reporting

 

i. Businesses fail due to a myriad of reasons ranging from economic
downturns, liquidity crisis in the markets, project failures not within the
control of the business, market disruptions, and internal factors such as poor
quality of leadership, serious governance failures including frauds, diversion
of funds for other than agreed upon end use, etc.

 

ii. To understand
the asymmetry on the expectations between auditors and stakeholders on business
failures, let us examine these situations:

 

(a) It is common and an inherent risk for a company which is in the
business of infrastructure, of a future asset-liability mismatch arising on
account of a project that is not getting completed for reasons beyond the
control of management. Loan instruments with a repayment schedule of more than
ten years are few and involve complexities because they are mostly
quasi-equity, lenders are inherently averse to fund long term, etc. There is a
continuing risk of the project getting delayed, resulting in a serious asset
liability mismatch. The risk that a delay can seriously weaken the company’s
ability to service debt on the due dates can be seriously jeopardised in the
matter of a single quarter, leaving the auditor with an extremely small window
to call out the risk of not honouring a payment on the due date.
“Round-Tripping” is therefore a common occurrence in the financial sector and
is ordinarily not associated with a collapse. It is common practice for lenders
to “roll-over” loan instalments that fall due for payment and the parties enter
into an arrangement to pay at a later pre-determined date where the borrower
pays a few days after the due date. The lenders also understand that these are
“acceptable  aberrations” that occur
because of temporary mismatch in cash flows… all is accepted because of the
knowledge that the borrower is not a “fly-by-night” operator. But recent
examples prove that a single case of “round-tripping” can cause a series of
defaults.

 

(b) The auditors
would have, in the course of audit, examined and documented the risk of such
aberrations as “moderate” because of the overall solvency and profits. Also,
past record of payments on due dates would have resulted in the risk being
classified as “moderate”. In a case where the default happens on a
date subsequent to the balance sheet date but only a few days before audit sign
off and the lender communicates his unwillingness to “roll over,” there could
be a serious crisis and a chain reaction where no lender trusts the ability of
the business to honour its debts on due dates. The classification of audit risk
as “moderate” could become suddenly a matter of “suspect judgement.”

(c) Due to the
adoption of  fair value accounting, the
carrying value of a project may undergo a significant downward revision on
account of impairment close to balance sheet date. Estimates and year-end
valuations continue to pose the biggest challenge to auditors and more so in a
case where the business failure results in a roving inquiry into the entire
gamut of governance. Post-IFRS and Ind-AS, implementation and the use of
fair values, the “cushion” that was available in historical cost regime no
longer exists. Regulators and other stakeholders need to accept the fact that
these errors in estimates are inherent to the adoption of fair value
accounting.

 

3.3.7 The
challenges of Holding Subsidiary company relationships:

 

i. In India, the
auditing standards require the auditors of the consolidating entity to rely on
the work of the component auditor without having to review all of the work
papers of the subsidiaries. The Companies Act 2013 provides the consolidating
auditors access to the work papers of all the component auditors.

 

ii. However, SEBI plans
to make it mandatory for auditors of parent companies to review the work of all
the auditors of subsidiary companies before being approved by the board. This
possibly arises on account of the crisis at IL&FS where Regulators believe
that auditors of the parent companies were not familiar with the processes and
risks at the subsidiary level, resulting in various irregularities including,
mainly, the misuse of funds transfers and “ever-greening” of loans at the
subsidiaries’ level.

 

iii. The
traditional view that each company is an independent legal entity is being
challenged by authorities all over the world because of certain specific
reasons. The Holding Company invariably exercises significant control over
all major board decisions at the subsidiary level by controlling the board
composition, centralised operating decisions such as purchases, funding,
significant transactions between the parent and the subsidiaries, common
statutory and internal auditors and policies on risk ethics and compliance. Given
all these inter-dependencies, it is very difficult to hold that the subsidiary
boards and management are independent and responsible for their
governance-related matters. As a result, members on the board of a holding
company are no longer insulated against charges of governance failures at the
subsidiary level. The same holds good for auditors of the holding company: in
most instances, almost all the material subsidiary accounts are audited by
them, they circulate detailed audit instructions and in a few cases, almost all
significant audit matters are discussed by them with the component auditors of
the material subsidiaries, their audit committees and respective boards.

 

iv. The SEBI
believes that parent company auditors cannot be merely “consolidating” without
an understanding of the key audit risks and significant audit matters by the
respective component auditors and, how they have been discussed and dealt with
in the auditors’ reports.

 

v. Parent company
auditors will therefore need to extend their involvement to obtain detailed
understanding of all key matters including key risks identified during audit
planning meetings risk, how the audit tests were designed to deal with these
risks including the risk of fraud and internal control weaknesses.

 

4. HOW DO AUDITORS RESPOND IN THIS HEIGHTENED LEVEL OF RISK AND LITIGATIVE ENVIRONMENT?

 

We shall deal with
the three top level changes that auditors must make in their audit
strategy to address the heightened level of risk of frauds and business
failures and the litigative environment that exists. These are in addition to
the audit tests prescribed in the standards of auditing prescribed by the ICAI:

 

(a) Audit
Planning: More often than not, the time and qualitative attention that
auditors devote to plan the audit is inadequate. Audit planning must focus
categorically on the issue of various aspects of risk: Risks inherent to the
business are the most critical because they define what the risk framework
should be. Hitherto there has been a lack of focus on factors that could
significantly impact business continuity and these risks typically include the
main risks of business and governance failure. This risk summary will be a
critical document that needs to be updated at every stage of the audit because
new risks emerge as the auditor gains deeper insights into the business. The
auditor must discuss this list internally with the team and with all those who
are entrusted and charged with governance: the Board, the management, the audit
committee and the internal auditors at key stages of the audit to assess how
these risks are being addressed. These discussions must be documented in
detailed manner such that the principle of ‘due care’ is established;

 

(b) Evaluating
the Corporate Governance Framework: Assess the quality and
independence of the Corporate Governance Framework: Typical “red flags” include
a weak set of “independent directors” who typically do not stand up to discuss
potential risks to governance, internal auditors who structurally report to the
finance head, the presence of significant related party transactions,
reluctance to discuss incidents of fraud, ignoring whistleblower incidents…as a
result, the auditor is the only effective link in the entire corporate
governance structure.

 

(c) Paying
attention to the ‘Critical Audit Matters’ (CAM) section at every stage
of the audit: Most often discussion on CAM happens in the later stages of
audit, an area that is, in the current context, the most effective line of
defence. Clients also demonstrate resistance to discuss CAM at the last minute,
exposing the auditor to serious risks.

 

(d) Evaluating
the Directors’ Report and MD&A: These two sections are typically
areas of inadequate focus because they are made available only a couple of days
before audit sign off. It is critical to examine these two sections for
inadequacies in management reporting of business risks, key business developments
such as dealing with potential failures to meet loan repayment obligations,
etc.

 

(e) Making
effective use of Management Rep Letters: It has been established time
and again that Rep Letters are not a critical line of defence and do not
substitute substantive audit verification tests that the auditor is required to
perform. However, ‘Minutes’ of discussions and explanations received from
Management serve as ideal “back up.” It is also common practice to discuss
Management Rep Letters with Audit Committees for the important representations
made by management. As a rule, auditors should expect Rep Letters to help only
in situations where no alternative sources of “comfort” exist or are available.
In such case too, auditors must consider drawing attention to important
representations made in the audit report by way of EoM or in extreme cases by
way of a “Qualification.”

 

5. CONCLUSIONS

 

While the primary
responsibility for the prevention and detection of fraud continues to rest with
management, auditors must accept that the responsibility to adopt robust audit
procedures and ferret out “red flags” that are indicative of imminent failures
in governance, risk and even business. For example, significant erosion of
asset values due to ‘mark to market’ considerations should seriously bother the
auditor not only from an asset impairment perspective but from the ability of
the business to service external debt. Similarly, asset liability mismatches
that could seriously erode the confidence and comfort of lenders require
significant audit attention; this is the new reality that auditors must accept;

 

It is imperative for
auditors to get audit files and documentation on Public Interest Entity (PIE)
audits “cold reviewed” by an independent team before date of sign off. This
process involves time and must be ‘in-built’ into the time commitment made by
the auditor to the client on date of audit closure;

 

Management
Discussion & Analysis (MD&A) and Board Reports are important documents
that the auditor should review before audit clearance since they communicate
what the management “holds out” in terms of what management perceives are the
key risks and how they are being dealt with… the structure of the 10K that
SEC Registrants file would be a good benchmark.

 

Non-audit services
proposed to be rendered should be subject to internal ‘risk clearances’ and
audit
committee approvals to avoid any vulnerabilities that may arise in case a
serious fraud is detected and the question of auditor independence becomes the
subject matter of litigation.

 

Communications with
those charged with governance is as much a cultural issue as it is a technical
one. Special skills are necessary to structure these conversations such that
the auditor can establish to any regulatory authority that the auditors have
done all that was expected to be done.

 

DETERMINING INCREMENTAL BORROWING RATE UNDER Ind AS 116

BACKGROUND

Ind AS 116 requires a
lessee to discount the lease liability using the interest rate implicit in the
lease if that rate can be readily determined. If the interest rate implicit in
the lease cannot be readily determined, then the lessee should use its incremental
borrowing rate. The interest rate implicit in the lease is likely to be similar
to the lessee’s incremental borrowing rate (IBR) in many cases. This is because
both rates, as they have been defined in Ind AS 116, take into account the
credit standing of the lessee, the length of the lease, the nature and quality
of the collateral provided and the economic environment in which the
transaction occurs. However, the interest rate implicit in the lease is
generally also affected by a lessor’s estimate of the residual value of the
underlying asset at the end of the lease and may be affected by taxes and other
factors known only to the lessor, such as any initial direct costs of the
lessor. It is likely to be difficult for lessees to determine the interest rate
implicit in the lease for many leases, particularly those for which the
underlying asset has a significant residual value at the end of the lease.
Consequently, the standard requires use of the IBR in these situations.

 

The lessee’s IBR is the rate that the lessee
would have incurred on debt obtained over a similar term for the specific
purpose of acquiring the leased asset. The lessee’s IBR may be equivalent to a
secured borrowing rate if that rate is determinable, reasonable and consistent
with the financing that would have been used in the particular circumstances.
The lessee’s IBR should reflect the effect of any compensating balances or
other requirements present in the lease that would affect the lessee’s
borrowing cost for similar debt. The IBR should also reflect the effect of any
third party guarantees of minimum lease payments obtained by the lessee, to the
extent that similar guarantees of debt payments would have affected the
borrowing costs. However, the lessee’s IBR should not include any component
related to the lessee’s cost of capital (i.e., the IBR should not reflect the
effect of lessee’s use of a combination of debt and equity to finance the
acquisition of the leased asset).

 

If the lessee’s financial condition is such
that third parties generally would be unwilling to provide debt financing, the
IBR of the lessee might not be readily determinable. In these rare cases, the
lessee should use the interest rate for the lowest grade of debt currently
available in the market place as its IBR.

 

Three steps are critical in determining the
IBR, namely: (a) the reference rate, (b) the financing spread adjustment, and
(c) lease-specific adjustment. These aspects are discussed below.

 

REFERENCE RATE

This will generally be the relevant
government bonds or currency swap rates (e.g., LIBOR) reflecting a risk-free
rate. The borrowings should be matched with the currency of the cash outflows
on the lease so that foreign exchange risk is removed. For example, lease cash
flows denominated in USD or GBP (or any other currency) should be matched with
the appropriate risk-free rates, such as those determined from US Treasury
Bills or UK Gilts.

 

The repayment profile should be considered
when aligning the term of the lease with the term for the source of the reference
rate. Risk-free rates exist for different durations. Therefore, the chosen rate
should be matched with the lease term, as defined by Ind AS 116. The relevant
duration of government bonds to consider is not the total lease term but a
weighted average lease term. While a risk-free rate determined from government
bonds or interest rate yield curves assumes repayment of the capital at
maturity, for an operating lease the repayments are typically spread over the
lease period.

 

Example: Foreign currency leases

Ez Co, an Indian airline company with INR
functional currency, leases aircrafts; the lease payments are specified in USD
and the interest rate implicit in the lease is not readily determinable. For
making the lease payments, Ez has borrowed in USD and taken a forward contract
to hedge against INR / USD exchange fluctuation risks. The USD loan interest
rate is 4% per annum and the hedge cost is 2% per annum. The currency in which
the lease is determined forms part of the economic environment for which the borrowing
rate is assessed. It is the US dollar incremental borrowing rate that has to be
determined. In this case, the IBR is 4% (subject to any further adjustments
required by the Standard) and not 6%.

 

FINANCING SPREAD ADJUSTMENT

For determining the spread, lessees should
use credit spreads from debt with the appropriate term. If the same is not
available, it will have to be estimated. The data available to entities to
determine their financing spread adjustment will depend on the type of company
and their financing structures.

 

Nature of debt financing

Type of entity

Data points available

Multiple debt financing arrangements

Large listed entities

Multiple data points

A bank loan

Small companies

Single data point

No significant debt financing arrangements

Cash surplus company

None

 

For entities with zero debt and / or net
cash balances, consideration should be given to both historical as well as
future debt facilities. The historical position may not be representative of
the current position of the company. It is incorrect to assume that companies
in this situation will have a zero spread, as Ind AS 116 requires the discount
rate to reflect the rate of interest the lessee would have to pay to borrow.
Companies with few data points on their credit spread should seek indicative
pricing from several banks or look to comparable data points available, such as
similar sized companies in a similar industry.

 

Ind AS 116 is very clear that the IBR is
lessee-specific. Therefore, it is important to evaluate what rate the lessee
would achieve on his own even if theoretically all funding would ultimately be
achieved through a group debt structure. Depending on who is the issuer, and
whether there are written guarantees from the group for the lease payments in
place, it may mean that in some cases a group credit spread that is applicable
to all lessees in a group may be more relevant. In determining an IBR, the
overall level of indebtedness of the entity (i.e., leverage) and whether the
value of the lease results in a change to the leverage ratio such that it
warrants a higher IBR, should be considered.

 

LEASE SPECIFIC ADJUSTMENT

The key requirement of Ind AS 116 is that the
IBR is directly linked to the asset itself, rather than being a general IBR. To
an extent, the lease is a secured lending arrangement as the lessor can reclaim
the underlying property. The security of the underlying asset should
potentially reduce the credit spread charged by a lender. If there are no data
points with respect to secured borrowing rates the lessee may consider asking
banks or lenders, or use valuation specialists. While all leases will reflect a
secured borrowing position, in practice certain assets may be more valuable to
a lessor and easier to redeploy. For example, the costs of repossessing an
asset of low value (e.g., a Xerox machine) or low duration relative to its cash
flow would be high. Consequently, the security would be largely irrelevant. On
the other hand, in larger value assets with a longer duration (e.g., office
space), the benefit of having security is more valuable because the lessor will
not be at a significant loss in the event of default by the lessee.

 

PROPERTY YIELDS

In the basis for conclusions of IFRS 16,
property yields are specifically identified as a potential data point for
companies to consider: ‘The IASB noted that, depending on the nature of the
underlying asset and the terms and conditions of the lease, a lessee may be
able to refer to a rate that is readily observable as a starting point when
determining its incremental borrowing rate for a lease (for example, the rate
that a lessee has paid, or would pay, to borrow money to purchase the type of
asset being leased, or the property yield when determining the discount rate to
apply to property leases). Nonetheless, a lessee should adjust such observable
rates as is needed to determine its incremental borrowing rate as defined in
IFRS 16.’

 

The valuation typically is determined by a
multiplier being applied to the rental income to be received, with the
multiplier representing 1/Yield. Using property yield is more suitable to
valuing commercial property where all likely buyers in the market view the
asset as an investment, for example, valuing
commercial properties. Using property yield is less suitable for owner-occupied
property (e.g., residential properties). Property yields are determined by
assessing the yield profile from recent, comparable sales of similar assets
with similar characteristics. The ‘equivalent yield’ reflected by comparable
sales represents the weighted average of current and future rental income,
smoothing out the effect of rent-free periods or vacancy. In determining the
property yield, the risk to be considered includes location, quality of
property, specification, future rental and capital growth prospects, the
tenants’ credit profile and local supply / demand dynamics. For companies
wanting to use property yields to help them determine lease specific
adjustments, the following assumptions are relevant:

 

(i)   The currency of property
lease cash flows is aligned with the currency in which the property is valued;

(ii)   The duration of the property
yield data points available are aligned to the weighted average term of the
lease; and

(iii)  The property yields are
aligned to the characteristics of the property lease being assessed (quality,
sector and location of the property).

 

Practical questions and answers

Query

Ind AS 116 defines the lessee’s incremental
borrowing rate as ‘The rate of interest that a lessee would have to pay to
borrow over a similar term, and with a similar security, the funds necessary to
obtain an asset of a similar value to the right-of-use asset in a similar
economic environment.’ What does ‘similar term’ mean in the context of a lease
with a non-cancellable period followed by one or more optional periods? Does
similar term imply:

 

(a)  A debt for a period equal to the
non-cancellable term?

(b) A debt for a period equal to the maximum term
(including the periods covered by the options to renew)?

(c)  A debt for a period equal to the
non-cancellable term with extension options?

(d) A debt for a period equal to the lease term as
determined in accordance with Ind AS 116 (i.e., taking into account whether or
not it is reasonably certain to exercise the option/s to renew).

 

Response

The discount rate should be consistent with
the cash flows that are to be discounted and since those cash flows take into
account only the rentals over the lease term as determined according to Ind AS
116, (d) is the right answer.

Query

Ind AS 116
defines the lessee’s incremental borrowing rate as ‘The rate of interest that a
lessee would have to pay to borrow over a similar term, and with a similar
security, the funds necessary to obtain an asset of a similar value to the
right-of-use asset in a similar economic environment.’ What does ‘similar
security’ mean in the context of a lease that grants to the lessee the
right-of-use (ROU) for the underlying asset for a period of time? Sometimes,
there could be some guarantees by the parent company or another company in the
group. Can the parent company’s IBR be used?

 

Response

If parent
provides guarantee on the subsidiary’s debt the pricing of the lease would be
more influenced by the credit risk associated with the parent. The rate used by
the subsidiary should reflect the IBR of the parent, unless the subsidiary is
able to obtain financing on a stand-alone basis without the parent or other
related entities guaranteeing the debt. If that is not the case, the parent’s
IBR would be a more appropriate rate to estimate.

 

However,
allowing a subsidiary to look up at the parent’s borrowing rate without looking
at anything else, such as the currency exchange rates, may not be appropriate.
Even with a guarantee from the parent company, there are other factors that
could influence the pricing (and the implicit rate) offered by the lessor (such
as tax and other local regulations for example). The lessee should always look
at its own borrowing rate and take into account the impact of any guarantees
provided by the parent company to the lessor. This could be done by soliciting
quotes from local lenders for similar conditions and guarantees. Corporate
borrowing rates may be used as a starting point. However, appropriate
adjustments are usually necessary to take into account specific facts and
circumstances of the lease. The inter-company rate on loans from the parent to
the subsidiary generally should not be used as the lessee’s incremental
borrowing rate.

 

Query

Ind AS 116
defines the lessee’s incremental borrowing rate as ‘The rate of interest that a
lessee would have to pay to borrow over a similar term, and with a similar
security, the funds necessary to obtain an asset of a similar value to the
right-of-use asset in a similar economic environment.’ What does ‘similar
value’ mean?

 

Response

The
right-of-use (ROU) asset rather than the underlying asset shall be considered
as a security with similar value. The value of the ROU
asset does not include payments that are not lease payments (e.g., variable
payments not based on an index or rate). Similarly, the lease payments relating
to optional periods that are not included in the lease term should also be
excluded.

 

Query

A company is able to estimate the IBR at
which it would borrow to buy a truck (10 years’ useful life) or property.
Whether the same IBR can be applied if the asset is not the truck but rather a
5-year right of use (ROU) or the asset is not property but an ROU of the
property, or say only two floors of a building are leased?

 

Response

Whilst there is a practical difficulty in
determining the IBR in the case of an ROU, it is necessary to do so and it will
not be the same as the IBR of the truck or the property.

 

A lessee should start with the rate it would
incur to purchase the underlying asset, but that rate would require adjustment
to reflect ‘an asset of similar value to the ROU asset’. Adjustments may be
both negative and positive depending on the type of asset and risks associated
with the residual value of the asset.  

 

DEMERGER TRANSACTION UNDER Ind AS

QUERY

  •      A has control over its100%
    subsidiary B.
  •      There are 5 investors
    (shareholders – X, X1, X2, X3 and X4) in A. No investor controls or jointly
    controls or has significant influence on A.
  •      A, B and all the investors in
    A follow Ind AS. All the investors measure their investment in A at FVTPL. A’s
    accounting policy is to measure investments in subsidiary and associates at
    cost in separate financial statements.
  •      Due to certain regulatory
    issues, A should not be controlling B.
  •      Consequently, B issues its
    shares to the investors in A without any consideration, which will reduce A’s
    shareholding in B to 40%. Accordingly, B becomes A’s associate.
  •      The number of shares which A
    held in B, pre and post the transaction has not changed, as shares have been
    distributed by B directly to the shareholders of A. However, A’s holding in B
    is reduced to 40%.
  •      Investor X, one of the 5
    investors, is holding 100 shares in A at fair value of INR 200. Investor X
    continues to hold 100 shares and has received shares of B for no consideration.
  •      All investors are treated
    equal in proportion to their shareholding.
  •      The decision to undertake the
    above transaction had the unanimous approval of the board of directors of B.

 

Pre- and post-restructuring shareholding pattern is depicted in the
diagram below:

How shall A, B and investor X account for this transaction in their Ind
AS separate financial statement (SFS)?

RESPONSE

Accounting
in SFS of investor X

View 1 – There is no change in X’s situation except that now X is directly
holding in B instead of through A. Consequently, X will simply split the fair
value of its holding in A into A’s share and B’s share on relative fair value
basis. Under this view, there is no P&L impact.

 

To support
this view, one may draw an analogy from ITFG 20 issue 4. In that fact pattern,
there is transfer of a business division from an associate to fellow associate.
ITFG concluded that there is no ‘exchange’ of investments. Investor continues
to hold the same number and proportion of equity shares in A Limited
(Transferor associate) after the demerger as it did before the demerger.
Therefore, applying this principle, the ‘cost’ of the new shares received in B
is represented by the amount derecognised by X Limited in respect of its
investment in A Limited. The accounting is presented below, with assumed
figures. However, one should be mindful that in ITFG’s case, investment is
carried at cost, whereas in the given case these investments are carried at
fair value. Consequently, if the fair value of shares in A pre-transaction is
less than the aggregate fair value of shares in A and B post-transaction, this
accounting may result in subsequent gains to investor X, which needs to be
recognised in the P&L.

 

In X’s SFS

Particulars

Dr. (INR)

Cr. (INR)

Investment in A (relative fair value)

Investment in B (relative fair value)

To investment in A (pre-receipt of B’s share)

80

120

 

 

200

 

 

View 2 – X is having investment in financial instrument, which are carried at
FVTPL. Post the transaction, X shall fair value its investment in A and B; if
there is any gain due to unlocking of value or other factors, gain should be
recognised in P&L immediately.

In X’s SFS

Particulars

Dr. (INR)

Cr. (INR)

Investment in B(@ fair value)      Dr

To Investment in A (change in fair value)

To gain on exchange – P&L (if any)

140

 

110

30

 

 

Note: Fair value of
investment in B and change in fair value of investment in A are hypothetical
and for illustrative purposes only. The gain of INR 30 reflects unlocking of
value in the hands of investors.

 

Accounting
in the SFS of A

View 1 – The number of shares which A held in B pre and post the transaction
has not changed. As the cost of investment for holding the same number of
shares has not changed and A has not received or distributed any shares, the
investments will continue to be recorded at the same cost, even though the
investment is now an associate. However, A will test the investment for
impairment as per Ind AS 36 and record the impairment charge to P&L, if
any. Analogy can be drawn from transactions wherein subsidiary issues shares to
outside unrelated shareholders and thereby the parent loses control and that investment
becomes as associate. In such a case, the common practice in SFS of parent is
that the investment continues to be recorded at cost (subject to impairment).

 

  •    Additionally, at the ultimate
    shareholders level per se nothing has changed. Therefore, it cannot be
    inferred that any dividend has been distributed to the shareholders by A. The
    decision is taken by the ultimate shareholders, and A does nothing substantial.
    At best, A is merely a pass through; that, too, indirectly rather than
    directly. Consequently, A is neither receiving any dividends nor distributing
    any dividends. However, due to the dilution, its investment in B will be tested
    for impairment.

 

  •    To support View 1, there can be
    multiple ways of looking at this transaction:

•   A is giving up the value of its
underlying investment in subsidiary B to its shareholders. A has not declared
and is not obliged to distribute any dividends (hence Ind AS 10 Appendix A Distribution
of Non-cash Assets to Owners does not apply). Neither is there a demerger
from A’s perspective. Consequently, A’s Investment in B will be credited at
fair value, book value, or brought to its post impaired value, with the
corresponding impact taken to equity.

•   This is merely a restructuring
arrangement where the subsidiary is now split between A and the ultimate
shareholders. There are no dividends received or paid. The decision of
splitting the shares is taken by ultimate shareholders, rather than A. A does
nothing. Consequently, A’s investment in B will be only tested for impairment.

 

In View 1, there is no credit to the P&L in the SFS of A.

 

View 2 – A
has not declared and is not obliged to distribute any dividends, but there is
an indirect distribution by A to its shareholders. In the absence of any
specific guidance to this unique fact pattern, and based on Ind AS 8
Paragraph10, A may draw analogy from Appendix A to Ind AS 10. Accordingly,
applying the guidance on distribution of non-cash assets to the owners, A shall
create a dividend payable liability out of its reserves, and then record the
distribution of non-cash asset (indirect receipt of shares of B) in its books
at fair value of the assets distributed, and the difference between dividend
payable (at fair value) and the investment in B (at proportionate cost of
deemed dilution) would be recorded as a gain in the P&L.

In SFS of A

Particulars

Dr. (INR)

Cr. (INR)

On creation of dividend
payable
liability at fair value

Equity Dr

To Dividend Payable

 

 

1000

 

 

 

1000

On distribution of dividend

Dividend payable (@ fair
value)

To Investment in B

(@Proportionate Cost)

To P&L (Gain) [Balancing
figure]

 

1000

 

 

900

 

100

 

Note: Fair value of dividend
payable and proportionate value of investment in B are hypothetical and for
illustrative purposes only.

 

Accounting
in the SFS of B

From B’s perspective, additional shares are being issued to ultimate
shareholders for which no consideration is received. Consequently, B will
credit share capital and debit equity. Essentially, the debit and credit is
reflected within the equity caption and there is no P&L impact.

 

CONCLUSION

Had A
directly distributed its investment in B to its shareholders, so that its
shareholding in B is reduced to 40%, the application of Ind AS 10 Appendix A
would result in View 2 only, from the perspective of SFS of A. However, in the
absence of any specific guidance under Ind AS with respect to SFS, the author
believes that different views have emerged. Moreover, it is unfair that a
restructuring transaction to comply with regulations should result in a P&L
gain. The ITFG may provide necessary clarifications.  

 

UNINSTALLED MATERIALS AND IMPACT ON REVENUE RECOGNITION

BACKGROUND


Contract Co (CoCo) enters
into a contract with a customer to refurbish a 40-storey building and install
new lifts for a total consideration of INR 1,62,000. The promised refurbishment
service, including the installation of the lifts, is a single performance
obligation satisfied over time. The refurbishment will be performed over a three-year
period. The total revenue is expected to be as follows:

 

TOTAL EXPECTED REVENUE

 

 

INR

Transaction
price

1,62,000

Expected
costs

 

Lifts

81,000

Other
costs

54,000

Total
expected costs

1,35,000

Expected
gross margin

27,000

 

 

The contract costs incurred
over the three-year period are as follows:

 

CONTRACT COSTS OVER  THREE YEARS

           

 

Year 1

Year 2

Year 3

Total

 

INR

INR

INR

INR

Other
costs incurred

18,000

18,000

18,000

54,000

Cost
of lifts delivered to site but not yet installed at year-end

81,000

–

–

81,000

Total
costs incurred

99,000

18,000

18,000

1,35,000

 

At the end of Year 1,
included in the total costs of INR 99,000 are the costs incurred to purchase
the lifts worth INR 81,000. These lifts had been delivered at the site at the
end of Year 1 but had not yet been installed. The lifts were procured from a third-party
supplier and CoCo was not involved in either the designing or the manufacture
of the lifts. These lifts were installed at the end of Year 2. CoCo recognises
revenue over time, applying an input method based on costs incurred. Assume
that in arriving at the agreed transaction price, CoCo had applied the
following mark-up to its costs:

 

COST MARK-UP BY THE COMPANY

 

 

Cost

Mark-up

Transaction

Price

Gross Margin

 

INR

INR

INR

%

Cost
of lifts

81,000

7,200

88,200

8.2

Other
costs

54,000

19,800

73,800

26.8

Total

1,35,000

27,000

1,62,000

16.7

 

 

CoCo has determined that it
acts as a principal in accordance with Ind AS 115.B34-B38, because it obtains
control of the lifts before they are transferred to the customer.

 

QUERY 1

CoCo uses an input method
based on costs incurred. How should it determine the amount of revenue, profit
and gross margin to be recognised in its financial statements for Year 1, Year
2 and Year 3?

 

YEAR 1

The general principle of
over time revenue recognition in Ind AS 115 is that the pattern of revenue
recognition should reflect the entity’s performance in transferring control of
goods and services to the customer (see Ind AS 115.39). Paragraph B19 of Ind AS
115 notes that when an input method is used, an entity should exclude the
effects of any inputs that do not reflect the entity’s performance to date. It
specifically requires that revenue is only recognised to the extent of costs
incurred if:

 

(a) the goods are not
distinct; (b) the customer is expected to obtain control of the goods
significantly before receiving services relating to the goods; (c) the cost of
the transferred goods is significant relative to the total expected costs to
completely satisfy the performance obligation; and (d) the entity procures the
goods from a third party and is not significantly involved in designing and
manufacturing the same (but the entity is acting as a principal in accordance
with paragraphs B34-B38).

 

Therefore, CoCo excludes
the cost of the lifts from the cost-to-cost calculation in Year 1 because the
cost of the lifts is not proportionate to CoCo’s measure of progress towards
performing the refurbishment. Paragraph B19 is met because:

 

(i) The
lifts are not distinct. The refurbishment and installation of the lifts represents
one single performance obligation;

(ii) The
customer obtains control of the lifts when they arrive on its premises at the
end of Year 1, but installation of the lifts is only performed at the end of
Year 2;

(iii) The
costs of the lifts are significant relative to the total expected costs of the
refurbishment; and

(iv) The
lifts were procured from a third party and CoCo is not involved in designing or
manufacturing the lifts.

 

CoCo
therefore adjusts the measure of its progress towards completion and excludes
the uninstalled lifts from the costs incurred when determining the entity’s
performance to date:

 

 

DETERMINING THE ENTITY’S PERFORMANCE

       

 

INR

Total costs incurred to date:

99,000

Less: uninstalled lifts

(81,000)

 

18,000

 

CoCo then
calculates the percentage of performance completed to date:

 

INR 18,000
other costs (excluding lifts) / INR 54,000 total other costs (excluding lifts)
= 33.33% complete. CoCo recognises revenue to the extent of the adjusted costs
incurred and does not recognise a profit margin for the uninstalled lifts:

PROFIT MARGIN RECOGNISED

 

 

Year 1

 

INR

Total transaction price

1,62,000

Less: Cost of lifts

(81,000)

Adjusted revenue (excluding lifts)

81,000

% of performance completed to date

33%

Revenue for the period (excluding lifts)

27,000

Revenue recognised for cost of lifts

81,000

Total revenue for the period

1,08,000

Less: Costs for the period

(99,000)

Profit for the period

9,000

Profit margin (profit / total revenue)

8.33%

 

The above
accounting is clearly in accordance with Ind AS 115 and there are no
interpretation issues. However, the accounting in the following years is not
clear under Ind AS 115, which is the subject of this discussion.

 

YEARS 2 & 3

At the end
of Year 2 the lifts have been installed and an additional INR 18,000 of costs
has been incurred. Ind AS 115 does not contain specific guidance on the
accounting for the previously uninstalled materials that have now been
installed. Possible approaches for the accounting in the remaining years are:

 

View 1
– Continue to exclude the cost of the lifts from the cost-to-cost calculation
in the remaining periods of the contract;

View 2 –
Include the cost of the lifts in the cost-to-cost calculation once the lifts
have been installed and use a contract-wide profit margin;

View 3
– The cost-to-cost calculation would continue to exclude the cost of the lifts;
however, once the lifts have been installed, an applicable profit margin on the
lifts would be recognised as revenue;

View 4 – Since Ind  AS 115 is not specific in its requirements,
Views 1, 2 or 3 might be acceptable depending on the facts and circumstances.
It is necessary to consider whether the approach selected meets the overall
principle in Ind AS 115.39 that the amount of revenue should ‘depict an
entity’s performance in transferring control of goods or services promised to a
customer’. This principle once selected should be applied consistently.

 

View 1
– Continue to exclude the cost of the lifts from the cost-to-cost calculation
in the remaining periods of the contract;

Under this
approach, no profit margin would be recognised for the installed lift. The
profit margin derived from the lifts is instead shifted to the other services
in the contract as costs for those services are incurred.

 

COSTS INCURRED TO DATE

 

 

Year 1

Year 2

Year 3

 

INR

INR

INR

Total costs incurred to date

99,000

1,17,000

1,35,000

Less: Cost of lifts delivered but not installed at end of Year 1

(81,000)

(81,000)

(81,000)

Adjusted costs incurred to date (excl. lifts)

18,000

36,000

54,000

% of performance completed to date

33%

67%

100%

Revenue recognised to date (excl. lifts)

27,000

54,000

81,000

Revenue recognised for cost of lifts

81,000

81,000

81,000

Cumulative revenue recognised to date

1,08,000

1,35,000

1,62,000

 

 

REVENUE FOR THREE YEARS

 

 

Year 1

Year 2

Year 3

Total

 

INR

INR

INR

INR

Revenue for the period (excluding lifts)

27,000

27,000

27,000

81,000

Add: Revenue for cost of lifts

81,000

 

 

81,000

Revenue for the period

1,08,000

27,000

27,000

1,62,000

Less: Costs for the period

(99,000)

(18,000)

(18,000)

(1,35,000)

Profit for the period

9,000

9,000

9,000

27,000

Profit margin

8%

33%

33%

17%

 

Arguments for View 1:

 

Under B19(b)
only one accounting treatment applies to goods that meet the conditions set out
in B19(b). B19(b) does not distinguish goods that have been installed from
those that have not yet been installed. As per para B19(b), a faithful
depiction of an entity’s performance might be to recognise revenue at an amount
equal to the cost of goods used to satisfy a performance obligation if the
entity expects at contract inception that certain conditions are met.

The Basis
for Conclusions to IFRS 15 notes that the aim of the adjustment is to reflect
the same profit or loss and margin as if the customer had supplied those goods
themselves for the entity to install or use in the construction activity.
Paragraph BC172 of IFRS 15 notes: For goods that meet the conditions in paragraph
B19(b) of IFRS 15, recognising revenue to the extent of the costs of those
goods ensures that the depiction of the entity’s profit (or margin) in the
contract is similar to the profit (or margin) that the entity would recognise
if the customer had supplied those goods themselves for the entity to install
or use in the construction activity [IFRS 15.BC172]. If the customer had
supplied the lifts itself, then CoCo would not have recognised any profit or
margin on the lifts.

 

Per
paragraph IE98 from Illustrative Example 19, the adjustment to cost-to-cost can
be read to be applied throughout the entire life of the contract, in
accordance with paragraph B19 of Ind AS 115, the entity adjusts its measure of
progress to exclude the costs to procure the elevators from the measure of
costs incurred and from the transaction price. The entity recognises
revenue for the transfer of the elevators in an amount equal to the costs to
procure the elevators (i.e., at a zero margin).

 

Arguments against View 1:

 

View 1 does not reflect the
reality of the transaction as an entity would typically charge a margin for
procurement (the extent of the margin would likely depend on whether the item
is generic or of a specialised nature – a higher margin is likely to be applied
for items that are specialised in nature or that are harder to source), and
would not recognise a profit margin on the item when it is installed. Rather,
the margin is being shifted to the other services in the contract as costs for those
services are incurred. However, such margins may not be material when the
entity is procuring a generic item and is not involved in its design.

 

View 1 would
result in a different cumulative amount of revenue being recognised using the
same input method at the end of Year 2 when there has been a significant delay
between delivery and installation compared to when there is no delay – even
though the same amount of work has been performed at the end of Year 2. This is
because B19(b)(ii) would not be met because the customer does not obtain
control of the goods significantly before receiving the services.

 

View 2
– Include the cost of the lifts in the cost-to-cost calculation once the lifts
have been installed.

Under this approach, once the lifts have been installed, the cost of the
lifts would be included in cost-to-cost calculations.

 

COST-TO COST CALCULATIONS

 

 

Year 1

Year 2

Year 3

 

INR

INR

INR

Total costs incurred to date

99,000

1,17,000

1,35,000

Less: cost of lifts delivered but not yet installed

(81,000)

N/A

N/A

Costs incurred to date

18,000

1,17,000

1,35,000

% of POCM to date (rounded off)

33%

87%

100%

Revenue recognised to date

27,000

1,40,400

1,62,000

Revenue recognised for cost of lifts

81,000

N/A

N/A

Cumulative revenue recognised to date

1,08,000

1,40,400

1,62,000

                       

 

Year 1

Year 2

Year 3

Total

 

INR

INR

INR

INR

Revenue for the period

27,000

32,400

21,600

81,000

Add: Revenue for costs of lifts

81,000

N/A

N/A

81,000

Revenue for the period

1,08,000

32,400

21,600

1,62,000

Less: Costs for the period

(99,000)

(18,000)

(18,000)

(1,35,000)

Profit for the period

9,000

14,400

3,600

27,000

Profit margin

8%

44%

17%

17%

 

Arguments for View 2:

The
guidance in Illustrative Example 19 and the Basis for Conclusions to IFRS 15
focuses on the situation before the goods are installed, so the adjustment to
the cost-to-cost calculation only applies on goods that have been delivered but
not yet installed.

 

The
relevant extracts from the section for ‘Uninstalled materials’ in the Basis for
Conclusions are as follows:

 

BC171 of IFRS 15 states: The boards observed that if a customer
obtains control of the goods before they are installed by an entity… The boards
noted that recognising a contract-wide profit margin before the goods are
installed could overstate the measure of the entity’s performance and,
therefore, revenue would be overstated… [emphasis added].

BC172: The
boards noted that the adjustment to the cost-to-cost measure of progress for
uninstalled materials… (emphasis added).

 

BC174: …Although
the outcome of applying paragraph B19(b) of 1FRS 15 is that some goods or
services that are part of a single performance obligation attract a margin, while any uninstalled materials attract only a zero margin…

 

Arguments against View 2

When the
profit margin applicable to the procured item(s) is significantly different
from the profit margin attributable to other goods and services to be provided
in accordance with the contract, the application of a contract-wide profit
margin will overstate the amount of revenue and profit that is attributed to
the procured item(s). This is not consistent with the underlying principle in
Ind AS 115.39, which is that the amount of revenue recognised should ‘depict an
entity’s performance in transferring control of goods or services promised to a
customer’ (i.e., the satisfaction of an entity’s performance obligation).

 

As noted
in the analysis for Year 1 above, Ind AS 115.B19(b) includes guidance for
uninstalled material at the point at which control has passed to the customer.
This guidance is noted as being an example of ‘faithful depiction’ of an
entity’s performance. Consequently, when there are significantly different
profit margins attributable to procured item(s), it is necessary to adjust the
amount of revenue that is attributable to those procured item(s).

 

View 3
– Once the lifts have been installed, an applicable profit margin is recognised
for the lifts separately from the rest of the project:

 

APPLICABLE PROFIT MARGIN

       

 

Year 1

Year 2

Year 3

 

INR

INR

INR

Total costs incurred to date

99,000

1,17,000

1,35,000

Less: cost of lifts delivered but not yet installed

(81,000)

(81,000)

(81,000)

Adjusted costs incurred to date (excl. lifts)

18,000

36,000

54,000

% of performance completed to date

33%

67%

100%

Revenue recognised to date (excl. lifts)

24,600

49,200

73,800

Revenue recognised for lifts (mark-up included in Years 2 &
3)

81,000

88,200

88,200

Cumulative revenue recognised to date

1,05,600

1,37,400

1,62,000

 

       

 

Year 1

Year 2

Year 3

Total

 

INR

INR

INR

INR

Revenue for the period (excl. lifts)

24,600

24,600

24,600

73,800

Add: Revenue for lifts

81,000

7,200

0

88,200

Revenue for the period

1,05,600

31,800

24,600

1,62,000

Less: Costs for the period

(99,000)

(18,000)

(18,000)

(1,35,000)

Profit for the period

6,600

13,800

6,600

27,000

Profit margin

6%

43%

27%

17%

 

Arguments for View 3:

Same
arguments as for View 2, but it also addresses the downside of View 2 of
overstating profit margin once the materials are installed. Proponents of View
3 argue that this would most faithfully depict the economics of the transaction.

 

Arguments against View 3:

Mark-ups /
profit margins could be subject to management manipulation.

 

The
approach seems to have been considered but rejected by the boards as noted in
paragraph BC171 of IFRS 15. Alternatively, requiring an entity to estimate a
profit margin that is different from the contract-wide profit margin could be
complex and could effectively create a performance obligation for goods that
are not distinct (thus bypassing the requirements for identifying performance
obligations) [IFRS 15.BC171].

 

QUERY 2 –
assuming either View 2 or View 3 is followed for Question 1:

 

Where the
profit margins attributable to different components of a contract that is
accounted for as a single performance obligation are significantly different,
is it appropriate to use an input method as a measure of progress?

 

View 1

Yes. Although
different profit margins might arise from different parts of a contract, the
fact that the seller has a single performance obligation means that Ind AS 115
does not require those different components to be separately identified.
Proponents of this view note that IFRS 15.BC171 would appear to support this
approach: ‘Alternatively, requiring an entity to estimate a profit margin that
is different from the contract-wide profit margin could be complex and could
effectively create a performance obligation for goods that are not distinct
(thus bypassing the requirements for identifying performance obligations).’ It
is also noted that Example 19, which has different components that would
typically be expected to have different profit margins, is based on the vendor
using an input method to measure progress towards contract completion.

 

View 2

No. Ind AS
115.39 includes the objective that is required to be followed when measuring
progress where a performance obligation is satisfied over time, which is: ‘…The
objective when measuring progress is to depict an entity’s performance in
transferring control of goods or services promised to a customer (i.e., the
satisfaction of an entity’s performance obligation.’ Proponents of View 2
consider that, in the fact pattern set out above, the use of an input method,
with a single overall profit margin being allocated to costs incurred, would
result in an overstatement of performance for the transfer of the lifts and an
understatement of performance for the transfer of other services.

 

Supporters of View 2 also question whether the lifts are in fact part of
a single performance obligation. If the seller can procure the lifts
separately, then the customer could also procure the lifts, meaning that the
procurement of the lifts could be viewed as being a separate performance
obligation.

 

This
conclusion would also appear to be supported by IFRS 15.BC172, in that: ‘…For
goods that meet the conditions in paragraph B19(b) of IFRS15, recognising
revenue to the extent of the costs of those goods ensures that the depiction of
the entity’s profit (or margin) in the contract is similar to the profit (or
margin) that the entity would recognise if the customer had supplied those
goods themselves for the entity to install or use in the construction
activity.’

 

View 3

Ind AS115 is not specific in its requirements. Consequently, either View
1 or View 2 are acceptable as an accounting policy choice, to be applied
consistently to similar transactions.

 

AUTHOR’S VIEW AND
CONCLUSION

On Question
1,View 1 and View 2 are the two acceptable views, though on balance View 1 is
more preferred. View 3 and View 4 are not acceptable. View 1 practically makes
sense because it sticks with one approach throughout the period. This approach
is also consistent with Ind AS 115.B19 and meets the spirit of the requirement
in the Standard. View 2 may be accepted because Ind AS 115.B19 only applies to
uninstalled materials and once they are installed, then an entity goes back to
the general model for measuring progress.

 

On the
second question, View 1 is more appropriate. There is generally a better
alignment in margin using the input method, but not a guarantee of having a
consistent margin throughout in all cases.

 

The key
question is whether the use of the input method would be a faithful depiction
of the entity’s performance – and the response is in the affirmative. In any case, the standard
does not provide an option of applying input method, using different margins
for different components.  

 

DETERMINING THE LEASE TERM FOR CANCELLABLE LEASES

FACT PATTERN


A lease contract of a
retail outlet in a shopping mall allows for the lease to continue until either
party gives notice to terminate the contract. The contract will continue
indefinitely until the lessee or the lessor elects to terminate it and includes
stated consideration required during any renewed periods (referred to as
“cancellable leases” in the rest of the document). Neither the lessor nor the
lessee will incur any contractual cash payment or penalty upon exercising the
termination right. The lessee constructs leasehold improvements, which cannot
be moved to another premise. Upon termination of the lease, these leasehold
improvements will need to be abandoned, or dismantled if the lessor so
requests.

 

QUESTION


Can the lease term go
beyond the date at which both parties can terminate the lease (inclusive of any notice period)?

 

TECHNICAL DISCUSSION


View 1:
No. The lease term cannot go beyond the date where the lessee can enforce a
right to use the underlying asset, i.e. the end of the notice period. The
existence of economic penalties (eg; cost of shifting) does not create
enforceable rights and obligations.

The definition of “lease
term” in Ind AS 116 refers to lessee’s rights and reads as follows:

 

The
non-cancellable period for which a lessee has the right to use an underlying
asset, together with both:

 

a)  Periods covered by an option to extend the
lease if the lessee is reasonably certain to exercise that option; and

b)  Periods covered by an option to
terminate the lease if the lessee is reasonably certain not to exercise that
option.

 

B34 of Ind AS 116 contains
further guidance and states:

 

In
determining the lease term and assessing the length of the non-cancellable
period of a lease, an entity shall apply the definition of a contract and
determine the period for which the contract is enforceable. A lease is no
longer enforceable when the lessee and the lessor each has the right to
terminate the lease without permission from the other party with no more than
an insignificant penalty.

 

Appendix A of Ind AS 116
clarifies that the word “contract” is defined in other standards and
used in Ind AS 116 with the same meaning, i.e. “an agreement between two or
more parties that creates enforceable rights and obligations”.

 

For example, paragraphs 10
and 11 of Ind AS 115 include the following more detailed guidance about “contracts”:

 

10. A contract is an
agreement between two or more parties that creates enforceable rights and
obligations. Enforceability of the rights and obligations in a contract is a
matter of law. Contracts can be written, oral or implied by an entity’s
customary business practices. The practices and processes for establishing
contracts with customers vary across legal jurisdictions, industries and
entities. In addition, they may vary within an entity (for example, they may
depend on the class of customer or the nature of the promised goods or
services). An entity shall consider those practices and processes in
determining whether and when an agreement with a customer creates enforceable
rights and obligations.

 

11. Some
contracts with customers may have no fixed duration and can be terminated or
modified by either party at any time. Other contracts may automatically renew
on a periodic basis that is specified in the contract. An entity shall apply
this Standard to the duration of the contract (ie the contractual period) in
which the parties to the contract have present enforceable rights and
obligations.

 

Both B34 and the definition
of a contract in Appendix A of Ind AS 116 is cross-referenced to BC127 in the
Basis of Conclusions of IFRS 16, specifically deals with “cancellable leases”
as follows:

 

Cancellable
leases

For the
purposes of defining the scope of IFRS 16, the IASB decided that a contract
would be considered to exist only when it creates rights and obligations that
are enforceable. Any non-cancellable period or
notice period in a lease would meet the definition of a contract and, thus,
would be included as part of the lease term. To be part of a contract, any
options to extend or terminate the lease that are included in the lease term
must also be enforceable; for example the lessee must be able to enforce its
right to extend the lease beyond the non-cancellable period. If optional
periods are not enforceable, for example, if the lessee cannot enforce the
extension of the lease without the agreement of the lessor, the lessee does not
have the right to use the asset beyond the non-cancellable period.
Consequently, by definition, there is no contract beyond the non-cancellable
period (plus any notice period) if there are no enforceable rights and
obligations existing between the lessee and lessor beyond that term. In
assessing the enforceability of a contract, an entity should consider whether
the lessor can refuse to agree to a request from the lessee to extend the
lease.

 

This conclusion is entirely
consistent with a “right-of-use model” based on recognising and measuring the
rights that the lessee controls and has had transferred to it by the lessor.
Including a renewal which the lessee cannot enforce without the agreement of
the lessor would unduly recognise in the right of use optional periods that do
not meet the definition of an asset. Even if the lessee has a significant economic
incentive to continue the lease, this does not turn a period subject to the
lessor’s approval into an asset because the lessee does not control the
lessor’s decision, unless the lessor’s termination right lacks substance. This
is a very high hurdle, which would be expected to be extremely rare and require
objective evidence.

 

View 2:
Yes, the lease term go beyond the date at which both parties can terminate the
lease.

 

Supporters of view 2
believe that an entity should evaluate the relevant guidance in the standard.
In considering the guidance in the standard, View 1 believes Ind AS 116 is
clear the lease term cannot be longer than the period in which the contract is
enforceable. However, Ind AS 116 is equally clear that a contract is
enforceable until both parties could terminate the contract with no more than
an insignificant penalty – which may be a period beyond the termination notice
period.

 

In the fact pattern above,
while the lease can be terminated early by either party after serving the
notice period, the enforceable rights in the contract (including the pricing
and terms and conditions) contemplate the contract can continue beyond the
stated termination date, inclusive of the notice period. In the fact pattern
above, there is an agreement which meets the definition of a contract (i.e., an
agreement between two or more parties that create enforceable rights and
obligations). However, the mere existence of mutual termination options does
not mean that the contract is automatically unenforceable at a point in time
when a potential termination could take effect.

 

Ind AS 116.B34 provides
explicit guidance on when a contract is no longer enforceable:

 

“A lease
is no longer enforceable when the lessee and the lessor each has the right to
terminate the lease without permission from the other party with no more than
an insignificant penalty.”

 

Therefore, when either
party has the right to terminate the contract with no more than insignificant
penalty there is no longer an enforceable contract. However, when one or both
parties would incur a more than insignificant penalty by exercising its right
to terminate – the contract continues to be enforceable. The penalties should
be interpreted broadly to include more than simply cash payments in the
contract. The wider interpretation considers economic disincentives.

 

While the IFRS16.BC127 does
not discuss the notion of “no more than insignificant penalty”, supporters of
View 2 believe that Ind AS116.B34 should be evaluated based on the wording in
the standard (i.e., taking into account the economic disincentives for the
parties). To the extent that the lessee has a more than insignificant economic
disincentives (e.g., significant leasehold investments) to early terminate the
lease, the 2nd sentence in B34 will not be applicable. However, on
the other hand, if one or both parties have only insignificant economic
disincentives to terminate, say, after five years, the lease is not considered
enforceable after five years and hence the lease term cannot exceed five years.
Ind AS116.B34 does not directly provide guidance as to how long the lease term
should be. Rather, it provides guidance as to when a contract is no longer
enforceable and thus no longer exists.

 

While Ind AS 116.B34 and
B35 provide guidance on evaluating the period in which a contract continues to
be enforceable and how to evaluate lessee and lessor termination options, they
do not address how to evaluate the lease term once the enforceable period of
the contract has been determined (i.e., at least until both parties no longer
have a more than insignificant penalty if they were to terminate the contract).
To determine the lease term, the parties would apply Ind AS 116.18-19 and
B37-40 (i.e., the reasonably certain threshold). “Reasonably certain” is a high
threshold and the assessment requires judgement. It also acknowledges the
guidance in Ind AS 116.B35 which indicates lessor termination options are
generally disregarded (“If only a lessor has the right to terminate a lease,
the non-cancellable period of the lease includes the period covered by the
option to terminate the lease.”)

Thus, in this fact pattern
above, it is possible that the lease term may exceed the notice period. The
lease term is the non-cancellable (notice) period together with the period
covered by the termination option that it is reasonably certain the lessee will
not exercise such termination option.

 

However, the lease term
cannot be no longer than the period the contract is enforceable (i.e., the
point in time in which either party may terminate the lease without permission
from the other with no more than an insignificant economic disincentive,
inclusive of any notice period). 

 

If the facts were different
and the contract had an end date but contemplates the lease might be extended
if both the lessee and lessor agree to new terms and conditions (including new
pricing) there may be no enforceable contract but rather an invitation to enter
into new negotiations.

 

In light of the compelling
arguments in both views, the author recommends that the Ind AS Transition
Facilitation Group (ITFG) should address this issue in consultation with the
IASB staff or IFRIC.

 

 

 

ASSESSMENT OF BUSINESS MODEL FOR NON-BANKING FINANCIAL COMPANIES (NBFCs)

INTRODUCTION


India Incorporated continues its journey
with the next phase of adoption of Ind As by Non-Banking Finance Companies
in two phases commencing from the accounting period beginning 1 April, 2018.
Whilst there are several implementation and transition challenges, assessment
of the business model is an important area which is likely to impact most
NBFCs.

 

The initial plan of the MCA was to implement
Ind AS for the entire gamut of financial service entities covering NBFCs, banks
and insurance entities, which has been deferred by a year for banks and by two
years for insurance companies. Accordingly, the discussion in this article is
restricted only to NBFCs.

 

It may be pertinent to note that the RBI
had constituted a Working Group to deal with the various issues relating
to Ind AS Implementation by Banks which had submitted a detailed
report in September, 2015 which may be equally important and
relevant to NBFCs since there is a fair degree of similarity in their business
models and the same would be also taken into account in the course of our
subsequent discussions.

 

BUSINESS MODEL ASSESSMENT FOR FINANCIAL
ASSETS (INCLUDING THE MEASUREMENT AND CLASSIFICATION)


Assessing the business model for holding
financial assets is the anchor on which the entire accounting for financial
assets rests. Before going into the assessment of the business model for
financial assets it is necessary to understand as to what constitutes a
financial asset, since for NBFCs it represents the single most important
component in the Balance Sheet and how its initial measurement is determined.

 

Meaning and Nature of Financial Assets Ind AS-32 defines a financial asset as any asset that is:

a)  Cash

b)  An equity instrument of another entity

c)  A contractual obligation to receive cash or
another financial asset from another entity or to exchange financial assets or
financial liabilities with another entity under conditions that are potentially
favourable to the entity.

 

As can be seen
above, an equity instrument needs to be evaluated from the perspective of an
issuer and the same is defined in Ind AS-32 as any contract that
evidences a residual interest in the assets of an entity after deducting all
its liabilities. Accordingly, from the point of view of the holder an
equity instrument is an asset / instrument in which the entity does not have a
right to receive a fixed contractual amount of principal or interest.

 

Accordingly, by
default any instrument which does not meet the definition of an equity
instrument from an issuer’s perspective would be regarded as a debt instrument
in which there is generally a contractual cash flow involved.

 

Initial Measurement of Financial Assets


As per Ind AS-109
an entity shall initially measure its financial assets at their
fair value plus or minus any transaction costs that are directly attributable
to the acquisition of the financial assets in case of those falling under the
FVTPL category (discussed later).

 

The best evidence of the fair value on initial
recognition is normally the transaction price. However, if the NBFC determines that the fair
value based on quoted prices in an active market for identical items, or
based on observable and unobservable inputs like interest rates, yields, credit
spreads etc., is different, the same shall be recognised as a day one gain or
loss. The common areas where such adjustments are required are staff and
related party loans and refundable premises deposits which carry preferential
interest rates or no interest rates.

 

Classification of Financial Assets


Under Ind AS-109,
understanding the business model under which financial assets are held is the
key criterion for determining their classification and subsequent measurement
and accounting. Ind AS-109 requires that all financial assets are required to
be classified under the following three categories for subsequent measurement
purposes:


a)  Amortised Cost

b)  Fair value through profit or loss (FVTPL)

c)  Fair value through other comprehensive income
(FVTOCI)

 

The classification
depends upon the following two criteria and options elected by the entity:

a)  The entity’s business model for
managing the financial assets, and

b)  The contractual cash flow characteristics
of the financial assets.

 

Further, there are separate
classification requirements for:

a)  Equity Instruments

b)  Debt Instruments

 

Equity
Instruments


Since equity instruments
do not involve the right to contractually receive fixed and determinable cash
flows whether through principal or interest, their classification is more dependent
upon the intention of whether it is “held for trading” (discussed
later). However, in situations in which the instruments are not held for
trading, the entity needs to exercise an irrevocable choice as to whether
it wants to elect the FVTOCI option. A tabulation of the choices
available is depicted hereunder:

 

 

 

Accordingly, all
equity instruments which are “held for trading” are required to be mandatorily
classified as FVTPL, whereas for all other instruments, the entity can make an
irrevocable option to classify the same as FVTOCI or elect the FVTPL option
(discussed later). The following are some of the key points which are
relevant regarding the FVTOCI classification of equity instruments:


a)  Classification as FVTOCI is not mandatory
though it cannot be used for equity instruments “held for trading”.


b)  The classification needs to be made on initial
recognition and is irrevocable.


c)  The election can be made on an instrument by
instrument basis and is not an accounting policy choice.


d)  If the entity elects this option then all fair
value changes on the particular instrument, excluding dividends, are recognised
through OCI and no recycling is permitted to Profit and Loss even on disposal,
though the cumulative gain or loss at the time of disposal may be transferred
within equity to retained earnings.


e)  There are no separate impairment requirements.


f)   Ind AS-101 gives the entity a choice to
designate the equity instruments on the basis of facts and circumstances that
exist on the date of transition to Ind AS.

 

Debt Instruments


The classification of debt instruments is dependent upon the business
model which refers to how an entity manages its financial assets so as to
generate cash flows i.e. whether the entity will collect the cash flows
by holding the financial asset till maturity or sell those assets or both.
A tabulation of the choices available is depicted hereunder:

 

 

The following are some of the key points which are relevant regarding
the FVTOCI classification of debt instruments:


a)  For debt instruments meeting
the above prescribed criteria, FVTOCI classification is mandatory, unless
FVTPL option is exercised as discussed below.


b)  For such debt instruments, interest income,
impairment and foreign exchange changes are recognised in profit and loss
whereas all other changes are recognised directly in OCI.

c)  On derecognition, cumulative
gains and losses previously recognised in OCI are reclassified from equity to
profit and loss.


d)  Ind
AS-101 gives the entity a choice to designate the debt instruments on the basis
of facts and circumstances that exist on the date of transition to Ind AS.

 

Option to Designate Financial Assets at FVTPL


Irrespective of the satisfaction of any of the above conditions for
amortised cost or FVTOCL designation, Ind AS-109 provides an option to
irrevocably designate a financial asset as measured at FVTPL if doing so eliminates
or significantly reduces a measurement mismatch, which is also referred to as
an ‘accounting mismatch’, which would otherwise arise if a different basis
is followed.
Though this is an accounting policy choice, it is not required to be applied
consistently for all similar transactions. Ind AS-109 provides the following
guiding principles to designate financial assets as measured at FVTPL:

 

a)  When the financial asset is
part of a hedging relationship.


b)  When the financial assets,
financial liabilities or both share a common risk such as interest rate risk
that gives rise to offsetting changes as part of the entity’s ALM policy.


c)  When a group of financial
assets is managed and performance is evaluated on a fair value basis such as
investment management, venture capital companies or stock broking companies.

 

Held for
Trading


Apart from the option to designate financial assets at FVTPL as
discussed above, another important consideration for FVTPL designation is
whether the financial assets are “held for trading” for which Ind AS-109 has
provided certain guiding principles which are briefly discussed hereunder:

 

a)  The financial assets are
acquired ‘principally’ for the purpose of selling in the near term e.g. stock
in trade held by a stock broker.


b)  The financial asset is part of a portfolio of
financial instruments that are managed together and for which there is evidence
of a recent actual pattern of short-term profit taking.


c)  ‘Trading’ generally reflects active and
frequent buying/selling with the objective of generating a profit from
short-term fluctuations in the price. However, churning of portfolio for risk
management purposes is not necessarily ‘trading’ activity.  

 

Business Model Assessment


Guiding
Principles


The following are some of the guiding principles laid down in Ind AS-109
which need to be considered whilst assessing and determining the business model
for managing financial assets, in the context of debt instruments, some of
which have also been reiterated in the RBI Working Group Report, referred to
earlier in the context of Banks which may also be pertinent to NBFCs:

 

a)  Assessing the entity’s business model for
managing financial assets is a matter of fact and not merely an assertion. It
has to be based on relevant and objective evidence including but not limited to
how the performance of the business model and the financial assets held within
the same are evaluated by the entity’s key management personnel, their risks and
how the personnel are compensated.


b)  The assessment is based on how groups of
financial assets are managed to achieve a particular business objective and is not
an instrument by instrument analysis, though at another level it is also not an
entity level assessment.

c)  A few exceptions against the stated portfolio
objectives may not necessitate a change in the business model e.g. a few sales
out of a portfolio which is on the “hold to collect” business model. In such
situations what needs to be considered are factors like the frequency, timing
and reasons for the sales and expectations of the future sales activity.


d)  Business model assessment is done based on
scenarios reasonably expected to occur and not on exceptional or extreme
situations such as ‘worst case scenario’ or ‘stress case scenario’.

 

Amortised Cost –
Business Model Test


Some of the key
features for assessing the business model test of holding on to a financial
asset for amortised cost determination areas are as under:


a)  To evaluate the entity’s business model to
hold financial assets to collect contractual cash flows, the frequency,
value and timing of sales in prior periods and the reasons for such sales have
to be analysed. Also, future expectations about such sales is required
to be analysed. It is important to bear in mind that higher or lower sales than
the previous expectations is not a prior period error.


b)  In real time business it is not always
practical to hold all the financial assets until their maturity, regardless of
the business model. Hence, some amount of selling/buying or so called ‘churning
of portfolio’ is expected and permitted. However, if more than infrequent
number of sales are made out of a portfolio or those sales are more than
insignificant in value, then there will be a need to assess and
validate how such sales are consistent with the business model whose objective
is to collect contractual cash flows.  

 

It would be useful
at this stage to analyse certain common situations where the business model
test of holding would not fail or fail from a practical perspective, before
getting into the assessment of the subsequent criteria of the contractual cash
flow test:

 

Circumstances when the business model test would not
necessarily fail

Circumstances when the business model test may generally fail

Infrequent  sales to meet unforeseen funding needs.

Holding
financial assets to meet everyday liquidity needs.

Purchases
of loan portfolio instead of originating loan portfolio, which may include
credit impaired loans.

Loans
originated with an intention to sell in the near future.

Sales
due to increase in credit risk of the financial assets which can be
demonstrated either with entity’s credit risk management policy or in some
other way. This could also include sales to manage credit concentration risk
regardless of the increase in credit risk.

Portfolio
of financial assets that meet the definition of ‘held for trading’ as
discussed above even if they are held for a long period.

Sales
effected closer to maturity where the proceeds approximately equal the
remaining contractual cash flows.

 

    

Amortised Cost –
Cash Flow Characteristics Test


Another equally
important test or criterion to be met for classification of financial assets as
subsequently measured at amortised cost is the characteristics of the cash
flows arising from the financial asset. Ind AS-109 provides that for this
purpose, the contractual terms of the financial asset should give rise on
specified dates to cash flows that are solely payment of principal and the
interest on the principal outstanding (SPPI).

 

Ind AS-109 defines
interest, for the purpose of the above assessment, as consideration for the
following:

 

a)  the time value of money.

b)  credit risk associated with the principal
amount outstanding during a particular period of time.

c)  other basic lending risks (such
as liquidity risk) and costs (such as administration for holding
the financial asset).

d)  profit margin.

 

Ind AS-109 defines
principal, for the purpose of the above assessment, as fair value of
the financial asset at the date of initial recognition. This initial amount may
change subsequently if there are repayments of the principal amount.   

 

For the purposes of
the above assessment, principal and interest payments should be in the currency
in which the financial asset is denominated. The following are some of the practical
considerations which are relevant for assessing the SPPI test:

 

a)  Modified (or imperfect) Time Value of Money
Element: This kind of situation arises when the financial asset’s interest
rate is reset periodically and the tenor of rate (benchmark rate) does not
match the tenor of interest period e.g. interest rate for a term loan is reset
monthly but rate is reset to one year rate. In such cases, entity will have to
assess whether the cash flows represent SPPI. This has to be demonstrated as
follows:


  • Compute (undiscounted) cash
    flows as if benchmark rate tenor matches interest period and compare it with
    cash flows (undiscounted) as per contractual terms (i.e. tenors do not match).

  • Above computation has to be
    done for entire period of the financial asset and hence consideration of facts
    that affect future interest rates and estimation would be required.
  • If the cash flows under
    above two scenarios are significantly different then the modified time value of
    money element does not represent SPPI.


b)  Rates set by Regulators: These shall be
considered as proxy for time value of money element, provided it is set by
broadly considering the passage of time element and does not introduce exposure
to risks and volatility inconsistent with basic lending arrangement.


c)  Pre-payment or extension options pass
the SPPI test, provided that the repayment amount substantially represents
unpaid principal and interest accrued as well as reasonable compensation for
early payment or extension of payment period.


d)  Floating or Variable Rates: Provisions
that change the timing or amount of payments of principal and interest fail the
SPPI test unless it is a variable interest rate that is a consideration for the
time value of money and credit risk and other basic lending risk associated
with the principal outstanding and the profit margin.

 

Key
Implementation and Transition Challenges


The current requirements for classification and accounting for
investments by NBFCs were quite simple and hence shifting over to an Ind AS
regime is expected to present a fair share of challenges both in initial
transition and on-going implementation. Further, though all Ind AS requirements
are required to be applied retrospectively on the date of transition, Ind
AS-101 provides certain exceptions thereto, one of them being that the entity
should assess the business model criteria on the basis
of facts and circumstances on the date of transition. Finally, the measurement
basis for all financial assets on initial recognition would henceforth be at
the fair value for which also Ind AS-101 provides for prospective application
on or after the date of transition to Ind AS. In spite of the aforesaid
exemptions from retrospective application, NBFCs are likely to face certain
transition and on-going implementation challenges, which are briefly discussed
hereunder:

 

a)  Treatment of existing
investments classified as current: As per the existing AS-13, all
investments that by their nature are readily realisable and are intended to be
held for not more than one year from the date on which they were made, are
regarded as current investments. Under Ind AS, all such investments may not
automatically meet the held for trading criteria especially in respect of
equity instruments, and especially if these are continuing for periods in
excess of one year on the date of transition. Accordingly, a fresh evaluation
of the purpose, nature and intention of such investments would need to be
undertaken to categorise them under the appropriate bucket. Also,
investments in mutual funds would generally fall under the FVTPL
category based on the “look through” test since there are no defined
contractual cash flows even in case of fixed maturity plans.

b)  Documentation and business
model assessment: – The classification requirements based on the criteria
discussed above may not be straitjacketed in all cases and would need to be
documented in a fair degree of detail based on the activity level and type of
business of the NBFC. The existing risk management and ALM policies especially
in case of smaller and unlisted entities would need to be recalibrated to
capture the various scenarios under Ind AS.


c)  Fair value determination:
The initial measurement of all financial assets at fair value would be a game
changer for many NBFCs. Whilst initially the transaction price would be the
fair value in many cases, this would need to be carefully evaluated in the case
of transactions with related parties, transactions not on an arm’s length basis
or transactions under duress, since in such cases the fair value at which other
market participants enter into the transactions would need to be considered which
would represent a day one gain or loss. Finally, the on-going assessment of the
fair value especially in case of financial assets which are not readily
tradeable or quoted on an active market would present challenges especially in
cases where there are not many observable inputs to determine the fair value,
since it could be based on significant judgements which more often than not
could be biased. This would make it inherently difficult for a comparison
between entities and also involve significant costs and efforts which may not
be always commensurate with the benefits.


d)  Link with liquidity crisis:
The current liquidity crisis which has engulfed many NBFCs may necessitate
selling of portfolios of financial assets the impact of which on the continued
assessment of the business portfolio would need a closer assessment requiring a
reclassification of debt instruments and loans from amortised cost to FVTOCI
for subsequent measurement.


e)  Judgements: Finally, the
assessment of the business model involves significant judgements and
assumptions which need to be constantly evaluated by the key management
personnel on several matters like determining the frequency and volume of sales
so as to rebut the business model of held to sale, whether interest rates reset
is on time value and the other criteria discussed earlier, the manner of
determining the pricing for financial assets and the inputs involved therein
since all of this would ultimately impact the business model assessment and the
consequential classification and measurement of financial assets. It may be
noted that the RBI working group has recommended the fixing of certain
thresholds to determine as to when the volume of sales could be considered frequent
so as to rebut the business model of “held to sale” criteria.

 

CONCLUSION


The above
evaluation is just the tip of the iceberg on a subject for which there may not
always be straitjacketed answers. However, the business model assessment is
here to stay and it would impact the way the financial statements are evaluated
and also impact the auditors and prove to be a bonanza for specialists to
develop fair values, who could laugh all the way to the bank!

 

 

CHANGING RISK LANDSCAPE FOR AUDIT PROFESSION, WITH SPECIAL EMPHASIS ON NFRA AND OTHER RECENT DEVELOPMENTS

Mr. N.P. Sarda, Past President of the ICAI and a
well-known teacher to many in the profession, delivered a remarkable speech at
the BCAS on 9th January, 2019. BCAJ received requests from many
members to publish some of the key points of that talk. We are publishing this
summary just in time before the audit season for unlisted entities commences. A
summary cannot convey the full import of his presentation but we hope this
piece will enable the professionals to get a bird’s-eye view of the changing
landscape of the audit profession. We would recommend that you also watch the
two-hour-long talk on the BCAS You Tube channel.

 

In the last couple of years, the frequency and scale of
frauds revealed to stakeholders and the public at large has been astonishing.
Many would have thought that post-Satyam scandal lessons were learnt and proper
governance practices put in place. However, with irregularities at Punjab
National Bank (PNB), Infrastructure Leasing & Financial Services
(IL&FS), amongst others, coming to the fore, the burning questions about
loopholes in the system, accountability, risk management, etc., are again up
for debate in the corporate world.

 

In the aftermath of the scams, the National Financial
Reporting Authority (NFRA) was formed to tighten the regulatory aspects and
monitor the quality of audit. This led to issues such as overriding powers of
the NFRA over the ICAI, questioning auditors about the professional work, etc.
In this article, we provide various aspects of this development, the issues
therein and their impact. The following broad headings cover the key aspects
dwelt upon by Mr. Sarda.

 

INCREASING RISKS AND CHALLENGES

Economic and regulatory changes are taking place at a rapid
pace. We have witnessed substantive reforms, viz., the Companies Act, 2013, Ind
AS and Auditing standards that are aligned with International frameworks,
Income Computation and Disclosure Standards and Corporate Governance
requirements to enhance transparency and certainty. In the wake of these
developments across various regulations and rising incidents of frauds, the
risks and challenges in auditing are also increasing. This is on account of the
following:

 

  •   Increasing size and spread of business
    entities and groups (locations,  subsidiaries, geographies, SPVs, number of
    transactions, frauds    );
  •    Multiple investments and special purpose
    entities;
  •    Multiplicity of inter-entity transactions and
    transfer of funds;
  • Rise in the volume and amount of transactions
    and of frauds;
  •    Complex nature of business transactions (complex
    instruments and contracts    );
  •    Rapid changes and volatility (what took a
    decade now takes less than a year    );
  •    Need for valuation and making provisions
    (towards pending demands and litigations) based on estimates at year end;
  •    Stress on fair value (subjective concept) as
    against historical cost;
  •    Increasing
    component of intangible assets and challenges in valuing them (wide variation
    in methodologies; valuation may not be valid over a period of time);
  •    Various risk factors such as market risk,
    credit risk, risk due to emerging technologies;
  •    Failure of business entities / industries;
  •    Technology tools in audit becoming a priority
    – checking controls / processes designed through computers, integration of
    different business softwares of an organisation, use of data analytics;
  •    Lack of practice of reconciliation,
    confirmations and certifications of ledger balances (through internal and
    external sources);
  •    Various checks and balances built for proper
    governance and prevention of frauds (such as concurrent audits, inspections by
    regulators, Audit Committee, Risk Management Committee, whistle-blower policy)
    may fail due to neglect or oversight and ineffectiveness of respective roles,
    leaving the statutory auditor to face all the criticism and blame;
  •    Need for investigations and forensic audit
    for a wide range of frauds involving falsification or fabrication of documents
    and records, frauds by collusion, management override of controls, frauds
    perpetrated by management;
  •    Society expects the auditor to unearth all
    frauds, while the auditors believe that such expectations are unrealistic and,
    therefore, the gaps in expectations, promises and actual performance. Though
    the primary responsibility of discovering frauds lies with the governance and
    management teams, the auditors will have to upgrade their standard of
    performance to detect all the material frauds by designing suitable audit
    programmes and procedures;
  •    Every time a scam is reported, instant
    judgements are passed in media as to why auditors did not report them. Without
    proper examination of the factual situation, audit documentation, etc. (were
    any financial statements during the period of fraud certified by the auditor,
    was it bona fide error or gross negligence, was it a planned collusion?)
    there is presumption of audit failure;
  •   Other risks like unrecorded and unusual
    transactions, significant related party transactions, doubts about going
    concern assumption, revenue recognition issues, off balance sheet items;
  •    Temptation and pressure to show improved
    results vis-à-vis last quarter, lack of emphasis on long-term
    sustainability;
  •    Frauds disguised through fraudulent reporting
    and misappropriation of assets.

 

SPECIFIC INSTANCES OF FRAUDS, SCAMS AND FAILURES

There have been several
financial scams causing distress, including with famous and reputed corporates.
The list of ten biggest corporate frauds includes Enron, World Com, sub-prime
mortgage crisis, Satyam Computers, Daewoo, Fannie Mae and Freddie Mac, AIG,
Phor-Mor, Bernie Madoff and Barlow Clowes. The findings reveal that these were
management-driven frauds wherein fraudulent financial reporting was resorted
to, in order to cover misappropriation of assets or a deteriorating financial
position. This requires increased professional scepticism from audit.

Let us look at some instances of fraud and the modus
operandi followed:

1. The Harshad Mehta fraud – bank funds used to finance stock
exchange transactions using portfolio management;

2. Sub-prime mortgage crisis – the model of giving loans
solely on mortgage of immovable properties, without any requirement of
repayment of loan by borrowers, failed as the values of the mortgaged
properties declined;

3. Satyam Computers – this involved manipulation of computer
systems, generation of fake invoices, overstating figures of revenue, profits,
bank balances. To cover up, forged bank statements, deposit receipts and
confirmations were produced by the management;

4. Kingfisher Airlines – the consortium of public sector
banks lent huge amounts of money to the airlines as part of a restructuring
exercise, after the loan account was classified as a non-performing asset.
This was questioned in the backdrop of the situation wherein the company was
reporting huge losses, the absence of adequate collateral securities, etc. The
loan funds were diverted out of India through financial transactions;

5. PNB – Letter of Undertaking to secure overseas credit from
other lenders was issued without cash margin through SWIFT system that was
not linked with Core Banking Solution. Due to this loophole, the
undertakings issued remained outside the books and, thus, remained undetected;

6. IL&FS – short-term borrowings were used for financing
long-term projects resulting in liquidity crisis. Due to long recovery
period from large infrastructure projects, it defaulted in repayment of
short-term loans (asset-liability mismatch).

 

NFRA

To ensure greater reliability of financial statements,
section 132 of the Companies Act, 2013 introduced the provisions relating to
NFRA. These were notified on 13th November, 2018.

 

Applicability

The classes of companies and body corporates governed by NFRA
(Rule 3) include:

(a) Companies whose
securities are listed on stock exchange in / outside India

(b) Unlisted public
companies

– paid up capital not less
than Rs. 500 crores

– annual turnover not less
than Rs. 1,000 crores

– loans, debentures,
deposits not less than Rs. 500 crores

(monetary thresholds – as
on 31st March of the preceding year)

(c) Insurance, banking,
electricity companies, etc.

(d) A subsidiary or
associate company outside India having income or net worth exceeding 20% of the
consolidated income or net worth of the Indian company.

 

Functions

The main functions of NFRA (Companies Act read with NFRA
Rules, 2018) are:

 

a. Make recommendations on Accounting and Auditing Policies
and Standards (after receiving recommendations from the ICAI);

b. Monitor and enforce compliance with Accounting Standards:

– may review financial statements of company / body corporate

– may require them to produce further information /
explanation

– may require presence of officers of company / body
corporate and its auditor

– based on inquiry, any fraud above Rs. 1 crore will be
reported to government;

c. Monitor and enforce compliance with Auditing Standards:

– may review working papers and audit communications

– may evaluate sufficiency of the quality control system and
manner of documentation

– may perform other testing of audit supervisory and quality
control procedures

– may require an auditor to report on its governance
practices and internal processes designed to promote audit quality and reduce
risk

d. Oversee the quality of service of the profession
associated with ensuring compliance with such standards and suggest measures
for improvement in quality of service; may refer cases to Quality Review Board
constituted under the Chartered Accountants’ Act and call for information, and
/ or a report from them;

e. Maintenance of details of auditors of companies specified
in Rule 3;

f. Promote awareness on compliance of accounting and auditing
standards;

g. Co-operate with national and international organisations
of independent audit regulators.

 

Powers

NFRA is entrusted with powers to investigate either suo
motu or on a reference made to it by the Central Government (for prescribed
class of companies) into matters of professional or other misconduct (as
defined in the Chartered Accountants Act). As per the Supreme Court decision in
the case of Gurvinder Singh, other misconduct will include any act that brings
disrepute to the profession, whether or not related to his professional work
and not necessarily done in his capacity as a CA. It is also provided that
where NFRA has initiated the investigation, no other institute or body can
initiate or continue any proceedings in such matters.

 

Where professional or other misconduct is proved, the
consequences are two-fold:

 

a. Penalty: For individuals – Rs. 1 lakh, may extend to 5
times the fees

For firms – Rs. 10 lakhs, may extend to 10 times the fees

b. Debarring the member or the firm from practice for a
minimum period of 6 months, not exceeding 10 years, applicable even to company
/ body corporate not governed by Rule 3.

 

NEED OF NFRA – ARGUMENTS

Several perceptions had led to the constitution of the NFRA.
We have analysed them below with valid arguments:

 

1. Frauds like Satyam and PNB – the disciplinary
mechanism of the ICAI being a creation of its own members, is ‘not independent’

The ICAI functions under the Ministry of Corporate Affairs,
the disciplinary procedure is laid down in the Act itself and government
nominees are present in every proceeding. As against the earlier practice of
involvement of Council members twice (at stages of prima facie and final
decision), after amendment to the Chartered Accountants Act in 2006, the
Director of Discipline (not a member of the Council) reports cases to the Board
of Discipline (Schedule I cases) and the Disciplinary Committee (Schedule II
cases). The government nominees are present in all the 3 bodies.

 

No allegation of bias has ever been raised – that the process
is not carried out judiciously. Rather than creating a separate body, the NFRA,
the government can appoint more nominees in the disciplinary mechanism of the
ICAI.

 

No other institute or body has taken such strict disciplinary
action against its own members as has been done by the ICAI. This is evidenced
by the fact that in the Satyam case various members have been debarred for
life, while in the PNB case the ICAI started suo motu action, without a
formal complaint. As for the member, such disciplinary proceedings are a
punishment in itself and result in loss of reputation. The ICAI has made
tremendous efforts to formulate and spread knowledge of compliance with standards
as part of CPE. QRB, FRRB and Peer Review are some other mechanisms that have
been working effectively.

 

2. Delay in disciplinary proceedings of ICAI

While this was true earlier, through amendments to the
Chartered Accountants Act in 2006, appointment of multiple Directors of
Discipline or Disciplinary Committees was allowed in order to avoid delays.

 

During the process, requests for adjournments and stay (for
proceedings ongoing with other regulatory authorities or Courts) caused delays
as this is a judicial process. Against this, the NFRA rules provide for a
summary procedure within 90 days where an opportunity for personal hearing may
or may not be given. It is important to strike a balance between the two
extremes – that the opportunity granted for hearing may be misused, but a
contrary stand can be harsh on the member.

 

3. With amounts and frequency of corporate and bank
frauds rising, the authorities had to take drastic action

It is assumed that all problems will be solved once NFRA sets
in. However, what kind of action is envisaged under it? Prevention and
detection of fraud is a very large area. NFRA provisions don’t address the
aspect of prevention of fraud; they are restricted to limited areas of action
against statutory auditors for gross misstatement in financial statements on
account of non-compliance of accounting and / or auditing standards. The
consideration is that there was something wrong in the accounting and auditing
standards and that was the reason of misconduct by the members.

 

It is presumed that if action is taken against the member,
frauds will not take place. But there are no steps for the detection of fraud
until certification of the financial statements by the auditor (exception fraud
noticed during search, later reported to government). The functions of NFRA do
not include aspects of deterrent action on perpetrators of fraud and / or other
checks and balances for prevention of fraud. In short, the focus of NFRA is
on the police and not on the thief!

 

4. Non-detection of
fraud by an auditor considered as fraudulent act and a case of professional
misconduct. Strict regulation could reduce such instances

In the backdrop of failure
to report frauds, fingers are pointed at auditors with allegations that the
auditors colluded with management and it is an intentional act involving gross
negligence. However, it is not prudent to draw any conclusion without examining
the facts. It could be a bona fide omission (not part of audit sample
selection), or an error of judgement, or that the time available to auditor was
not commensurate with the volume of business. May be, the skills of the auditor
have not kept up with those of the fraudster! The presumption that
non-detection of fraud is a fraudulent act or is professional negligence / misconduct
and that frauds can be reduced by a strict regulation like NFRA is far-fetched.

 

Importantly, enough stress has to be placed on relevant
internal controls, internal checks and balances required in the management and
governance of large entities. If they are not adequate, the statutory audit, on
its own and on a standalone basis, will not be effective. If negative
presumptions about the role of auditors continue, then new talent may hesitate
to enter the auditing profession.

 

NFRA AND OTHER REGULATORS – A TUSSLE

The question arises whether
it was necessary to have a separate disciplinary mechanism when ICAI already
has one. The ICAI had urged the Central Government against setting up the NFRA
(a legal fight is not possible because the ICAI functions under the Ministry of
Corporate Affairs). This, in fact, is the legal opinion of Mr. Mukul Rohatgi,
former Attorney General, that the NFRA encroaches on the powers of the ICAI.
Under the Constitution, if any institution has specific powers (ICAI in this case
regarding disciplinary mechanism), other institutions cannot have the same
mandate.

 

In a case filed before the
Delhi High Court by the Chartered Accountants’ Association, the Court has
granted stay on initiation of disciplinary action by NFRA. The final verdict is
pending on the matter of SEBI debarring PwC for 2 years (stay by the Supreme
Court).

 

The overlap and conflict between NFRA and other bodies gives
rise to the following issues:

 

1. Where NFRA has not initiated the proceedings, can ICAI do
it (different language in Act and Rules)?

2. Whether NFRA’s jurisdiction would apply to every act of
misconduct of a chartered accountant, or only relating to financial statements?

3. Would NFRA apply to the auditor of every branch of all
banks?

4. If an auditor is debarred by NFRA, the impact will extend
to his every audit appointment including for companies not covered by Rule 3.

5. There is no provision in the NFRA rules for complaints by
any stakeholder against Rule 3 companies. It is restricted to cases referred by
government or suo motu action. Even ICAI would not have jurisdiction to
address such complaints.

 

While the guilty must be punished, it is equally important
that innocents are not harassed.

 

ROLE OF ICAI POST-NFRA

The ICAI will make recommendations on Accounting and Auditing
Standards to NFRA. The role of Quality Review Board to oversee the quality of
audit service rendered would continue. Towards this, an effective role can be
played by having efficient structure and process of inspection. The aspect of
improving and strengthening the expertise and quality of work of internal
auditors, experts in designing and implementing internal controls, computer
controls, etc. also needs be seen.

 

There is no change in
jurisdiction and powers of ICAI over auditors, other than those of Rule 3
entities. The ICAI ought to regulate over matters not governed and administered
by NFRA provisions, as discussed above.

 

ACTION FOR AUDITORS

The change in the regulatory environment and expectations
demands that auditors develop and deliver high-quality service to reinforce the
relevance of audit. The skill sets and manner of executing audit need to
evolve. We have highlighted below the perspective for the auditors about what
they need to do.

a. Focus on upgrading
professional skills (including industry specialisation);

b. Audit firms to devise
and implement quality controls and best practices;

c. Appropriate audit
planning considering industry, client, nature of business, controls in place,
systems and procedures, accounting policies followed;

d. Undertake risk
assessment on the basis of evaluation of internal controls and computer
controls;

e. Design audit procedures
based on findings of risk assessment (e.g. special procedures may be required
for unusual transactions and evaluation of uncertainties and estimates;

f. Apply audit techniques
including computer-aided tools;

g. Develop expertise on
Accounting and Auditing Standards and strictly adhere to them;

h. Have a trained and
talented audit team for execution;

i. Stress on detailed
documentation;

j. Exercise
professional scepticism;

k. Quality control in
Audit Firms;

l. Consultation with other
experts, wherever required;

m. Constructive
discussions and communication with management and with those charged with
governance on internal controls, risk management and provide valuable insights;

n. Giving value-added
insights;

o. Appropriate reporting
of Key Audit Matters.

 

CONCLUDING REMARKS

The success of NFRA would depend upon the constitution of its
members, the experts appointed, their expertise and approach, its finance and
infrastructure, the effectiveness of coordination with ICAI in respect of
Accounting and Auditing Standards and assistance of the Quality Review Board.

 

Risks are becoming the focal point. The
responsibilities of the auditor are increasing. With public sentiment turning
negative and some lowering of confidence in the independent auditor’s work,
there is a fear that professionals may stay away from the audit domain.

IMPACT OF ORDINANCE DATED 20th SEPTEMBER, 2019

The tax ordinance of
September, 2019 has made significant changes in the income-tax provisions and
the income-tax rates.

 

Prior to
this, existing domestic companies were liable to tax at the basic rate of
either 25% or 30%. The effective tax rate ranged from 26% to 34.94% after
considering surcharge of 7% / 12% and health and education cess of 4%.

 

The tax rate of 25% was
applicable to two types of domestic companies, viz., (a) those having turnover
or gross receipts not exceeding Rs. 400 crores in tax year 2017-18; and (b) new
domestic manufacturing companies set up and registered on or after 1st
March, 2016 fulfilling specified conditions.

 

With
effect from the tax year 2019-20, domestic companies shall have an option to
pay income tax at the rate of 22% plus 10% surcharge and 4% cess, taking the
effective tax rate (ETR) to 25.17%, subject to the condition that they will not
avail specified tax exemptions or incentives under the ITA. Such an option,
once exercised, cannot be subsequently withdrawn. Companies exercising such option will not be required to pay Minimum Alternate Tax (MAT).

 

Domestic companies claiming
any tax exemptions or incentives shall also be eligible to exercise such an
option after the expiry of the tax incentive period.

 

Subsequently, the CBDT has
clarified that domestic companies opting for the 22% concessional tax rate
(CTR) will not be allowed to set off the following while computing the total
income and their tax liability:

 

(i) Brought forward ‘losses’
on account of additional depreciation arising in any tax year prior to opting
for the 22% CTR;

(ii) Brought forward credit of
taxes paid under MAT provisions of the Indian Tax Law (ITL) in any tax years
prior to opting for the 22% CTR in view of inapplicability of MAT provisions to
a domestic company which opts for the 22% CTR.

 

Further, the CBDT clarified
that in the absence of any time-line for exercising of option to claim 22% CTR,
the domestic company, if it so desires may opt for the 22% CTR after it has
exhausted the accumulated MAT credit and unabsorbed additional depreciation by
being governed by the regular taxation regime existing under the ITL prior to
the ordinance.

 

The comparative effective tax
rates before and after exercise of the option are as follows:

 

Sr

Nature of domestic
company

Current ETR (%)

ETR on Exercise of
Option (%)

Reduction in tax
liability

1

Total
turnover or gross receipts = INR4b during FY 2017-18 or new manufacturing
companies incorporated between 1st March, 2016 and 30th
September, 2019

 

• Income < INR
10m

• Income > INR
10m, but < INR 100m

• Income > INR
100m

26%

27.82%

29.12%

25.17%

25.17%

25.17%

0.83%

2.65%

3.95%

2

Optional
tax rate for new manufacturing companies incorporated on or after
1st October, 2019

 

• Income < INR
10m

• Income > INR
10m, but < INR 100m

• Income > INR
100m

26%

27.82%

29.12%

17.16%

17.16%

17.16%

8.84%

10.66%

11.96%

3

Other
domestic companies

 

 

• Income < INR
10m

• Income > INR
10m, but < INR 100m

• Income > INR
100m

31.2%

33.38%

34.94%

25.17%

25.17%

25.17%

6.03%

8.21%

9.77%

 

There are numerous tax issues
relating to the recent ordinance. From an accounting perspective, it converges
to a few important questions. These are discussed below and are equally
applicable to AS (Indian GAAP) as well as Ind AS.

 

Question

Does the ordinance have any
effect on the 31st March, 2019 financial statements (which were yet
to be issued at the time the ordinance was announced)?

 

Response

The ordinance was not an
enactment / substantive enactment at the balance sheet date, i.e. 31st
March, 2019. Consequently, the tax charge and deferred taxes are based on the
pre-ordinance rates / income tax provisions. However, it is a subsequent event
which needs the disclosure below in the notes to accounts. This disclosure may
need suitable modification to the fact pattern. For example, the impact
quantification may not be appropriate / required where the impact cannot be
estimated with reasonable certainty or is not material.

 

Pursuant to the Taxation Laws
(Amendment) Ordinance, 2019 (Ordinance) issued subsequent to the balance sheet
date, the tax rates have changed with effect from 1st April, 2019
and the company plans to pay tax at the revised rates. If those changes were
announced on or before reporting date, deferred tax asset (or / and deferred
tax liability) would have been reduced by xxxx. The tax charge or (credit) for
the year would have been increased / (decreased) by xxxx.

 

Question

The company currently has MAT
credit and unabsorbed depreciation. It is currently evaluating the tax position
and has not decided whether it should adopt new rates now or later. How should
the matter be dealt with in the quarter ended September, 2019 interim results?

 

Response

The ordinance is an abiding
law that came into force in September, 2019. Accordingly, the impact on tax
expenses based on the option elected by the company needs to be considered in
the September quarter financial results. Merely stating that the company is in
the process of evaluating the impact will not comply with Ind AS / AS
requirements. It is also possible that a decision made in the September, 2019
quarter may change at the year-end. The impact of change on the tax expense
will constitute a change in the accounting estimate which will have to be
properly explained both under Ind AS and AS.

 

Question

On transition to Ind AS 115 /
Ind AS 116, the transition adjustment along with deferred tax impact was
recognised in equity. Where should the subsequent changes in deferred taxes due
to the ordinance be recognised?

 

Response

The subsequent changes to
deferred tax impact is taken to P&L and not to equity even if the earlier
deferred tax was charged or credited to equity; for example, deferred tax
impact taken to equity on transitioning to Ind AS 115 / 116 or transitioning to
Ind AS under Ind AS 101. In the author’s view, the fact that deferred tax was
charged / credited to opening equity does not mean that subsequent changes in
the deferred tax asset or liability (for example, as a result of change in tax
rates) will also be recognised in equity. Rather, management needs to determine
(using the entity’s new accounting policy) where the items on which the
deferred tax arose would have been recognised if the new policy had applied in
the earlier periods (backward tracing). Therefore, if Ind AS 115 / 116 was
always applicable, the adjustment made to equity on transition would have ended
up in the P&L. Consequently, the subsequent changes in deferred tax due to
change in tax rates should also be taken to the P&L account.

 

Question

With
respect to 31st March, 2020 accounts, whether the full tax impact is
considered in the September, 2019 quarter or spread over the three remaining
quarters, namely, September, 2019; December, 2019; and March, 2020?

 

Response

Due to the change in tax rates
/ provisions, there may be a substantial adjustment to the DTA / DTL balance.
For example, a company may be availing tax incentives due to which huge amounts
of DTA / DTL may have got accumulated. If the company decides to fall in the
new regime of taxation, a significant amount of DTA / DTL will need to be
adjusted. The impact of the adjustment has to be taken to the P&L and
cannot be deferred beyond the financial year in which the change occurs. There
are two acceptable approaches, viz., considering the full impact in the
September quarter, and the alternative approach of spreading it over the three
quarters. The reason for two acceptable approaches is as follows:

 

In determining the effective
average annual tax rate as required by Ind AS 34, it is necessary to estimate closing
deferred-tax balances at the end of the year because deferred tax is a
component of the estimated total tax charge for the year. This conflicts with
Ind AS 12 which requires deferred tax to be measured at enacted or
substantially enacted tax rates. It is therefore not clear as to when in the
annual period the impact of remeasuring closing deferred tax balances for a
change in tax rate is recognised. Consequently, two practices have emerged to
determine the tax charge for the interim period:

(a)   The estimated tax rate does not include the impact of remeasuring
closing deferred tax balances at the end of the year. It is not included in the
estimated ‘effective’ average annual tax rate. Consistent with the treatment of
tax credit granted in a one-off event, an entity may recognise the effect of
the change immediately in the interim period in which the change occurs
(Approach 1).

(b)   The estimated rate includes the impact of
remeasuring closing deferred tax balances at the end of the year. In this
approach the effect of a change in the tax rate is spread over the remaining
interim periods via an adjustment to the estimated annual effective income tax
rate (Approach 2).

 

It’s an accounting policy
choice to be followed consistently. The example below explains the two
approaches:

 

Example: Impact of change
in tax rate on tax charge / (credit) in the interim period

 

Company X’s applicable tax
rate in first quarter (June, 2019) was 40%. In the second quarter (September,
2019) the tax rate was changed retrospectively from 1st April, 2019
to 25%. Opening temporary difference on which deferred tax asset was created is
Rs. 40,000, which is expected to reverse after three years.

 

Approach
1 – Adjust the impact of change in tax rate in the quarter in which change occurs

Quarter profit

Profit for the
quarter as per statutory

books (A)

 

Incremental
depreciation in tax books (B)

Tax (loss) / profit
for the quarter as per tax return

C = A-B

 

Tax rate (D)

Tax charge in books
(excluding effect of change in tax rate)
E = A*D

Impact of change in
tax rate (F)1

Total tax charge in
books (including deferred tax) G = E + F

ETR (G/A)

June

50,000

50,000

–

40%

20,000

 

20,000

40%

Sep

40,000

35,000

5,000

25%

10,000

(1,500)

8,500

21%

Dec

40,000

25,000

15,000

25%

10,000

 

10,000

25%

March

30,000

(10,000)

40,000

25%

7,500

 

7,500

25%

 

1,60,000

1,00,000

60,000

 

 

 

46,000

 

 

Approach
2 – Adjust the impact of change in tax rate over the period of remaining
quarters (the impact cannot be carried forward beyond the end of the financial year)

 

Quarter profit

Profit for the quarter as per

statutory books (A)

 

Incremental depreciation in tax books
(B)

Tax (loss) / profit for the quarter as
per tax return

C = A-B

 

Tax rate (D)

Tax charge in books (excluding effect of
change in tax rate)

E = A*D

Impact of change in tax rate (F)2

Total tax charge in books (including
deferred tax)

G = E+F

ETR (G/A)

June

50,000

50,000

–

40%

20,000

–

20,000

40%

Sep

40,000

35,000

5,000

25%

10,000

(545)

9,455

24%

Dec

40,000

25,000

15,000

25%

10,000

(545)

9,455

24%

March

30,000

(10,000)

40,000

25%

7,500

(410)

7,090

24%

 

1,60,000

1,00,000

60,000

 

 

 

46,000

 

 

2Reversal of excess provision made in 1st
quarter, i.e., 50,000*15% = 7,500 and reversal of opening deferred tax asset
created at higher rate, i.e., 40,000*15% = 6,000, i.e., 1,500 over the next
three quarters in the ratio of book profits (40000:40000:30000) minus
non-deductible temporary difference (zero in this fact pattern).

 

CONCLUSION

The author believes that both
views discussed above are based on sound arguments and are equally acceptable.

 

 

Ind AS ACCOUNTING IMPLICATIONS FROM SUPREME COURT RULING ON PROVIDENT FUND

For many small entities,
the Supreme Court (SC) order will have a crippling effect at a time when they
are already suffering the blow of demonetisation. The ruling may also trigger a
whole litigious environment not only on Provident Fund (PF), but also around
other labour legislation such as bonus, gratuity, pension, etc. This article
deals only with the limited issue of accounting and disclosure under Ind AS
arising from the SC ruling on PF. Entities are required to do their own legal
evaluation or seek legal advice and consider an appropriate course of action.

 

BACKGROUND

Under the PF Act, the PF
contributions are required to be calculated on the following:

 

  •    Basic wages;
  •    Dearness allowance;
  •    Retaining allowance; and
  •    Cash value of any food
    concession.

 

An allowance like city
compensatory allowance, which is paid to compensate/neutralise the cost of
living, will be in the nature of dearness allowance on which PF contributions
are to be paid u/s. 6 of the EPF Act.

 

The term ‘basic wages’ is
defined to mean all emoluments which are earned by an employee in accordance
with the terms of contract of employment and which are paid or payable in cash,
but does not include the following:



  •    Cash value of any food
    concession;
  •    Dearness allowance, house
    rent allowance, overtime allowance, bonus, commission or any other similar
    allowance payable in respect of employment;
  •    Present made by the
    employer.

 

Multiple appeals were
pending before the SC on the interpretation of definition of ‘basic wages’ and
whether or not various allowances are covered under its definition for
calculation of PF contributions. The Court pronounced its ruling on 28th
February, 2019 on whether various allowances such as conveyance allowance,
special allowance, education allowance, medical allowance, etc. paid by an
employer to its employees fall under the definition of ‘basic wages’ for
calculation of PF contributions. It ruled that allowances of the following
nature are excluded from ‘basic wages’ and are not subject to PF contributions:



  •    Allowances which are
    variable in nature; or
  •    Allowances which are
    linked to any incentive for production resulting in greater output by an
    employee; or
  •    Allowances which are not
    paid across the board to all employees in a particular category; or
  •    Allowances which are paid
    especially to those who avail the opportunity, viz., extra work, additional
    time, etc.

 

The SC placed reliance on
the following rulings:

 

  •    Bridge and Roof Co.
    (India) Ltd. vs. Union of India     – The crucial test for coverage of allowances
    under the definition of ‘basic wages’ is one of universality. If an allowance
    is paid universally in a particular category, then it must form part of ‘basic
    wages’. It also held that the production bonus which is paid based on
    individual performance does not constitute ‘basic wages’.

 

  •    Muir Mills Co. Ltd. vs.
    Its Workmen     – Any variable earning which may vary from individual to
    individual according to their efficiency and diligence will be excluded from
    the definition of ‘basic wages’.

 

  •    Manipal Academy of
    Higher Education vs. PF Commissioner     – A component which is universally,
    necessarily and ordinarily paid to all across the board is included. The
    question was whether the amount received on encashment of earned leave has to
    be reckoned as ‘basic wages’. The Court answered the query in the negative and
    held that ‘basic wages’ never intended to include the amount received for leave
    encashment. It held that the test to be applied is one of universality. In the
    case of encashment of leave, the option may be available to all the employees,
    but some may avail of it and some may not. That does not satisfy the test of
    universality.

 

  •  Kichha Sugar Company Limited through General Manager vs. Tarai
    Chini Mill Majdoor Union, Uttarakhand     – The dictionary meaning of ‘basic
    wages’ is a rate of pay for a standard work period exclusive of such additional
    payments as bonuses and overtime.

 

Employers paid various
allowances such as travel allowance, canteen allowance, special allowance,
management allowance, conveyance allowance, education allowance, medical
allowance, special holidays, night shift incentives and city compensatory
allowance to their employees. Most employers have not considered these cash
allowances as part of ‘basic wages’ for calculation of PF contributions.
Consequently, many employers will suffer huge financial and administrative
burden to comply with the SC order.

 

INTERIM ACCOUNTING GUIDANCE
ON PF MATTER


For the
year ended 31st March, 2019 in Ind AS financial statements (and
Indian GAAP), should a provision on the incremental PF contribution be made
prospectively or retrospectively?

 

The SC ruling has clarified
the term ‘basic wages’, but has created huge uncertainties around the following
issues:



  •    From which date will the
    order apply?
  •    Whether HRA that is paid
    across the board to all employees should be included or excluded from ‘basic
    wages’?
  •    For past periods, whether
    employer’s liability is restricted to its own contribution or will also include
    the employees’ contribution, in accordance with the PF Act?
  •    A review petition has been
    filed in the SC by Surya Roshni Ltd., raising several issues. What will
    be the outcome of this petition?
  •    What is the impact of the
    SC order on employees drawing ‘basic wages’ greater than Rs. 15,000?
  •    How will the order be
    complied with for employers using contract labour?

 

A very vital aspect will
arise for the consideration of the employers and the PF authorities as to the
date from which the judgement should be made effective. It will all depend upon
the position to be taken by the PF authorities and the position taken by the
employers. The SC only interprets the law and does not amend the law. The
interpretation laid down by the Hon’ble SC to any particular statutory
provisions shall always apply from the date the provision was introduced in the
statute book, unless it is a case of prospective overruling, i.e., the Court,
while interpreting the law, declares it to be operative only prospectively so
as to avoid reopening a settled issue. In the instant case, there is nothing on
record to even remotely suggest that the order pronounced by the Hon’ble SC is
prospective in its operation.

 

The PF law does not lay down
any limitation period and/or look back period for determination of dues u/s. 7A
of the EPF & MP Act, 1952. This may cause grave and undue hardship to the
employee as well as the employer if the demands for the prior period without
imputing a reasonable time limitation is sought to be recovered from the
employer. Therefore, in the event any differential contribution is sought to be
recovered from employers by the PF authorities, the employers may press the
plea of undue hardship to salvage and/or limit their liability for the prior
period by referring to the decision of the Hon’ble SC rendered in the case of Shri
Mahila Griha Udyog Lijjat Papad vs. Union of India & Ors. reported in 2000.

 

Alternatively, it can also
be argued that the employers in any event cannot be saddled with the liability
to pay the employees’ contribution for the retrospective period given that the
employer has no right to deduct the same from the future wages payable to the
employees as held by the Hon’ble SC in the case of District Exhibitors
Association, Muzaffarnagar & Ors. vs. Union of India reported in AIR (1991)
SC. There is no settled jurisprudence on what would constitute a reasonable
period.

 

Given the uncertainty at
this juncture, it would be advisable for the employers to comply with the said
Judgement dated 28th February, 2019 prospectively, i.e., effectively
from 1st March, 2019 and thereafter, if any claims are made by the
PF authorities for the retrospective period, the same can be dealt with
appropriately having regard to the facts and circumstances of each case.

 

There is uncertainty on the
determination of the liability retrospectively, because theoretically there is
no limit on how much retrospective it can get, and can begin from the very
existence of the company or the beginning of the law. Additionally, the review
petition and the fact that the PF department will need to consider hardship
before finalising a circular to give effect to the SC order, is exacerbating
the uncertainty. Furthermore, companies are not required to retain accounts for
periods beyond certain years. In rare cases, when a liability cannot be
reliably estimated, Ind AS 37, paragraph 26 states as follows, “In the
extremely rare case, where no reliable estimate can be made, a liability exists
that cannot be recognised. That liability is disclosed as a contingent
liability.” This approach can be considered for the purposes of Ind AS (and
Indian GAAP) financial statements for the year ended 31st March,
2019.

 

It should also be noted
that there is little uncertainty that the order will at the least apply from 28th
February, 2019. Consequently, a provision for both employers’ and employees’
contribution for the month of March, 2019 along with likely interest should be
included in the provision. However, any provision for penalty at this stage may
be ignored. For the purposes of an accounting provision, HRA should be excluded
from ‘basic wages’ even if these are paid across the board to all employees,
because under the PF Act ‘basic wages’ excludes HRA. However, the SC order has
created uncertainty even on this issue and employers may take different
positions on this matter.

 

The above position will
remain dynamic and may change with further developments. The following note
should be included in the financial statements as a contingent liability:

 

“There are numerous
interpretative issues relating to the SC judgement on PF dated 28th
February, 2019. As a matter of caution, the company has made a provision on a
prospective basis from the date of the SC order. The company will update its
provision, on receiving further clarity on the subject.”

 

The above
note is a contingent liability and not a pending litigation. Therefore, this
matter should not be cross-referenced as a pending litigation in the main audit
report.

 

SHOULD
A PROVISION BE MADE FOR EMPLOYEES DRAWING SALARY ABOVE Rs. 15,000 PER MONTH,
SINCE PF DEDUCTION FOR THESE EMPLOYEES IS IN ANY CASE VOLUNTARY?


Domestic
workers with basic salary exceeding Rs. 15,000 per month may not get impacted
due to this ruling – where PF contributions are made by the employer on full
basic salary or on minimum Rs. 15,000 per month. Such domestic workers may be
covered under proviso to Para 26A of the PF Scheme. The SC has not dealt with
this aspect in its ruling. At the outset, it may be noted that the provisions
of the EPF Scheme do not, inter alia, apply to an employee whose pay
exceeds Rs. 15,000 per month. Such an employee is construed as an excluded
employee within the meaning of Para 2(f)(ii) of the EPF Scheme and an excluded
employee is not statutorily entitled to become a member of the statutory PF
under Para 26(1) of the EPF Scheme. Even if the membership of the PF is
extended to such an employee in terms of Para 26(6) of the EPF Scheme, the PF
contribution statutorily required to be made by the employer in respect of such
an employee is restricted to Rs. 15,000 per month in terms of the proviso to
Para 26-A(2) of the EPF Scheme.

 

Even otherwise, it is well
settled by the decision of the Hon’ble SC rendered in the case of Marathwada
Gramin Bank Karamchari Sanghatana & Ors. vs. Management of Marathwada
Gramin Bank & Ors. that the employer cannot be compelled to pay the
amount in excess of its statutory liability for all times to come just because
the employer from its own trust has started paying PF in excess of its
statutory liability for some time. Therefore, no obligation can be cast upon the
employer to remit PF contributions in excess of its statutory liability under
the EPF Scheme. Having said that, the service regulation and/or contract of
employment entered into by the employer with the employees should not be
inconsistent and/or should not provide otherwise.

 

Another view is that the
employees in the workman category may demand the PF contributions on the
increased basic wages. If the demand is not met, they can raise an industrial
dispute under the Industrial Disputes Act, 1947 for grant of such increase. In
the case of management staff, though they cannot take up the matter under the
Industrial Disputes Act, in law, they can enforce their right through a Civil
Court. Whether or not the bargaining staff or the management staff will demand
the enhanced basic wages is altogether a different matter, but in law they have
a right to raise a demand.

 

For the purposes of an
accounting provision, most employers will assess that Ind AS 37 does not
require a provision with respect to PF contributions for employees drawing
salary greater than Rs. 15,000 at this juncture, because the liability is
remote.  

 

LESSEE’S LEASE OBLIGATION – BORROWINGS VS. FINANCIAL LIABILITY

ISSUE

Ind AS 17 Leases required lessees to
classify leases as either finance leases or operating leases, based on certain
principles, and to account for these two types of leases differently. The asset
and liability arising from finance leases was required to be recognised in the
balance sheet, but operating leases could remain off-balance sheet.

 

Information reported about operating leases
lacked transparency and did not meet the needs of users of financial
statements. Many users adjusted a lessee’s financial statements to capitalise
operating leases because, in their view, the financing and assets provided by
leases should be reflected on the balance sheet. Some tried to estimate the
present value of future lease payments. However, because of the limited
information that was available, many used techniques such as multiplying the
annual lease expense by eight to estimate, for example, total leverage and the
capital employed in operations. Other users were unable to adjust and so they
relied on data sources such as data aggregators when screening potential
investments or making investment decisions. These different approaches created
information asymmetry in the market.

 

The existence of two different accounting
models for leases, in which assets and liabilities associated with leases were
not recognised for operating leases but were recognised for finance leases,
meant that transactions that were economically similar could be accounted for
very differently. The differences reduced comparability for users of financial
statements and provided opportunities to structure transactions to achieve an
accounting outcome.

 

To bridge the problems discussed above, IFRS
16 Leases was issued. Correspondingly, in India the Ministry of
Corporate Affairs issued Ind AS 116 – ‘Leases’, which is notified and
effective from 1st April, 2019 and replaces Ind AS 17. Ind AS 116 requires
lessees to recognise a liability to make lease payments and a corresponding
asset representing the right to use the underlying asset during the lease term
for all leases, except for short-term leases and leases of low-value assets, if
the lessee chooses to apply such exemptions. For lessees, this means that more
liabilities and assets are recognised if they have leases, compared to the
earlier standard, Ind AS 17.

 

Ind AS 116 requires lease liabilities to be
disclosed separately from other liabilities either in the balance sheet or in
the notes to accounts. However, Indian companies are also required to comply
with the presentation and disclosure requirements of division II – Ind AS
Schedule III to the Companies Act, 2013 (Ind AS-compliant Schedule III). As per
the Schedule III format, under financial liabilities – borrowings are required
to be presented separately. Borrowings need to be further bifurcated and
presented in the notes to accounts as follows:

 

Borrowings shall be classified as: (a) Bonds
or debentures; (b) Term loans (i) from banks or (ii) from other parties; (c)
Deferred payment liabilities; (d) Deposits; (e) Loans from related parties; (f)
Long-term maturities of finance lease obligations; (g) Liability
component of compound financial instruments; (h) Other loans (specify nature).

 

Neither Schedule III nor the guidance note
on Schedule III issued by the Institute of Chartered Accountants of India has
been revised to take cognisance of the change in the lease accounting (due to
introduction of Ind AS 116), under which there is no classification as finance
leases or operating leases for lessees. On implementation of Ind AS 116 w.e.f.
1st April, 2019 lessees will not bifurcate leases into finance leases and
operating leases and all leases will be capitalised (subject to a few
exemptions). To comply with the disclosure requirement mentioned in the
preceding paragraph, there is confusion whether (a) all lease liabilities
should be classified as borrowings; or (b) all lease liabilities should be
shown as financial liabilities because the requirement to disclose finance
lease obligation as borrowings by lessees no longer applies (the lessee does
not distinguish between operating and finance lease); or (c) for purposes of
disclosure only, the lessee distinguishes the lease as finance and operating
and discloses the finance lease obligations as borrowings and operating leases
as financial liabilities.

 

If lease obligations are presented as
borrowings in the financial statements, it will negatively impact debt
covenants, the debt-equity ratio, and will have other significant adverse
consequences for lessees. It may be noted that globally, under IFRS, companies
will not be subjected to such adverse consequences because they do not have to
comply with Schedule III or an equivalent requirement.

 

In summary, the following questions emerge:

 

1. On application of Ind AS 116, whether
lessee would disclose the entire lease obligation in its financial statements
under financial liabilities or borrowings?

2. Though not required under Ind AS 116,
whether lessees need to bifurcate all leases into finance lease and operating
lease only for the limited purpose of complying with the disclosure requirements
of Ind AS-compliant Schedule III?

 

RESPONSE

The following three views are theoretically
possible:

 

OPTIONS AND RATIONALES

 

Options

Rationale

Option 1 –

Present entire lease
obligation under financial liabilities as separate line item either on the
face of balance sheet or in the notes to accounts

Ind AS 1 deals with the presentation of financial
statements and it does not require borrowings to be presented as a minimum
line item on the face of the balance sheet. As per para 54(m) – Financial
liabilities [excluding amounts shown under 54 (k) – Trade and other payable
and 54 (l) – provisions] need to be presented as minimum line item on the
face of the balance sheet.

 

Accordingly, in the absence of
Schedule III, borrowings would have been presented as financial liabilities
in the financial statements. Under IFRS, this is indeed the case and there is
no requirement to show borrowings separately from financial liabilities;

 

Ind AS 116 requires lease liabilities to be disclosed
separately from other liabilities either in the balance sheet or in the notes
to accounts. It does not require such financial liabilities to be termed as
borrowings;

 

Schedule III requires finance lease obligation to be
disclosed under borrowings. However, under Ind AS 116, there is no finance
lease classification for lessees and all leases are capitalised, subject to
some exemptions. Since there is no finance lease obligation under Ind AS 116,
nothing is required to be presented as borrowings;

 

Further, Schedule III states the following which may
be used as the basis to present it separately from borrowings:

 

“Line items, sub-line items and sub-totals shall be
presented as an addition or substitution on the face of the Financial
Statements when such presentation is relevant to an understanding of the
company’s financial position or performance, or to cater to industry or
sector-specific disclosure requirements, or when required for compliance with
the amendments to the Companies Act, 2013, or under the Indian Accounting
Standards.”

 

It may be noted that Option 1 is completely in
compliance with the accounting standards.

Option 2 –

Present entire lease obligation as borrowings

As Ind AS 116 does not require bifurcation of leases
into finance and operating and requires all leases (other than short-term and
low-value leases) to be capitalised, the entire lease liabilities need to be
disclosed in borrowings to comply with the spirit of Ind AS-compliant
Schedule III requirements;

 

Further, this will also eliminate the difference
between the two categories of companies, i.e., Borrow to buy vs. Leasing the
assets.

Option 3 –

Bifurcate leases into finance and operating and
disclose only finance lease obligations as borrowings. Operating leases will
be presented as financial liabilities

Though Ind AS does not require bifurcation but to
comply with the Schedule III one may need to do such bifurcation;

 

Accordingly, disclose finance lease obligations as
borrowings and operating lease obligations as financial liabilities.

 

 

 

CONCLUSION AND THE WAY FORWARD

The author does not believe that Option 3
is appropriate, because it is not so intended under the Standard or Schedule
III. Additionally, this issue has arisen because Schedule III is not amended
post -Ind AS 116, to either eliminate the requirement to disclose finance lease
obligations as borrowings, or alternatively to require all lease obligations
(other than low-value and short-term leases) to be disclosed as borrowings.

 

Between Option 1 and 2, MCA
needs to make its position clear, either through a separate notification or by
amending Schedule III. In the absence of that, an ITFG clarification will be
necessary to ensure consistency in the financial reporting.  

 

ACCOUNTING OF DIVIDEND DISTRIBUTION TAX

Started as “Accounting Standards” in
August, 2001. Dolphy Dsouza was the first contributor and had at that time
“agreed to write a series of eight articles on AS 16 to AS 23”. However, till
date – to the joy of the readers – continues as the sole contributor giving the
most important aspects of accounting standards. The feature got a suffix to its
name in July, 2002 – gap in GAAPs – and was called “Accounting Standards: Gap
in GAAPs”. Since the arrival of Ind AS it is renamed as at present.

This monthly feature carries
clarifications, commentary, comparison, and seeks to clarify about accounting
concepts and practices. The author says, “Accounting was never a debated topic
in India as much as tax is. Hopefully, my feature has a small hand in bringing
accounting to the centre stage” He shared another secret benefit: “People know
me because they have seen an unusual name in the BCA Journal for the last 18
years.  I once even got a hefty hotel
discount, as the hotel owner was a CA and an avid reader of the BCAJ!”

 

ACCOUNTING OF DIVIDEND DISTRIBUTION TAX

 

Prior to 1st June, 1997,
companies used to pay dividend to their shareholders after withholding tax at
prescribed rates. The shareholders were allowed to use tax deducted by the
company against tax payable on their own income. Collection of tax from
individual shareholders in this manner was cumbersome and involved a lot of
paper work. To make dividend taxation more efficient, the government introduced
the concept of dividend distribution tax (DDT). Key provisions related to DDT
are given below:

 

(a) Under DDT, each company distributing dividend
needs to pay DDT at stated rate to the government. Consequently, dividend
income will be tax free in the hands of shareholders.

(b) DDT is payable even if no income-tax is payable
on the total income, e.g., a company that is exempt from tax on its entire
income will still pay DDT.

(c) DDT is payable within fourteen
days from the date of (i) declaration of any dividend, (ii) distribution of any
dividend, or (iii) payment of any dividend, whichever is earliest.

(d) DDT paid by a company in this manner is treated
as the final payment of tax in respect of dividend and no further credit
therefore can be claimed either by the company or by the recipient of dividend.
However, dividend received is tax free in the hand of all recipients (both
Indian/ foreign).

(e) Only dividend received from domestic companies
is exempt in the hands of recipient. Dividend received from overseas companies
which do not pay DDT is taxable in the hands of recipient, except for the
impact of double tax relief treaties, if any.

(f)  No DDT is required to be paid by the ultimate
parent on distribution of profits arising from dividend income earned by it
from its subsidiaries. However, no such exemption is available for dividend
income earned from investment in associates/ joint ventures or other companies.
Also, no exemption is available to a parent which is subsidiary of another
company.

 

DDT accounting under Ind AS 12 involves
certain issues. The most important issue is that for the entity paying
dividend, whether DDT is an income-tax covered within the scope of Ind AS 12?
Will DDT be an equity adjustment or a P&L charge or this is an accounting policy
choice?

 

Consider that in the structure below,
company B distributes dividend to its equity shareholders, i.e., company A and
pays DDT thereon.

 

 

For DDT accounting in SFS and CFS of B, one
may consider paragraphs 52A/ 52B and 65A of Ind AS 12.

 

“52A     In
some jurisdictions, income taxes are payable at a higher or lower rate if part
or all of the net profit or retained earnings is paid out as a dividend to
shareholders of the entity. In some other jurisdictions, income taxes may be
refundable or payable if part or all of the net profit or retained earnings is
paid out as a dividend to shareholders of the entity. In these circumstances,
current and deferred tax assets and liabilities are measured at the tax rate
applicable to undistributed profits.

 

52B      In
the circumstances described in paragraph 52A, the income tax consequences of
dividends are recognised when a liability to pay the dividend is recognised.
The income tax consequences of dividends are more directly linked to past
transactions or events than to distributions to owners. Therefore, the income
tax consequences of dividends are recognised in profit or loss for the period
as required by paragraph 58 except to the extent that the income tax
consequences of dividends arise from the circumstances described in paragraph
58(a) and (b).”

 

“65A.    When
an entity pays dividends to its shareholders, it may be required to pay a
portion of the dividends to taxation authorities on behalf of shareholders. In
many jurisdictions, this amount is referred to as a withholding tax. Such an
amount paid or payable to taxation authorities is charged to equity as a part
of the dividends.”

 

One may argue that DDT is in substance a
portion of dividend paid to taxation authorities on behalf of shareholders. The
government’s objective for introduction of DDT was not to levy differential tax
on profits distributed by a company. Rather, its intention is to make tax
collection process on dividends more efficient. DDT is payable only if
dividends are distributed to shareholders and its introduction was coupled with
abolition of tax payable on dividend. DDT in substance does not adjust the
corporate tax rate, and is a payment to equity holders in their capacity as
equity holders. This aspect is also recognised in the IASB framework. Thus, DDT
is not in the nature of income-taxes under paragraphs 52A and 52B. Rather, it
is covered under paragraph 65A. Hence, in the SFS and CFS of company B, the DDT
charge will be to equity. The Accounting Standards Board (ASB) of the ICAI has
issued a FAQ regarding DDT accounting. The FAQ confirms this position with
regard to accounting SFS and CFS of company B. However, this position is very
contentious globally and there is a strong argument to treat DDT as an
additional tax in substance. Therefore, though there is no difference in the
Ind AS and IFRS standard on DDT, the practice applied in India may be different
from the practice applied globally.

 

In the SFS of the company receiving
dividend, i.e., company  A, net dividend
received is recognised as income. In CFS of company A, there is no dividend
distribution to an outsider. Rather, funds are being transferred from one
entity to another within the same group, resulting in DDT pay-out to an entity
(tax authority) outside the group. Hence, in the CFS of company A, DDT cannot
be treated as equity adjustment; rather, it is charged to profit or loss.

 

If company B as well as company A pay
dividend in the same year, company B will pay DDT on dividend distributed.
Under the income-tax laws, DDT paid by company B is allowed as set off against
the DDT liability of company A, resulting in reduction of company A’s DDT
liability to this extent. In this scenario, an issue arises how should the
company A treat DDT paid by company B in its CFS?

 

One view is that DDT paid relates to company
B’s dividend. From a group perspective, for transferring cash from one entity
to another, cash/tax was paid to the tax authorities. Hence, it should be
charged to P&L in company A’s CFS. The other view is that due to offset mechanism,
no DDT in substance was paid on dividend distributed by company B. Rather,
company A has paid DDT on its dividend distribution to its shareholders. Hence,
DDT should be charged to equity in company A’s CFS to the extent of offset
available.

 

The ITFG has clarified that second view
should be followed. Under this view, the following table explains the amount to
be charged to P&L and to equity in company A’s CFS:

 

Scenario 1

DDT paid by B

A’s DDT liability

Offset used by A

Equity charge in A’s CFS

P&L charge in A’s CFS

I

30,000

30,000

30,000

30,000

Nil

II

30,000

20,000

20,000

20,000

10,000

III

30,000

40,000

30,000

30,000 + 10,000

Nil

 

 

The above is a simple example where both
parent and subsidiary pay dividends concurrently.  It may so happen that a subsidiary has
distributable profits, but will distribute those, beyond the current financial
year.  In such a case, in parent’s CFS, a
DTL should be recognised at the reporting date in respect of DDT payable on
dividend expected to be distributed by the subsidiary in near future. Absent
offset benefit, the corresponding amount is charged as expense to P&L.
However, there is no direct requirement related to recognition of asset toward
offset available.

 

Considering the above, the ITFG (Bulletin 9)
has stated that at the reporting date, the parent in its CFS will recognise DTL
in respect of DDT payable on dividend to be distributed by subsidiary. The
corresponding amount is charged to P&L. In the next reporting period, on
payment of dividend by both entities and realisation of offset, the parent will
credit P&L and debit the amount to equity. Effectively, the ITFG views
require DDT on expected distribution to be charged to P&L in the first
reporting period which will be reversed in the immediate next period. The
authors believe that the ITFG view does not reflect substance of the
arrangement. Moreover, such an approach will create an unwarranted volatility
in P&L for two reporting periods which should be avoided. The standard
requires creation of a DTA if there is a tax planning opportunity in place. If
the parent company has a strategy in place to distribute dividends to its
shareholders out of the dividends it receives from its subsidiaries, within the
same year, then it will be able to save on the DDT. Consequently, corresponding
to the DTL, an equivalent DTA should also be recognised in the first reporting
period. We recommend that ITFG may reconsider its views on the matter.

 

ITFG (Bulletin 18) has subsequently changed
its position and clarified that accounting treatment of DDT credit depends on
whether or not it is probable that the parent will be able to utilise the same
for set off against its liability to pay DDT. This assessment can be made only
by considering the particular facts and circumstances of each case including
the parent’s policy regarding dividends, historical record of payment of
dividends by the parent, availability of distributable profit and cash,
etc.  The revised ITFG position is a step
in the right direction.

 

In light of the ITFG 18, a few important
questions and clarifications are given below:

  •     Firstly, whether the ITFG
    is mandatory? The answer to this would depend upon an assessment of whether the
    ITFG interpretation reflects a reasonable and globally acceptable
    interpretation of the standard. The view in ITFG 18, is in my opinion a
    reasonable and correct interpretation, and should therefore be considered
    mandatory.
  •     Secondly, when changing the
    practice to comply with ITFG 18, would it be a change in estimate or change in
    policy or an error?  In line with global
    practice with respect to issuance of IFRICs from time to time the author
    believes that the change is a change in an estimate rather than a change in an
    accounting policy or an error.
  •     Lastly, should the ITFG be
    implemented as soon as it is issued? This is more of a practical issue. It may
    not always be possible for entities to comply with an ITFG in the accounts of
    the quarter in which it is issued. 
    Nonetheless, entities should give effect to the ITFG in the following
    quarter.      

 

 

ACCOUNTING OF FINANCIAL GUARANTEES

Query

Subsidiary has provided a financial
guarantee to a bank for loan taken by Parent. Subsidiary does not charge Parent
any guarantee commission. How is the guarantee accounted in the separate
financial statements of the Parent and Subsidiary assuming the guarantee is an
integral part of the arrangement for the loan?

 

Response

Subsidiary recognises the financial
guarantee liability (unearned financial guarantee commission) at fair value, in
its books at the date of issuance to the bank. Since the subsidiary does not
receive any consideration from the Parent, it has effectively paid dividends to
Parent.  Consequently, the corresponding
debit should be made to an appropriate head under ‘equity’. It would not be
appropriate to debit the fair value of the guarantee to profit or loss as if it
were a non-reciprocal distribution to a third party as it would fail to
properly reflect the existence of the parent-subsidiary relationship that may
have caused Subsidiary not to charge the guarantee commission. Under Ind AS
115, the unearned financial guarantee commission recognised initially will be
amortised over the period of the guarantee as revenue and consequently, the
balance of the unearned financial guarantee commission would decline
progressively over the period of the guarantee. However, in addition to
amortising the unearned financial guarantee commission to revenue, at each
reporting date, Subsidiary is required to compare the unamortised amount of the
deferred income with the amount of loss allowance determined in respect of the
guarantee as at that date in accordance with the requirements Ind AS 109. As
long as the amount of loss allowance so determined is lower than the
unamortised amount of the deferred income, the liability of Subsidiary in
respect of the guarantee will be represented by the unamortised amount of the
financial guarantee commission. However, if at a reporting date, the amount of
the loss allowance determined above is higher than the unamortised amount of
the financial guarantee commission as at that date, the liability in respect of
the financial guarantee will have to be measured at an amount equal to the
amount of the loss allowance. Accordingly, in such a case, Subsidiary will be
required to recognise a further liability equal to the excess of the amount of
the loss allowance over the amount of the unamortised unearned financial
guarantee commission.

 

As regards the Parent, in the fact
pattern, financial guarantee provided by Subsidiary is an integral part of the
arrangement for the loan taken by Parent from the bank. Therefore, in
accordance with the principles of Ind AS 109, separate accounting of such
financial guarantee is not required. However, the ITFG (Bulletin 16) felt that
as per Ind AS 109, fees associated with the guarantees that are an integral
part of generating an involvement with a financial asset or a financial
liability are taken into account in determining the effective interest rate for
the financial asset/financial liability. Therefore, the provision of guarantee
by Subsidiary without charging guarantee commission is analogous to a distribution/
repayment of capital by Subsidiary to Parent. To reflect this substance, Parent
should credit the fair value of the guarantee to its investment in Subsidiary
and debit the same to the carrying amount of the loan (which would have the
effect of such fair value being included in determination of effective interest
rate on the loan). Subsequently, ITFG revised Bulletin 16. As per the revised
requirement, Parent will debit the fair value of the guarantee to the carrying
amount of the loan. If the investment in subsidiary is accounted at cost or
FVTPL, the corresponding credit will be recognised in the P&L account. If
the investment in subsidiary is accounted at FVTOCI, the credit will be
recognised in the P&L account as dividend received, unless the distribution
clearly represents recovery of part of the cost of the investment.

 

The
author believes that the accounting of the financial guarantee by the grantor
is inevitable because financial guarantee is a financial liability in
accordance with the definition contained in Ind AS 32. However, there is no
requirement for the beneficiary to record a financial guarantee provided by a
grantor for which no commission is charged, in the way suggested by the ITFG.
This is also the global practice. The implication of the ITFG view is that
in all cases, where any transaction between group companies are subsidised, the
transaction will be recorded at its fair value rather than at the transaction
price. This is certainly not required by Ind AS and could have unintended consequences,
particularly in the case of merger and amalgamation transactions. Furthermore,
it will create opportunities for group companies to create unnecessary credit
going to the P&L account of the separate financial statements. The only
requirement under Ind AS for such transactions would be appropriate disclosures
in accordance with the requirements of Ind AS 24 Related Party Disclosures.

Ind AS vs. ICDS Differences

The author Dolphy D’Souza has
provided a detail list of differences between Ind AS and ICDS.  ICDS are closer to Indian GAAP than Ind
AS.  The differences between ICDS and Ind
AS have further exacerbated due to introduction of new standards, such as, Ind
AS 115 Revenue from Contracts with Customers. 
These differences will further increase over time. Consequently, an Ind
AS company will be required to track these differences to enable tax
computation.  If the differences are
numerous, it is best that the tracking is done in the system rather than
outside the system such as on excel spread-sheets.

 

Point of Difference

Ind AS

ICDS

Ind AS 1 vs. ICDS I

Changes in accounting policies –
accounting of the impact

Change in accounting policy allowed only
when required by an Ind AS or results in more reliable and relevant
information. Requires retrospective application of changes in accounting
policies.

Change in accounting policy allowed only
when there is reasonable cause. ICDS does not provide any guidance on how to
account for the impact. Impact of change generally debited or credited to
current P&L.

Correction of prior period errors

Requires correction to be made for the
retrospective period.

Correction is made for the relevant
period, and previously filed ITR’s are revised.

Change in Mark to markup losses / gain

MTM loss/gain on derivative is
recognised in P&L unless designated as hedge.

Losses shall not be recognised unless
recognition is in accordance with provision of other ICDS. Instances of
losses permitted under ICDS are;

 

 

??Inventory valuation loss

 

 

???Loss on construction contract on POCM basis

 

 

??MTM forex loss on monetary item (include forward and option
for hedging)

 

 

??Provision for liability on reasonable certainty basis

 

 

Losses which may not be allowed as
deduction are as given below;

 

 

??Foreseeable loss on construction contract

 

 

??MTM on derivative (for example, commodity contracts) other
than forward and option for hedging covered by ICDS VI

 

 

CBDT FAQ dt 23rd March, 2017
clarified that same principle will apply to MTM gain as well.

Ind AS 2 vs.
ICDS II

Change in cost formula

Considered as change in an accounting
policy

Cannot be changed without reasonable
cause.

Inclusion of statutory levies in value
of inventory

Inventory to be valued net of creditable
statutory levies (like GST)

Inventory to be valued inclusive of
creditable statutory levies (like GST). 
However, this is just a matter of semantics, and the net profit as per
ICDS and Ind AS on this account will not be different.

Ind AS 115
vs. ICDS III and ICDS IV

Scope

Ind AS 115 deals with revenue arising
from contract with customers

ICDS III (Construction Contracts) and
ICDS IV (Revenue) are similar to erstwhile Indian GAAP AS 7 and AS 9.

Revenue recognition principle

Revenue is recognised based on five step
model on transfer of control to customer

For goods, revenue is recognised on
transfer of risk and rewards. For services, revenue is recognised to the
extent of stage of completion of contract

Identification of performance obligation

Detail requirements apply for
identifying and recognising revenue on multiple-element contracts

Do not require or prohibit
identification of performance obligation.

Allocation of transaction price

Allocated to performance obligation
identified based on relative standalone selling price.

Not covered in ICDS

Variable consideration

Methodology for estimating and
recognising variable consideration is set out in detail in the standard.

Currently, entities may defer measurement
of variable consideration until uncertainty is removed. For e.g. claims in
construction contracts are recognised on final certainty.

Sales return

Revenue is recognised after deducting
estimated return. Sales returns result in variable consideration.

No guidance is provided in ICDS

Significant financing

Revenue is adjusted for significant
financing and presented separately as finance cost/income

Revenue is not adjusted for time value
of money

Non-cash consideration

Measured at fair value

No guidance provided

Onerous contract

Expected losses are recognised as an
expense immediately.

Losses incurred on a contract will be
allowed only in proportion to the stage of completion

Real estate revenue

If the entity has a right to receive
payment for work completed to date, POCM is applied. Else completed contract
method needs to be followed.

Exposure draft issued. Requires POCM.

Early stage contract

Revenue recognised to the extent of cost
if there is no reasonable certainty.

Reasonable certainty threshold of 25% is
specified.

 

Revenue is recognised to the extent of
costs incurred when up to 25% of the work is completed otherwise
proportionate method will apply.

Service contract

Revenue is recognised on transfer of
control.

POCM applied. Straight-line method, if
service contract involves indeterminate number of acts over specific period
of time.

 

Completed contract, if duration < 90
days

Retention money

Retention monies are a deduction from
the revenue bill, which is paid by the customer on satisfactory completion of
contract or warranty period. The retention monies are treated as normal
revenue.

Same as Ind AS. Retention is part of
overall contract revenue and is recognised subject to reasonable certainty of
its ultimate collection.

Ind AS 16 vs. ICDS V

Major spare parts

Recognised as Inventory if do not meet
Ind AS 16 criteria. As per Ind AS 16 property plant and equipment are items
that;

??Are held for use in production or supply of good, and


??Are expected to be used during more than
one period.

Machinery spares which can be used only
in connection with a Tangible fixed asset and where use is irregular, have to
be capitalised.

 

E.g., Spares which can be used with
multiple machine will be considered as inventory under ICDS whereas these
will be capitalised and depreciated in Ind AS.

Major inspections

They are capitalised. Remaining amount
from previous inspection is derecognised.

No guidance.

Ind AS 21 vs. ICDS VI

Foreign currency

Functional currency is currency of
primary economic environment in which company operated. Foreign currency is
currency other than functional currency.

Reporting currency is INR except for
foreign operation. Foreign currency is currency other than reporting
currency.

Scope exception

Foreign exchange gain/loss regarded as
adjustment to interest cost is scoped out.

The adjustment is considered as
borrowing cost under
Ind AS.

No such scope exclusion.

Capitalisation of exchange differences
on long term foreign currency monetary item for acquisition of fixed assets

Exchange difference is debited/credited
to P&L

? On imported assets S43A allows capitalisation

 

??With respect to local assets all MTM exchange differences are
included in taxable income

Forward exchange contracts on balance
sheet items, such as forward contract for debtor or creditor

Derivatives are measured at fair value
through P&L, if hedge accounting is not applied.

Any premium or discount shall be amortised
as expense or income over the life of the contract. Exchange difference on
such a contract shall be recognised as expense/income in the period in which
the exchange rate changes.

Forward exchange contract to hedge
foreign exchange risk of firm commitment or highly probable forecast
transaction

Derivatives are measured at fair value
through P&L, if hedge accounting is not applied.

Section 43AA introduced by Finance Act
2018 requires exchange differences on forward exchange contracts to be
recognised as per ICDS. Premium, discount or exchange difference, shall be
recognised at the time of settlement as per ICDS VI.

Foreign exchange contract for trading or
speculative purposes

Derivatives are measured at fair value
through P&L

Section 43AA introduced by Finance Act
2018 requires exchange differences on forward exchange contracts to be
recognised as per ICDS. Premium, discount or exchange difference, shall be
recognised at the time of settlement as per ICDS VI.

Foreign currency translation reserve
(FCTR)

Accumulated in reserves. Recognised in
P&L on disposal, deemed disposal or closure of branch.

FCTR taxed similar to FX
assets/liabilities; ie, monetary items are restated at closing exchange rates
but non-monetary items are stated at historical rates. FCTR balance (excludes
impact on non-monetary items) as on 1 April, 2016 shall be recognised in the
previous year relevant to assessment year 2017-18 to the extent not
recognised in the income computation in the past.

Ind AS 20
vs. ICDS VII

Government Grant – recognition

Not recognised unless there is a
reasonable assurance that the entity shall comply with the conditions
attached to them and the grants will be received.

 

Mere receipt of grant is not criteria of
recognition.

Similar to Ind AS, except recognition is
not postponed beyond the date of actual receipt.

Ind AS 20
vs. ICDS VII

Export Incentive

When it is reasonably certain that all conditions
will be fulfilled and the collection is probable.

In the year in which reasonable
certainty of its realisation is achieved.

Grant in the nature of promoters
contribution

No such concept.

No such concept.

Sales tax deferral benefit

Grant benefit imputed based on time
value of money. Benefit capitalised, if related to acquisition of asset. Else
credited to P&L.

No benefit imputed

Ind AS 109 /
ICDS VIII

Securities (quoted) – held for trading

Mark to market gain/loss recognised in
the P&L

Lower or cost or NRV to be carried out
category-wise.

 

Securities held by banks and Public
Financial Institutions to be valued as per extant RBI Guidelines.

Ind AS 23
vs. ICDS IX

Qualifying asset

Assets which takes substantial period of
time to get ready for its intended use.

No condition w.r.t substantial period of
time except inventory ( 12 months).

Capitalisation of general borrowing cost

Weighted average cost of borrowing is
applied on funds that are borrowed generally and used for obtaining a
qualifying assets.

Allocation is based on average cost of
qualifying asset to average total assets.

Borrowings – Income on temporary
investments

Reduced from the borrowing costs
eligible for capitalisation

Not to be reduced from the borrowing
costs eligible for capitalisation.

Commencement of capitalisation

Capitalisation of borrowing cost
commences, when the construction activity commences.

In case of specific borrowings, from the
date on which funds were borrowed. In case of general borrowings, from the
date on which funds were utilised.

Suspension of capitalisation

Capitalisation of borrowing cost
suspended during extended period in which active development is interrupted.

No guidance.

Ind AS 37
vs. ICDS X

Recognition of contingent assets
/reimbursement

Virtual certainty is required for
recognition.

Reasonable certainty is required for
recognition. Test of ‘reasonable certainty’ is not in accordance with section
4/5 of Income-tax Act. Hypothetical income not creating enforceable right
can’t be taxed.

Discounting of long term provision

Required

Not allowed.  

 

 

WHAT’S IN A NAME? PREFERENCE SHARE VS. FCCB

Query


Top Co, whose functional
currency is INR, has issued preference shares to a foreign investor. As per the
terms, at the end of 3-years from the issuance date, the holder has the option
to either redeem each preference share for cash payment of USD 10 or to get 10
equity shares of Top Co for each preference share. Whether the equity
conversion option represents an equity instrument or a (derivative) financial
liability of Top Co?

 

Response


ITFG
responded to a similar issue in Bulletin No. 17 and its view is reproduced
below.

 

ITFG view


Ind AS 32,
Financial Instruments: Presentation lays down the principles for the
classification of financial instruments as financial assets, financial
liabilities or equity instruments from the issuer’s perspective. As per
paragraph 11 of Ind AS 32, “A financial liability is any liability that is:

 

(a)  a contractual obligation :

(i)    to deliver cash or another financial asset
to another entity; or

(ii)    to exchange financial assets or financial
liabilities with another entity under conditions that are potentially
unfavourable to the entity; or

(b)   a contract that will or may be settled in the
entity’s own equity instruments and is:

(i)    a non-derivative for which the entity is or
may be obliged to deliver a variable number of the entity’s own equity
instruments; or

(ii)    a derivative that will or may be settled
other than by the exchange of a fixed amount of cash or another financial asset
for a fixed number of the entity’s own equity instruments. For this purpose,
rights, options or warrants to acquire a fixed number of the entity’s own
equity instruments for a fixed amount of any currency are equity instruments if
the entity offers the rights, options or warrants pro rata to all of its
existing owners of the same class of its own non-derivative equity instruments.
Apart from the aforesaid, the equity conversion option embedded in a convertible
bond denominated in foreign currency to acquire a fixed number of the entity’s
own equity instruments is an equity instrument if the exercise price is fixed
in any currency. …….

 

As per the
above definition, as a general principle, a derivative is a financial liability
if it will or may be settled other than by the exchange of a fixed amount of
cash or another financial asset for a fixed number of the entity’s own equity
instruments. The term ‘fixed amount of cash’ refers to an amount of cash fixed
in functional currency of the reporting entity. Since, an amount fixed in a
foreign currency has the potential to vary in terms of functional currency of
the reporting entity due to exchange rate fluctuations, it does not represent
“a fixed amount of cash”. However, as an exception to the above general
principle, Ind AS 32 regards the equity conversion option embedded in a
convertible bond denominated in a foreign currency to acquire a fixed number of
entity’s own equity instruments to be an equity instrument if the exercise
price is fixed in any currency, i.e., whether fixed in functional currency of
the reporting entity or in a foreign currency. [It may be noted that the
corresponding standard under IFRSs (viz., IAS 32) does not contain this
exception].

 

Ind AS 32
makes the above exception only in the case of an equity conversion option
embedded in a convertible bond denominated in a foreign currency, even though
it explicitly recognises at several places that other instruments can also
contain equity conversion options. Given this position, it does not seem that
the above exception can be extended by analogy to equity conversion options
embedded in other types of financial instruments denominated in a foreign
currency such as preference shares.

 

In view of
the above, the equity conversion option forming part of terms of issue of
preference shares under discussion would be a (derivative) financial liability.

 

Authors’ point of view


  •  It appears that the above opinion provides unwarranted emphasis
    on the nomenclature of the instrument rather than the terms and conditions of
    the instrument. It may be noted that an instrument is classified based on its
    terms and conditions under Ind AS, rather than its nomenclature. In other
    words, from an Ind AS perspective, there is no difference in how the preference
    share or the bond is accounted, if they contain similar terms and conditions.
    From that perspective, it appears unreasonable that the exemption of treating
    the conversion option fixed in foreign currency as equity is allowed only for
    conversion options in bonds and not for conversion options in preference
    shares, though both instruments are similarly accounted under Ind AS.
  •  Whilst a preference share and a bond under the Indian Companies
    Act have different liquidation rights, from the point of view of RBI
    regulations and Ind AS accounting there is no difference. Consequently, all
    that an entity has to do is to nomenclate a preference share as a bond or
    structure it like a bond. Sometimes debt covenants with existing bond holders
    may prohibit an entity from issuing new bonds. In those cases, there will be a
    restriction on the entity from raising funds using a bond. On the other hand,
    raising foreign funds using a preference share with a conversion option may be
    debilitating from an accounting and balance sheet perspective.
  •    The ITFG opinion has not
    provided a strong case or basis for making a difference between accounting for
    conversion option contained in a bond and that contained in a preference share.
    Neither has it defined the term bond and preference share, which may result in
    different interpretation. However, common practice will be to use the same
    definition contained in the Companies Act. The exemption for a bond and not for
    a preference share appears arbitrary and rule based, rather than based on sound
    and solid accounting principles.

 

Final Remarks


The ITFGs main argument is
that the carve-out from IAS 32 was meant to operate more like an exemption
rather than based on a sound principle. In the long run carve-outs is not the
preferred option, particularly if those are not supported by a strong basis of
conclusion or a well-defined principle. In addition to the possibility of
multiple interpretation of the carve-out, it will camouflage gearing in
financial statements and create confusion in the minds of investors. The
International Accounting Standard Board has issued a discussion paper titled Financial
Instruments with Characteristics of Equity (FICE). The objective of the
discussion paper is to clearly set out the principles of debt vs. equity.
Indian standard setters will have an opportunity of participating in this
discussion and eliminating any differences between the IFRS and Ind AS standard
with respect to debt vs equity classification.

 

At last, I am reminded of a
quote from Shakespeare’s Romeo and Juliet – “What’s in a name? that which we
call a rose by any other name would smell as sweet.” The ITFG has proved
him wrong!!  

 

 

 

KEY DIFFERENCES BETWEEN IND AS 116 AND CURRENT IND AS

Ind AS 116
will apply from accounting periods commencing on or after 1st April,
2019 for all companies that apply Ind AS; once the same is notified by the
Ministry of Corporate Affairs.


The following is a summary of the
key differences between Ind AS 116 and current Ind AS

 

Ind AS 116          1st April 2019

Current Ind AS

Definition of a lease

A lease is a contract, or part of a contract, that conveys the
right to control the use of an underlying asset for a period of time in
exchange for consideration.  To
determine if the right to control has been transferred to the customer, an
entity shall assesses whether, throughout 
the period of use, the customer has the right to obtain substantially
all of the economic benefits from use 
of the identified asset and the right to direct the  use of the identified asset.

Ind AS 17 defines a lease 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. Furthermore, Appendix C
of Ind AS 17 Determining whether an Arrangement contains a Lease, it
is not necessary for an arrangement to convey the right to control the use of
an asset to be in scope of Ind AS 17.

Recognition exemptions

 

 

Short term leases-lessees

Lessees can elect, by class of underlying asset to which the
right of use, relates, to apply a method similar to Ind AS 17 operating lease
accounting, to leases with a  lease
term of 12 months or less and without a purchase option

Not applicable

Leases of low value assets- lessees

Lessees can elect, on a lease-by-lease basis, to apply a method
similar to Ind AS 17 operating lease accounting, to leases of low-value
assets (e.g., tablets and personal computers, small items of office furniture
and telephones).

Not applicable

Classification

 

 

Lease classification-lessees

Lessees apply a single recognition and measurement approach for
all leases, with options not to recognise right-of-use assets and lease
liabilities for short-term leases and leases of low-value assets.

Lessees apply a dual recognition and measurement approach for
all leases. Lessees classify a lease as a finance lease if it transfers
substantially all the risks and rewards incidental to ownership. Otherwise a
lease is classified as an operating lease.

Measurement

 

 

Lease payments included in the initial measurement-lessees

At the commencement date, lessees (except short-term leases and
leases of low-value assets) measure the lease liability at the present value
of the lease payments to be made over the lease term. Lease payments include:

a. Fixed payments (including in-substance fixed payments), less
any lease incentives receivable

b. Variable lease payments that depend on an index or a rate,
initially measured using the index or rate at the commencement date

c. Amounts expected to be payable by the lessee under residual
value guarantees

d. The exercise price of a purchase option if the lessee is
reasonably certain to exercise that option

At the commencement of the lease term, lessees recognise finance
leases as assets and liabilities in their statements of financial position at
amounts equal to the fair value of the leased property or, if lower, the
present value of the minimum lease payments, each determined at the inception
of the lease. Minimum lease payments are the payments over the lease term
that the lessee is or can be required to make, excluding contingent rent,
costs for services and taxes to be paid by and reimbursed to the lessor,
together with, for a lessee, any amounts guaranteed by the lessee or by a
party related to the lessee.  Variable
lease payments are not part of the lease liability.

 

e. Payments of penalties for terminating the lease, if the lease
term reflects the lessee exercising an option to terminate the lease

The cost of the right-of-use asset comprises:

a. The lease liability

b. Lease payments made at or before the commencement date, less
any lease incentives received

c. Initial direct costs

d. Asset retirement obligations, unless those costs are incurred
to produce inventories

No assets and liabilities are recognised for the initial
measurement of operating leases.

Reassessment of lease liability-lessees

After the commencement date, lessees shall remeasure the lease
liability when there is a lease modification (i.e., a change in the scope of
a lease, or the consideration for a lease that was not part of the original
terms and conditions of the lease) that is not accounted for as a separate
contract.

Lessees are also required to remeasure lease payments upon a
change in any of the following:

•  The lease term

• The assessment of whether the lessee is reasonably certain to
exercise an option to purchase the underlying asset

• The amounts expected to be payable under residual value
guarantees

• Future lease payments resulting from a change in an index or
rate

Not dealt with by current Ind AS

Lease modifications

 

 

Lease modifications to an operating lease-lessors

Lessors account for a modification to an operating lease as a
new lease from the effective date of the modification, considering any
prepaid or accrued lease payments relating to the original lease as part of
the lease payments for the new lease.

Not dealt with by current Ind AS

Lease modifications which do not result in new separate
leases-lessees and lessors

Lessees:

a) Allocate the consideration in the modified contract

b) Determine the lease term of the modified lease

c) Remeasure the lease liability by discounting the revised
lease payments using a revised discount rate with a corresponding adjustment
to right-of-use asset

In addition, lessees recognise in profit or loss any gain or
loss relating to the partial or full termination of the lease.

Lessors:

If a lease would have been an operating lease, had the
modification been in effect at the inception date, lessors in a finance
lease:

i.  Account for the
modification as a new lease

ii.  Measure the carrying
amount of the underlying asset as the net investment in the lease immediately
before the effective date of the modification.

Otherwise the modification is accounted for in accordance with
Ind AS  109 Financial Instruments.

Not dealt with by current Ind AS

Presentation and disclosure

 

 

Presentation-lessees

Statement of financial position-present right-of-use assets
separately from other assets. If a lessee does not present right-of-use
assets separately in the statement of financial position, the lessee is
required to include right-of-use assets within the same line item as that
within which the corresponding underlying assets would be presented if they
were owned and disclose which line items in the statement of financial
position include those right-of-use assets.

Lease liabilities are also presented separately from other
liabilities. If the lessee does not present lease liabilities separately in
the statement of financial position, the lessee is required to disclose which
line items in the statement of financial position include those liabilities.

Statement of profit or loss-present interest expense on the
lease liability separately from the depreciation charge for the right-of-use
asset. Interest expense on the lease liability is a component of finance
costs, which paragraph 82(b) of Ind AS 1 Presentation of Financial
Statements requires to be presented separately in the statement of profit
or loss.

Cash flow statement – classify cash payments for the principal
portion of the lease liability within financing activities; cash payments for
the interest portion of the lease liability applying the requirements in Ind
AS 7 for interest paid – as operating cash flow or cash flow resulting from
financing activities (depending on entity’s policy); and short-term lease
payments, payments for leases of low-value assets and variable lease payments
not included in the measurement of the lease liability within operating
activities.

Presentation in the statement of financial position- not dealt
with by current Ind AS

 

Statement of profit or loss-operating lease expense is presented
as a single item

 

Cash flow statement- for operating leases, cash payments are
included within operating activities

Disclosure-lessees and lessors

Detailed disclosures including the format of disclosure, are
required under Ind AS 116. In addition, qualitative and quantitative
information about leasing activities is required in order to meet the
disclosure objective.

Quantitative and qualitative disclosures are required, but
generally fewer disclosures are required than under Ind AS 116.

Sale
and leaseback transactions

 

 

Sale and leaseback transactions determining whether a sale has
occurred

Seller-lessees and buyer-lessors apply the requirements in Ind
AS  115 to determine whether a sale has
occurred in a sale and leaseback transaction.

Ind AS 17 focuses on whether the leaseback is an operating or
finance lease and does not explicitly require the transfer of the asset to
meet the requirements for a sale in accordance with Ind AS 18 for
seller-lessees and buyer-lessors.

Sale and leaseback transactions accounting by seller-lessees

The seller-lessee measures the right-of-use asset arising from
the leaseback at the proportion of the previous carrying amount of the asset
that relates to the right-of-use retained by the seller-lessee and recognises
only the amount of any gain or loss that relates to the rights transferred to
the buyer-lessor.

If a sale and leaseback transaction results in a finance lease,
any excess of sales proceeds over the carrying amount are deferred and
amortised over the lease term.

 

If a sale and leaseback transaction results in an operating
lease, and it is clear that the transaction is established at fair value, any
profit or loss is recognised immediately.

Sale and leaseback transactions-accounting by seller-lessees for
transactions not at fair value

If the fair value of the consideration for the sale of an asset
does not equal the fair value of the asset, or if the payments for the lease
are not at market rates, an entity is required to measure the sale proceeds
at fair value with an adjustment either as a prepayment of lease payments
(any below market terms) or additional financing (any above market terms) as
appropriate.

If a sale and leaseback transaction results in an operating
lease and the sale price is

• Below fair value – any profit or loss is recognised
immediately except that, if the loss is compensated for by future lease
payments at below market price, it is deferred and amortised in proportion to
the lease payments over the period for which the asset is expected to be used

• Above fair value – the excess over fair value is deferred and
amortised over the period for which the asset is expected to be used

Business 
Combinations

 

 

Business combinations – acquiree is a lessee – initial
measurement

The acquirer is not required to recognise right-of-use assets
and lease liabilities for leases with a remaining lease term less than 12
months from the acquisition date, or leases for which the underlying asset is
of low value.

The acquirer measures the right-of-use asset at the same amount
as the lease liability, adjusted to reflect favourable or unfavourable terms
of the lease, relative to market terms.

There is no exemption for leases with a remaining lease term
less than 12 months from the acquisition date, or leases for which the
underlying asset is of low value.

 

An intangible asset is recognised if terms of operating lease
are favourable relative to market terms and a liability is recognised if
terms are unfavourable relative to market terms.

 

An intangible asset may be associated with an operating lease,
which may be evidenced by market participants’ willingness to pay a price for
the lease even if it is at market terms.

 

 

 

 

DIFFERENCES BETWEEN IFRS & Ind AS

The author Dolphy D’Souza has provided a detail
list of differences between IFRS and Ind AS. 
Different stakeholders will find this beneficial in different ways.  Companies seeking to prepare pure IFRS
financial statements for fund raising or global listing or group consolidation,
can use this to align their Ind AS financial statements to IFRS.  The standard-setters can use this list to
reduce or eliminate the differences.  If
Ind AS standards are fully aligned to IFRS standards, it will improve India’s
credibility in the global markets.

IFRS 1 differences

Deemed cost exemption for property, plant and equipment

IFRS 1 permits a first-time adopter to
measure its items of property, plant and equipment (PPE) at deemed cost at
the transition date. The deemed cost can be:

  • The
    fair value of the item at the date of transition
  • A
    previous GAAP revaluation at or before transition date, if revaluation meets
    certain criteria

Similar exemption is also available for
intangible assets and investment property measured at cost.

Ind AS 101 also provides similar deemed
cost exemption. In addition, if there is no change in the functional currency
at the transition date, Ind AS 101 allows a first-time adopter to continue
with the previous GAAP carrying value for all of its PPE as recognised in the
previous GAAP financial statements at the transition date. The same is   used as deemed cost at that date, after
making adjustment for decommissioning liabilities.

 

In Ind AS CFS, the previous GAAP amount
of the subsidiary is the amount used in the previous GAAP CFS. If an entity
avails the option under this paragraph, no further adjustments to the deemed
cost so determined is made.

 

Similar exemption is also available for
intangible assets and investment property. 
Fair value as deemed cost exemption is not allowed for investment
property.

Additional exemptions relating to composite leases and land
lease

Under IFRS 1, an entity classifies a
lease based on the lease terms that are in force at its date of transition
based on the circumstances that existed at the inception of the lease.

Ind AS 101 provides the following
additional exemptions:

 

  • When
    a lease includes both land and building elements, a first time adopter may
    assess the classification of each element as finance or operating lease at
    the date of transition to Ind AS based on the facts and circumstances existing
    as at that date.

 

  • If
    there is any land lease newly classified as finance lease, then the first
    time adopter may recognise asset and liability at fair value on that date.
    Any difference between those fair values is recognised in retained earnings.

Exchange differences arising on long-term monetary items

IAS 21 requires exchange differences
arising on restatement of foreign currency monetary items, both long term and
short term, to be recognised in the income statement for the period.

Under the erstwhile Indian GAAP,
companies recognised exchange differences arising on restatement of foreign
currency monetary items, both long term and short term, in the profit or loss
immediately. Alternatively, they were given an irrevocable option to defer/
capitalise exchange differences on long-term foreign currency monetary items.

IFRS 1 differences

 

 

For the companies applying second option
under the erstwhile Indian GAAP, Ind AS 101 provides an additional option.
They may continue to account for exchange differences arising on long-term
foreign currency monetary items recognised in the financial statements for
the period ending immediately before the beginning of first Ind AS reporting
period using the previous GAAP accounting policy. Ind AS 21 does not apply to
exchange differences arising on such long term foreign currency monetary
items.

Additional exemption relating to amortisation of toll roads

IAS 38 has a rebuttable presumption that
the use of revenue-based amortisation method is inappropriate for intangible
assets.

The old Indian GAAP allowed revenue
based amortisation for toll roads. 
Under Ind AS, an entity on first time adoption of Ind AS may decide to
retain the previous GAAP amortisation method for intangible assets arising
from service concession arrangements related to toll roads recognised in
financial statements for the period immediately before the beginning of the
first Ind AS reporting period.

 

Under Ind AS 38, the guidance relating
to amortisation method does not apply to the assets covered in the previous
paragraph.

Additional exemption relating to non-current assets held for
sale and discontinued operations

There is no exemption under IFRS 1
relating to non-current assets held for sale and discontinued operations.

Ind AS 101 allows a first-time adopter
to use the transition date circumstances to measure the non-current assets
held for sale and discontinued operations at the lower of carrying value and
fair value less cost to sell.

Previous GAAP

IFRS 1 defines the term “previous GAAP”
as a basis of accounting that a first-time adopter used immediately before
adopting IFRS. Thus, an entity preparing two complete sets of financial
statements, viz., one set of financial statements as per the Indian GAAP and
another set as per the US GAAP, may be able to choose either GAAP as its
“previous GAAP.”

Ind AS 101 defines the term “previous
GAAP” as the basis of accounting that a first-time adopter used immediately
before adopting Ind AS for its statutory reporting requirements in India. For
instance, the companies preparing their financial statements in accordance
with section 133 of Companies Act, 2013, will consider those financial
statements as previous GAAP financial statements.

 

Consequently, it is mandatory for Indian
entities to consider their Indian GAAP financial statements as previous GAAP
for transitions to Ind AS.

Differences from other IFRS standards

Current/ non-current classification on breach of debt covenant

If an entity breaches a provision of a
long-term loan arrangement on or before the period end with the effect that
the liability becoming payable on demand, the loan is classified as current
liability.

 

This is the case even if the lender has
agreed, after the period end and before the authorisation of the financial
statements for issue, not to demand payment as a consequence of the breach.
Such waivers granted by the lender or rectification of a breach after the end
of the reporting period are considered as non-adjusting event and disclosed.

First, Ind AS 1 refers to breach of
material provision, instead of any provision. This indicates that breach of
immaterial provision may not impact loan classification.

 

Second, under Ind AS 1, waivers granted
by the lender or rectification of breach between the end of the reporting
period and the date of approval of financial statements for issue are treated
as adjusting event. A corresponding change has also been made in Ind AS 10.

Analyses of expenses in the statement of profit and loss

IAS 1 requires an entity to present an
analysis of expenses recognised in profit or loss using a classification
based on either their nature or their function within the entity, whichever
provides the information that is reliable and more relevant.

Ind AS 1 requires entities to present an
analysis of expenses recognised in profit or loss using a classification
based on their nature only. Thus, there is no option to use functional
classification for presentation of expenses.

Materiality and aggregation

IAS 1 requires:

??each
material class of similar items to be presented separately in the financial
statements; and

??items
of a dissimilar nature or function to be presented separately unless they are
immaterial

Ind AS 1 modifies these requirement by
adding the words ‘except when required by law.’  Hence, if the applicable law requires
separate presentation/ disclosure of certain items, they are presented
separately irrespective of materiality.

Differences from other IFRS standards

 

Also,
IAS 1 states that specific disclosure need not be provided if the same is
considered immaterial.

 

Presentation of financial statements

IAS 1 provides broad illustrative
format.

In addition to the broad illustrative
format included in Ind AS 1, Schedule III prescribes a detailed format for
presentation of financial statements and disclosures. The disclosures include
information required under certain Indian statutes.  Companies Act, 2013 also requires certain
statutory disclosures (eg contribution to political parties) to be made in
Ind AS financial statements.

Cash flow statement –

Classification of interest paid and interest and dividend
received

For non-financial entities, interest
paid and interest and dividends received may be classified as ‘operating
activities’. Alternatively, interest paid and interest and dividends received
may be classified as ‘financing activities’ and ‘investing activities’
respectively.

Ind AS 7 does not give an option.  It requires non-financial entities to
classify interest paid as part of ‘financing activities’ and interest and
dividend received as ‘investing activities’.

Cash flow statement –

Classification of dividend paid

Dividend paid may be classified either
as operating or financing cash flows.

Dividend paid is classified as financing
cash flows.

Bargain purchase gains

Where consideration transferred for
business acquisition is lower than the acquisition date fair value of net
assets acquired, the gain is recognised in the income statement after a
detailed reassessment.

Ind AS 103 requires bargain purchase
gain to be recognised in OCI and accumulated in the equity as capital
reserve. However, if there is no clear evidence for the underlying reason for
bargain purchase, the gain is directly recognised in equity as capital
reserve, without routing the same through OCI. A similar change has also been
made with regard to bargain purchase gain arising on investment in associate/
JV, accounted for using the acquisition method.

Common control business combinations

IFRS 3 excludes from its scope common
control business combinations.

Ind AS 103 requires business
combinations of entities or businesses under common control to be mandatorily
accounted using the pooling of interest method. The application of this
method requires the following:

  • Assets
    and liabilities of the combining entities are reflected at their carrying
    amounts.
  • No
    adjustments are made to reflect fair values, or recognise any new assets or
    liabilities.
  • Financial
    information in respect of prior periods is restated as if business
    combination has occurred from the beginning of the earliest period presented.
  • The
    balance of the retained earnings appearing in the financial statements of the
    transferor is aggregated with the corresponding balance appearing in the
    financial statements of the transferee; alternatively, it is transferred to
    general reserves, if any.
  • The
    identity of the reserves is preserved and appear in the financial statements
    of the transferee in the same form in which they appeared in the financial
    statements of the transferor.
  • The
    difference between the amount recorded as share capital issued plus any
    additional consideration in cash or other assets and the amount of share
    capital of the transferor is transferred to capital reserve and presented
    separately from other capital reserves.

Foreign currency convertible bonds (FCCB)

A fixed amount of foreign currency does
not result in fixed amount in the entity’s functional currency. Consequently,
FCCBs, where the conversion price is fixed in foreign currency, do not meet
“fixed-for-fixed” criterion to treat the conversion option as equity. Hence,
FCCBs are generally treated as a hybrid financial instrument containing a
liability component and the conversion option being a derivative. The
derivative element is measured at fair value at each reporting date and
resulting gain/ loss is recognised in the profit or loss for the period.

Ind AS 32 contains an exception to the
definition of financial liability. As per the exception, the equity
conversion option embedded in a convertible bond denominated in foreign
currency to acquire a fixed number of entity’s own equity instruments is
considered an equity instrument if the exercise price is fixed in any
currency. Hence, entities will treat the conversion option as fixed equity
and no fair valuation thereof is required.

Differences from other IFRS standards

Straight-lining of lease rentals in operating leases

Rental under an operating lease are
recognised on a straight-line basis over the lease term unless another
systematic basis is more representative of the time pattern of the user’s
benefit.

Lease payments under an operating lease
are recognised as an expense on a straight-line basis over the lease term
unless either:

a) Another systematic basis is more
representative of the time pattern of the user’s benefit, or

b) Payments to the lessor are structured
to increase in line with expected general inflation to compensate for the
lessor’s expected inflationary cost increases. If payments to the lessor vary
because of factors other than general inflation, then this condition is not
met.

Uniform accounting policies

Compliance with uniform accounting
policies is mandatory.

Ind AS 28 also requires the use of
uniform accounting policies. However, an exemption on the grounds of
“impracticability” has been granted for associates. This is for the reason
that the investor does not have “control” over the associate and it may not be able to
influence the associate to prepare additional financial statements or to
follow the accounting policies that are followed by the investor.

Use of the fair value model for investment property (IP)

An entity has an option to apply either
the cost model or the fair value model for subsequent measurement of its
investment property. If the fair value model is used, all investment
properties, including investment properties under construction, are measured
at fair value and changes in the fair value are recognised in the profit or
loss for the period in which it arises. Under the fair value model, the
carrying amount is not required to be depreciated.  Among other options, companies are allowed
to use fair value as deemed cost exemption for IP at the date of transition
to IFRS.

Ind AS 40 does not permit the use of
fair value model for subsequent measurement of investment property. It
however requires the fair value of the investment property to be disclosed in
the notes to financial statements. 
Also, consequent to the above change, companies are not allowed to use
fair value as deemed cost exemption for IP at the date of transition to Ind
AS.

Grants in the form of
non-monetary assets

IAS 20 provides an option to entities to
recognise government grants in the form of non-monetary assets, given at a
concessional rate, either at their fair value or at the nominal value.

Ind AS 20 requires measurement of such
grants only at their fair value. Thus, the option to measure these grants at
nominal value is not available under Ind AS 20.

Grants related to assets

IAS 20 gives an option to present the
grants related to assets, including non-monetary grants at fair value, in the
balance sheet either by setting up the grant as deferred income or by
deducting the grant in arriving at the carrying amount of the asset.

Ind AS 20 requires presentation of such
grants in the balance sheet only by setting up the grant as deferred income.
Thus, the option to present such grants by deduction of the grant in arriving
at the carrying amount of the asset is not available.

Use of equity method to account for investments in
subsidiaries, joint ventures and associates in SFS

IAS 27 allows an entity to use the
equity method to account for its investments in subsidiares, joint ventures
and associates in its SFS. Consequently, an entity is permitted to account
for these investments either

  • At
    cost
  • In
    accordance with IFRS 9
  • Using
    the equity method

This
is an accounting policy choice for each category of investment.

Ind AS 27 does not allow the use of
equity method to account for investments in subsidiaries, joint ventures and
associates in SFS. This is because Ind AS considers equity method to be a
manner of consolidation rather than a measurement basis.

Confidentiality exemption

IAS 24 does not provide any exemption
from disclosure requirements on the grounds of confidentiality requirements
prescribed in any statute or regulation.

Ind AS 24 exempts an entity from making
disclosures required in the standard if making such disclosures will conflict
with its duties of confidentiality prescribed in a statute or regulation.

Definition of close members of the family of a person

As per IAS 24, “close members of the
family” of a person are those family members who may be expected to
influence, or be influenced by, that person in their dealings with the
entity. They may include

a)
the person’s spouse or domestic partner and children,

Definition “close members of the family”
under Ind AS 24 is similar.

 

In
addition to relations prescribed under IFRS, it includes brother, sister,
father and mother in sub-paragraph (a).

Differences from other IFRS standards

 

b) children of the person’s spouse or
domestic partner, and

c) dependents of the person or the
person’s spouse or domestic partner

 

Differences in local implementation

Classification of refundable deposits received from
customers/ suppliers

Deposits received from the customer/ dealer
are refundable on demand if the connection/ dealership is surrendered.
Deposits being repayable on demand are classified as current.

The ITFG has originally clarified that
refundable deposit repayable on demand should be classified as current. However,
this clarification was subsequently withdrawn by the ITFG.  Consequently, many entities present them as
non-current liabilities.

Application of the pooling of interest method in common
control business combinations

IFRS 3 excludes from its scope common
control business combinations.

Ind AS 103 requires common control
business combination to be accounted for using the pooling of interest
method. The ITFG has provided the following guidance on the use of SFS vs.
CFS numbers:

  • Where
    a subsidiary merges with the parent, then it would be appropriate to
    recognise combination at the carrying amounts appearing in the CFS of the
    parent, since nothing has changed from group perspective.
  • If
    a subsidiary is merged with other fellow subsidiary, then the amount as
    appearing in the SFS of the merging subsidiary should be used for application
    of the pooling of interest method.

Date of accounting for common control business combination

No specific guidance. Globally, business
combinations including those under common control are generally accounted
from the date on which all substantive approvals are received.

In India, many merger & amalgamation
schemes need to be approved by the Court/ National Company Law Tribunal
(NCLT). In Indian scenario, the court/ NCLT approval is considered to be
substantive and is not merely a rubber stamping.  The ITFG has clarified that in a common
control business combination, the court/ NCLT approval received after the
reporting date and before approval of the financial statements for issue
would be treated as an adjusting event.

Determination of 
functional currency for the entity and its branch

Depending on specific facts, functional
currency for a branch can be different from that of the company.

A company is carrying on two businesses
in completely different economic environments, say, one INR and the other
USD. The ITFG has stated that the functional currency is determined at the
company level. Hence, functional currency should be same for both the
businesses.

SFS of parent: Impact of Interest free loan to subsidiary on
transition to Ind AS (Guidance provided by ITFG under Ind AS on matters which
are not relevant under IFRS)

  •  Under the erstwhile Indian GAAP, interest free loans to subsidiaries are
    accounted for at nominal amount. Under Ind AS, such loans are accounted at
    fair value. Any difference in nominal amount and fair value is added to
    investment subsidiary.
  • What
    happens to fair value impact of past loans outstanding at transition date?
    The company has used previous GAAP carrying amount as deemed cost option for
    measuring investment in subsidiary on the date of transition to Ind AS.

The
ITFG has clarified that any difference between the carrying amount and fair
value of loan will be added to the investment measured at cost.

Treatment of dividend distribution tax (DDT) – (Guidance
provided by ITFG under Ind AS on matters which are debatable under IFRS)

As per the tax provision in India,
companies paying dividend are required to pay dividend distribution tax.  The ITFG has clarified that the company is
paying DDT on behalf of shareholders. Hence, it should be treated as
distribution of profit and debited to SOCIE.

 

In
case of DDT paid by subsidiary on dividend distributed to holding company,
the holding company can claim deduction for tax paid by subsidiary against
its own tax liability pertaining to dividend distribution.  The ITFG has clarified that DDT paid by subsidiary
on dividend distributed to holding company is charged to P&L in CFS.  This is because there is a cash outflow for
the group to a third party; i.e., the tax authorities. Timing of charge is
based on Ind AS 12 principles. 
However, if a portion / total tax paid is claimed as set off against
holding company’s DDT liability (on dividends paid to its own shareholders) ,
then the offset amount is recognised in SOCIE and not P&L in CFS.  DDT paid on dividend distributed to NCI is
recognised in SOCIE.

Other minor differences

Variable consideration – Penalties

Under IFRS 15, the amount of
consideration, among other things, can vary because of penalties.

Under Ind AS 115, where the penalty is
inherent in determination of transaction price, it will form part of variable
consideration. For example, where an entity agrees to transfer control of a
good or service in a contract with a customer at the end of 30 days for
INR100,000 and if it exceeds 30 days, the entity is entitled to receive only
INR95,000, the reduction of INR5,000 will be regarded as variable
consideration. In other cases, the transaction price will be considered as
fixed.

Disclosure of reconciliation between revenue and contracted
price

IFRS 15 requires extensive qualitative
and quantitative disclosures including those on disaggregated revenue,
reconciliation of contract balances, performance obligations and significant
judgments.

Ind AS 115 contains all the disclosure
requirement in IFRS 15. In addition, Ind AS 115 requires presentation of a reconciliation
between the amount of revenue recognised in statement of profit or loss and
the contracted price showing separately adjustments made to the contracted
price, for example, on account of discounts, rebates, refunds, price
concessions, incentives, bonus, etc. specifying the nature and amount of each
such adjustment separately.

Exchange differences regarded as adjustment to interest costs

In accordance with IAS 23, borrowing
cost includes exchange difference arising from foreign currency borrowings to
the extent that they are regarded as an adjustment to interest costs.
However, it does not provide any specific guidance on measurement of such
amounts.

Ind AS 23 is similar to IAS 23. However,
Ind AS 23 provides following additional guidance on manner of arriving at
this adjustment:

  • The
    adjustment should be of an amount equivalent to the extent to which the
    exchange loss does not exceed the difference between the costs of borrowing
    in functional currency when compared to the costs of borrowing in a foreign
    currency.
  • If
    there is an unrealised exchange loss which is treated as an adjustment to
    interest and subsequently there is a realised or unrealised gain in respect
    of the settlement or translation of the same borrowing, the gain to the extent
    of the loss previously recognised as an adjustment should also be recognised
    as an adjustment to interest amount.

Statements of comprehensive income/ Statement of profit and
loss

With regard to preparation of statement
of profit and loss, IFRS provides an option either to follow the single
statement approach or to follow the two statement approach. An entity may
present a

  • single
    statement of profit or loss and other comprehensive income, with profit or
    loss and other comprehensive income presented in two sections; or
  • it
    may present the profit or loss section in a separate ‘statement of profit or
    loss’ which shall immediately precede the ‘statement of comprehensive
    income’, which shall begin with profit or loss.

Ind AS 1 allows only the single statement
approach and does not permit the two statements approach.  For deletion of two statements approach,
consequential amendments have been made in other Ind AS also.

Frequency of reporting

In accordance with IAS 1, an entity
consistently prepares financial statements for each one-year period. However,
for practical reasons, some entities prefer to report, for example, for a
52-week period. IAS 1 does not preclude this practice.

Ind AS 1 does not permit entities to use
a periodicity other than one year to present their financial statements.

Earnings Per Share –

Applicability

IAS 33 applies only to an entity whose
ordinary shares or potential ordinary shares are traded in a public market or
that files, or is in the process of filing, its financial statements with a
securities commission or other regulatory organisation for the purpose of
issuing ordinary shares in a public market.

This scope requirement has been deleted
in the Ind AS as the applicability or exemptions is governed by Companies
Act, 2013 and the rules made thereunder. 
Since there is no exemption from disclosing EPS under the Companies
Act, all companies covered under Ind AS need to disclose EPS.

Presentation of EPS in separate financial statements

IAS 33 provides that when an entity
presents both consolidated financial statements (CFS) and separate financial
statements (SFS), it provides EPS related information in CFS.

Ind AS 33 requires EPS related
information to be disclosed both in CFS and SFS. In CFS, such disclosures
will be based on consolidated information. In SFS, such disclosures will be
based on information given in the SFS.

Other minor differences

Segment reporting Application

IFRS 8 applies only to an entity whose
ordinary shares or potential ordinary shares are traded in a public market or
that files, or is in the process of filing, its financial statements with a
securities commission or other regulatory organisation for the purpose of
issuing ordinary shares in a public market.

This scope requirement has been deleted
in the Ind AS as the applicability or exemptions is governed by Companies
Act, 2013 and the rules made thereunder. 
Currently, the Companies Act does not exempt any company (except few
government companies in defence sector) from presentation of segment
information.

Aggregation of transactions for related party disclosure

IFRS does not provide any guidance on
the aggregation of transaction for disclosure purposes.

Ind AS 24 provides an additional
guidance whereby items of similar nature may be disclosed in aggregate by
type of related party. However, this is not done in such a way as to obscure
the importance of significant transactions. Hence, purchases or sales of
goods are not aggregated with purchases or sales of fixed assets. Nor a
material related party transaction with an individual party is clubbed in an
aggregated disclosure.

Regulatory Deferral Accounts 
– Explanation to the definition of “previous GAAP”

IFRS 14 defines the term “previous GAAP”
as a basis of accounting that a first-time adopter used immediately before
adopting IFRS.

Ind AS 114 defines the term “previous
GAAP” as the basis of accounting that a first-time adopter used immediately
before adopting Ind AS for its reporting requirements in India. Further an
explanation has been added to the definition to consider the Guidance Note on
Accounting for the Rate Regulated Activities issued by the ICAI to be the
previous GAAP.

Regulatory Deferral Accounts 
– Scope

An entity is allowed to apply the
requirements of IFRS 14 in its subsequent financial statements if and only
if, in its first IFRS financial statements, it recognised regulatory deferral
account balances by electing to apply the requirements of IFRS 14.

Ind AS 114 contains similar requirement.
In addition, its states that an entity applies the requirements of previous
GAAP in respect of such regulated activities:

  • in
    the case of an entity subject to rate regulation coming into existence after
    Ind- AS coming into effect; or
  • if
    its activities become subject to rate regulation subsequent to preparation
    and presentation of its first Ind AS financial statements.

Repeat application of IFRS/Ind AS

IFRS 1 states that an entity that
stopped applying IFRS in the past and chooses, or is required, to resume
preparing IFRS financial statements has an option to either apply IFRS 1
again or to retrospectively restate its financial statements as if it had
never stopped applying IFRS.

Ind AS 101 does not contain this
provision. Rather, MCA roadmap states that once a company opts to follow Ind
AS, it will be required to follow the Ind AS for all the subsequent financial
statements.

Presentation of comparative information

IFRS 1 requires comparative information
for minimum one year. If an entity elects, it can give comparative
information for more than one year.

The ITFG has clarified that due to the
Companies Act notification, a first-time adopter can give Ind AS comparative
information only for one year.

Exemption relating to borrowing cost

IFRS 1 permits a first time adopter to
apply the requirements of IAS 23 from the date of transition or from an
earlier date as permitted by the transitional requirements of IAS 23.

There is no such exemption under Ind AS
101, since Indian GAAP requires the borrowing cost relating to qualifying
assets to be capitalised if the criteria laid down in AS 16 (Indian GAAP) are
fulfilled.

Small and medium-sized entities

The IASB had issued a separate IFRS for SMEs in July
2009. IFRS for SMEs is based on the fundamental principles of full IFRS, but
in many cases, it has been simplified to make the accounting requirements
less complex and to reduce the cost and effort required to produce the
financial statements. To achieve this, the IASB removed a number of the
accounting options available under full IFRS and attempted to simplify
accounting, including recognition and measurement principles, for SMEs in
certain areas.

Whilst the standard provides a broad
level definition of an SME to help in understanding the entities to which
IFRS for SMEs is applicable, the preface to the standard indicates that the
decision as to which entities are required or permitted to apply the standard
will lie with the regulatory and legislative authorities in each
jurisdiction.

In India, there is no separate standard
for SMEs that will correspond to IFRS for SMEs.  As per the MCA roadmap, Ind AS applies in
phases to:

  • Listed
    companies;
  • Non-listed
    companies having net worth of INR 250 crores or more;
  • Holding,
    subsidiary, joint venture and associate companies of the above companies

 

All other companies will continue to
apply Indian GAAP or they may adopt Ind AS voluntarily. ICAI is separately
upgrading Indian GAAP to bring it closer to Ind AS. In certain cases, the
ICAI may use IFRS for SMEs principles while revising Indian GAAP.  

AMENDMENTS IN FORM 3CD ANNEXED TO TAX AUDIT REPORT

Section 44AB relating to Tax Audit was inserted in the Income
tax Act by the Finance Act, 1984. Tax Audit requirement has become effective
from A.Y. 1985-86.  The above provision
for compulsory Tax Audit in cases of assessees carrying on business or profession
and having annual Turnover or Gross Receipts exceeding certain specified limits
was introduced with a view to provide authentic information to the Assessing
Officer with the return of income. Separate Tax Audit report Form 3CA for
Corporate assessees and Form 3CB for non-corporate assessees have been
notified. In these Audit Reports it is specifically stated that “Statement of
Particulars required to be furnished under Section 44AB is annexed herewith in
Form No:3CD”. In other words, the intention from the beginning has been that
Form 3CD will give certain specified particulars (i.e. information) relating to
the accounts audited by the Tax Auditor. In other words, the Assessing Officer
is provided with authentic information to enable him to frame the assessment
without further verification.

 

The initial draft of Tax Audit Report with statement of
particulars, as prepared by the Taxation Committee of the Institute of
Chartered Accountants was notified by CBDT with certain modifications. The Tax
Audit Report as notified in A.Y. 1985-86, continued with minor modifications
upto A.Y. 1998-99. In the subsequent years, Form 3CD has been revised from time
to time and additional responsibilities are placed on Tax Auditors. Originally,
Tax Auditors were only required to give information about certain items
appearing in the Financial Statements. Later on reporting requirement in Form
3CD required the Tax Auditor to express his opinion on certain items of
income/expenditure and state whether the same is taxable as income or allowable
as expenditure.

 

At present, Form 3CD contains 41 items (with several
sub-items) in respect to which information or opinion is to be given. By
notification dated 20th July, 2018, Form 3CD is amended with effect
from 20th August, 2018.  The
amendments made in this Form places additional responsibility on Tax Auditors.
Nine new items viz. 29A, 29B, 30A, 30B, 30C, 36A, 42, 43 and 44 are added.
Besides these items, some additional information is called for in the existing
items. It may be noted that this amended Form 3CD is to be used in respect of
Tax Audit Report given on or after 20/08/2018. If the Tax Audit Report is given
before 20/08/2018, the old Form 3CD is to be used. Since the amendments made in
Form 3CD will put additional responsibilities on Tax Auditors and some
important issues of interpretation will arise, an attempt is made in this
article to analyse the amendments made in Form 3CD.

 

1. New Clause 29A

This is a new item under which, if any amount is to be
included as income chargeable u/s. 56(2)(ix) in the case of the assessee, the
nature of the income and the amount of income will have to be given. Section
56(2)(ix) provides that any amount received by the assessee as advance or
otherwise in the course of negotiations for transfer of a capital asset is
taxable as income from other sources, if the said amount is forfeited and the
capital asset is not transferred.

 

2.  New clause 29B

Under this new item, if any amount is includible in the
income of the assessee u/s. 56(2)(x), the details about the nature and amount
of income will have to be given. It may be noted that section 56(2)(x) provides
that, if the assessee receives any gift or any movable or immovable property
for a consideration which is less than the Fair Market Value from a
non-relative, the difference in the value, if it is more than Rs. 50,000/- will
be taxable as income from other sources.

 

3.  New clause 30A

Under this item the Tax
Auditor has to state whether primary adjustment to transfer price, as referred
to in section 92CE(1), has been made during the previous year. If so, details
of such primary adjustment and amount of such adjustment should be stated. It
may be noted that this provision is applicable only if the primary adjustment
is more than Rs. 1 crore. If the excess money available with the associated
enterprise is required to be repatriated to India u/s. 92CE(2), whether such
remittance has been made within the prescribed time limit is also to be stated.
If not, the amount of imputed interest income on such amount which has not been
remitted to India within the prescribed time limit will have to be stated. This
item relates to International Transactions for which separate Tax Audit Report
u/s. 92E is required to be submitted in Form 3CEB. It is not understood as to
why this information is included in Form 3CD instead of Form 3CEB.

 

4.   New clause 30B

Under this item information about expenditure incurred by way
of interest, exceeding Rs. 1 crore,
as referred to u/s. 94B is to be given. This section applies to an Indian
Company or a permanent establishment (PE) of a foreign company in India. If
such Company or PE borrows money in India and pays interest, exceeding Rs.1 crore, and such interest is deductible
in computing income from business or profession in respect of foreign debt to
an associated enterprise, the deduction is limited to 30% of EBITDA or interest
paid, whichever is less. The information to be given under this item is as
under:-

 

(i)   Amount
of Interest Expenditure referred to in section 94B

 

(ii)   30%
of EBITDA for the year

 

(iii)  Amount
of Interest which exceeds 30% of EBITDA

 

(iv)  Information
of unabsorbed interest expenditure brought forward and carried forward u/s.
94B(4). It may be noted that u/s. 94B(4) interest expenditure which is not
allowed as deduction in one year u/s 94B is allowed to be carried forward for 8
years and will be allowed, within the limit u/s. 94B(2), in the subsequent
year.

 

5.  New clause 30C

(i)  Under
this item the Tax Auditor has to state whether the assessee has entered into an
impermissible avoidance arrangement, as referred to in section 96 during the
previous year. If so, nature of such arrangement and the amount of tax benefit
arising, in the aggregate, to all the parties to such arrangement should be
stated.

 

(ii)  This
is one item where the Tax Auditor has to give his opinion whether any
particular arrangement made by the assessee is for tax avoidance and is an
impressible arrangement. For this purpose one has to refer to sections 95 to
102 dealing with the General Anti-Avoidance (GAAR) provisions and section 144BA
of the Income tax Act. Reading these sections it will be noticed that the Tax
Auditor cannot give his opinion on the question whether GAAR provisions are
applicable in the case of the assessee and what is the tax benefit received by
all parties to this arrangement.

 

(iii) It may be noted that under Rule 10U it is provided that GAAR
provisions are not applicable to an arrangement where the benefit to all the
parties to the arrangement does not exceed, in the aggregate, Rs. 3 crore. Under Item 30C it is not
clarified whether the information is to be given only if the total tax benefit
exceeds Rs. 3 crore or in all cases.

 

(iv) If
we refer to procedure for declaring an arrangement as impermissible avoidance
arrangement, as provided in section 144BA, it will be noticed that even the
Assessing Officer cannot decide whether a particular arrangement is covered by
GAAR provisions. This procedure is as under:

 

(a) The
Assessing Officer (AO) can, at any stage of assessment or reassessment, make a
reference to the Principal Commissioner or Commissioner (CIT) for invoking
GAAR.

 

(b) On
receipt of this reference, the CIT has to give hearing to the assessee within
60 days and to decide whether GAAR provisions should be invoked.

 

(c) If
the CIT is satisfied with the submissions of the assessee he will have to
direct the AO not to invoke GAAR provision.

 

(d) If
the CIT is not satisfied with the submissions of the assessee, he has to refer
the matter to the “Approving Panel”.

 

(e) After
this reference by the CIT, it is for the Approving Panel to declare any
arrangement to be impermissible or not within six months.

(f)  It
is only after the above procedure is followed and the Approving Panel has
declared an arrangement as impermissible avoidance arrangement that the AO can
proceed to determine the tax consequences of such arrangement.

 

(v) In
view of the above provisions of sections 95 to 102 and 144BA, it can be
concluded that a Tax Auditor is not competent to say that a particular arrangement
is an impermissible avoidance arrangement. Even the AO or CIT has no authority
to decide whether the arrangement is an impermissible avoidance arrangement. It
is only the Approving Panel which can declare an arrangement as impermissible
avoidance arrangement.

 

(vi)
In view of the above, various Professional and Trade Bodies had made
representations to CBDT for deletion of Item 30C from Form 3CD. In response to
this, by a Notification dated 17/8/2018, the CBDT has deferred this Item upto
31/3/2019. Therefore, in the Tax Audit Report for A.Y. 2018-19 Item 30C in Form
3CD is not applicable. However, it is necessary to make a strong representation
to CBDT to delete this item altogether in subsequent years also.  If this item is not deleted in subsequent
years, it will be advisable for the Tax Auditor to put the following Note under
Item 30C.

 

“I am unable to express any opinion as to whether the
assessee has entered into an impermissible avoidance arrangement, as referred
to in Section 96, during the previous year. Whether an arrangement is an
impermissible avoidance arrangement or not can only be declared by the
Approving Panel as provided in Section 144BA(6) of the Income tax Act and I am
not authorised to express opinion in this matter.”

 

6.  Existing clause
31

Under this item particulars about loan or deposit taken or
given in cash as referred to in section 269SS and 269T are to be stated. Now,
following additional particulars are required to be given about certain
transactions as referred to in section 269ST. This is a new section which has
come into force from 01.04.2017. The section provides that no person shall
receive Rs. 2 lakh or more, in the
aggregate, from another person, in a day, or in respect of a single transaction
or in respect of transactions relating to one event or occasion in cash. In
other words, all such transactions have to be made by account payee cheques,
bank draft or by any electronic media. The following particulars of such
transactions are now to be stated under Item 31.

 

(i)  Particulars
of each receipt in cash of an amount exceeding Rs. 2 lakh, in the aggregate, as specified in section 269ST, from
a person in a day or in respect of a single transaction or in respect of
transactions relating to one event or occasion from a person (herein referred
to as receipt / payment in a day) are to be given. Here, particulars relating
to name, address, PAN of the payer, nature of transaction, amount received and
date of receipt is to be given.

 

(ii)  Particulars
of each such receipts of an amount exceeding Rs.
2 lakh in a day by a cheque or bank draft which is not an account payee
cheque or a bank draft.  In some cases it
may be difficult to find out whether the 
cheque/ bank draft is marked as account payee. In such cases the tax
auditor should follow the Guidance Note on Audit u/s. 44AB issued by ICAI
wherein certain directions are given while reporting about cash loans received
and repaid u/s. 269SS/ 269T under Item No.31.

 

(iii) Particulars of each payment in cash of an amount exceeding Rs. 2 lakh, in the aggregate, as specified
in section 269ST, to a person, in a day, are to be given.  Here, particulars of the name, address, PAN
of the payee; value of transaction amount paid and date of payment are to be
stated.

 

(iv) In
the above case, if the payment is made by cheque / bank draft which is not
marked “Account Payee”, the particulars of the same will have to be given. 

 

As stated above, if the tax auditor
is not able to ascertain this fact, he should follow the Guidance Note on Tax
Audit u/s 44AB issued by ICAI, relating to Item No.31 dealing with reporting on
section 269 SS / 219T.

 

7.  Existing clause
34

At present particulars about tax deducted or collected at
source (TDS/TCS) are to be given. Under Item 34(b) if the assessee has not
furnished the statement of TDS or TCS within the prescribed time to the Tax
Authorities, certain particulars are to be given. This Item 34(b) is now
replaced by another Item 34(b) which requires the tax Auditor to state (i) TAN,
(ii) Type of Form, (iii) Due date for furnishing the statement of TDS/TCS to
Tax Authorities, (iv) Date of furnishing the statements of TDS/TCS and (v)
Whether this statement contains information about all details/transactions
which are required to be reported. If not, a list of details/transactions not
reported to be given.  It may be noted
that at present such list of unreported items is not required to be given.
Preparation of such list is the additional responsibility put on the Tax Auditor.

 

8.  New clause 36A

Under this new item the Tax Auditor has to state, whether the
assessee has received any advance or loan from a closely held company in which
he holds beneficial interest in the form of equity shares carrying not less
than 10% of voting power. If so, the amount of advance or loan and the date of
receipt is to be given. In other words, the Tax Auditor will now have to give
his opinion whether there is any advance or loan received which is to be
treated as “Deemed Dividend” u/s. 2(22)(e). This is going to be difficult as
there are so many conflicting judicial pronouncements on the interpretation of
section 2(22)(e). Even the tax department had difficulty in deciding the person
who should be taxed on the deemed dividend u/s. 2(22)(e). For this reason
section 115-O has been amended by the Finance Act, 2018. Section 115-O now
provides that the closely held company giving such advance or loan to a related
party as specified in section 2(22)(e), on or after 1/4/2018, will have to pay
tax at the rate of 30% plus applicable surcharge and cess.  Therefore, the requirement contained in Item
36A will apply for Tax Audit for A.Y. 2018-19 only.

 

9.  New clause 42

Under this item, if the assessee is required to file Forms
61, 61A or 61B with appropriate authorities, the particulars relating to the
same will have to be furnished. These particulars are (i) Income tax Department
Reporting Entity Identification Number, (ii) Type of Form, (iii) Due date for
furnishing the statement, (iv) Date of furnishing the same and (v) Whether the
Form contains the information about all details/transactions which are required
to be reported.  If this is not done, a
list of the details/transactions which are not reported.

 

The above requirement will place additional burden on the Tax
Auditor who will have to study the requirements of the following Sections,
Rules and Forms.

 

(a)  Section
139A(5), Rules 114C and 114D and Forms 60 and 61. These deal with declarations
received by the assessee in Form 60 from persons who have applied for PAN u/s.
139A.

(b) Section
285BA, Rule 114E and Form 61A.  This
refers to obligation of a person to furnish statement of financial transactions
or reportable account u/s. 285BA.

 

(c)  Section
285BA, Rule 114G and Form 61B. This also relates to the requirements of section
285BA relating to Annual Information Reporting.

 

10. New clause 43

This new item relates to report to be furnished in respect of
International Group u/s. 286. If the assessee or its parent or alternate
reporting entity is liable to furnish the Report u/s. 286(2), the following
information is to be furnished.

 

(i)    Whether
such Report u/s. 286(2) is furnished

 

(ii)   Name
of parent entity or alternate entity

 

(iii)  Date of furnishing the Report

 

11.  New clause 44

The Tax Auditor has now to furnish break-up of total
expenditure of entities registered or not registered under GST. It is not clear
as to whether the details are to be given only of expenditure such as telephone
expenses, professional fees and similar expenses or of purchases of raw
materials, stores, finished goods etc. The following details of expenditure are
to be given.

 

(i)   Total
amount of expenditure incurred during the year. Since break-up of the
expenditure is to be given the total expenditure under each head of expenditure
such as telephone, professional fees etc., will have to be given.

 

(ii)   Expenditure
in respect of entities registered under GST to be specified under different
categories viz. (a) Goods or Services exempt from GST (b) Entities falling
under composition scheme, (c) Entities which are registered under GST and (d)
Total payment to registered entities.

 

(iii)  Expenditure
relating to entities not registered under GST.

 

Reading this item it is not clear as
to why this information is called for. This information has no relevance with
the determination of total income or determination of tax liability under the
Income tax Act. Various Professional and Trade Bodies had made representations
to CBDT for deletion of this Item. In response to this, by a Notification dated
17/8/2018, the CBDT has deferred this Item upto 31/3/2019. Therefore, in the
Tax Audit report for A.Y. 2018-19 this Item is not now applicable. However,
efforts should be made to get this Item deleted even for subsequent years.

 

12. Some Additional Information to be Given

There are some other items in Form 3CD where specific
information is to be given. Some additional information is to be given under
these items in the amended Form 3CD. These items are as under:

 

(i)   In
Item No:4 GST Registration Number is to be given.

 

(ii)   In
Item 19 details of amounts admissible under various sections are to be given at
present. Now information of amount admissible u/s. 32AD dealing with Investment
in new plant or machinery in notified backward areas in certain States is to be
given. Similarly, this information is now to be given in Item 24 also.

 

(iii)  In
Item No:26 dealing with information relating to various items listed in section
43B, information about any sum payable by the assessee to the Indian Railways
for the use of Railway Assets which has not been paid during the accounting
year will have to be given.

 

TO SUM UP

From the above amendments in Form 3CD it will be noticed that
the Tax Auditor who gives his Tax Audit Report on or after 20/08/2018 will have
to devote considerable extra time to report on the new items added in Form
3CD.  As discussed above, he will have to
give his opinion about interpretation of section 2(22)(e) relating to deemed
dividend which is going to be difficult. Further, the Item 30C requiring the
Tax Auditor to express his opinion whether the assessee has entered into an
impermissible tax avoidance arrangement and what is the tax benefit to the
parties to such arrangement is beyond the authority of a Tax Auditor. Item 44
requiring particulars about GST transactions has no relationship with
computation of income or tax and therefore, this item should also be deleted
from Form 3CD. Although CBDT has notified that Items 30C and 44 are not
applicable for Tax Audit Report for A.Y. 2018-19, it is necessary to make a
strong representation for deletion of these two items from Form 3CD for
subsequent years also. There are some new areas in which the additional
particulars will have to be given by the Tax Auditor. Collection of these
particulars will be time consuming and the time between the publication of
amendments in Form 3CD and the date by which tax audit report is to be given
may not be found to be sufficient. It is essential that such important
amendments in Form 3CD should be made by CBDT well in advance after due consultation with the Institute of Chartered
Accountants of India and all other stakeholders. 




 

Percentage Of Completion Method (POCM) Illustration For Real Estate Companies Under Ind AS 115 & Comparison With Guidance Note (GN)

Background

On 28th March
2018, the Ministry of Corporate Affairs (MCA) notified the new revenue
recognition standard, viz., Ind AS 115 Revenue from Contracts with Customers.
Ind AS 115 is applicable for the financial years beginning on or after 1st
April 2018 for all Ind AS companies. It replaces virtually all the existing
revenue recognition requirements under Ind AS, including Ind AS 11 Construction
Contracts, Ind AS 18 Revenue and the Guidance Note on Accounting
for Real Estate Transactions (withdrawn by ICAI vide announcement dated
01-06-2018) (GN).

 

One of the industries where
the impact is significant is the real estate industry. In addition to not being
able to apply POCM invariably, there are numerous other accounting challenges.
Here we take a look at the following issues:

 

1.  Evaluating if building is a separate
performance obligation (PO) from the underlying land in a single-unit vs. a
multi-unit sale.

2.  Understanding clearly the requirements for
POCM eligibility under Ind AS 115.

3.  Where a real estate sale is eligible for POCM
– the differences in POCM between the GN and Ind AS 115.

4.  POCM illustrations under the GN and Ind AS
115, highlighting the underlying differences.

 

Whether Land &
Buildings are separate POs?

The diagram below depicts
the requirements with respect to identifying goods and services within a
contract.

 


Whether land and building
are two separate POs will depend upon whether the underlying real estate sale
is a single-unit or a multi-unit sale. An example of a single-unit sale is
where a customer is sold an individual plot of land with a construction of a
villa on that plot of land. In this example, the customer receives the
ownership of the land and the villa. On the other hand, a multi-unit sale is
where a customer is sold a flat in a multi-floor, multi-unit building. Here the
customer receives the finished apartment and the undivided interest in the
land.

 

In the case of a
single-unit sale, land and building in most circumstances will be separate POs.
The International Financial Reporting Interpretation Committee (IFRIC)
considered this issue and felt land and building are two separate POs for the
following reasons:

 

–   When
evaluating step 1 above, whether goods/services are capable of being distinct
based on the characteristics of the goods or services themselves; the
requirement in the standard is to disregard any contractual limitations that
might preclude the customer from obtaining readily available resources from a
source other than the entity. Further, customer could benefit from the plot of
land on its own or together with other resources.

 

–   When
evaluating step 2 above, it is important to understand if the relationship
between land and building is functional or transformative. The relationship
between land and building is functional, because building cannot exist without
the land; its foundations will be built into the land. However, in order for
the two POs to be combined as one PO, the relationship has to be
transformative. The relationship between land and building is not
transformative. The building does not alter or transform the land and vice-versa.
There is no integration or the two POs do not modify each other.

 

In the case of a multi-unit
sale, the undivided interest in the land and the building in most circumstances
will be one PO because the customer receives a combined output, i.e. a finished
apartment. The customer does not benefit from the undivided interest in the
land on its own or buy it independently or use it with other readily available
resources. The customer does not receive ownership of the land. The real estate
entity may probably transfer the land after project completion to a society
established by all the home-owners.

 

When is over-time (POCM) revenue recognition
criterion met under Ind AS 115?

An entity shall recognise
revenue when (or as) the entity satisfies a performance obligation by
transferring a promised good or service (i.e. an asset) to a customer. An asset
is transferred when (or as) the customer obtains control of that asset. For
each performance obligation, an entity shall determine at contract inception
whether it satisfies the performance obligation over time or satisfies the performance
obligation at a point in time. If a performance obligation is not satisfied
over time (explained later), an entity satisfies the performance obligation at
a point in time. The Standard describes when performance obligations are
satisfied over time. Consequently, if an entity does not satisfy a performance
obligation over time, the performance obligation is satisfied at a point in
time. The point in time is the time when the control in the goods or service is
transferred to the customer.

 

An entity transfers control
of a good or service over time and, therefore, satisfies a performance
obligation and recognises revenue over time, if one of the following criteria
is met:

 

(a) the customer simultaneously receives and
consumes the benefits provided by the entity’s performance as the entity
performs (for example, interior decoration in the office of the customer);

 

(b) the entity’s performance creates or enhances an
asset (for example, work in progress) that the customer controls (as defined in
the Standard) as the asset is created or enhanced; or

 

(c) the entity’s performance does not create an
asset with an alternative use to the entity and the entity has an enforceable
right to payment for performance completed to date.

 

Let us consider an example,
to see how the above criterion is applied.

 

Example 1 – Application of Over time revenue
recognition criterion

 

Issue

–   An
entity is constructing a multi-unit residential complex

 

–   Customer
enters into a binding sales contract with the entity for a specified unit

 

–   The
customer makes milestone payments as per contract, which cumulatively are less
than work completed to date plus a normal profit margin

 

–    A
significant contract price is paid by customer to entity on delivery (but the
contract is enforceable under Ind AS 115)

 

–   In
case customer wishes to terminate the contract, either customer or entity can
identify a new customer, who will pay the remaining amount as per milestone
schedule.

–    The
new customer compensates the original buyer, for payments made to date. The
compensation may be higher or lower than the cumulative payments made by the
original customer

 

–    The
contract is silent when new buyer cannot be identified. However, as per local
laws, the entity cannot enforce claim for remaining payments from the original
customer.

 

Whether the performance
obligation is satisfied at a point in time or over time?

 

Response

Similar issue was
considered by IFRIC.

 

IFRIC Agenda Decision : Revenue
recognition in constructing a multi-unit building:

Ind
AS 115 Para

Analysis

Met
(v) / Not met (X)

35
(a) – The customer is receiving and consuming the benefits of the entity’s
performance as the entity performs

Entity’s
performance creates an asset, i.e., the real estate unit that is not consumed
immediately.  Therefore this criterion
is not met.

X

35
(b) – The entity creates or enhances an asset that the customer controls as
it is created or enhanced

Control
criterion not  met because:

? Asset created is the real
estate unit itself and not the right to obtain the real estate unit in the future
– The right to sell or pledge this right is not evidence of control

? Customer has no ability to
direct the construction or structural design of the real estate

? Customer’s exposure to
change in market value does not give the customer the ability to direct use
of the unit

X

35
(c) – (i) The entity’s performance does not create an asset with alternative
use and

 

(ii)
the entity has a right to payment for performance completed to date

In
most of the contract, the asset created by an entity’s performance does not
have an alternative use to an entity

v

Entity
may not have enforceable right to payment for performance completed to date,
because:

 

? The customer can walk away
without making the rest of the payment

 

To
meet this criterion, entity should have a contractual/legal right to receive
payments for work completed to date including a reasonable profit
margin.  A satisfactory resolution of
the problem does not mean that the entity has an enforceable right to payment
for work completed to date.

X

Many real estate companies in India may not
qualify for POCM on transition date contracts. 
However, the third criterion discussed above can be incorporated in
future contracts to achieve POCM recognition.

 

 

Example 2 – Over time revenue recognition requirement
met

 

Issue

–   An
entity is constructing a multi-unit residential complex. A customer enters into
a binding sale contract with the entity for a specified unit.

–   The
customer pays a non-refundable deposit upon entering into the contract and will
make progress payments during construction of the unit. The contract has
substantive terms that preclude the entity from being able to direct the unit
to another customer.

 

–    In
addition, the customer does not have the right to terminate the contract unless
the entity fails to perform as promised.

 

–    If
the customer defaults on its obligations by failing to make the promised
progress payments as and when they are due, the entity would have a right to
all of the consideration promised in the contract if it completes the
construction of the unit.

–   The courts have previously
upheld similar rights that entitle developers to require the customer to
perform, subject to the entity meeting its obligations under the contract.

 

Does the
real estate entity meet the criterion for overtime recognition of revenue?

 

Response

–   The
entity determines that the asset (unit) created by the entity’s performance
does not have an alternative use to the entity because the contract precludes
it from transferring the specified unit to another customer.

 

–    The
entity does not consider the possibility of a contract termination in assessing
whether the entity is able to direct the asset to another customer.

 

–   The
entity also has a right to payment for performance completed to date. This is
because if the customer were to default on its obligations, the entity would
have an enforceable right to all of the consideration promised under the
contract if it continues to perform as promised.

 

–   Therefore,
the terms of the contract and the practices in the legal jurisdiction indicate
that there is a right to payment for performance completed to date.

 

Consequently, the criteria
for recognising revenue over time under Ind AS 115 are met and the entity has a
performance obligation that it satisfies over time.

 

What is enforceable right to payment?

There are a couple of
points one needs to consider to understand if a real estate contract provides
an enforceable right to payment:

 

1.  The enforceable right to payment for work
completed to date would include cost incurred to date plus a normal profit
margin.

 

2.  The right should be enforceable both under the
contract as well as legislation.

 

3.  The law may provide contract enforceability,
however the RERA authorities may issue interpretations and judgement that are
consumer friendly. The Maharashtra Estate Regulatory Authority in Mr.
Shatrunjay Singh vs. Arkade Art  Phase 2
opined that the customer is not eligible for refund of the amounts paid to the
developer even if customer is not able to pay due to financial difficulty.
However, it did not rule that the contract was enforceable against the
customer, and that the entity had a right to collect payment for work completed
to date. Real estate entities should therefore clearly evaluate the legal
position and obtain legal opinions to support over time revenue recognition.
Since different RERA authorities may take different positions, a real estate
entity should obtain legal opinion for all major states where it has
operations.

 

4.  The right to payment does not mean that the
entity has the right to invoice every day or week or month or other than based
on mile-stone. Rather, if the customer walks-away from the contract, the entity
should be able to enforce payment for work completed to date (plus normal
profit margin).

 

5.  The existence of the right is important.
Whether the real estate entity chooses to exercise the right is not relevant.

 

6.  A satisfactory resolution of the problem as
explained in Example 1, does not mean that the real estate entity has an
enforceable right to payment. A clear enforceable right to payment should be
granted both under the contract and the legislation.

 

7.  If a customer can walk away by paying a
penalty (which is not equal to or greater than cost incurred to date plus
normal profit margin), then there is no enforceable right to payment.

 

8.  In a 10:90 scheme, the contract itself may not
be enforceable. However, in a mile-stone based real estate contract, a 10%
received upfront, may be sufficient to demonstrate contract enforceability.
Evaluating contract enforceability and right to payment is a continuous process
throughout the project period.

 

POCM under GN vs Ind AS 115

Even when real estate
entities meet the POCM criterion under Ind AS 115, the POCM as per the GN
(withdrawn) and Ind AS 115 are dissimilar in many respects. A comparison is
given below.

 

Point
of difference

GN

Ind
AS 115

Threshold
for revenue recognition

??All
critical approvals obtained

??Construction
and development costs = 25%

??Saleable
project area is secured by
contracts = 25%

??Realised
contract consideration = 10%

 

Revenue
to be recognised straight-away and there is no condition for achieving any
threshold.  However, contract
enforceability criterion is required to be met for recognizing revenue.  Therefore, more revenue will be recognised
upfront under Ind AS 115 as compared to the GN. If the entity is unable to
reasonably estimate progress, an entity should recognise revenue upto cost
incurred to date, unless the contract is onerous.

Borrowing
cost

Included
in POCM

Borrowing
costs cannot contribute to performance. Therefore borrowing costs would be
excluded from the measure of progress.

Land
cost

Included
in POCM, when threshold is achieved.

Preferred
view is that it is included in POCM on commencement of the project.

20:80/
10:90 Schemes

Revenue
can be recognised subject to thresholds

Contract
may not be eligible as valid contract under Ind AS 115

Financing
component

No
requirement to separate financing component

Explicitly
required to separate financing component

 

 

POCM under GN

 

Illustration

 

Particulars

Scenario 1

Scenario 2

Total
saleable area

20,000 sq. ft.

20,000 sq. ft.

Estimated
Project Costs

 

 

Land
cost

INR 300 lakh

INR 300 lakh

Construction
cost

INR 300 lakh

INR 300 lakh

Cost
incurred till end of reporting period

 

 

Land
cost

INR 300 lakh

INR 300 lakh

Construction
cost

INR 60 lakh

INR 90 lakh

Total
Area Sold till the date of reporting period

5,000 sq. ft.

5,000 sq. ft.

Total
Sale Consideration as per Agreements of Sale executed

INR 200 lakh

INR 200 lakh

Total
sales consideration (estimated)

INR 800 lakhs

INR 800 lakh

Amount
realised till the end of the reporting period

INR 50 lakh

INR 50 lakh

Fair
value of the land & building (each)

INR 400 lakhs

INR 400 lakhs

 

Response

 

Particulars

Scenario 1

Scenario 2 – land is considered as contract
activity

Scenario 2 – land is not considered as contract
activity

Construction
and development costs = 25%

60/300 = 20%

90/300 = 30%

90/300 = 30%

Saleable
project area is secured by contracts = 25%

5,000/20,000 = 25%

5,000/20,000 = 25%

5,000/20,000 = 25%

Realised
contract consideration

=
10%

50/200 = 25%

50/200 = 25%

50/200 = 25%

POCM

360/600 = 60%

390/600 = 65%

90/300 = 30%

Revenue
can’t be recognised in scenario 1, as first condition is not met

 

 

 

(i)
Revenue Recognised

–

INR 130 lakhs

(200 * 65%)

INR 60 lakhs

(200*30%)

(ii)
Proportionate Cost /

–

INR 97.5 lakhs

(600 * 65%*1/4)

INR 45 lakhs

(600*30%*1/4)

Profit
[ (i) – (ii) ]

–

INR 32.5 lakhs

INR 15 lakhs

WIP

INR 360 lakhs

(300+60)

INR 292.5 lakhs

(390-97.5)

INR 345 lakh

(390-45)

 

 

1.  In Scenario 1, construction and development
cost criterion of 25% is not fulfilled and since threshold is not met, no
revenue is recognised.

 

2.  Scenario 2 where land is considered as
contract activity is clearly in accordance and as illustrated in the GN. Once
the 25% criterion is met, land is included in the determination of the POCM and
revenue/cost is recognised on that basis.

 

3.  Scenario 2 where land is not considered as
determining the contract activity (POCM) is the author’s interpretation of
Paragraph 5.4 of the GN. Paragraph 5.4 of the GN states that “Whilst the method
of determination of state of completion with reference to project cost incurred
is the preferred method, this GN does not prohibit other methods of
determination of stage of completion, eg, surveys of work done, technical
estimation, etc.”

 

POCM under Ind AS 115 in single-unit apartment

As already discussed above,
in a single-unit apartment, in most cases, land and building will be two
separate POs. The question that arises at what point in time revenue on land is
recognised. Theoretically there are three options on how land revenue is recognised
at (a) commencement, (b) settlement or (c) over time. These options are
presented below based on the earlier illustration (scenario 2).

 

When land revenue is recognised?

View 1 – 
Commencement

 

View 2 – Settlement

 

View 3 –Overtime

POCM

90/300 = 30%

 

90/300 = 30%

 

90/300 = 30%

 

Land

Building

Total

Land

Building

Total

Land

Building

Total

(i)
Revenue Recognised

100

(400*1/4)

30

(400*1/4*

30%)

130

0

30

(400*

1/4*

30%)

 

30

30

(400*

1/4*

30%)

 

30

(400*1/4
*30%)

 

60

(ii)
Proportionate Cost

75

(300*1/4)

 

22.5

(300*1/4*

30%)

 

97.5

0

22.5

(300*

1/4

*30%)

 

22.5

22.5

(300*

1/4*

30%)

 

22.5

(300*1/4*
30%)

 

45

Profit  [(i) – (ii)]

25

7.5

32.5

0

7.5

7.5

7.5

7.5

15

WIP

225

(300-75)

 

67.5

(90-22.5)

 

292.5

300

67.5

(90-22.5)

 

367.5

277.5

(300-22.5)

 

67.5

(90-22.5)

 

345

 

 

Revenue
and cost of land is recognised at the completion of the contract.

 

 

 

The author believes that
View 1 below is the most appropriate response.

 

View 1: Control of the land
at commencement

 

The author believes land
revenue is recognised at commencement since the control of the land transfers
once the contract is enforceable. The contract restricts the ability of the
real estate entity to redirect the land for another use. Besides, the customer
has the significant risks and rewards of ownership from that time. Although the
legal title of the land does not transfer until settlement, this view considers
that the retention of legal title in this fact pattern is akin to a protective
right because the customer will not pay for the land until settlement.
Therefore, this contract is like many other contracts where the asset is
acquired on deferred payment terms. In this view, the real estate entity will
need to confirm that the existence of a contract criteria are met in IND AS
115.9, in particular that it is it is probable that the builder will collect
the consideration to which it will be entitled in exchange for the land and
house (single-unit) construction services.

View 2: Control of the land
transfers at settlement

 

Control of the land
transfers at settlement, which is when legal title transfers to the customer.
This provides clear evidence that the customer has obtained control of the
land. This outcome would also be consistent with other real estate sales
contracts that do not have a specific performance clause.

 

However, the major drawback
of this view is that it is counterintuitive for a  customer
to obtain  control
(forInd AS 115 purposes) of the
house prior to the obtaining control of the land. Hence this view is not
appropriate.

 

View 3: Control of the land
also transfers over time to the customer

 

Over time revenue
recognition is applicable to land because the real estate entity is
contractually restricted from redirecting the land to others. Besides the right
to sue for specific performance applies to the contract as a whole ( i.e land
and house construction). However, the major shortcoming of this view is that
the real estate entity’s performance does not create or enhance the land—the
land already exists. In other words land is not getting created, enhanced or
transformed overtime. Hence, this view is not appropriate.

 

POCM under Ind AS 115 in multi-unit apartment

As already discussed above,
in a multi-unit apartment land and building is treated as one performance obligation.
Theoretically there are 3 options available on how to apply POCM in a
multi-unit apartment where construction meets the overtime requirement in
35(c).

 

Options

If
land and building is a not separate PO

View
1

– Land treated as an input
cost and included in determination of POCM margins

– Consequently significant
revenue/cost gets recognised at commencement

View
2

– Land treated as an input
cost but not included in POCM

– Revenue recognised to the
extent of the input cost – no margins are recognised

– Significant revenue/cost
gets recognised at commencement

View
3

– POC determined on the basis
of development cost to date (excluding land) vs total development cost
(excluding land). POC is then applied on total contract revenue

– Consequently all
revenue/cost (including land) gets recognised overtime

 

 

View 1 and 3 seem
acceptable views, and are demonstrated below (Scenario 2)

 

Particulars

View 1

View 3

POCM

390/600 = 65%

90/300 = 30%

(i)
Revenue Recognised

INR 130 lakhs

(200*65%)

INR 60 lakhs

(200*30%)

(ii)
Proportionate Cost

INR 97.5 lakhs

(600*65%* 1/4)

INR 45 lakhs

(600*30%*1/4)

Profit
[(i) – (ii)]

INR 32.5 lakhs

INR 15 lakhs

WIP

INR 292.5 lakhs

(390-97.5)

INR 345 lakh

(390-45)

 

 

Conclusion

Ind AS 115 is very
complicated. The interpretations around Ind AS 115 are still emerging globally
and in India. Real estate entities will need to carefully study, analyse and
apply the requirements, without jumping to straight-forward conclusions. 

 

USEFUL LIFE UNDER IND AS 16 PROPERTY, PLANT AND EQUIPMENT AND LEASE TERM UNDER IND AS 116 LEASES

QUERY

A lessee enters into a lease for an office
property. The lease has a non-cancellable term of 5 years and contains an
option for the lessee to extend the lease for a further 5 years. The rentals
for the period under the extension option (i.e., years 6-10) are at market
rates. Upon commencement of the lease term, the lessee incurs cost constructing
immoveable leasehold improvements specific to the property. The useful life of
the leasehold improvement is 7 years. At the commencement date of the lease,
the lessee expects, but is not reasonably certain, to exercise the extension
option. The economic penalty of abandoning the leasehold improvement at the end
of the non-cancellable term of the lease is not so significant as to make
exercise of the renewal option reasonably certain. Over what period does the
lessee depreciate leasehold improvements?

 

RESPONSE

View 1 – The
useful life of the leasehold improvements is 5 years

 

Appendix A to Ind
AS 116 defines lease term as: “The non-cancellable period for which a lessee
has the right to use an underlying asset, together with both:

u    (a) periods covered by an
option to extend the lease if the lessee is reasonably certain to exercise that
option; and…”

 

In this case, since
the lessee is not reasonably certain to exercise the option to extend the
lease, the lease term is 5 years for the purpose of Ind AS 116. 

 

Ind AS 16 (56)
states that:

“…all the following
factors are considered in determining the useful life of an asset:

u    (a) expected usage of the
asset. Usage is assessed by reference to the asset’s expected capacity or
physical output.

u    (b) expected physical wear
and tear, which depends on operational factors such as the number of shifts for
which the asset is to be used and the repair and maintenance programme, and the
care and maintenance of the asset while idle.

u    (c) technical or commercial
obsolescence arising from changes or improvements in production, or from a
change in the market demand for the product or service output of the asset…

u    (d) legal or similar limits
on the use of the asset, such as the expiry dates of related leases.” (emphasis
added.)

Keeping in mind the
legal limits, the useful life of the leasehold improvements is 5 years.

 

View 2 – The
useful life of the leasehold improvements is 7 years

 

The useful life of
the leasehold improvement is based on its expected utility to the entity [Ind
AS 16(57)]. To determine the expected utility, the lessee would consider all
the factors in paragraph 56 of Ind AS 16. While paragraph 56(d) of 16 should be
considered, the factor regarding “expected usage of the asset” in paragraph
56(a) of Ind AS 16 is equally relevant in determining the useful life. The
condition contained in paragraph 56(d) of Ind AS 16 reflects the necessity to
consider the existence of legal or other externally imposed limitations on an
asset’s useful life. The ability to extend the lease term is within the control
of the lessee and is at market rates so there are no significant costs or
impediments to renewal.   The term
“expected usage of the asset” for the determination of useful life of an asset
indicates a lower threshold than the “reasonably certain” threshold for
including the extension period in the lease term for Ind AS 116 purposes.

 

In accordance with
Ind AS 16 (51), if the assessment of useful life changes (for example, the
lessee no longer expects to exercise the lease renewal option) the change shall
be accounted for as a change in an accounting estimate. In such circumstances,
the entity may also need consider whether there is an impairment.

 

AUTHOR’S VIEW

The author believes
that there is greater merit in View 1, because it  results in harmony between the way lease term
and useful life of the leasehold improvements are determined.  

 

 

 

IMPLEMENTATION OF EXPECTED CREDIT LOSS MODEL FOR NON-BANKING FINANCIAL COMPANIES

Introduction 

 

India has already embarked on the journey
towards adoption of Indian Accounting Standards (IndAS) with effect from the
financial year ended 31st March, 2017 in two phases for prescribed
classes of companies other than the financial service entities. This journey
continues with the next phase of adoption of Ind As by Non-Banking Finance
Companies (NBFC) in two phases commencing from the accounting period
beginning 1st April, 2018. Whilst there are several implementation
and transition challenges, by far the biggest challenge  for NBFCs lies in implementing and designing
an Expected Credit Loss model for making impairment provisions for financial
assets.

 

The initial plan of the MCA was to implement
Ind AS for the entire gamut of financial service entities covering NBFCs, banks
and insurance entities, which has been deferred by a year for banks and by two
years for insurance companies. Accordingly, the discussion in this article is
restricted only to NBFCs.

 

It may be pertinent to note that the RBI
had constituted a Working Group to deal with the various issues relating
to Ind AS Implementation by Banks which had submitted a detailed
report in September 2015, which may be equally important and
relevant to NBFCs since there is a fair degree of similarity in their business
models and the same would be also taken into account in the course of our
subsequent discussions. Apart from the said report there has been no
other regulatory guidance from the RBI or other sector specific regulators,
except from the National Housing Bank (NHB), which regulates Housing Finance
Companies, which is discussed subsequently.

 

 

 

DETERMINATION OF EXPECTED CREDIT LOSS (ECL)

 

NBFCs are currently mandated by the RBI to
follow a standardised rule based approach to determine the impairment of loans
in accordance with the prudential norms which requires classification of loans
into standard, sub-standard, doubtful and loss categories by prescribing the
minimum provisioning requirements under each category and hence the underlying
theme is the “incurred loss” model.

 

In contrast, Ind AS-109 dealing with
recognition and measurement of Financial Instruments has significantly modified
this approach for measuring and assessing impairment based on the entity’s assessment
of the expected credit loss over a 12 month period or for the entire duration
for all financial assets under amortised cost or FVTOCI category. However,
the RBI guidelines do mandate a minimum provision for different categories of
standard assets ranging from 0.4% to 2% which in a way is a form of an ECL
model, though the approach is quite different under Ind AS. This is expected to
be a game changer for all NBFCs and thus merits special attention in terms of
its approach as well as its implementation and transition challenges.

 

 

 

APPROACH TO DETERMINE THE ECL

 

As per Ind AS-109, ECL is required to be
computed on the basis of the probability weighted outcome as the present
value of the difference between the cash flows that are due to the entity in
accordance with the terms of the financial asset and the expected cash flows.
However, Ind AS -109 does not prescribe the methods or techniques for
computing the ECL and hence it is an area which is prone to a lot of subjectivity,
judgement and complexity for NBFCs.

 

It may be pertinent to note at this stage,
that in March 2012, the RBI had released a ‘Discussion Paper on Introduction
of Dynamic Loan Loss Provisioning Framework for Banks in India’  which provided a broad framework to compute
expected loss provisioning based on the industry average for some select asset
classes. Subsequently, vide its circular dated 7th February,
2014 the RBI advised banks to develop necessary capabilitiesto compute their
long term average annual expected loss for different asset classes, for
switching over to the dynamic provisioning framework.

 

Whilst these guidelines (which are still
to be implemented) are applicable to banks, NBFCs may find it useful atleast in
the initial stages to refer to these guidelines for developing their own models
based on the broad computational principles as discussed below.

 

Mathematically, ECL can be represented as under:

 

ECL = EAD*PD*LGD

 

Where:

EAD refers to
the Exposure at Default or the Credit Loss

PD refers to Probability
of Default

LGD refers to
Loss Given Default

 

It would be pertinent at this stage to
discuss the principles, implementation issues and challenges for each of
the above concepts.

 

Credit Loss

 

Ind AS-109 defines credit loss as the difference between all contractual cash flows that are
due to an entity in accordance with the contract and all the cash flows that
the entity expects to receive (i.e. all cash shortfalls), discounted at the
original effective interest rate(or credit-adjusted effective interest rate for
purchased or originated credit-impaired financial assets).

 

An entity shall estimate cash flows by
considering all contractual terms of the financial instrument (for example,
prepayment, extension, call and similar options) through the expected life of
that financial instrument. The cash flows that are considered shall also
include cash flows from the sale of collateral held or other credit
enhancements that are integral to the contractual terms. There is a
presumption that the expected life of a financial instrument can be estimated
reliably. However, in those rare cases when it is not possible to reliably
estimate the expected life of a financial instrument, the entity shall use the
remaining contractual term of the financial instrument.

 

Assessing the credit loss / EAD is likely to
present several implementation and transition challenges in the Indian context,
the main ones of which are indicated below:

 

a)   Inadequate and inappropriate data: –
The existing guidelines for making provisions for NPAs are based on default
triggers based on time / due dates and may not always capture the estimated
cash flows from the facilities and related collaterals over the life of the
facility. It is thus imperative for NBFCs to evaluate their existing systems
and make suitable modifications and determine the additional data points
keeping in mind the time and cost constraints vis a-vis the benefits.

 

b)   Individual versus collective assessment:-
Whilst for the small ticket and individual facilities it may not be possible,
feasible and cost effective to assess the EAD for each facility, entities would
still need to group these facilities based on shared / common characteristics
like type of facility, type of borrowers, regional and other similar
considerations. However for corporate and large ticket loans, the assessment
would need to be done individually for which appropriate triggers for
classification would need to be laid down based on assessment of various
factors some of which may involve subjectivity and judgements. An indicative
criteria can be the assessment criteria laid down by the RBI under the BASLE II
and III guidelines for retail and non- retail classification by Banks for
assessing capital adequacy, which though not strictly applicable could be a
useful guide and accordingly for all non-retail exposures, the individual
assessment needs to be done.

c)   Cash flows from and realisability of
Collaterals:- This is likely to be by far the biggest challenge since
traditionally in our country enforcing of collaterals is a cumbersome legal
process which may in certain cases stretch upto a generation and beyond! These
and other similar factors would need to be assessed whilst evaluating the
present value of the cash flows. Also in many cases, fair value specialists
would need to be employed which would increase the costs and result in
significant judgements and potential bias which may vitiate the true picture.

 

 

 

Probability of Default (PD)

 

PD is an important constituent for computing
the ECL. However, the term is not specifically defined in the Ind As. It is a
financial term describing the likelihood of a default over a particular time
horizon. PD is the risk that the borrower will be unable or unwilling to repay
its debt in full or on time. The risk of default is derived by analysing the
borrower’s capacity to repay the debt in accordance with contractual terms. PD
is generally associated with financial characteristics such as inadequate cash
flow to service debt, declining revenues or operating margins, high leverage,
declining or marginal liquidity, and the inability to successfully implement a
business plan. In addition to these quantifiable factors, various qualitative
factors like the borrower’s willingness to repay along with factors like the
economic, business and industry factors relating to his area of operations also
must be evaluated.To summarise the PD is dependent on the overall credit
rating of the borrower which would factor in the above aspects, amongst
others.

 

Since it involves a fair degree of judgement
and estimation, entities would need to use appropriate internal statistical
models to assess the PD for various types of exposures over a 12 month
period or over the life of the exposure, as per the requirements laid down
under Ind AS discussed subsequently. This has also been reiterated by the RBI
in its Working Group Report. However, the report also refers to the Concept
Paper on Dynamic Provisioning, discussed earlier, which could be used as a
basis. The Paper has calculated the PD based on a study of data from 9 Banks
which represent approximately 40% of the total business under the following 4
categories of loans and worked out the PD. The only drawback in this
method is that it is calculated on the basis of the “percentage of
incremental NPAs during the year to the outstanding loans at the beginning of
the year”, whereas ideally the PD should be calculated based on the number of defaults
rather than the amount of default.

 

 

 

Weighted Average PD of Various Asset Classes

Type of Loans

PD

Corporate Loans

0.92

Retail Loans

3.16

Housing Loans

1.28

Other Loans

2.56

Total Loans

1.82

 


The above analysis though not entirely conclusive, fairly reflects the
differences in the PD based on the credit risks of the different types of
portfolio in the Indian scenario. However the same was based on a study which
is over five years old and the validity thereof, in the context of the current
economic and political environment, especially in case of corporate loans which
have a lower PD than retail remains questionable. Hence it is important for an
entity to have a dynamic and flexible statistical tracking mechanism.

 

Though the above discussion is in the
context of Banks, it may serve as a useful indicator / benchmark pending the
creation / generation of their own statistical models for NBFCs. However, NBFCs
are cautioned not to blindly use these without substantiating the same based on
data including, if required,  taking the
help of experts.

 

 

 

Loss Given Default (LGD)

 

Like PD, LGD is
also an important constituent for computing the ECL. However, the term like in
case of PD is not specifically defined in the Ind As. LGD is the amount of
money a lender loses when a borrower defaults on a loan. The most frequently
used method to calculate this loss compares actual total losses to the total
amount of potential exposure sustained at the time that a loan goes into default.
In most cases, LGD is determined after a review of anentity’s entire portfolio,
using cumulative losses and exposure for the calculation. For secured
exposures, it involves assessing the realisable value and assessing the
foreclosure amount of the collaterals, which as we have seen earlier can be a
challenge in our environment. In simple terms, LGD represents the economic
or business loss rather than the accounting loss.

 

Since it involves a fair degree of judgement
and estimation, entities would need to analyse the defaults and the losses
at an overall portfolio level which as discussed earlier can represent a
significant challenge for many Indian entities. This has also been
reiterated by the RBI in its Working Group Report. However, the report also
refers to the Concept Paper on Dynamic Provisioning, discussed earlier,
together with the Internal Ratings Based Approach under BASLE II for
determining Capital Charge for Credit Risks vide its circular dated December,
2011 by the RBI, to be framed by Banks, which could be used as a basis. The
Concept Paper has calculated the LGD based on a study of data of a
pool of NPAs from 9 Banks which represent approximately 40% of the total
business under the following 4 categories of loans and worked out the same. Whilst
the method is not entirely fool proof and free from doubt, it is a good initial
indicator prior to design of appropriate statistical models by the NBFCs.

 

Average LGD Estimates of Various Asset
Classes

Type of Loans

Average LGD (%)

Corporate Loans

36.07

Retail Loans

33.36

Housing Loans

8.02

Other Loans

79.09

Total Loans

45.48

 

 

Like in the case of the PD, the above
analysis though not entirely conclusive, fairly reflects the differences in the
LGD based on the credit risks of the different types of portfolio in the Indian
scenario. However, the same was based on a study which is over five years old
and the validity thereof, in the context of the current economic and political
environment, remains questionable. Further, the lower LGD in the case of
Housing Loans appears to be primarily due to the collateral value of the
property financed, the recovery and enforcement thereof may present challenges.
Hence it is important for an entity to have a dynamic and flexible statistical
tracking mechanism

 

As is the case with the calculation of
PDs, though the above discussion is in the context of Banks, it may serve as a
useful indicator / benchmark pending the creation / generation of their own
statistical models for NBFCs. However, NBFCs are cautioned not to blindly use
these without substantiating the same based on data including, if
required,  taking the help of experts.

 

 

 

STEPS TO CALCULATE THE ECL

 

The first step to calculate the ECL is to
classify the financial assets into different stages or buckets as tabulated
hereunder based on which the subsequent calculations for the extent of
impairment on ECL basis can be determined.

           

 

Stage 1

Stage 2

Stage 3

 

 

 

 

Stage

Financial Asset is originated or purchased

Credit Risk has increased significantly in respect of the financial asset since
initial recognition

The Financial Asset is credit impaired

 

 

 

 

ECL provision required

Twelve months ECL

Life time ECL

Life time ECL

 

 

 

 

Recognition of Interest Revenue (discussed in a subsequent
section

EIR on gross carrying amount

EIR on gross carrying amount

EIR on amortised cost basis

                       

As can be seen from the above, the following
are the key triggers for assessing impairment on the basis of life time
expected credit losses:

  •     Assessment of increase
    in the credit risk; and
  •   Determining receivables
    which are credit impaired    .

 

Let us now proceed to briefly understand the
principles laid down in Ind AS-109 for assessing both these.

 

Increase in the Credit Risk

Whilst the assessment of increase in the
credit risk is qualitative and judgemental, IndAS-109 has laid down certain
principles which are summarised hereunder:

 

  •    At each reporting date, an
    entity shall assess whether the credit risk on a financial instrument has
    increased significantly since initial recognition. When making the assessment,
    an entity shall use the change in the risk of a default occurring over the
    expected life of the financial instrument instead of the change in the amount
    of expected credit losses. To make such assessment, an entity shall consider reasonable
    and supportable information    , that is available without undue cost or
    effortthat is indicative of significant increases in credit risk since initial
    recognition.
  •    If reasonable and supportable
    forward-looking information is available without undue cost or effort    , an
    entity cannot rely solely on past due information when determining
    whether credit risk has increased significantly since initial recognition.
  •    However, when information
    that is more forward-looking than past due status     (either on an individual
    or a collective basis) is not available without undue cost or effort, an
    entity may use past due information to determine whether there have been
    significant increases in credit risk since initial recognition.
  •   Regardless of
    the way in which an entity assesses significant increases in credit risk, there
    is a rebuttable presumption that the credit risk on a financial asset has
    increased significantly since initial recognition when contractual payments are
    more than 30 days past due.
  •    Ind AS-109 has
    provided a list of information / criteria which may be relevant
    for assessing changes in credit risk. An illustrative list of the same is
    provided below:

a) an actual
or expected significant change in the party’s external credit rating.

b) an actual
or expected significant change in the operating results of the party.

c)
significant changes in the value of the collateral supporting the obligation or
in the quality of third-party guarantees or credit enhancements, which are
expected to reduce the debtor’s economic incentive to make scheduled
contractual payments or to otherwise have an effect on the probability of a
default occurring.

 

Assessing Credit Impaired Financial
Asset:

 

For identifying receivables which are credit
impaired, Ind AS-109 defines a “credit impaired financial asset” as under:

 

“A financial asset is credit-impaired
when one or more events that have a detrimental impact on the estimated future
cash flows ofthat financial asset have occurred. Evidence that a financial
asset is credit-impaired include observable data about the following events:

 

(a) significant
financial difficulty of the issuer or the borrower;

 

(b) a breach of
contract, such as a default or past due event;

 

(c) the lender(s) of the
borrower, for economic or contractual reasons relating to the borrower’s
financial difficulty, having granted to the borrower a concession(s) that the
lender(s) would not otherwise consider;

 

(d) it is
becoming probable that the borrower will enter bankruptcy or other financial
reorganisation;

 

(e) the
disappearance of an active market for that financial asset because of financial
difficulties; or

 

f) the purchase
or origination of a financial asset at a deep discount that reflects the
incurred credit losses.

 

It may not be possible to identify a
single discrete event instead, the combined effect of several events may have
caused financial assets to become credit-impaired.”

 

One of the common criteria which is
practically applied in assessing credit impairment is to identify whether there
is a default or a past due event. In this context, Ind AS-109
provides that when defining default for the purposes of determining the risk of
a default occurring, an entity shall apply a default definition that is consistent
with the definition used for internal credit risk management purposesfor the
relevant financial instrument and consider qualitative indicators (for example,
financial covenants) when appropriate. However, there is a rebuttable
presumption that default does not occur later than when a financial asset is 90
days past due unless an entity has reasonable and supportable information to
demonstrate that a more lagging default criterion is more appropriate.

 

Accordingly, though the Ind AS
provides 30 and 90 day thresholds these are not sacrosanct like the existing
NPA guidelines and need to be evaluated in the context of other qualitative and
judgemental factors which need to be appropriately disclosed.  

 

Accordingly, it is imperative for NBFCs to
establish their own internal credit risk rating models, subject
to cost and volume considerations for different categories of risks, rather
than blindly adopt the 30 and 90 days rebuttable presumptions indicated above.
Let us now proceed to briefly examine the implementation and transition
challenges

 

 

 

IMPLEMENTATION AND TRANSITION CHALLENGES

 

Framing Internal Credit Risk Rating
Models

 

Currently in the case of NBFCs, there are no
specific regulatory guidelines which provide for the establishment of credit
risk management policies on the lines as prescribed by the RBI under the BASLE
II and III framework for Banks, except the generic requirement under the
Companies Act, 2013 and the Listing Guidelines to frame Risk Management
Policies. Accordingly, the transition from a rule based regulator specified
criteria approach that largely ensures consistency of application across the
system to an ECL framework that is largely subjective based on management
judgement and being data intensive, necessitates fairly sophisticated credit
modelling skills and would represent an enormous challenge not only for the
NBFCs but also for auditors, regulators and supervisors, especially for the
small and medium sized as well as closely held entities.

 

Accordingly, NBFCs are advised and expected
to develop their own internal credit risk rating models as part of their
overall Credit Risk Management Policies under the Supervision of the Board with
implementation support from the Risk Management Committee. For this purpose the
broad steps which need to be followed are outlined below:

 

a)   Framing an internal risk rating module for
different types of financial assistance and different types of financial
instruments, which evaluates each proposal for different types of risks,
security available, financial performance of the borrower etc.

 

b)   Based on the scrutiny of the proposals
against the above parameters a scoring module is developed which assigns scores
on a range of 1-10, 1-100 etc., which in turn is linked to a grade. An
illustrative scoring grid is as under:

 

 

SCORE

GRADE

95-100

AAA

85-94

AA

75-84

A

55-74

B

25-54

C

1-25

D

 

 

Based on the above assessment any facility
granted to a borrower with a grading of C or D would represent increased credit
risk and hence would fall under stage 2 as discussed earlier thereby
necessitating a life time ECL calculation.

 

c)  A comparison of the above internally assessed
ratings can be compared with the externally assigned ratings to the borrowers
by the recognised external credit rating agencies.

 

d)  Periodic review of the above established
ratings through internal assessment coupled with audit assistance in certain
cases. For this purpose a review / assessment is undertaken of the servicing
and repayment of the facility, financial performance of the borrower, the
industry / business environment in which the borrower operates etc.

 


Normally, from a practical perspective, any rating down grade by more than
two notches would imply a default or credit impaired status necessitating the
movement of the exposure to stage 3 as discussed earlier, in addition to the
other specific qualitative parameters discussed.

 

The RBI working
group has discussed certain issues in the context of Banks pertaining to
identification of and the on-going assessment of increase in the credit risk as
under, which may be relevant and a useful indicator for NBFCs on initial transition,
subject to appropriate corroboration thereof with the existing data and the
peculiar nature of operations of each NBFC and pending any specific guidance
relating to NBFCs from the RBI:

 

a)  The Group suggested that the RBI could
prescribe rule based indicative criteria for significant deterioration in
credit risk.

 

b)  Whilst the group felt that the 30 days past
due scenario is quite common, Banks should take this opportunity to educate
their customers of making contractual payments within 30 days and also
simultaneously strengthen their credit monitoring mechanisms.

 

c)  In the context of the 90 days default
criteria, the Group suggested that RBI may continue to define default for
consistency across the banking system keeping in view the Basel framework as
well as the Ind AS 109 prescriptions. Banks may be permitted the discretion to
formulate more stringent standards.

 

d)  The Group also noted that Ind AS 109 envisages
other types of defaults, e.g., breach of covenants, which are not accompanied
by payment defaults. With respect to such defaults (not accompanied by payment
defaults), banks will need to build up adequate records to evidence the impact
of these events on the level of credit risk
and if these events constitute a significant increase in credit risk.

 

e)  Finally, the Group also
noted that RBI vide its circular DBOD.No.BP.520/21.04.103/2002-03 dated
October 12, 2002 had issued a Guidance Note on Credit Risk Management that
inter-alia advised banks to adopt credit risk models depending on their size,
complexity, risk bearing capacity and risk appetite, etc. and accordingly
advised Banks to adopt the same, since based on which it is reasonably expected
that banks should be able to put in place at least some basic measures of expected credit losses.

 

Regulatory Challenges

The NHB vide its circular dated 16th
April, 2018 has broadly laid down the following requirements:

 

a)  In terms of the provisions of paragraph 24 of
the Housing Finance Companies (NHB) Directions, 2010 (“Directions”) on
Accounting Standards, in terms of which the Accounting Standards and Guidance
Notes issued by the Institute of Chartered Accountants of India shall be
followed in so far as they are not inconsistent with any of the Directions.

 

b)  All Housing Finance Companies to follow the
extant directions on Prudential Norms, including on asset classification,
provisioning etc. issued by the NHB.

c)  With regards to the implementation of Ind
AS, HFCs are advised to be guided by the extant provisions of Ind AS, including
the date of implementation.

 

A plain reading of
the aforesaid circular seems to suggest the following interpretation
alternatives:

 

a)  HFCs should continue to follow the existing
directions including the prudential and asset classification norms whilst
determining their capital adequacy ratio, which seems to imply that the working
as per the existing NPA norms would continue. Thus it appears that a
separate set of regulatory accounts would need to be maintained.

 

b)  For preparing the statutory accounts, the Ind
AS principles would need to be followed, which implies that the ECL model
should also be followed.

 

c)  Companies should accordingly adopt the
ECL model and compare the provision as per the same with the existing NPA
provisioning guidelines and the higher of the two should be followed since the
intention of the NHB seems to ensure that the regulatory minimum provisions
should be maintained. This is also the recommended alternative as suggested by
the RBI working group in its report.

 

There is currently no similar circular
which has been issued by the RBI for application by the NBFCs other than HFCs,
thereby creating a lot of ambiguity and leaving the field open to varying
interpretations, which could involve substantial time, efforts and costs which
may not be commensurate with the benefits and expose the NBFCs to potential
regulatory scrutiny.It is strongly recommended that appropriate clarifications
are issued by the RBI in this regard.

 

CONCLUSION

 

The above evaluation is just the tip of the
ice-berg on a subject that is quite vast and complex. However, the ECL model is
here to stay and it would impact the way the financial statements are evaluated
and also impact the auditors and prove to be a bonanza for specialists to
develop statistical models who could laugh all the way to the bank! 

 

CONSOLIDATION OF CSR TRUSTS UNDER Ind AS

Background

Many Indian corporates have set up
Special Purpose Not-for-Profit Entities (NFP) to undertake corporate social
responsibility (CSR) activities as required u/s. 135 of the Companies Act,
2013. The CSR activities are either undertaken by the Company directly or
through a charitable trust under The Indian Trusts Act, 1882, section 8 company
under the Companies Act 2013 or a society under the Societies Registration Act,
1860. The sponsoring company will provide adequate funds or donations to the
trust, society or the section 8 company so that it can carry out the relevant
activities as required under the Companies Act, 2013. A question arises as to
whether such NFP should be consolidated under Ind AS 110, Consolidated
Financial Statements by the sponsoring company.

 

Under Ind AS 110, an investor
controls an investee and consequently consolidates it when it is exposed, or
has rights, to variable returns from its involvement with the investee and has
the ability to affect those returns through its power over the investee. Thus,
an investor controls an investee if and only if the investor has all the
following:

 

(a) Power
over the investee,

 

(b) Exposure,
or rights, to variable returns from its involvement with the investee, and

 

(c) The
ability to use its power over the investee to affect the amount of the
investor’s returns.

 

Arguments supporting consolidation of the
NFP

Following are the arguments
supporting consolidation:

 

  • Under Ind AS 110, variable returns are seen more broadly, and
    will include exposure to loss or expenses from providing funds, donation,
    credit or liquidity support and intangible benefits on reputation and image
    from good governance practices. By hand-picking the members of the governing
    body of the NFP, the sponsor of the NFP ensures that it has power over the NFP
    either explicitly or implicitly. Using these powers, the sponsoring company
    ensures that the NFP undertakes the desirable CSR activity, which meets its compliance
    and other needs.

 

Ind AS 110 does not apply to
post-employment benefit plans or other long-term employee benefit plans to
which Ind AS 19, Employee Benefits, applies. However, there are no such
exemptions for NFPs. Moreover, the accounting for long term employee benefit
plans under Ind AS 19 effectively recognises the net assets and liabilities of
the Trust, i.e., the net defined benefit liability (asset) is determined after
taking into account the fair value of the plan assets and the relevant disclosures
are included in the separate financial statements and CFS of the company.

 

The NFP is controlled by the
sponsoring company for its own benefit and is not specifically exempted from
preparing CFS. Hence, an NFP should be consolidated.

 

  • CSR activities prior to the Companies Act, 2013 were undertaken
    voluntarily. After the Companies Act, 2013, it has also become a
    quasi-mandatory requirement. If a company does not spend on CSR, as required by
    the Companies Act, 2013 it has to make appropriate disclosures in the
    Director’s report. There are numerous activities a company has to undertake for
    the purposes of complying with the various laws of the land. The cost of all
    such compliance activities are included in the separate and consolidated
    financial statements (CFS). Since CSR is a cost incurred to conduct business in
    the country as required by legislation, it should be included and consolidated
    in the financial statements. The NFP is merely an extension of the Company
    created to ensure compliance with the Companies Act, 2013. A company that
    undertakes CSR activities directly would have in any case included the CSR
    spend in its separate financial statements and CFS. Whether the CSR activities
    are under taken directly or through a trust, society or company, the outcome
    with respect to financial statements should be the same.

 

  • Even in cases, where the CSR activity is not linked to compliance
    but is undertaken for altruistic purposes, consolidation will still be
    required. This is because in such cases, for reasons already described above,
    the company has an exposure to variable returns in the form exposure to loss
    from funding or providing liquidity support for running the CSR entity. In
    addition, there will be intangible returns by way of enhancement or damage to
    reputation and image.

 

Conclusion

The
author believes that the NFP created for CSR activities should be consolidated
in accordance with the requirements of Ind AS.

EXTERNAL AUTHORITY FOR DISCIPLINARY ACTION AGAINST AUDITORS

1.  Introduction 

 

At present the Council of the Institute of
Chartered Accountants of India (ICAI) has power to ensure that its members
maintain discipline while discharging their professional and other duties.
Sections 21, 21A to 21D of the Chartered Accounts Act (CA Act) provide for
mechanism for conducting Disciplinary proceedings and for awarding punishment
to erring members of ICAI. Sections 22,22A to 22G of CA Act provide for filing
appeals before the Appellate Authority appointed u/s. 22. The First schedule to
the CA Act gives a list of Professional Misconduct by members in their dealings
with other members of ICAI or with the Institute. The Second Schedule to the
Act gives a list of Professional Misconduct by members in practice in their
dealings with their clients.  Section 132
of the Companies Act, 2013 (Act), which has now come into force provides for
constitution of a “National Financial Reporting Authority” (NFRA). By a
Notification dated 21.03.2018 the Central Government has notified the
constitution of NFRA. U/s. 132 of the Act, NFRA is authorised to recommend to
the Central Government to notify Accounting and Auditing Standards as well as
to take disciplinary action against Auditors of some specified companies and
bodies corporate. This action can be taken against the Firms of Auditors as
well as against partners of the Firm. Thus an External Authority is now set up
to take disciplinary action against Auditors of specified entities.  The existing powers of the Council of ICAI to
take disciplinary action against such Auditors is now taken away and entrusted
to the NFRA.  However, ICAI will continue
to have powers regarding disciplinary matters in cases of Auditors of entities
other than specified entities.

 

The National Financial Reporting Authority Rules,
2018, have been notified on 13th November, 2018. These Rules have
come into force on 14th November, 2018.  Significant changes have been made by section
132 of the Companies Act, 2013 and the above Rules in the matter of
disciplinary action against Auditors. In this article some of the important
provisions relating to disciplinary action that can be taken against Auditors
of specified entities by NFRA are discussed.

 

 

 

2.   CONSTITUTION
OF NFRA

 

(i)    Section
132(3) of the Act provides that NFRA shall consist of a  Chairperson, who shall be a person of
eminence and having expertise in accountancy, auditing, finance or law and such
other members, not exceeding 15, consisting of part-time and full-time members
as may be prescribed.

 

(ii)    NFRA
(Manner of Appointment and other Terms and Conditions of Service of Chairperson
and Members) Rules, 2018 notified on 21.03.2018 provide for various matters
relating to appointment, service conditions of Members of NFRA and other
matters. According to these Rules the Central Government has to appoint a
Chairperson, Three Full-Time Members and Nine Part-Time Members of NFRA. The
Rules provide for their qualifications, service conditions and other matters.

 

3.   THE
POWERS OF NFRA

 

The powers which NFRA can exercise are listed in
section 132(4) as under:-

 

(i)    Power
to investigate, either on its own or on a reference  made by the Central Government, in case of
such class of  bodies  corporate or persons, as may be prescribed,
into the matters  of professional or
other misconduct committed by a  Chartered
Accountant or a Firm of Chartered Accountants. Once NFRA initiates this
investigation, ICAI or any other body will have no authority to initiate or
continue any proceedings in such matters of misconduct.

 

(ii)    NFRA
shall have the same powers as vested in a Civil Court under Code of Civil
Procedure, 1908. In other words, it can issue summons, enforce attendance,
inspect books and other records, examine witnesses etc.

 

(iii)   If
any professional or other misconduct is proved, NFRA can impose penalty as
under:

u
In the case of an individual CA, minimum penalty of Rs.1 lakh which may extend
to 5 times of the fees received by the individual.

u
In the case of a C.A. Firm, minimum penalty of Rs. 5 lakh which may extend to
10 times the fees received by the Firm.

u
NFRA can debar any Chartered Accountant or a CA Firm from practice for a
minimum period of six months or for such higher period not exceeding 10 years.

 

(iv)   Any
person / firm aggrieved by any order of NFRA can file appeal before the
National Company Law Appellate Tribunal. This appeal can be made in such manner
and on payment of such fees as may be prescribed.

 

(v)   The
above provisions of section 132 will override any provisions contained in any
other statute. This will mean that the Council of ICAI will not be able to
exercise its powers relating to disciplinary action against auditors of
specified entities. Even powers to formulate accounting and auditing standards,
ensure quality of audit etc., are now vested in NFRA.  To this extent the autonomy conferred on ICAI
under the C.A.  Act, 1949, is partially
taken away.

 

(vi)   By a
Notification dated 13th November, 2018, the Central Government has
issued the “National Financial Reporting Authority Rules, 2018” (NFRA Rules).
These Rules specify the class of companies and bodies corporate governed by
NFRA for taking disciplinary action against Auditors of these entities, the
functions and duties of NFRA and other related matters. The provisions of these
Rules are discussed below.

 

4.   CLASS OF
ENTITIES GOVERNED BY NFRA – (RULE 3)

 

(i)    Rule 3
of NFRA Rules gives power to NFRA to (a) monitor and enforce compliance with
the  Accounting and Auditing Standards,
(b) Oversee the quality of Service of the Auditor u/s. 132 (2), and (c)
Undertake investigation u/s. 132 (4) of Auditors of the following class of
Companies and Bodies Corporate (Specified Entities).

 

(a)   All
Companies which are listed on Stock Exchanges in India or outside India.

 

(b)   Unlisted
Public Companies having (i) paid-up capital of Rs. 500 crore or more, (ii)  Turnover of Rs.1,000 crore, or more, or (iii)
Aggregate outstanding Loans, Debentures and Deposits of Rs. 500 crore or more
as at 31st March of the immediately preceding Financial Year.

 

(c)   Insurance
Companies, Banking Companies, Companies engaged in Generation or Supply of
Electricity and Companies Governed by any Special Act or Bodies Corporate
incorporated by any Act in accordance with the provisions of section 1(4)(b) to
(f) of the Act.

 

(d)   Any
Body Corporate or Company or person or any class of Bodies Corporate or
Companies or persons, on reference made to NFRA by the Central Government in
Public Interest. It may be noted that section 3 of the Limited Liability
Partnership Act, 2008 provides that an LLP registered under that Act is a Body
Corporate. Therefore, it appears that Auditors of any LLP, irrespective of its
capital, turnover or borrowings, will now be governed by the NFRA Rules if such
a case is referred to NFRA by the Government. Apparently, this does not appear
to be the intention of these Rules. We will have to wait for some clarification
from the Central Government in respect of this matter.

 

(e)   A Body
Corporate incorporated or registered outside India which is a Subsidiary or
Associate Company of an Indian Company or a Body Corporate referred to in (a)
to (d) above, if the income or net worth of such subsidiary or Associate
Company exceeds 20% of the consolidated income or net worth of such Indian Company
or Body Corporate referred to in (a) to (d) above.

 

(ii)    Auditors
of the above companies and bodies corporate have to file a return in the
prescribed form with NFRA on or before 30th April of every year
under Rule 5.

 

(iii)   A
Company or a Body Corporate, other than a Company Governed under this  Rule, shall continue to be governed by NFRA
for a period  of 3 years after it ceases
to be listed or its paid-up capital, turnover, or aggregate borrowing falls
below the limits stated in (i) (b) above.

 

5.   REPORTING
OF AUDITORS APPOINTMENT

 

The above Rule provides for reporting about
Auditors’ particulars by a Body Corporate as under:

 

(i)    Every
existing Body Corporate, other than a Company Governed by this Rule, has to
inform NFRA, within 30 days (i.e. on or before 14th December, 2018),
particulars of Auditor holding office on 14th November, 2018 in Form
NFRA-1.

 

(ii)    Every
Body Corporate, other than a Company governed by this Rule shall, within 15
days of the appointment of its Auditor u/s. 139(1), inform NFRA about the
particulars of its Auditor in Form NFRA-1.

 

(iii)   Every
Body Corporate incorporated or registered outside India (as referred to in Para
4(i) (e) above) has also to file the particulars of its Auditors in Form NFRA
-1 within the above time limit.

 

It may be noted that if the NFRA Rules apply to an
LLP, irrespective of its capital, turnover or borrowings, all small and big
LLPs will have to file particulars of their existing Auditors on or before
14.12.2018 in Form NFRA-1.  This is going
to be a difficult task for an LLP.
Similarly, a Foreign Body Corporate to which Rule 3 is applicable will
have to file Form NFRA-1 within the above time limit. The above Rule states
that particulars of Auditors appointed u/s. 139(1) of the Act are to be given.
It may be noted that section 139(1) refers to appointment of Auditors of
Companies registered under the Companies Act, 2013. It does not refer to
appointment of Auditors by a Body Corporate.
Further, Form NFRA-1 requires the Body Corporate to state whether the
Auditor’s appointment is within the limit of 20 Audits provided in section
141(3)(g) of the Act. This limit applies to 20 Audits of Companies and not to
Bodies Corporate. To this extent, compliance with the reporting requirements of
Rule 3(3) will become difficult. It is difficult to understand why such onerous
duty is cast on all Bodies Corporate including LLP and Foreign Bodies
Corporate.  Further, the time limit of
one month from the publication of Rules is too short as most of the bodies
corporate may not be aware of this requirement. It is not understood as to what
public interest is going to be served by bringing the Auditors of all LLPs
under NFRA when Auditors of all Private Companies and most of the Public
Unlisted Companies are kept outside the purview of NFRA.

 

6.   FUNCTIONS
AND DUTIES OF NFRA (RULE 4)

 

Section 132 (2) of the Act read with Rule 4 of
NFRA Rules provides for functions and duties of NFRA as under:

 

(i)    NFRA
shall protect the public interest and interest of investors, creditors and
others associated with Companies and Bodies Corporate, listed under Para 4(i)
(a) to (f) above, by establishing high quality standards of accounting and
auditing.

 

(ii)    NFRA
will exercise effective oversight of accounting functions performed by the
above companies and bodies corporate and auditing functions performed by the
Auditors of the above entities.

 

(iii)   Maintain
particulars of Auditors appointed by the above companies and bodies corporate.

 

(iv)   Recommend
Accounting Standards and Auditing Standards for approval by the Central
Government.  For this purpose NFRA shall
receive from ICAI recommendations for modification of existing accounting and
auditing standards or for issue of new standards before making recommendations
to the Central Government.

 

(v)   Monitor
and enforce compliance with the Accounting and Auditing Standards notified by
the Central Government.

 

(vi)   Oversee
the quality of service of Auditors associated with ensuring compliance with the
above standards and suggest measures for improvement in the quality of service.

 

(vii)  Promote
awareness in relation to the compliance of the Accounting and Auditing   standards. For this purpose it may
co-operate with National and International Organisations of Independent Audit
Regulators to establish and oversee adherence to these standards.

 

(viii) Perform
such other functions and duties as may be necessary or incidental to the above
functions and duties.

 

(ix)   Discharge
such functions as may be entrusted by the Central Government by Notification.

 

7.   MONITORING
AND ENFORCING COMPLIANCE WITH ACCOUNTING STANDARD (RULE 7)

 

For discharging this function, NFRA has the
following powers:

 

(i)    It may
review the Financial Statements of the above specified entities and may issue a
notice to such Entity or its Auditor to provide further information or
explanation.  It may also call for
production of the relevant documents for inspection.

 

(ii)    It
may require personal presence of the officers of the Entity or its Auditor for
seeking additional information or explanation.

 

(iii)   It
shall publish its findings relating to non-compliance by any such entity on its
website or in such other manner as it considers fit.

 

(iv)   If, in
a particular case, NFRA finds that any Accounting Standard is not followed, it
can decide on the further course of investigation.

 

 

 

8.   MONITORING
AND ENFORCING COMPLIANCE WITH AUDITING STANDARDS (RULE 8)

 

For discharging the above function, NFRA has the
following powers relating to the Auditors of the specified entitie:

 

(i)    To
review the working papers of Auditors, including the Audit Plan and other Audit
Documents as well as any communication relating to the Audit.

 

(ii)    To
evaluate the sufficiency of the quality control system of the Auditor and the
manner of documentation of the system by the Auditor.

 

(iii)   To
perform such other testing of the audit, supervisory and quality control
procedures of the Auditor as may be considered necessary or appropriate.

 

(iv)   It may
require the Auditor to report on its governance practices and internal
processes designed to promote audit quality, protect its reputation and reduce
risks, including risk of failure of the Auditor.  It may take such action on this report as may
be necessary.

 

(v)   NFRA
can require the Auditor to appear before it personally and obtain from him
additional information or explanation in connection with the conduct of the
Audit.

 

(vi)   NFRA
shall publish its findings relating to non-compliance with the Auditing
Standards on its website or in such manner as it considers fit.  In respect of proprietary or confidential
information, such publication will not be made but the same may be reported to
the Central Government.

 

(vii)  In a
case where NFRA finds that any law or professional or other standard has been
violated by the Auditor, it may decide to conduct further investigation and
take action against the Auditor.

 

9.   OVERSEEING
THE QUALITY OF SERVICE BY THE AUDITOR (RULE 9)

 

(i)    On the
basis of the review made by NFRA, as stated above, it can direct the Auditor to
take measures for improvement of audit quality. This may include suggestions to
change the audit process, quality control and audit reports.  It may also specify a detailed plan with time
limits.

 

(ii)    It
shall be the duty of the Auditor to make the required improvements and send a
report to NFRA explaining as to how he has complied with the directions of
NFRA.

 

(iii)   NFRA
shall monitor the improvements made by the Auditor and take such further
action, depending on the progress made by the Auditor, as it thinks fit.

 

(iv)   NFRA
may refer, with regard to overseeing the quality of Auditors of the specified
entities, to the Quality Review Board (QRB) of ICAI and call for a report or
information in respect of such Auditors from QRB as it may deem appropriate.

 

10. INVESTIGATION
ABOUT PROFESSIONAL OR OTHER MISCONDUCT (RULE 10)

 

(i)    NFRA
has power to investigate in the following circumstances.

 

(a)   Where
any reference is received from the Central Government for investigation into
any matter of professional or other misconduct u/s. 132(4) as stated in Para 3
above.

 

(b)   Where
NFRA decides to undertake investigation into any matter on the basis of its
compliance or oversight activities.

 

(c)   Where
NFRA decides to undertake investigation suo motu in any matter of
professional or other misconduct by the Auditor of the specified entities

 

(ii)    If
during the investigation, NFRA finds that any of the specified entities has not
complied with the Act or the Rules or which involves fraud amounting to Rs. 1
crore or more, it shall repot its finding to the Central Government.

 

(iii)   On or
after 14th November, 2018, the action in respect of cases of
professional or other misconduct against the Auditors of specified entities
shall be initiated by NFRA only.  No
other Institute or Body can initiate such action against the Auditor. Further,
no other Institute or Body shall initiate or continue any proceedings in such
cases where NFRA has initiated an investigation as stated above. This will mean
that if any case against the Auditor of a specified entity is pending before
ICAI on  14.11.2018, the same will have
to be transferred to NFRA if NFRA decides to investigate in the same matter.

 

(iv)   The
action in respect of cases of professional or other misconduct against Auditors
of companies and other entities (other than the specified entities) shall
continue to be investigated by ICAI as provided in the CA  Act.

 

(v)   For the
above purpose Explanation below section 132(4) provides that the expression
“Professional or other Misconduct” shall have the same meaning as assigned to
it u/s. 22 of the Chartered Accountants Act. Therefore, NFRA will have to
decide  such cases of misconduct as
provided in section 22 and the First and Second Schedules of the C.A. Act.

 

(vi)   It may
be noted that Rule 10 provides that NFRA shall initiate investigation against
the Auditors of specified entities u/s. 132(4) on a reference being made by the
Central Government.  There is no provision
for investigation by NRFA on the basis of a compliant by a shareholder,
creditor or any other person who has a grievance against Auditors of the
specified entities.  It is, therefore,
presumed that such complaints by shareholders, creditors etc., will have to be
investigated by ICAI under its Disciplinary Jurisdiction.

 

11. DISCIPLINARY
PROCEEDINGS (RULES 11 AND 12)

 

The procedure for conducting Disciplinary
Proceedings by NFRA against Auditors of specified entities is given in Rule 11
and 12.  Briefly stated, this procedure
is as under:

 

(i)    NFRA
can start disciplinary proceedings against Auditors of specified entities on
the basis of (a) a reference received from the Central Government, (b) finding
of its Monitoring, enforcement or oversight activities, or (c) material
otherwise available on record. If NFRA believes that sufficient cause exists to
take action against the Auditors u/s. 132(4), it shall refer the matter to its
concerned Division dealing with Disciplinary matters. This Division will then
issue show-cause notice to the Auditors.

 

(ii)    Rule
11(2) and 11(3) specifies the various matters which will be stated in the
show-cause notice. Copies of documents relied upon by NFRA and extracts of
relevant portions from the Report of the Investigation and other records are to
be enclosed with the show-cause notice.
The procedure for service of show-cause notice is given in Rule 11(4).

 

(iii)   Rule
11(5) states that the concerned Division shall dispose of the show-cause notice
within 90 days of the assignment through a summary procedure as may be
specified by NFRA. The concerned Division will pass a reasoned order in
adherence to the principles of natural justice.
For this purpose, where necessary or appropriate, opportunity of being
heard in person will be given. The concerned Division will also take into
consideration the submissions made by the Auditors and the relevant facts and
circumstances and material on record before passing the order. There is no
clarity whether the hearing will be given by a Bench of the members of NFRA and
whether the above order will be passed by such Bench. Again, it is not clear as
to how many members of NFRA will constitute such Bench.

 

(iv)   The
above order passed by the concerned Division of NFRA shall specify that (a) No
further action is to be taken against the Auditors, (b) Caution the Auditors,
or (c) Punishment by levy of penalty and/or debarring the Auditors from
practice is awarded as specified in section 132(4). Such Penalty may be as
stated in Para 3(iii) above.  The above
order shall not become effective for a period of 30 days from the date of issue
or for such other period as the order may specify for the reasons given in the
order.

 

v)    The
above order has to be served on the Auditors and copies of the order have to be
sent by NFRA to (a) the Central
Government, (b) ICAI, (c) C & AG (if the case relates to Auditors of
a  Government Company), (d) SEBI (if the
case relates to Auditors of a listed Company), (e) RBI (if the case relates to
Auditors of a Bank or NBFC), (f) IRDA (if the case relates to Auditors of an
Insurance Company), (g) Concerned regulator in
a foreign country (if the case relates to  a Non-Resident Auditor).  Further this order is to be published on the
Website of NFRA.

 

(vi)   If the
above order imposes a monetary penalty on the Auditors the same is to be
deposited within 30 days of the date of the order. If appeal is filed against
the above order by the Auditor, he has to deposit 10% of the amount of the
penalty with the Appellate Tribunal. If within 30 days of the above order the
Auditor does not pay the penalty nor file appeal against the order, NFRA,
without prejudice to any other action, will inform the Company / Body Corporate
of which he was the Auditor. Upon receipt of such intimation the Company / Body
Corporate shall remove such Auditor in default and appoint any other Auditor in
accordance with the provisions of the Act.

 

(vii)  If the
order imposes a penalty on the Auditor or debars the Auditor from practice,
NFRA will send copies of such order to all Companies / Bodies Corporate in
which the Auditor is functioning as Auditor. On receipt of such information,
all such Companies / Bodies Corporate shall remove that Auditor from his
position as Auditor and appoint another Auditor in accordance with the
provisions of the Act.

 

(viii) In all
the above cases where the order of NFRA is stayed or where penalty is to be
paid, the time limit of 30 days is from the date of the order. Since the time
given u/s. 421 for filing appeal to the Appellate Tribunal is 45 days from the
date of service of the order, Rule 11 and 12 should have given time to the
Auditor of 45 days for payment of penalty from the date of service of the order
of NFRA. Further, as stated in  (vi) and
(vii) above, Rule 12 provides for intimation to be given to the specified
companies or bodies corporate about the order of NFRA awarding punishment by
way penalty or debarring  the Auditor
from practice so that he is removed from his office as auditor in that company
/ body corporate. In the interest of justice, such intimation should not be
given by NFRA if the appeal filed by the Auditor before judicial authorities is
pending. Again, it may so happen that the action is taken by NFRA for
professional or other misconduct by an Individual who is one of the partners of
a Firm of Chartered Accountants. In such a case if the penalty is levied in the
case of that Individual or he is debarred from practice, the Firm of Chartered
Accounts which is the Auditor of the company / body Corporate should not be removed
from its office as Auditor of that company / body corporate. The provision in
Rule 12 to remove the Auditor from his position as Auditor of a company / body
corporate in a case where only penalty is levied by NFRA is very harsh and
needs to be modified.

 

 

12. OTHER
MATTERS

 

(i)    Rule
13 provides that if any company or any officer of the company or an Auditor or
any other person contravenes any of the provisions of these Rules, such
company, its officer, Auditor or other person in default shall be punishable
under the provisions of section 450 of the Act. This section provides for levy
of Fine on the defaulting company, officer, Auditor or other person of an
amount upto Rs.10,000 and in case of continuing default, of a further Fine
which may extend to Rs.1,000 per day when the default continues. 

 

(ii)    Rules
14 to 19 provide for various matters such as (a) Role of the Chairperson and
full-time members of NFRA, (b) Constitution of advisory committees, study
groups, task force, (c) Measures to be taken for the promotion of awareness and
significance of Accounting and Auditing Standards, Auditor’s Responsibilities,
Audit Quality and such other matters through education, training, seminars,
workshops, conferences, publicity etc., (d) Maintenance of   confidentiality  and security of information, (e) Avoidance of
conflict of interest and (f) Association with International Associations and
securing International Assistance.

 

13. TO SUM UP

 

(i)    NFRA
is established as an External Authority for taking Disciplinary Action against
Auditors by section 132 of the Companies Act, 2013. There was some resistance
by the CA profession and, therefore, this section was not brought into force
when the Companies Act, 2013 came into force on 1.4.2014. Section 132(3) and
(11) was brought into force on 21.03.2018. Section 132(1) and (12) came into
force on 01.10.2018 and section 132(2), (4), (5), (10) (13) (14) and (15) came
into force on 24.10.2018.  S/s. (6) to
(9) were deleted w.e.f.  9.2.2018.

 

(ii)    The
justification for creating such External Authority (NFRA) is given by the
Committee of Experts, appointed by the Ministry of Corporate Affairs, in their
Report dated 25.10.2018. In this Report they have stated as under:



“In the aftermath of Enron, the U.S. enacted
the Sarbanes Oxley Act, 2002. The Supreme Court in its judgment dated February
23, 2018 has referred to this statute to examine the need of an oversight
mechanism for the audit profession. This law inter alia provided for the
setting up of the Public Company Accounting Oversight Board (PCAOB) as an
independent audit regulator to oversee the audits of public companies.
Similarly, U.K. also has a two-tier structure, where the Financial Reporting
Council (FRC) is the independent regulator for the audit profession.

 

In the Indian context, the Satyam incident has
been a wake-up call for policy-makers. Pursuant to the global trend of shift
from Self-Regulatory Organisation (SRO) model to an independent regulatory
model for the audit profession, the Companies Act, 2013 provided for the setting
up of the National Financial Report Authority (NFRA).

 

However, the continued opposition to the
establishment of NFRA has delayed the implementation of this critical reform.
Consequently, although the Companies Act, 2013 was enacted in August 2013, the
section establishing NFRA was notified
only on March 21, 2018 along with the NFRA Chairperson and Members’
Appointment Rules, 2018. Once NFRA becomes fully operational, it will be
adequately equipped to handle the contemporary challenges in relation to
auditors, audit firms and networks operating in India.”

 

(iii)   Reading
the provisions of section 132 of the Act and the above NFRA Rules framed by the
Central Government, it is evident that the autonomy of ICAI to issue Accounting
and Auditing Standards and taking disciplinary action in cases of erring
members is now curtailed. The function of ICAI will be restricted to only
recommending changes in the existing Accounting and Auditing Standards or
Suggesting new Standards. Whether to issue such Standards or not or in which
form they should be issued will be decided by NFRA and the Central Government.
Even the function of monitoring, enforcing, compliance, overseeing quality of
service  rendered by the CA profession,
suggesting measures for improvement in quality of professional service,
promoting awareness in relation to the compliance of Accounting and Auditing
Standards which was hitherto in the domain of ICAI, has been transferred to
NFRA.  Disciplinary jurisdiction which
was hitherto within the domain of ICAI has now been curtailed because NFRA is
now entrusted with the task of taking disciplinary action against the Auditors
of all listed companies, large unlisted Public Companies, Banks, Insurance
Companies Electricity Companies and Bodies Corporate. These provisions will
reduce the importance of ICAI as it is now left with the task of giving
education to students of CA Courses, conducting examinations and awarding
membership and Certificate of Practice to those who have passed the
examinations.  Even the measures to be
taken for the promotion of awareness and significance of Accounting and
Auditing Standards, Auditors Responsibilities, Audit Quality and  such other matters through education,
training, Seminars, Workshops, Conferences and Publicity which were in the
exclusive  domain of ICAI, its Regional
Councils and Branches will now come under the domain of NFRA under Rule 16.

 

(iv)   From
the above analysis of the provisions of section
132 of the Act and NFRA Rules it is evident that Auditors of the specified  companies and bodies corporate will have to
be more vigilant  while rendering their
professional services to these entities. Some questions of interpretations will
arise during the course of implementation of these Rules.  Therefore, it is necessary that a strong
representation is made for modification of these Rules in respect of the
following matters:

 

(a)   In Rule
3 it should be clarified that the expression “Body Corporate” shall not include
LLP. In fact no public interest is involved in the case of an LLP and,
therefore, Auditor of LLP should not be brought within the supervision of NFRA.

 

b)    In Rule
3(2) it is provided that every existing body corporate should file Form NFRA-1
giving details of its Auditors within 30 days of publication of these Rules.
This time limit is too short and it should be extended up to 90 days from the
date of publication of the Rules (i.e. up to 14.02.2019).

 

(c)   In Rule
10 it is necessary to clarify that the Investigation by NFRA about the
misconduct of the Auditors of any specified entity shall be only in respect of
their conduct relating to statutory audit of the entity. In this Rule the
expression used is “Professional or Other Misconduct”, which is very wide. It
includes conduct of an Auditor in his personal life as well as  his conduct while rendering professional
services other than the Audit Service.

 

(d)   In Rule
10 it is stated that the NFRA will start investigation against the Auditor of
specified entities on a reference being made by the Central Government or on its
own on the basis of the available records. It is essential that this Rule
should provide that any shareholder of a specified company or its creditor or
any other person can approach NFRA if there is a complaint against the Auditor
of a specified entity.

 

(e)   In
Rules 11 and 12, for the reasons stated in Para 11 (viii) above, the period of
30 days should be increased to 45 days. Further, information about the order
passed by NFRA should not be given to specified entities if the Auditor has
filed appeal against the order of NFRA and the judicial proceedings are
pending.

 

(f)    As
stated in Para 11(viii) above, if the order passed by NFRA is against the
conduct of an Individual who is a Partner of the Audit Firm and no punishment
is awarded to the Firm, the disqualification as auditor of the specified entity
should not extend to the Firm.

 

(g)   Rule 11
deals with Disciplinary Proceedings to be followed by NFRA or making inquiry
against the Auditor of a specified entity. There is no clarity as to who will
give hearing to such Auditor. It is necessary to clarify that such hearing will
be given by a Bench of two or three Members of NFRA.  It is also necessary to clarify that any
Authorised person or Advocate will be allowed to assist such Auditor at the
time of hearing.

 

(v)          Establishment of NFRA with such wide
powers is a new experiment in India. As these provisions will have retroactive
application, in as much as matters relating to earlier years may also be
referred to NFRA, let us hope that NFRA takes into consideration the
limitations within which the Auditors have to discharge their Audit function
and adopts a sympathetic view while dealing with the disciplinary cases against
such Auditors.

Acquisition date v Appointed date

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Acquisition
date v Appointed date

In India, merger and acquisition schemes that require a court/ tribunal
approval will have an appointed date, mentioned in the scheme, which is the
date from which the merger and acquisition is accounted.  The scheme becomes effective when the court
order is passed and the order is filed with the Registrar of Companies.  The appointed date is a very important date,
since from an income-tax legislation perspective, that is the date when the
amalgamation or acquisition accounting is done and the carry forward of any
business losses is allowed to the transferee.

The Indian GAAP accounting standards were also aligned to this
concept.  AS-14, Accounting for Amalgamations, itself did not expressly contain any
discussion around the difference between the appointed date and effective
date.  However, an EAC opinion required
the accounting of the combination from the appointed date mentioned in the
court scheme, once the court approval was received.  From an income-tax perspective, the company
would need to file revised returns to reflect the combination from the
appointed date.

With the introduction of Ind AS, the Indian GAAP position is no longer
valid for companies that apply Ind AS. 
As per paragraph 8 of Ind AS 103 Business
Combinations, the acquirer shall identify the acquisition date, which is
the date on which it obtains control of the acquiree.

An investor controls an investee when it is exposed, or has rights, to
variable returns from its involvement with the investee and has the ability to
affect those returns through its power over the investee.  An investor shall consider all facts and
circumstances when assessing whether it controls an investee and the date of
obtaining control.

The date on which the acquirer
obtains control of the acquiree is generally the date on which the acquirer
legally transfers the consideration, acquires the assets and assumes the liabilities
of the acquiree—the closing date. However, the acquirer might obtain
control on a date that is either earlier or later than the closing date. For
example, the acquisition date precedes the closing date if a written agreement
provides that the acquirer obtains control of the acquiree on a date before the
closing date.  An acquirer shall consider
all pertinent facts and circumstances in identifying the acquisition date.

Determination of acquisition date
under Ind AS may not always be straight-forward, particularly in a transaction
that involves a court scheme.  Such court
schemes may involve common control transactions involving entities under common
control or acquisition that involves independent or non-related parties.  Careful analysis of the facts and
circumstances and judgement would be necessary to determine the date of
acquisition.

When an independent party is
acquired, determining the acquisition date is important because at that date
the assets and liabilities are fair valued and goodwill and minority interest
is determined.  From the acquisition date
the acquired entity results are included in the financial statements of the
acquirer.

Business combinations
involving entities or businesses under common control shall be accounted for
using the pooling of interests method. The pooling of interest method is carried
out as follows:

i.  The
assets and liabilities of the combining entities are reflected at their
carrying amounts.
 ii. No
adjustments are made to reflect fair values, or recognise any new assets or liabilities.
The only adjustments that are made are to harmonise accounting policies.   

iii. The
financial information in the financial statements in respect of prior periods
should be restated as if the business combination had occurred from the
beginning of the preceding period in the financial statements, irrespective of
the actual date of the combination.

When a business
combination is effected after the balance sheet but before the approval of the
financial statements for issue by either party to the business combination,
disclosure is made in accordance with Ind AS 10 Events after the Reporting
Period, but the business combination is not incorporated in the financial
statements.

 From an Ind AS perspective,
the business combination date in a common control transaction determines two
things:

i.      The
year in which the combination is accounted. 
Therefore, assuming the combination date is financial year 17-18, the
accounting will be done in the financial year 17-18.  However, the financial information for the
financial year 16-17, will be restated as if the business combination had
occurred from the beginning of the financial year 16-17.
 ii.      
If
the business combination date falls after the balance sheet but before the
approval of the financial statements for issue by either party to the business
combination, disclosure is made in accordance with Ind AS 10 Events after
the Reporting Period, but the business combination is not incorporated in
the financial statements.

Agreements or court schemes may
provide a retrospective date of business combination.  Irrespective of such date, the date for
business combination under Ind AS 103 is the date on which the control is
actually obtained.  This may or may not
correspond to the date specified in the agreement or the appointed date in a
court scheme.

Some business
combinations cannot be finalized without a regulatory approval or a court
approval.  An investor controls an investee when it is exposed,
or has rights, to variable returns from its involvement with the investee and
has the ability to affect those returns through its power over the
investee.  It is necessary to consider
the nature of regulatory approval in each case, to determine the date when
control is passed.

 To illustrate, consider a business
combination involving three telecom companies, under a court scheme.  Though the court may approve the scheme, it
does not become effective till the transaction is approved by the Department of
Telecom (DOT)/ TRAI and the Competition Commission and the final order is filed
with ROC.  In this scenario, the last of
the date of final approval from DOT/ TRAI and the Competition Commission may be
the acquisition date.  Consider another business
combination, involving entities under common control.  Essentially two 100% subsidiaries of the
parent are merging to form one company. 
The shareholder of the companies, which is the parent company, has
approved the merger in the annual general meetings.  There are no creditors and no minority
shareholders.  No approval is required of
the Competition Commission or any other regulator, and there are no
complexities in the transaction. 
Essentially in such circumstances, the court order may be deemed to be a
formality, and the date of shareholders resolution approving the combination
may be the date of business combination. 

In a transaction between two
independent parties, the date the control passes is the date when the
unconditional offer is accepted.  When
the agreement is subject to substantive preconditions, the date of acquisition
will be the date when the last of the substantive precondition is fulfilled.

The Madras High Court by way of its
order dated 6 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.

The two examples below explain how
the requirements of Ind AS and the court scheme can be aligned.

Acquisition of an
Independent Party

 Company
A (Acquisitive) wants to acquire Company B (Willing).  Acquisitive and Willing are involved in
running some business.  The acquisition
requires several important formalities to be completed including the approval
of the court.  One of the pre-condition
of the acquisition is the completion of all formalities and the receipt of
court approval.  Acquisitive follows
the financial year.  Acquisitive and
Willing enter into a binding agreement (subject to the above pre-condition) on
1 April 2016.  The appointed date
mentioned in the court scheme is 1 April 2016.  The formalities and the final court approval
for Willing to be subsumed in Acquisitive are received on 1 September 2016.

 Under
Ind AS 103, the acquisition date is 1 September 2016.  This is the date when Acquisitive will do a
fair value accounting and determine goodwill and minority interest.  Acquisitive will fair value the assets and
liabilities of Willing at 1 September 2016. 
Legally, for normal income tax computation, Acquisitive will consider
the profits of Willing for the full financial year 16-17.  However, in Ind AS financial statements,
Acquisitive will not account for Willings profits from 1 April 2016 to 31
August 2016 as its own profits; rather the profits for that period would
increase the fair value of net assets of Willings and reduce the amount of goodwill
recognized by Acquisitive.

 In
order to comply with the requirements of Ind AS, Acquisitive may consider the
following two options:

  •  Acquisitive
    relies on the Madras High Court judgement in Equitas.  Consequently, the
    appointed date and the effective date could be set out in the court scheme,
    as the date when the court passes the final order approving the acquisition,
    1 September 2016. The appointed date cannot be 1 April, 2016, because it
    would not be in compliance with Ind AS.
  •  Appointed
    date for tax purposes and tax financial statements can be 1 April 2016.
    However, the scheme should clearly provide that for accounting purposes in
    Ind AS financial statements, date determined under Ind AS 103 will be used.  In this fact pattern, the said date would
    be 1 September, 2016.  Some legal
    luminaries have opined that it is possible to follow this path and that the
    courts have an unfettered power to do so.

The
author believes that in general, the first alternative should be preferred as
it ensures consistency between tax and accounting treatment. Also, there will
be no need to file revised tax return for past periods or maintain two set of
financial statements, one for tax purposes and another for Ind AS purposes.

It
may be noted that for MAT purposes, the financial statements are required to
be in compliance with accounting standards. 
Therefore, for MAT purposes the financial statements should be
prepared with 1 September 2016 as the date of acquisition.  In other words, the Ind AS compliant
financial statements will be the relevant financial statements for the
purposes of MAT.  From an income tax
computation perspective for the carry forward of losses or acquisition
accounting, the tax financial statements prepared with an appointed date 1
April, 2016 may be acceptable. 

For
normal income tax computation purposes, legal merger is from 1 April 2016.
Profits from 1 April 16 to 31 August 16 has to be offered to tax in hands of Acquisitive
even though it reflects as goodwill in Acquisitives’ Ind AS financial
statements. Specific provisions of the Income tax Act will govern tax
treatment of items like tax WDV of assets, allowance of certain expenses on
actual payment basis, disallowance for TDS default, etc. Transition of
business loss/unabsorbed depreciation will be of amounts as determined till
31 March 16. Normal income tax computation is generally not impacted by
accounting treatment in Ind AS financial statements.

However,
if the court scheme contains any unusual adjustments that are not consistent
with tax policies, those may not be acceptable.  For example, if the court scheme allows
derivative profits to be recognized by Acquisitive directly into reserves in
the tax financial statements, and the auditor has modified the audit report,
the derivative profits will be taxable under income-tax laws.

Business Combination
between Common Control Entities

 Company
A (Acquisitive) and Company B (Willing) are in the business of manufacturing
and selling cement.  Both Acquisitive
and Willing have a common parent.  The combination
of Acquisitive and Willing requires several important formalities to be
completed such as approval from the competition commission, clearance from
minority shareholders and creditors, other regulatory approvals, and the
final approval of the court. 
Acquisitive follows the financial year.  Acquisitive and Willing enter into a
binding agreement on 1 April 2016, subject to completion of all
formalities.  A resolution has been
passed by shareholders of both the companies, prior to that date, for
approving the transaction.  The
appointed date mentioned in the court scheme is 1 April 2016.  The formalities are completed and the final
court approval is received on 1 April 2017.

 Under Ind AS 103, the combination
date is 1 April, 2017.  This is the
date when Willing will merge into Acquisitive.  The combination is accounted by Acquisitive
in the financial year 2017-18, using the pooling of interest method.  However, the financial information of
Acquisitive for the financial year 16-17, will be restated as if the business
combination had occurred from the beginning of the financial year 16-17, ie
from 1 April 2016.

 If the formalities are
completed and the final court approval is received on 1 April 2018, the
combination is accounted by Acquisitive in the financial year 2018-19.
However, the financial information of Acquisitive for the financial year 17-18,
will be restated as if the business combination had occurred from the beginning
of the financial year 17-18, ie from 1 April 2017.

 In
order to comply with the requirements of Ind AS and ensure tax consistency as
discussed in previous example, Acquisitive would need to rely on the Madras
High Court judgement in Equitas.  Essentially the appointed date and the
effective date could be set out in the court scheme, as the date when the
court passes the final order approving the combination transaction.  The appointed date may not be 1 April,
2016, because it would not be in compliance with Ind AS.

 However,
Acquisitive may consider an option whereby it prepares separate accounts for tax purposes with an appointed
date of 1 April, 2016.  For MAT
purposes, Ind AS compliant financial statements will be the relevant
financial statements.  These aspects
are discussed in the previous example.

 Conclusion

The ICAI should
provide appropriate clarification on the above subject.  However, in the meanwhile, the principles
established in this article may be used to ensure compliance with Ind AS and
also fulfill the requirements of section 394 of the Companies Act.

FRAUD : Investigation techniques and other aspects –Part 1

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Variety in fraud investigation techniques: application of Vedic Mathematics
It is variety that makes life interesting and enjoyable. Virtually in every walk of life, we crave for variety. Take for instance our daily meals. Each meal we try to eat something different to make each meal more enjoyable. We try different kinds of breads, soups, vegetables, and fruits. We can actually survive just as well even if we have exactly the same items to eat everyday, but that would make our meals monotonous. Film makers make different kinds of films only because we would get bored of the same story over and over again. A cricket match would become absolutely boring if a batsman were to play each shot in the same identical manner. A popular batsman is one who has a range of different strokes and shots. Thus it has been correctly stated that variety is the spice of life.

Audit, investigation and forensic accounting are no exception to this maxim. It is very possible that if an auditor or an investigator approached every investigation with the same routine steps in a lackadaisical manner, a wrongdoer would be able to take suitable counter measures to ensure that he is protected and safe. Therefore it is absolutely essential to keep trying new methods, hitherto untried techniques and tools, and use a surprise element to get the best results. Research of algorithms, vedic scriptures can be extremely useful in this context. Many audits and investigations end at a dead end, or sometimes reach wrong conclusions, only because of the lack of application of imaginative and innovative methods.

The following is a case study where a chartered accountant was an advisor in an acquisition by a fruit juice manufacturing company. Initially by applying the standard auditing techniques, he felt that there was nothing serious to stop his client from acquiring a company owning a couple of mango farms based on details and information given. It was only after he looked at data differently, using ‘visual mathematics’ and an application of vedic mathematics that he was able to detect a sinister fraud.

Case Study: Fraud in mango farm sale
A fruit juice manufacturing company ABC was looking for more and more orchards and fruit plantations for expansion. In this hunt, they came across a proposal from a mango grower PQR in Maharashtra for sale of two mango farms. PQR had been growing mangoes and exporting them and seemed to have had a fairly good crop in the last season. The substantial part of the acquisition value was for the two fertile farms. The two mango farms commanded a rich premium because of their fertility and huge potential for growing mangoes in bulk. ABC had asked its CA to conduct a review of its financials and operating results for the last couple of years. Some extracts of the financial information given to him were as follows:

1. Farm A had 4 acres and Farm B was 6.3 acres in size. The potential for much greater crop of mangoes was huge and PQR had not been able to tap it because of its lack of resources. ABC realized that with more resources and better techniques the mango crop could be tripled.

2. Plucking and packing activity was performed over two days. The mangoes would be plucked and packed on the last two days of each month. On day 1, there would only be plucking activity and the mangoes would be stacked neatly. On day 2, the mangoes plucked the previous day would be washed and cleaned of all pesticide and then packed in boxes of one dozen each.

3. The packed mangoes from both the farms would be sent to the main godown where they would be counted and kept ready for export.

4. Costs of plucking and packaging for farm B were greater than farm A because it was further in the interior part of the district and labourers charged more to work at farm B

5. Costs of plucking and packaging during each month also varied based on demand supply of skilled labour in season time. Usually in May the cost would be the highest

The details of plucking and packaging costs per dozen are given in the table below

Conventional Audit checks did not throw up any adverse results.
The number of mangoes packed for each farm individually were not available, but the total mangoes packed for both farms for each month were physically verified by the management, as follows: March 720 mangoes, April, 2400 mangoes, and May 4800 mangoes. Though the CA was not conducting any investigation, he did have the responsibility of carrying out a special penetrative audit of the financial information given by PQR because ABC was going to invest a huge amount only based on the CA’s assessment. Therefore the CA applied all the conventional audit checks and tests. The bills for labourer’s payments were available in the form of wage sheets which prima facie looked satisfactory and his audit did have some routine queries but nothing serious.

The sales and collections audits and verifications using walk through tests also did not raise any alarm bells. These were also well documented. A decent price was earned by PQR for the sale of mangoes per reasonable market inquiries. In most respects, based on his routine audit techniques, the CA seemed to have derived a comfort in the financial information given. Under normal circumstances he would have given a ‘go ahead’ green signal to his client for acquisition of PQR.

How vedic mathematics helped the CA to spot a fraud by a mere visual look at the numbers.

The information given by PQR was incomplete in one important respect. The numbers of mangoes plucked and packaged in each farm for each month. This was important to determine the crop size and fertility of each farm. How could one find this? Actually applying mathematics using knowledge of algebra by solving simultaneous equations for each month it is possible. But that is a tedious task.

To illustrate, for the month of March, to find out how many mangoes were plucked and packaged, one would have to use algebra by using variables ‘x’ and ‘y’ to represent mangoes plucked and packed in farms A and B respectively. Then the cost information given above can be simply converted into a simultaneous equation in the conventional form as follows.

20x + 40y = 1200
70x + 85y = 4200

But solving such equations would be slightly tedious. However, through vedic mathematics, in one look, the viewer will be able to state that y = 0 in the above equations. How is this possible? Actually it is very simple.

A sutra of vedic mathematics called Anurupye Shunyamanayat’ states that if the co-efficients of one of the variables in a simultaneous equation are in the same ratio as the resulting values of each equation, then the other variable MUST BE ZERO

Thus in our above simultaneous equation of mangoes plucked and packaged in March

20x + 40y = 1200
70x + 85y = 4200

The coefficients of x are 20 and 70. Their ratio is therefore 2/7. The resulting values of each equation are 1200 and 4200. Their ratio is also 2/7. Since these two ratios are the same, the other variable, ‘y’ as per sutra 6 of vedic mathematics, anuraupye shunyamanayat, MUST be zero.

THUS THERE WERE ‘0’ MANGOES GROWN IN MARCH IN FARM B. BY USING THE SAME VEDIC MATHEMATICS APPROACH THERE WERE ‘0’ MANGOES GROWN IN FARM B FOR THE OTHER MONTHS AS WELL. THE COST FIGURES WERE IMAGINARY AND FICTITIOUS FOR FARM B.

In other words, Farm B was not producing any mangoes at all.

The fraud was a simple deception by PQR by claiming that mangoes were indeed being grown on farm B, even though it had no fertility to grow any mango at all.

Though it was the larger farm, since it was not a fertile plot, the price being demanded by PQR was an atrocious exponential value of its actual worth. ABC would obviously never be interested in purchasing such a farm. PQR’s labour costs were therefore nil for farm B and PQR was deceiving ABC by stating that mangoes were being plucked and packed in farm B. The CA then advised the client ABC not to go ahead with this acquisition.

What is important in this case study is that the CA always strived to upgrade his knowledge and he was always eager to learn new techniques and methods useful in his profession. He had recently been studying vedic mathematics. Vedic mathematics has some amazing solutions for certain types of mathematical problems. As we all know India discovered ‘0’ and a lot of vedic mathematics sutras are based on, or revolve around ‘0’. Among them, one of the sutras, sutra no 6 is ‘Anurupye Shunyamanayat’.

Vedic mathematics itself may be useful in a rare assignment, but what counted was the fact the CA was trying new things and different things every time to get better results. That, friends is the measure of life and true success.

Editor’s note: Fraud investigation and detection are an important area of practice for a chartered accountant. This involves acquisition of specialised knowledge. The law now casts an important duty in regard to reporting fraud on the auditor. Public expectations have now found statutory recognition. We have therefore thought it necessary to carry a series of articles by Mr. Chetan Dalal an expert on the subject. These will appear in the journal at intervals, that is probably in each alternate month. We hope readers will find this series useful.

Transitional Period for Rotation of Auditors

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BACKGROUND
May be to strengthen the road of independence of an auditor on which the very premise of any audit is built, the Companies Act, 2013 (“the 2013 Act”) has brought a prominent change in the appointment of auditors by introducing the concept of rotation of auditors. Many a times, an introduction of new provisions is subject matter of divergent views; the applicability of transitional provisions for the rotation of auditors faces the same fate. Presently, the companies are battling the question of how to interpret the transitional provision in relation to rotation of auditors as to whether the auditors, who have already been the auditors of the company for more than one or two terms of five years, as the case may be, are required to be changed in the annual general meeting (“AGM”) to be held on or before September 30, 2016 (for the companies having April to March as its financial year) or they can be continued for one more year, that is, upto AGM to be held on or before September 30, 2017 ? The issue has garnered a lot of attention and has been subject to varied and contrary views. Genesis of this article is to highlight the issue and provide an appropriate answer thereto.

PROVISIONS OF APPOINTMENT OF AUDITORS UNDER THE 2013 ACT
Section 139 of the 2013 Act deals with appointment of auditors. Section 139(1), inter alia, requires a Company to appoint auditor at the first AGM to hold office from the conclusion of that AGM till the conclusion of its sixth AGM and thereafter, till the conclusion of every sixth AGM. Section 139(2) provides for mandatory rotation of the auditors in case of all listed and other prescribed class of companies. Under the concept of rotation of auditors, the appointment of one term of five consecutive years for an individual as auditor or two terms of five consecutive years each for a firm as auditor is provided. The third proviso to section 139(2) provides for a transition period, that is, the companies existing on/before the commencement of the 2013 Act (from April 1, 2014), which are required to comply with such rotation are required to do so ‘within three years from the date of commencement of this Act’.

ISSUE TO INTERPRET
In the light of the third proviso to section 139(2), the issue that arises is – Whether the transition period for rotation is to be counted from the date of commencement of the 2013 Act, i.e. April 1, 2014, or from the date of conclusion of AGM held after the commencement of the 2013 Act ?

POSITION UNDER THE COMPANIES ACT, 1956
It is worthwhile to note that the appointment of the auditors has always been made from AGM to AGM, i.e. under the Companies Act, 1956 (for a year at a time) and continues to be so under the 2013 Act (though now for the maximum period of block of five years at a time). Thus, though auditors carry out audit for financial year(s), their appointment ranges from AGM to AGM and not for any particular year or financial year as such. This proposition, was also enunciated in the clarification issued by the Department of Company Affairs in the context of appointment of auditors under the Companies Act, 1956. In fact, in any event, if audit of more than one financial year is to be completed between two AGMs, the appointment would not be qua a specific financial year but the auditor so appointed at the AGM would carry out the audit of all financial years which were then pending for completion till the next AGM. Of course, it is a different matter that now under the 2013 Act, the provision for appointment is for a block of five years.

INTERPRETATION BY COMPANIES (AUDIT AND AUDITORS) RULES , 2014
Section 139(4) of the 2013 Act is very pertinent to the issue under discussion and which provides-

“The Central Government may, by rules, prescribe the manner in which the companies shall rotate their auditors in pursuance of s/s. (2).”

Rules prescribed in this regard by the Central Government are contained in the Companies (Audit and Auditors) Rules, 2014 and Rule 6 thereof is the most relevant to the issue. Rule 6, inter alia, contains illustrations explaining the rotation in case of individual auditor as well as in the case of an audit firm. The relevant portion of such Rule, being the illustration explaining rotation in case of audit firm, is reproduced herein:

Thus, whether one goes by Rule 6 or by the third proviso to section 139(2) to consider the transitional period ?

RULE 6 AND LEGISLATIVE INTENT
It must be appreciated that the provisions of law would have to be read and interpreted with underlying intent of the law makers. Such intent would have to be gathered from a combined reading of the provisions of the 2013 Act and the relevant Rules framed. It would be appreciated that, for such significant change in the provisions of law compared to prevailing position, law makers have thought it fit to provide for and grant enough transition time to the companies so as to smoothly adopt the new regime. In fact, the intention of the Legislature has been to provide reasonable time to companies so as to not only comply with the new requirement but also to do away with impediments or hardships which may result due to rotation of auditors. Such intention is evident from the discussion at the parliamentary committee (i.e. Yashwant Sinha Committee) before the enactment of the 2013 Act on the matter of section 139(2). Extract of minutes read as:

“…ii) Since a period of three years has been provided for companies as transitional period to align the tenure of auditors in accordance with the provisions of new Bill, which appears to be reasonable, no further change is necessary in the provisions…”

The words “….within three years from the date of commencement of this Act” should be read and interpreted in the manner which meets the underlying intent which is clearly spelt out in the Rules. In Rule 6, the illustration explaining the rotation mentions in the column heading, “Number of years for which an audit firm has been functioning as auditor in the same company [in the first AGM held after the commencement of provisions of section 139(2)]”. Thus, both law makers and law administrators obviously were aware of the fact that the term of an auditor is not with reference to ‘financial year’. This is also evidenced from the fact that the term used in the third proviso to section 139(2) is ‘year’ and not ‘financial year’.

If the term”….within three years from the date of commencement of this Act” is to be read verbatim, it would mean that the transition period would effectively be reduced to only two years instead of three years stated in the Act. While it is true that the literal rule of interpretation is the paramount rule of interpretation, there is no doubt that such literal interpretation should be in line with the intention of the legislature. A construction which will fructify the legislative intent is to be preferred. In fact, a beneficial provision is to be interpreted so liberally as to give it a wider meaning instead of giving it restrictive meaning which would negate the very object.

Now, note the observation and recommendation in the report of the Companies Law Committee (“the Committee Report”), set up on June 4, 2015, to make recommendations to the Government on issues arising from the implementation of the 2013 Act. Relevant Para 10.5 of the Committee Report reads as under:

“…The Committee noted that the three years’ transitional period provided to companies was reasonable and required no modification. Further, the intention of the legislation had been accurately translated in the Rules, and for this purpose, a transitional time period of three years had already been given. Hence, the Committee felt that there was no need for any change. However, the Committee, felt that Rule 6 ought to provide clarity that the three years’ transition period would be counted from AGM to AGM, and not from the commencement of the Act.”

[Underlined for emphasis]

The above recommendation of the Committee further leads to affirm that the intention of the legislature is that the transition period is to be computed not from the commencement of the Act but from AGM held after the commencement of the 2013 Act, as provided under Rule 6.

RULE TO PREVAIL
A question that may now be raised – would a rule override the provisions of the Act ? But it may also be appreciated that Rules made under an Act must be treated as if they are in the Act and have the same force as the sections in the Act. Rules can be resorted to for the purpose of construing the provisions of the statute where the provisions are ambiguous or doubtful and a particular construction has been put upon the statute by the rules.

In this connection, one must attend to the decision of the Hon’ble High Court of Delhi in the case of All India Lakshmi Commercial Bank Officers’ Union and Another vs. Union of India and Others [1985] 150 ITR 1, the relevant portion of which is reproduced herein:

“…Rule have to be so interpreted that they are intra vires. Recourse also cannot be had to the rules made under the authority of the Act for the purpose of construing the provisions of the statute except where the construction of the statute may be ambiguous or doubtful and a particular construction has been put upon the statute by the rules…”

In the present situation, the literal interpretation of the law, having regard to the intention of the legislature, no doubt that there exists some ambiguity in the provisions of the Act in relation to the computation of transitional period for rotation of auditors. Therefore, due consideration should be given to the interpretation laid down by the Rules, that is, Rule 6.

Further, the Hon’ble High Court of Delhi in the case of Bansal Export (P) Ltd. and Another vs. Union of India and Others 145 ITR 642 has held as under:

“…Delegated legislation should not be regarded as some form of inferior legislation – it carried out the maker’s command as effectively as does an Act or Parliament…” Also, the Hon’ble High Court of Allahabad in the case of Kanodia Cold Storage vs. Commissioner of Incometax [1995] 215 ITR 369 has observed as under:

“The Rules framed under the Act have statutory force of law, therefore…”

INSTANCES UNDER THE 2013 ACT WHERE RULES PROVIDED FOR SUBSTANTIVE LAW
Furthermore, there have been instances under the 2013 Act itself where the related rules have provided for something that was neither provided nor empowered by the Act. In fact, in few such cases, the Act was subsequently amended in order to incorporate such provisions so as to remove any kind of difficulty in interpretation or implementation thereof. Some such examples are –

Section 185 of Act prohibits a company from advancing any loan or giving any guarantee to its director or to any other person in whom the said director is interested. Transactions in the nature of loans and guarantees between a holding company and its wholly owned subsidiary (“WOS”) were exempted from the applicability of Section 185. This exemption was already provided for in the Companies (Meetings of Board and its Powers) Rules, 2014 as it has later been incorporated in the Act vide the Companies (Amendment) Act, 2015.

Further, the requirement of shareholders’ approval for a related party transaction between a holding company and WOS was dispensed with vide the Companies (Amendment) Act, 2015. This exception was earlier present under the Companies (Meetings of Board and its Powers) Rules, 2014 and now has been incorporated in the substantive law itself.

The Companies (Declaration and Payment of Dividend) Rules, 2014 were amended by the Companies (Declaration and Payment of Dividend) Amendment Rules, 2014 whereby companies were prohibited from declaring dividend unless the previous year or years’ losses and unabsorbed depreciation which had not been provided for by the company were set off against current year’s profits. This provision was incorporated in the substantive law by amendment to section 123 of the Act.

With regard to preparation of consolidated financial statements (“CFS”), Section 129(3) provided that a subsidiary includes a joint venture and associate. Through the Companies (Accounts) Rules, 2014, it was provided that the preparation of CFS shall not be required by a company which does not have a subsidiary or subsidiaries but has one or more associate companies or joint ventures or both for the financial year 2014-15.

In all these cases, since the related rules provided for unambiguous beneficial provisions, no noise was created about them. Our fraternity as well as the industry had accepted without any doubt the law created by the rules, even though it was not specifically provided under the Act. Ideally, the case of rotation of auditors would have followed suit. However, unfortunately, these provisions have been made subject to controversy.

CONCLUSION
One may argue that this provision contained in the rules should be incorporated in the substantive law by way of amendment in the Act or a suitable clarification. But, even in the absence of such an amendment or clarification, in view of the foregoing discussion, it leaves no doubt that for the auditors who are holding the office for 5 years or more or 10 years or more, as the case may be, before the commencement of the 2013 Act, the transition period of three years would be computed from AGM held after the commencement of the Act, that is, it would have commenced at the time when AGM was held on or after April 1, 2014 and would be operative till the time AGM is held somewhere in and around June – September 2017 to approve the financial statements for the financial year 2016-17.

It may also be appreciated that the rotation of auditors, being a transitional provision, would at the most, have effect only for another year, an amendment by way of an amendment Bill may never see the light of day. At best, a clarificatory notification may come through or the Central Government may exercise its power u/s. 470 of the 2013 Act and pass an order for removing the difficulty.

“The secret of change is to focus all of your energy, not on fighting the old, but on building the new.” – Socrates. The recent past has been a period of challenges with prosperity for the profession and the prosperity would sustain only if these changes and challenges are accepted in its right spirit. The mandatory provisions on rotation of auditors is a response to the aftermath of many crises that have been witnessed in the past and are here to stay. Thus, we accept the rotation as an effective tool for the independence in the auditing process so as to enhance the credibility of the financial statements.

Expectations – Forensic Audit

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What exactly is forensic accounting or forensic audit? How does it differ from an audit?

A very simple description of forensic accounting is the use of accounting, auditing and investigative skills to analyse financial information for use in legal proceedings. The word is “Forensic” means “suitable for use in a court of law”. Forensic accountants, also referred to as forensic auditors or investigative auditors, often have to give expert evidence at the eventual trial. There are many differences between an audit and a forensic audit. The most important difference between the two can be described as follows.

An auditor usually relies on documentary evidence for expressing an opinion, while a forensic auditor examines the reliability of the documentary evidence for making an assertion or a statement in a court of law. The forensic accountant has much greater responsibility and his report may have far reaching ramifications in a court of law. Forensic audit is specific to an issue and more often than not, its’ genesis is a dispute and its objectives and deliverables are unique in each situation. The forensic accountant usually visualises what kind of deliverables would be possible and there is some degree of flexibility in this aspect. However, an audit usually does not stem from any dispute and the objectives and disclosures of audits mandated under the Companies Act, 2013, or the Income Tax Act, 1961 etc are defined in the relevant Acts.

Forensic Audit – case study :

The concept of forensic audit can be best understood through a real life case. The chairman of a bank was worried. A borrower had failed to repay a huge loan of Rs 70 crores. The bank had two options. One option was to take legal recourse and commence recovery proceedings. The second option was to agree to the borrower’s request to fund a further 8 crore to revive his business. The borrower claimed that the recessionary conditions, which had caused his losses, had receded and now he had some big export orders on hand. Therefore he had a good chance to turn the corner and he expected to repay the loan to the bank in 4 years. Should the bank take the first option? If so it was certain that the legal battle would drag on for years and the chances of recovery, in the foreseeable future, were slim. On the other hand, in option two, the bank would be able to get the money back in 4 years. But the question was: “Is the borrower taking the bank for a ride? Was the past loss purely due to recessionary conditions and not due to mismanagement or siphoning of funds?” The borrower had indeed provided audited statements of his company for the past few years. However the information given in the audited financial statement and the auditor’s reports did not spell out reasons for the business loss. The financial information was not sufficient for the bank to ascertain whether there could have been any malpractice or abuse or misuse of assets or funds. This was a situation where the bank wanted information which was more specific, to enable it to decide which of the two options stated above should be selected. Essentially the bank wanted to know whether the borrower was a genuine victim of recessionary business conditions or not. The bank had to rule out the probability that the borrower was a manipulative, conniving, or deceptive borrower who had hoodwinked the bank in the past. The bank chairman was advised to get a forensic audit conducted to get answers to all these questions. The bank thus appointed a forensic accountant who was able to find a lot of information which provided valuable insights for the bank to take the right decision. The forensic audit report, on the one hand, prevented the bank from losing a further sum of Rs 8 crore per option two. On the other hand, the report facilitated the bank to go in for option one of recovery and legal proceedings including a police complaint for criminal actions of fraud and falsification of documents. What did the forensic auditor find out that the other officials in the bank, the auditor, the internal auditor, the tax auditor and others in corporate governance were unable to find? The forensic auditor found that the borrower had been transferring funds to satellite entities, which were his family concerns. Personal expenses and expenses of those satellite companies had been debited to the borrower’s company to show losses. Moreover the forensic auditor did some field investigation which revealed that the borrower used to take a lot of income in cash, thereby showing lesser sales. The combined effect of all these methods was that the borrower had been able to siphon out huge funds from those loaned by the bank and palm off such transfers as expenses resulting into losses. This process of collection of specific information and evidence which the bank could use for decision making and also for court proceedings is what is forensic auditing all about. The terms forensic accounting and forensic audit mean the same and are often used interchangeably.

What are the typical kind of forensic accounting assignments?

A large part of forensic accounting work relates to fraud detection and fraud investigation. Forensic accountants are asked to take up assignments relating to disputes, financial crimes, corrupt practices, business leakages and siphoning of funds, whistleblowers’ complaints of any kind, and the many other situations where any wrongdoing is suspected. Forensic accountants can be appointed by corporate management, third parties affected in any situation, bankers, or even under the law or by government agencies. In the last decade some of the really intensive users of forensic accountants are the police, ED, Reserve Bank of India, tax authorities and large public sector corporations. A recent trend is emerging where in individual courtroom cases even judges appoint forensic accountants for their own evaluation of disputes.

Does forensic accounting relate only to financial fraud?

Generally speaking, the answer is yes. However it would be incorrect to say that forensic accountants are not approached to investigate non financial crimes. For example in a public listed company there was a lady employee who got an obscene letter placed on her desk. She threatened to complain to the police. However the ethics counsellor stepped in and assured the lady that the company would look at this matter seriously and investigate and apprehend the culprit. They requested her to hold on till they completed an internal investigation. She relented and the ethics counsellor approached a professional forensic accountant and he did a remarkable job. The forensic accountant used his team which had comprehensive skill sets to perform computer forensics, interviewing techniques, and handwriting evaluation to nail the culprit. The aggrieved lady was satisfied and the company management was saved by the astute forensic accounting work. Similarly forensic accountants may even be used for marital disputes to understand what kind of assets and finances are held by the opposite spouse and to facilitate a fairer settlement. However such non financial cases are fewer in number.

What are the tasks usually performed by a forensic accountant?

A forensic accountant is expected to be able to perform all the tasks that an accountant and an auditor is able to perform. In addition, he should have in his team, reasonable expertise in interviewing, interrogation, data mining and investigative analysis, field investigations, computer forensics and handwriting and specimen signature analysis.

Steps in preforming forensic accounting

The broad steps in forensic accounting are (a) Establishing a clear mandate outlining specific objectives and deliverables, (b) data and evidence collection, (c) data analysis, and (d) evaluation of all data and evidence collected and finally (d) reporting.

Forensic accounting and fraud investigation have been gaining more and more importance particularly after the commencement of Companies Act, 2013. Opportunities for Chartered Accountants are plenty and appear to be increasing every day. It would be well worth the effort for chartered accountants to learn and implement forensic type techniques. They will be useful in regular audits in any case and further enhance their areas of practice in the foreseeable future.

EXPECTATIONS AND ESSENCE STATUTORY – INTERNAL – FORENSIC AUDITS

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Overview
The businesses in the today’s world have grown far bigger and complex. Who knew that a company will run the biggest taxi aggregation business without owning a single car and an e-commerce company will become the biggest retail marketplace without having any inventory or a warehouse. No one ever imagined that just with a click on the mobile phone one can do online shopping. Just when people started realizing the benefits of using plastic cards, cutting edge technology that replaced the need to carry the wades of paper currency, online wallets on the mobile phones came into vogue providing far more convenience to users for carrying out commercial transactions. With the new complexities in the businesses and to cover the monetary risks exposing the stakeholders the regulators across the globe have become stricter in terms of ensuring there is proper monitoring mechanisms and the interest of all is protected.

Stakeholders are using different kinds of audits to provide assurance to the capital markets, Board of Directors and also proactively prevent frauds.

The Companies Act, 2013 (“the Act”) has introduced certain path breaking concepts, such as mandatory auditor rotation, restriction on non-audit services etc. Under the Act every company needs to get its accounts audited by a statutory auditor meeting the qualifications prescribed thereunder, certain classes of companies need to get its internal audit carried out by a chartered / cost accountant. The Act has also introduced a requirement for the auditor to report on frauds noticed during the year to the Central Government. This points towards increasing focus and scrutiny over the operations and processes of the company requiring various types of audits being conducted, such as statutory audit, internal audit, forensic audit, etc. among other things. It is therefore important to understand the differences between these audits. These differ substantially in terms of its scope, legal requirements, status of the auditor, reporting, etc. In the ensuing sections we will try to cover the expectations of the stakeholders from these different types of audits in brief and understand the critical differences in their approaches and functioning.

Statutory Audit
Statutory audit is mandated by the Act under Section 143 and it requires that the books of account of the company, be audited by a chartered accountant who is a member of the Institute of Chartered Accountants of India (‘ICAI’). The appointment of statutory auditor is through a process whereby the appointment is proposed by the Board of Directors / Audit Committee and is approved by the Shareholders in the AGM.

The standards on auditing (‘SA’) issued by the ICAI states that the objective of audit is to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework.

The qualifications and disqualifications of the statutory auditor are specified under the Act. This covers, among other things, restriction on providing certain nonaudit services that could impair the statutory auditor’s independence, e.g. providing accounting services or internal audit services.

Generally the team of professionals carrying out the statutory audit comprises of chartered accountants who may be further assisted by tax specialists, IT specialists, etc. These specialists work under direct supervision of the statutory auditor who reviews the work performed by the specialists and takes responsibility for such work.

With the increasing complexity of the business operations and use of technology, the statutory auditors have also started rising up to the occasion by using technology in auditing, however, presently use of such technology is limited to:

– Sampling methodology
– Audit work flows
– CAATs
– Other analytical tools

The statutory auditor draws his powers from the statute that requires the company to provide access to the statutory auditor of company’s books of account, records and other information that is considered to be necessary for performing his duties.

From above it is clear that statutory audit entails examination of the books of account and records maintained by an entity so as to enable the auditor to satisfy himself that the financial statements are drawn as per the applicable reporting frame work and present a true and fair view of the financial state of affairs of the entity and profit or loss and cash flows for the period. The reporting format is as provided in the Standards on Auditing issued by the ICAI (now deemed to be prescribed by the Act) which is in the form of an expression of “an opinion” on the financial statements.

The primary objective of the statutory audit is to form an independent opinion on the financial statements and ensure that the financial statements confirm to the accounting framework prescribed under the relevant statute.

In summary the key features of statutory auditor comprise:

appointment by shareholders

auditor’s powers, qualifications, remuneration, responsibilities enshrined in the statute

communicates with the audit committee / board of directors

opines on the financial statements and the internal financial controls

opinion is made public

independent of the company which is being audited

report format prescribed by the ICAI

subject to class action suit

Internal Audit
The Act has prescribed internal audit for certain classes of companies which include all listed companies, unlisted public companies and private limited companies meeting the prescribed criteria. The internal auditor is appointed by the management, in consultation with the Board of Directors / Audit Committee. The ICAI has laid down Standards on Internal Auditing (SIA) for governing the audits carried out by chartered accountants in India. The Act also permits internal audit to be carried out by a cost accountant or such other professional as may be decided by the Board of Directors.

The Act has not defined any scope for the internal audit function. It is therefore driven more by the company’s / management’s requirements and can be very broad and may include any matter that affects the organizational objectives. Generally, there is a wide spectrum of areas as enlisted below covered through internal audit.

Risk management policies and procedures

Effectiveness, efficiency, and economy of operations and process

Internal controls and financial reporting

Routine operational activities

Analysis of financial and non-financial information

Audit of a particular areas of operations / financial reporting, e.g. factory assets, consumption process, cycle inventory counts, payroll system, payments of statutory dues, etc.

Audit of processes of the company over its procurements, sales, fixed assets and other records to report and financial statements close processes

Audit of compliance with factory laws, labour laws and other applicable laws, rules and regulations

Audit of IT systems Compared to statutory audit approach, use of technology in performing internal audit is more prevalent and includes but is not limited to:

– Sampling methodology
– Data analytics
– IT systems
– CAATs
– Other developed tools for business intelligence

The team performing internal audit can include chartered accountants, cost accountants, MBAs, Engineers or any commerce graduate. Members of the internal audit team can be employees of the company or external professional firm. The internal auditor, being appointed by the management and pursuance to the terms of reference of their engagement is governed by the internal policies of each company.

Hence the objective of internal audit extends more towards process improvements, identifying efficiencies and finding revenue leakages, etc. in operations rather than forming an opinion on the financial information. There is no specific format in which the internal auditor is required to report and the format generally varies – from issuing management letter comments, power point presentations to detailed textual report in the form of Agreed Upon Procedures (AUP) report. Unlike statutory audit, the report is not made available to the public.

In summary, the key features of internal audit are:

it is an appointment made by the audit committee / management
it is an “internal assurance function”
the report is for internal consumption
key focus is to ensure that operations of the company are carried out in an efficient manner
also ensure that operations of the company are carried out in accordance with the policies and procedures of the company

Forensic Audit
This audit is discretionary and is not governed under any statute. It is basically an investigative exercise. If the management or any stakeholder has any suspicion about the embezzlement or misappropriation of funds or other fraudulent activities occurring in the organization, a need for detailed investigation to confirm or dispense off such suspicion may be required and a forensic audit is undertaken.

Forensic engagements generally falls into several categories e.g.

Criminal offenses
Investigating fraudulent expense claims
Anti-Money Laundering,
Insurance claim damages;
Fraud relating to taxes;
Fraud relating to issuance / dealings in securities and other marketable instruments;
Disputes on pricing, covenants, warranties and representations, etc. in business combinations;
Dissolution, insolvency, bankruptcy and reconstruction;
Computer forensics.

Techniques such as data analytics through electronic data collation and mining with an objective to identify, reconstruct or confirm a financial fraud are widely used by the forensic auditors. The main steps involved in such forensic analytics are:

(a) collection of data that is required to be analysed,

(b) reconstructing and reorganizing data in a manner conducive to perform analytics,

(c) performing data analytics and exploratory techniques, and

(d) reporting the findings.

For example, exploration and analytical technique could effectively be applied in reviewing a procurement manager’s activity to assess whether there were any kickbacks taken. Another example is to perform analysis of the activities of sales team of a company to determine where the contracts were negotiated at a much lower price than the actual cost and resulting in loss to the company. The audit driven by high-end technology, and includes:
– Data analytics
– IT systems
– E-Discoveries
– GPS tracking
– Surveillances
– Cyber securities
– Professional hacking

Forensic audit requires an understanding of the business economics, financial reporting systems, data analytics for detecting frauds, gathering of evidence and investigation, and litigations and other civil/ criminal procedures. This will necessitate the requirement of specialized skills within the team performing such audits and could include chartered accountants, certified fraud examiners, lawyers, IT professionals, ex-police personnel, ex–investigators, etc. Banks have recently started conducting forensic audits to trace the end use of the funds and try to nail the defaulting borrowers.

Findings of the forensic auditor takes shape similar to that discussed in case of internal audit, i.e. it could vary in form of power point presentation to a detailed textual AUP report. Like internal audit report, the forensic audit report is also not available to the public.

Conclusion
As businesses are growing and becoming more complex there is a heightened expectations – through the objective, approach and reporting – from the three forms of audit, viz. statutory audit, internal audit and forensic audit. The skills required to perform these audit also vary and risks associated are also very different. The stakeholders clearly need specialized services and based on the aptitude and risk appetite we should decide which audits one should specialize in.

Impact on MAT from First Time Adoption (FTA) of Ind AS

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The MAT Ind AS Committee (hereinafter referred to as ‘Committee’) on 18th March 2016 issued a draft report on the ‘Framework for computation of book profit for the purposes of levy of Minimum Alternate Tax (MAT) u/s. 115JB of the Income-tax Act 1961 for Indian Accounting Standards (lnd AS) compliant companies in the year of adoption and thereafter’. The Report was revised on 23rd July 2016 (hereinafter referred to as ‘Framework’). The Framework is a draft and is subject to public comments and final changes. Once the Framework is final, the same will have to be incorporated in the Income-tax Act, to make it effective.

This article discusses the issues and challenges on first time adoption (FTA ) of Ind AS and the consequences for companies that fall under MAT . Though the revised Framework is an improvement from the pre-revised draft, the provisions do not appear to be fair or reasonable, and will significantly hamper the ease of doing business. In addition, the environment is most likely to become very litigious and painful.

The accounting policies that an entity uses in its opening Ind AS balance sheet at the time of FTA may differ from those that it previously used in its Indian GAAP financial statements. An entity is required to record these adjustments directly in retained earnings/reserves at the date of transition to Ind AS. The Committee noted that several of these items would subsequently never be reclassified to the statement of P&L account or included in the computation of book profits.

Consider a company has a net worth of Rs 500 crore, and therefore falls under phase 1of Ind AS implementation. Its date of transition to Ind AS is 1 April, 2015; comparative period is financial year 2015-16, and first Ind AS reporting period is financial year 2016-17. The company is engaged in several businesses and makes the following seven transition decisions at 1 April, 2015 in order to comply with Ind AS.

1. The company’s accounting policy for fixed assets is cost less depreciation under Ind AS. However, as per option available in Ind AS 101 all fixed assets are stated at fair value at date of transition. The revalued amount is a deemed cost of fixed assets at 1 April, 2015. In other words, the company’s policy is not to use revaluation on a go forward basis as the accounting policy. The uplift on revaluation is recorded in retained earnings and will never be recycled to the P&L account.

2. In the stand-alone accounts the company has several investments in subsidiaries which under Indian GAAP are stated at cost less diminution other than temporary. Under Ind AS the company will continue to account them at cost less impairment. However, as per option available in Ind AS 101 the investments in subsidiaries are stated at fair value at date of transition. The fair value is the deemed cost of investments at 1 April, 2015. Subsequently, the investments in subsidiaries are not fair valued but tested only for impairment. The uplift on fair valuation is recorded in retained earnings and will never be recycled to the P&L account.

3. Under Indian GAAP, the company discloses assets under a service concession arrangement (SCA) as intangible assets at cost and which does not include construction margin. On date of transition, the company accounts for the intangible assets in accordance with Ind AS 11 (Appendix A), treating them as service concession assets. Consequently, under Ind AS 11 (Appendix A), the construction margin is also reflected in the value of the intangible asset.Therefore at transition date, the value of the intangible assets will be increased with a corresponding increase in retained earnings. The increase in retained earnings will never be recycled to the P&L account. However, the increase in the value of the intangible asset will be amortized in the future years.

4. At 31 March 2015, the Company has a lease equalization liability under Indian GAAP for an operating lease. Under Ind AS 17, the Company is required to charge operating lease payments in the P&L account without equalizing the lease payments, since those lease payments are indexed to inflation. Consequently on the transition date, the company reverses the lease equalization liability and takes the credit to retained earnings. The increase in retained earnings will never be recycled to the P&L account.

5. The Company has a cash flow hedge reserve at 31 March 2015 under Indian GAAP, which meets all hedge accounting requirements under Ind AS. In accordance with Ind AS 101, the Company is required to maintain the cash flow hedge reserve, and recycle the same to the P&L account, in accordance with the principles of Ind AS 109.

6. The Company has a foreign branch and a positive foreign currency translation reserve (FCTR) in Indian GAAP stand alone accounts at 31 March 2015. In accordance with Ind AS 101, it restates the FCTR to zero on 1 April, 2015 – the date of transition. Consequently the corresponding effect is taken to retained earnings. The increase in retained earnings will never be recycled to the P&L account.

7. In addition to investments in subsidiaries the company has investments in unquoted securities that are held long term for strategic reasons, but which are neither, subsidiaries, associates or joint ventures. The Company designates these investments as FVOCI (Fair Value through Other Comprehensive Income). As per this accounting policy choice, the fair value changes are permanently recorded in reserves (not retained earnings) and are never recycled to the P&L account.

As per the Framework, the MAT implication for the above seven FTA items is given below, along with the author’s recommendation of the changes required and grounds for such recommendations.

The FTA adjustments made at 1 April, 2015 are to be appropriately dealt with to determine the book profits for MAT purposes. The big question is – Is it included in the book profits over three years starting from the comparative period, ie, financial year 2015-16 or in the year of FTA, ie, financial year 2016-17? Though the intent of the government may have been to include the adjustments in the book profits for 2015-16, it is no longer practically feasible to do so. It is most likely that the adjustments would be included to determine the book profits starting from the financial year 2016-17. Hopefully that clarity will come in the forthcoming budget, as this requirement would require an amendment to the Act. This is again an unpleasant outcome, given that companies would be paying advance taxes without the knowledge of the final law on this subject.

Conclusion
Companies need to make careful choices of FTA options to minimize a negative MAT impact. They can make those choices up till financial statements for year ended 31 March 2017 are finalized. However, changes in those choices will cause significant fluctuations in 2016- 17 quarterly results. For example, a company decides to carry forward fixed assets at previous GAAP carrying value as a transition choice to avoid any MAT liability on fair value uplift. Subsequently, in the last quarter, the budget clarifies that the fair value uplift on fixed assets will be completely tax neutral from MAT perspective. Because of the clarity, the Company prefers to fair value the fixed assets from the transition date instead of carrying them at previous GAAP carrying value. This would mean that the lower depreciation charge in the earlier quarters and the comparative period will have to be adjusted, thereby resulting in significant change in the reported numbers in the last quarter.

As a bold step, the Government may consider simplifying the MAT provision, and lower the MAT rates. Alternatively, AMT (Alternate Minimum Tax) regime applicable to noncorporate assesses and which is highly successful may be introduced for corporate assesses. However, given the time constraint it is generally understood, that the Government may not explore these choices.

Can a Company have two functional currencies?

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Query
Can a Company have two functional currencies for its two autonomous divisions? Travel & Logistics Ltd (TL or the Company) an Indian registered company has two independent business divisions, namely, hotel division which runs hotels in India and shipping division which runs global shipping operations. TL assessed the functional currency of the hotel division as rupee (INR) and shipping division as US $. It may be noted that substantial income and expense of the shipping division is in US $. If the shipping division was housed in a separate company, its functional currency would be US $.

In which currency, TL will prepare its Ind AS financial statements? Will it be (a) INR (b) US $ or (c) INR for hotel division and US $ for shipping division?

Response
A similar issue was discussed by the Ind AS Transition Facilitation Group (ITFG). The view of the ITFG and the Author’s view are expressed below.

View of ITFG
As per paragraph 8 of Ind AS 21, The Effects of Changes in Foreign Exchange Rates, functional currency is the currency of the primary economic environment in which the entity operates.

Further, paragraph 17 of Ind AS 21 states that: “In preparing financial statements, each entity – whether a stand-alone entity, an entity with foreign operations (such as a parent) or a foreign operation (such as a subsidiary or branch)—determines its functional currency in accordance with paragraphs 9–14 of Ind AS 21.”

Paragraphs 9-14 of Ind AS 21, elaborate the factors that need to be considered by an entity while determining its functional currency.

In view of the above, it is concluded that functional currency needs to be identified at the entity level, considering the economic environment in which the entity operates, and not at the level of a business or a division. Accordingly, if after applying paragraphs 9-14 of Ind AS 21, the Company concludes that its functional currency is USD at the entity level, then it shall prepare its financial statements as per USD.

Though not stated, the obvious extension of this interpretation is that if the Company concludes that its functional currency is INR at the entity level, then it shall prepare its financial statements as per INR.

Authors view
Under Ind AS 21, foreign operations are defined as “Foreign operation is an entity that is a subsidiary, associate, joint arrangement or branch of a reporting entity, the activities of which are based or conducted in a country or currency other than those of the reporting entity.”

It is interesting to note that the activities of the branch may be conducted in a different country or in the same country but in a different currency. Ind AS 21 uses the term ‘branch’ to describe an operation within a legal entity that may have a different functional currency from the entity itself. It does not describe a branch, in the classical sense, such as a Company in Mumbai has a branch in Chennai.

An entity may have an operation, eg a division that operates in a different currency environment from the rest of the entity. Though this may not be a branch in a classical sense, it would be a branch for the purposes of Ind AS 21, provided the operation of that division represents a sufficiently autonomous business unit.

Therefore in the given fact pattern, the entity will apply functional currency US $ for shipping division and INR for hotel division. This interpretation would not be challenged if the shipping division was registered as a separate company in India or as a separate branch abroad. Therefore it does not make any logical sense to challenge this view just because it is housed in one entity and is called a ‘division’ rather than a ‘branch’. Besides given the way the term branch is used in the Ind AS 21 context, the shipping division and hotel division should be evaluated separately for the purposes of determining the functional currency.

To state the entity’s Ind AS financial statements in the presentation currency, the results and financial position of its operations having different functional currencies will be included using the translation method set out in paragraph 38-43 of Ind AS 21. The entity shall translate: (a) assets and liabilities at the closing rate; (b) income and expenses at period average exchange rates; and all resulting exchange differences shall be recognised in other comprehensive income.

Conclusion
In view of the discussion and arguments provided above, the ITFG may reconsider its view on the above matter. In any case, the ITFG views are only recommendatory and are not binding.

Adjustment of Debenture Premium against Securities Premium in Ind AS

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Background

On April 1, 2011 a company issued zero coupon Nonconvertible debentures (NCDs) of INR 100 payable on 31 March, 2021 at a premium amount of INR 116 which provides an 8% IRR to the holder of the instrument. At the time of issuance of the NCDs, Companies Act, 1956 (1956 Act) applied. At current date, the provisions of the Companies Act, 2013 (2013 Act) have become applicable to the company.

The Company is covered under phase 1 of Ind AS roadmap notified under the Companies (Indian Accounting Standards) Rules, 2015 (as amended) and needs to start applying Ind AS from financial year beginning on or after 1 April 2016 with comparatives for the year ended 31 March 2016. Its date of transition to Ind AS will be 1 April 2015.

Section 78 of the 1956 Act ‘Application of premiums received on issue of securities’ states as below: “

(2) The securities premium account may, notwithstanding anything in s/s. (1), be applied by the company:

(a) In paying up unissued securities of the company to be issued to members of the company as fully paid bonus securities;

(b) In writing off the preliminary expenses of the company;

(c) In writing off the expenses of, or commission paid or discount allowed on, any issue of securities or debentures of the company; or

(d) In providing for the premium payable on the redemption of any redeemable preference securities or of any debentures of the company.”

Position taken by the Company under Indian GAAP For all periods including upto financial year ended 31 March 2016, the company is preparing its financial statements in accordance with Indian GAAP. With regard to Indian GAAP, the Companies (Accounting Standards) Rules, 2006, state as below:

“Accounting Standards, which are prescribed, are intended to be in conformity with the provisions of applicable laws. However, if due to subsequent amendments in the law, a particular accounting standard is found to be not in conformity with such law, the provisions of the said law will prevail and the financial statements shall be prepared in conformity with such law.”

The Company adjusted the entire premium payable on redemption i.e. INR 116 against the securities premium, in the year of issuance of NCDs, i.e. in year ended 31 March 2012. A corresponding premium liability of INR 116 was created.

From 1 April 2014, section 78 of the 1956 Act has been replaced by section 52 of the 2013 Act. Section 52 states as below: “

(2) Notwithstanding anything contained in s/s. (1), the securities premium account may be applied by the company—

(a) Towards the issue of unissued shares of the company to the members of the company as fully paid bonus shares;

(b) In writing off the preliminary expenses of the company;

(c) In writing off the expenses of, or the commission paid or discount allowed on, any issue of shares or debentures of the company

(d) In providing for the premium payable on the redemption of any redeemable preference shares or of any debentures of the company; or

(e) For the purchase of its own shares or other securities u/s. 68.

(3) The securities premium account may, notwithstanding anything contained in subsections (1) and (2), be applied by such class of companies, as may be prescribed and whose financial statement comply with the accounting standards prescribed for such class of companies u/s. 133,—

(a) In paying up unissued equity shares of the company to be issued to members of the company as fully paid bonus shares; or

(b) In writing off the expenses of or the commission paid or discount allowed on any issue of equity shares of the company; or

(c) For the purchase of its own shares or other securities u/s. 68.”

Based on the above, under the 2013 Act, on a go forward basis, Ind AS companies cannot charge debenture redemption premium against securities premium account. However, the word ‘and’ in section 52(3) also highlighted above lends itself to another technical argument. One could read the provision as restricting the use of securities premium only when two conditions are fulfilled, ie, (a) the class of companies are prescribed and (b) that class of companies are those that comply with accounting standards under section 133. Since no class of companies are yet notified u/s. 52(3), the restriction on use of securities premium will not apply.

Query under Ind AS

Under Ind AS 109 Financial Instruments, NCD liability is measured at amortised cost. The application of this principle implies that premium liability is accrued over the life of NCDs using the amortized cost method under effective interest method and debiting profit and Loss (P&L). In accordance with Ind AS 101 First Time Adoption of Ind AS, an entity is required to apply Ind AS retrospectively while preparing its first Ind AS financial statements except for cases where Ind AS 101 provides specific exemptions/ exceptions. Ind AS 101 does not contain any exemption/ exception with regard to the application of effective interest rate accounting for financial assets or liabilities.

The amortized cost under Ind AS on transition date at 1 April 2015 will be INR 136 (original cost of INR 100 and premium accrued of INR 36). On a go forward basis also premium will be accrued at an IRR of 8% and the same will be charged to the P&L a/c.

Whether the Company needs to reverse premium payable on redemption of NC Ds previously charged to the securities premium INR 80 (INR 116 – INR 36). Consequently, will the debenture premium of INR 80 be charged to future Ind AS P&L using the effective interest method?

Author’s Response

The author makes the following key arguments to support non-reversal of premium payable on redemption of NCDs previously charged to securities premium:

1. With regard to Ind AS, the Companies (Indian Accounting Standards) Rules, 2015 states as follow: “Indian Accounting Standards, which are specified, are intended to be in conformity with the provisions of applicable laws. However, if due to subsequent amendments in the law, a particular Indian Accounting Standard is found to be not in conformity with such law, the provisions of the said law shall prevail and the financial statements shall be prepared in conformity with such law.”

In light of the underlined wordings, the intention of Ind AS rules should not be construed as requiring reversals of actions done in accordance with the applicable laws.

2. Ind ASs have been notified under the Companies (Indian Accounting Standards) Rules, 2015, which is a subordinate legislation. It cannot override provisions of the main legislation. The action of the company in debiting its securities premium account in the relevant financial year was in accordance with the provision of section 78 of the 1956 Act. As per section 6 of the General Clause (GC) Act, the repeal of an enactment will not affect anything validly done under the repealed enactment. Hence, to the extent that any acts are validly done under any repealed provision of the 1956 Act, such action will not be affected upon corresponding provision of the 2013 Act becoming applicable. Therefore the application of the 2013 Act does not impact position taken in the past.

3. While section 78 of the 1956 Act allows premium on redemption to be adjusted against the Securities Premium, it does not prescribe the timing of such adjustment. Hence, it is permissible to make upfront adjustment for the premium at any time during the tenure of the debentures. The Company adjusted the entire debenture premium of INR 116 against the securities premium account in year ended 31 March 2012 is in accordance with the law and completely justified.

4. The financial statements for the year ended 31 March 2012 were approved by the shareholders. On the basis of the shareholders’ approval and the extant law, the securities premium was utilised. Section 78 of the 1956 Act/ section 52 of the 2013 Act contain specific requirement concerning creation as well as utilisation of the securities premium. Once the company has charged premium payable on redemption, it effectively tantamount to utilisation of the securities premium. One may argue that once utilised, in accordance with the extant provisions of the main law the premium cannot be brought back to life merely because of an accounting requirement contained in a subordinate legislation.

5. The 2013 Act only recognizes premium received on shares as balances that may be credited to securities premium account. In the present case the securities premium account has already been reduced by the full debenture premium amount. Therefore credit back to the securities premium account pursuant to any reversal is not permitted under the 2013 Act.

6. As discussed earlier in the article one view is that debenture redemption premium can be adjusted against securities premium account in accordance with section 52(3) because no notification as required u/s. 52(3) has yet been issued. If this interpretation is taken, then Ind AS companies will be allowed to use securities premium account to adjust debenture premium till such time a notification is issued by the MCA.

Conclusion

The transition from Indian GAAP to Ind AS will not impact actions previously taken by the company under other provisions of the Act (section 78 of the 1956 Act in this case). The Company can carry forward the Indian GAAP accounting (done in accordance with a law) in Ind AS financial statements. The Company need not reverse premium payable on redemption of NCDs previously charged to the securities premium INR 80 (INR 116 – INR 36). Consequently, the debenture premium of INR 80 will not be charged to future Ind AS P&L. The Company should make appropriate disclosures as required by the applicable Ind AS and governing laws in the financial statements.

It may be noted that the author’s view in this article is not consistent with the clarifications provided by the Ind AS Transition Facilitation Group (ITFG). However, it may be noted that the views of the ITFG are not those of the ICAI and are not binding on the members of ICAI.

IND AS ROAD MAP – CORPORATE vs. NBFC

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One of the key issues with the Ind AS roadmap is the alignment of implementation dates between NBFC companies and non NBFC companies. For example, phase 1 non NBFC companies go live on Ind-AS from 1-4-2016, with a transition date of 1-4-2015. The first Ind AS financial year will be 2016-17. In the case of NBFC, phase 1 companies will go live on Ind-AS from 1-4-2018, with a transition date of 1-4-2017. The first Ind AS financial year will be 2018-19. In the case of NBFC company, early adoption of Ind AS is prohibited. This poses a unique challenge to a consolidated group that has an NBFC company and a non NBFC company. Consider the diagram below.

When the NBFC is on the top of the structure, the problem is very acute. In this case, the non NBFC companies below the NBFC Parent company (M Co, T Co & S Co) will prepare Ind AS for financial year 2016-17 as they are in phase 1. For 2016-17, the NBFC Parent will prepare stand-alone and CFS under Indian GAAP, since it is prohibited from early adopting Ind AS. For purposes of consolidation by the NBFC Parent; M Co, T Co & S Co will have to continue preparing their accounts under Indian GAA P as well. Therefore M Co, T Co & S Co will end up preparing accounts both under Indian GAAP & Ind AS, which will be a huge burden.

When a NBFC is below a non NBFC company, the NBFC will prepare Indian GAAP accounts for standalone purposes and to enable non NBFC parent to prepare Ind AS CFS, the NBFC will also prepare Ind AS accounts. In the above diagram, the NBFC subsidiary will prepare Indian GAAP stand-alone financial statements since it is prohibited from early adopting Ind AS. However to enable M Co to prepare Ind AS CFS, the NBFC subsidiary will also need to provide Ind AS numbers to M Co.

Conclusion
A group that has NBFC and non NBFC companies will bear a huge burden of preparing financial statements under both Indian GAAP and Ind AS. RBI/ MCA can remove this burden by allowing NBFCs, particularly those that are not systemically important to early adopt Ind AS.

In the author’s opinion, in such an instance, NBFC should have the option of earlier adoption of Indian AS. A clarification will avoid confusion and duplication.

Ind AS 115 – Revenue From Contracts With Customers

The impact
of revenue is all pervasive and encompasses all entities. The standard brings
about a fundamental change in how entities will envision, recognise and measure
revenue. In this article the author briefly discusses the date of applicability
of Ind AS 115, the fundamental changes from current practice, key impacts for
certain industries and disclosure and other business implications. Given the
pervasive and fundamental impact of the standard, entities that have not
already started, should waste no time in preparing for Ind AS 115.

 

When does Ind AS 115
apply?

The Exposure Draft (ED)
issued by the ICAI states that the standard would apply from accounting periods
commencing on or after 1st April 2018.

 

However, it is not yet
notified by the Ministry of Corporate Affairs (MCA). In the past we have
observed instances where standards have been notified on the last day of the
financial year. Whilst there is no 100% guarantee that the standard would apply
from 1st April, 2018, companies should anticipate that it would be
notified by MCA before the end of the financial year, given the past
experience.

 

Whilst this is an unhappy
outcome, it may be noted that the ICAI had clarified the applicability date in
April 2017 and the ED was issued much earlier; providing enough opportunity to
prepare for implementation of the new standard. By the time this article is
published, it will be clear whether the standard has become applicable. It may
be noted that listed companies will have to churn out numbers under Ind AS 115
in the first quarter of 2018-19, and hence this is a highly onerous obligation,
than what may initially appear.

 

What are the fundamental
changes compared to the existing Ind AS 18 Revenue?

Ind AS 115 requires
perceiving revenue from the customer’s point of view; which is whether the
customer has received a stand-alone benefit from the goods or services it has
received. This is likely to impact accounting of connection, activation,
installation, admission, and similar revenue. This can be observed across
several industries, such as, telecom, power, cable television, education,
hospitality, etc. Consider for example, an electricity distribution
company installs an electric meter at the customer’s site. The meter certainly
benefits the customer, but it does not provide to the customer any independent
stand-alone benefit, because the meter is useless without the subsequent
transfer of power to the customer. Neither the customer can use the meter to
procure power from other distributors. Therefore, the customer has not received
any benefit from the meter on its own and consequently such connection income
is recognised overtime by the distribution company.

 

The other fundamental
change is that under Ind AS 115, an entity recognises revenue when control of
the underlying goods or services are transferred to the customer. This is
different from the current “risk and reward” model under Ind AS 18, where
revenue is recognised on transfer of risk and rewards to the customer. Consider
an entity transfers legal title and control of goods to a customer on free on
board (FOB) delivery terms. However, the entity reimburses the customer for any
damages or transit losses in accordance with its past practice. Under the Ind
AS 18, risk and reward model, some entities may have delayed recognition of
revenue till the time the customer has received and accepted the goods. This is
on the basis that the risk and rewards are transferred when the customer
receives and accepts the goods. Under the control model in Ind AS 115, revenue
will be recognised on shipment because control is transferred to customers at
shipment. As soon as the goods are boarded, the customer has legal title to the
goods, the customer can direct the goods wherever it wants and the customer can
decide how it wants to use those goods. In this situation, the entity will have
two performance obligations (1) sale of goods, and (2) reimbursing transit
losses. The total transaction price will be allocated between the goods and the
transit losses, and recognised when those respective performance obligations
are satisfied. However, in most situations, the performance obligation relating
to reimbursement of the transit losses may be insignificant, in which case it
may be ignored.

 

There are numerous other
changes that may not be fundamental, but still be very important. Take for
example, the discounting of retention monies. Currently under Ind AS 18 there
is debate on whether retention monies need to be discounted. This is because of
contradictory requirements in the standard. One view is that since revenue is
recognised at fair value, the retention monies need to be discounted to
determine the fair value of revenue. Ind AS 18 also states that “when the
arrangement effectively constitutes a financing transaction, the fair
value of the consideration is determined by discounting all future receipts
using an imputed rate of interest…………….The difference between the fair value
and the nominal amount of the consideration is recognised as interest revenue
in accordance with Ind AS 109.” This means that discounting is only required
when the arrangement contains a financing arrangement. Ind AS 18 was therefore
debatable.

 

On the other hand, Ind AS
115, is absolutely clear. Paragraph 62 states that “notwithstanding the
assessment in paragraph 61, a contract with a customer would not have a
significant financing component if any of the following factors exist: ………….(c)
the difference between the promised consideration and the cash selling price of
the good or service (as described in paragraph 61) arises for reasons other
than the provision of finance to either the customer or the entity, and the
difference between those amounts is proportional to the reason for the
difference. For example, the payment terms might provide the entity or the
customer with protection from the other party failing to adequately complete
some or all of its obligations under the contract.

 

Since retention monies are
held by customers as a measure of security to enforce contractual rights and
safeguard its interest, retention monies are not discounted under Ind AS 115.

 

Explain the five step model
in

Ind AS 115 and briefly
outline the impact on industry.

The model in the standard
is based on five steps, which are given below.

 

Step 1:
Identify the contract: A contract has to be enforceable and the transaction
price should be collectable on the day the contract is entered into. The
contract can be written or oral, but has to be enforceable. If the contract is
not enforceable revenue cannot be recognised.

 

Step 2:
Identify performance obligations: Within a contract there could be several
performance obligations. Performance obligations are basically distinct goods
and services within a contract from which the customer can benefit on its own.

 

Step 3: This
step requires determining the transaction price in the contract. Whilst in most
cases this would be fairly straight-forward, in certain contracts, it could be
complicated because of:

 

– Variable consideration (including application of the constraint)

– Significant financing component

– Consideration paid to a customer (for example, free mobile
offered to a customer that buys a telecom wireless package)

– Non-cash consideration

 

The standard deals in
detail on how to recognise, measure and disclose the above components.

 

Step 4: Allocate
the transaction price to the various performance obligations in the contract.

 

Step 5:
Recognise revenue when (or as) performance obligations are satisfied. This can
be at a point in time or over time.

 

The construct of the model
is very simple but when applied, can throw huge challenges and is very
different from current Ind AS 18. It may be noted, that there would be numerous
areas of differences and challenges for each industry. Below is a broad outline
of the impact of the standard and the interplay of the five steps on various
industries. It is a very brief summary of a few of the many issues, used only
for illustration purposes.

 

Real estate

Real estate entities offer
a 10:90 or similar schemes to customers. As per the scheme, the customer pays
10% of the contract value on signing the offer letter, followed by a 90%
payment when the unit is delivered to the customer. If real estate prices fall
significantly, the customer may simply decide not to take delivery, and allow
the 10% to be forfeited. In many jurisdictions, such contracts may not be
legally enforceable against the customer and when enforceable the legal system
could be a huge deterrent to recover the monies from the customer. If this is
the situation, there is no enforceable contract under Ind AS 115, and
consequently no revenue is recognised till such time the contract is enforceable
or the remaining 90% is received by the real estate entity.

 

Another hot topic for real
estate entities would be the method for recognition of revenue, i.e. whether
percentage of completion method (POCM) or completed contract method (CCM) would
apply when a building is constructed which has several units sold to different
customers. In this case, since the customer does not control the underlying
asset itself, as it is getting constructed, revenue is recognised only on
delivery of the real estate unit to the customer. This issue was discussed in
detail by IFRIC at a global level. IFRIC observed the following: although the
customer can resell or pledge its contractual right to the real estate unit
under construction, it is unable to sell the real estate unit itself without
holding legal title to the completed unit. Consequently, the real estate entity
is not eligible for overtime recognition of revenue. However, the standard
allows overtime recognition of revenue, in situations where the real estate entity
has the right to collect payments from the customer for work completed to date.
Such amounts should include cost and an appropriate margin. If the real estate
entity does not have such a right, in statute and contract, POCM recognition of
revenue is not allowed. In other words, revenue is recognised when the
completed unit is delivered to the customer. Real estate entities in India that
want to apply POCM should verify if the statute entitles them with such a
right. If such a right is provided in the statute, they should ensure that the
contract with the customer also provides such a right.

 

Pharmaceutical

Some Indian pharmaceutical
companies have sales in US, through a few large US distributors on a principal
to principal basis. However, the amount of revenue to be received from the US
distributors may be variable, as the contract may have a price capping
mechanism or provide an unlimited right of return to the US distributors. The
price capping mechanism ensures that if the entity sells the same products at a
lower price to other customers, the distributor would be entitled to a
proportionate refund.

 

The US distributors will
send a sales report containing quantity and value to the pharma company on a
quarterly basis. Under current standards, some pharmaceutical companies may not
recognise revenue on dispatch to the US distributor, but recognise revenue
based on reported sales at the end of each quarter; effectively treating the US
distributor as an agent. This is because the risks and rewards may not have
transferred to the US distributor who has an unlimited right of return and is
also entitled to the benefit from the price capping mechanism. Under Ind AS
115, the control of goods is transferred to the distributor on dispatch since
the US distributor has legal title and ownership of the goods.

 

The pharma company does not
have any rights to recover the products, except as a protective right in rare
situations. Consequently, the pharma company recognises revenue upfront when
the control of the goods is transferred to the distributor. Since revenue is
variable because of the price capping mechanism and the unlimited right of
return, the transaction price will need to be estimated in accordance with the
methodology prescribed in the standard.

 

Software Company

Many Indian software
companies applied the US GAAP accounting for Indian GAAP as well. Under US
GAAP, a software company needs to separately account for elements in a software
licensing arrangement only if Vendor Specific Objective Evidence (VSOE) of fair
value exists for the undelivered elements. An entity that does not have VSOE
for the undelivered elements generally must combine multiple elements in a
single unit of account and recognise revenue as the delivery of the last
element takes place. VSOE is not required under Ind AS 115. The standard
prescribes a methodology for determining and allocating the transaction price
to various elements, which uses VSOE but in its absence prescribes other
methods of determining the allocation of the transaction price to the various
elements.

 

Telecom

Telecom companies may offer
a free handset to customers along with a wireless telecom package (voice and
data). Currently, some telecom companies recognise the telecom package overtime
and the cost of the free handset is recognised as a sales promotion cost. Under
Ind AS 115, the total consideration will be split between the telecom package
and the handset, and recognised as those performance obligations are satisfied.
This would give a completely different revenue, cost and margin pattern
compared to current practice.

 

Engineering and
Construction

The standard contains a
detail set of requirements on how to account for contract modifications. For
example, an unpriced change order is common in construction contracts; wherein
the scope of work is changed by the customer but the price for the change is
not agreed. The standard would require that the revenue and cost estimates on
the contract are immediately updated, consequently percentage of completion
margins would change. The problem is that revenue from the change in scope is
variable and the standard requires caution in estimating the variable revenue,
whereas costs are fully estimated. Consequently, the initially estimated POCM
margins may decline.

 

Consumer products and other

industries

An entity may have sold
goods, but on request from the customer, would have held those goods in its
storage facility. This is often referred to as bill and hold sales and is
common across all industries. For example, some pharmaceutical companies may
have a stock pile program for vaccinations based on government directives or a
consumer goods company may hold goods sold at its storage location on request,
as the distributor may be short of storage space. Contrary to current practice,
under Ind AS 115, in many cases bill and hold sales may not qualify for revenue
recognition because the underlying goods are fungible. For example, the stock
pile program may not qualify for revenue recognition, if they are subject to rotation,
i.e., the entity can sell some from the pile to another customer and replace it
with fresh supplies. These arrangements do not meet the criterion for
recognition of revenue on bill and hold sales, though they may have fulfilled
the criterion under Ind AS 18.

 

Another common topic
relevant for a consumer goods and other companies is warranties. If the
warranties are sold separately, or warranty entails a service in addition to
assurance (such as an extended warranty period), they are accounted for as a
separate performance obligation, rather than as a cost accrual.

 

Currently, the entire
revenue is recognized upfront and estimated cost for warranty is provided.
Under Ind AS 115, revenue will be allocated between the goods and the warranty.
Revenue and cost of goods is recognised as soon as the goods are sold. Revenue
and cost on warranties is recognised overtime as the warranty service is
provided.

 

This will result in a
different revenue, cost and margin profile compared to current practice under
Ind AS 18. It may be noted, that if the warranties are assurance type
warranties, and not sold separately or contain extended terms, the accounting
under Ind AS 18 and Ind AS 115 is the same.

 

Which are the disclosure
requirements that are onerous?

There are numerous
disclosure requirements. Entities should not underestimate the disclosure
requirements. Here we discuss two key disclosure requirements.

 

1. Entities will be
required to provide disaggregated revenue information in the financial
statements. The standard requires such disclosure on the basis of major product
lines, geography, type of market or customer (government, non-government, etc.),
contract duration, sales channel, etc., whichever is the most
appropriate and relevant for the entity. The standard provides guidance on how
this disclosure is made, and suggests that existing information provided to the
CEO, board, analysts, etc. may be used, and one need not reinvent the wheel.

 

2. For contracts or orders
that require more than one year to execute, the standard requires disclosure of
(a) transaction price allocated to the unsatisfied or partially satisfied
performance obligations, and (b) time bands by which the obligations will be
fulfilled and revenue recognised. For the said purpose, quantitative or
qualitative measures can be used.

 

What are the business

implications of Ind AS 115?

Certainly when top line and
margins change compared to current accounting, it will have numerous
implications, such as on income-tax, bonuses that are dependent on
revenue/margins, revenue sharing arrangements, contract terms and conditions,
internal control over financial reporting, etc. For example, companies
may change the sales arrangement with their distributors, to provide them
control at the point of shipment, so that revenue can be recognised at
shipment, rather than when the customer accepts the goods.

 

Certain business implications may
not be immediately obvious. Some companies may accept onerous contracts, to
recover some portion of the fixed costs/capacity. The IFRIC is currently
discussing whether when providing for onerous contract full cost provision or
only incremental cost needs to be provided for. Now if full cost absorption is required,
more onerous losses get recognised earlier. This may be a deterrent for
companies to accept a contract that is onerous.

Perspectives On Fair Value Under Ind As (Part 2)

INTRODUCTION

Under Part 1 which was published in February 2018, we had discussed the broad principles underlying fair value measurement as enshrined in Ind AS 113- Fair Value Measurements. In this part,  we would be broadly understanding the requirements for measurement and disclosure of fair value for various types of assets, liabilities and equity under various Ind ASs as indicated in Part 1, coupled with the benefits and perils of fair value accounting followed by certain practical considerations for first time adoption by Phase II entities based on the learnings gathered from the Phase I entities.

BROAD PRESCRIPTION ON FAIR VALUE UNDER CERTAIN Ind ASs:
As indicated earlier, the following are the main Standards which prescribe the use of fair value either for measurement, disclosure or assessment purposes.

Ind AS 36- Impairment of Assets:

The broad objectives of this Standard are as under:

a) To observe if there are any indicators of impairment of various assets.
b) To measure the recoverable amount and compare the same with the carrying value of the asset.
c) To impair the assets if the carrying value is greater than the recoverable amount.

The key consideration for assessing impairment is the determination of the recoverable amount which is defined as the higher of the “Value in Use” or “Fair value less Costs of Disposal”.

“Value in Use” for the purpose of the above assessment is determined by estimating the future cash flows that can be derived from the continuous use of the asset including its realisable value on ultimate disposal and discounting the same at an appropriate rate after considering the risk, premium or discount as applicable.The principles underlying the present value technique as per Ind AS 113 as discussed in Part 1 need to be kept in mind whilst estimating the future cash flows and the discount rate to be applied for arriving at the value in use.

The “Fair Value less Cost of Disposal” for the purpose of the above assessment refers to the amount arising from the sale of an asset or CGU in an arm’s length transaction less the cost of disposal. The costs of disposal includes legal costs, stamp duty and other similar levies, as applicable, cost of removing the asset and direct incremental costs to bring the asset into a selling condition. However, finance costs and income tax expenses need to be excluded whilst determining the cost of disposal. For determining the fair values,  the principles as enunciated under Ind AS 113 as discussed in part 1 need to be kept in mind. However, there is no bar on the type of valuation technique to be used.

Apart from the other disclosures, Ind AS 36 requires the following specific disclosures dealing with fair value:

a) The basis used for determining the recoverable amount keeping in mind the fair value hierarchy as per Ind AS 113 discussed earlier.
b) The key assumptions and the discount rate considered for determining the value in use as defined above.

Ind AS 103- Business Combinations:

This Standard deals with the initial recognition of assets and liabilities in respect of business combinations which could be in the nature of acquisitions or amalgamation under common control transactions. In respect of business combinations accounted for under the “acquisition method”, the initial recognition of assets and liabilities is as under:

– Recognising and measuring all the identifiable assets, whether tangible or intangible, including those that are not previously recognised by the acquiree, and liabilities (including contingent liabilities) at fair value as determined as per Ind AS 113.

– Any contingent consideration which forms a part of the transaction also needs to be accounted at fair value in accordance with Ind AS 109 or 113, as applicable.

– Any goodwill resulting from the transaction needs to be tested annually for impairment in accordance with Ind AS 36 as discussed above.

This is one of the key Standards wherein extensive use of fair valuation is mandated. The broad principles governing fair valuation under Ind AS 113 would need to be kept in mind depending upon the nature of the assets and liabilities being acquired.

Further, apart from the other matters, the main challenge lies in identifying the intangible assets acquired as a part of the business combination which have not been recognised by the acquiree, but which meet the recognition and identifiability criteria and to allocate a fair value to them as a part of the overall consideration. This would require significant judgements based on the business rationale and other commercial considerations of the transaction. The broad principles governing the determination of fair value as discussed later, under Ind AS 38 – Intangible Assets would need to be kept in mind. The following are some of the broad categories related to intangible assets arising from acquisitions under business combination:
– Marketing
– Customer
– Artistic
– Contractual
– Technology

Ind AS 109- Financial Instruments:

This is another Standard which almost entirely rests on the premise of fair valuation. The underlying theme of the Standard is that all financial assets and liabilities should be initially measured at fair value as determined under Ind AS 113, which would normally be the transaction price, unless proved otherwise as discussed below.

Para B 5.1.2A of Ind AS 109 provides that the transaction price may need to be adjusted on initial recognition if there is a fair value as evidenced by a quoted price in an active market for an identical asset or liability (level 1) or based on a valuation technique that uses data only from observable markets (level 2).

The way the financial instruments are classified under Ind AS 109 drives their subsequent measurement.

Whilst the valuation of quoted financial instruments is quite straight forward, it is the valuation of unquoted and complex financial instruments, including derivatives, which poses various challenges given their hybrid nature and the difficulty in quantifying the associated risks. Whilst a detailed discussion of the valuation methods is beyond the scope of this study, the broad underlying principles are briefly touched upon hereunder.

For ease of understanding, financial instruments are classified into the following broad categories for valuation purposes:
a) Bonds and its variants
b) Forwards and futures
c) Call and put options
d) Equity Instruments

In respect of the instruments indicated in (a) to (c) above, determination of fair value needs to  consider the various specific features like conversion options, put and call options, caps and floors and various other subjective assessments and judgements which are captured through various mathematical models. However, if such instruments are traded and quoted on a recognised stock exchange, the challenges in determining fair value are much less.

Equity Instruments:

The valuation of equity instruments is dependent on the underlying valuation of the company which has issued these instruments. For this purpose, the appropriate valuation methodology from amongst the various methods as discussed earlier would need to be considered dependent upon the nature of the business / industry and the purpose of the valuation whether on a going concern or liquidation basis etc.
 
A question which often arises in case of unquoted equity shares is the basis and frequency with which the fair value needs to be measured due to lack of credible recent information being available and consequently whether the cost can be considered as the fair value. In this context, para B 5.2.3 of Ind AS 109 provides that in limited circumstances, cost may be an appropriate estimate of fair value, especially in case if insufficient more recent information is available to measure fair value, or if there is a wide range of possible fair value measurements and cost represents the best estimate of fair value within that range. Further, para B5.2.4 of Ind AS 109 provides for a list of some of the following indicators, amongst others, where cost might not be representative of the fair value:

a) Significant change in the performance of the investee compared with budgets, plans or milestones.
b) Changes in expectation that the investee’s technical product milestones will be achieved.
c) Significant change in the market for the investee’s equity or its products or potential products.
d) Significant change in the global economy or the economic environment in which the investee operates.
e) Significant change in the performance of comparable entities, or in the valuations implied by the overall market.

Ind AS 28- Investments in Associates and Joint
Ventures:

The Standard provides that an investment in an associate or joint venture should be accounted by using the equity method under which the investment is initially recognised at acquisition cost. Subsequent to the acquisition, the difference between the cost of the investment and the investee’s share of the net fair value of the identifiable assets and liabilities, determined in accordance with Ind AS 113, is accounted as under:

– Goodwill – if the cost of the investment is greater than the investee’s share of the net fair value of the assets and liabilities. This goodwill is to be adjusted with the carrying value of the investment and is neither eligible for amortisation nor is it to be tested for impairment.

– Capital Reserve– if the investee’s share of the net fair value of the assets and liabilities is greater than the cost of the investment.

Further, such investments are to be tested for impairment in accordance with Ind AS 36 as a single asset.

Ind AS 38- Intangible Assets:

Any intangible asset which satisfies the recognition criteria as per the Standard shall be measured at cost. However, in the following situations, the intangible assets are required to be measured at fair value:

– Business Combinations – As discussed above, in such cases the cost shall be the fair value as on the acquisition date.

– Government Grants – In such cases, the entity shall recognise both the intangible asset and the grant initially at the fair value as per Ind AS 20 – Accounting for Government Grants and Disclosure of Government Assistance.

– Acquisition for non-monetary consideration– If any intangible asset is acquired in exchange of non-monetary considerations, the cost shall be the fair value of the asset given up or the fair value of the asset received which is more evident.

An entity has an option of choosing the revaluation model for subsequent measurement of intangible assets. However, for this purpose, the revaluations shall be done with sufficient regularity to ensure that the carrying value does not differ materiality from the fair value determined in accordance with Ind AS 113. Further, the entire class of intangible assets shall be subjected to revaluation. The frequency of revaluation depends upon the changes in the fair value of the intangible assets being revalued.

Whilst a detailed discussion of the valuation methods to be adopted for intangible assets is beyond the scope of this study, the broad underlying principles are briefly touched upon hereunder.

– Income Approach– As discussed earlier, this approach converts future cash flows to a single present value and discounting the same based on a rate or return that considers the relative risk of the cash flows. This approach is most commonly used to value technology and customer related intangibles, brands, trademarks and non-compete arrangements. The following variations to the income approach are also used to measure certain types of intangible assets:

a) Multi period excess earnings method as discussed earlier.

b) Relief from Royalty method– which is generally used for assets subject to licencing. The fair value of the asset under this method is the present value of the licence fee avoided by owning the asset (i.e. the savings in royalty).

c) With and without method – the value of the intangible asset in question is calculated by taking the difference between the business value estimated under two sets of cash flow projections for the whole business and without the intangible asset in question.

– Market Approach – This method is used for certain type of assets which trade as separate portfolios such as FMCG or pharmaceutical brands or licences.

– Cost Approach – This method is adopted for certain types of intangibles that are readily replicated or replaced such as software, assembled workforce etc.

Further, all intangible assets with a finite useful life need to be amortised and tested for impairment in accordance with Ind AS 36. Finally, all intangible assets with an indefinite useful life need to be tested annually for impairment.

Ind AS 102- Share Based Payments:

Ind AS 102 deals with the following types of share based payments:

– Equity settled share based payments
– Cash settled share based payments
– Share based payment transactions with alternatives

All transactions involving share based payments are recognised as expenses or assets over the underlying vesting period. Transactions with employees are measured on the date of grant and those with non-employees are measured when the goods or services are received.

In case of measurement of equity settled share based payment transactions, the goods or services received by an entity are directly measured at the fair value of such goods or services received. However, in case such fair value cannot be estimated reliably, the fair value is measured with reference to the fair value of the equity instruments granted.

In case of measurement of cash settled share based payment transactions, the goods or services received by an entity and the liability incurred will be measured at the fair value of the liability. This liability has to be re-measured at each reporting date, up to the date of settlement and changes in the fair value are to be recognised in the profit or loss for the period.

In case of transactions with employees, the fair value of the equity instrument must be used and if it is not possible, the intrinsic value may be used.

The term fair value is defined in the Standard as the amount for which an asset could be exchanged, a liability settled, or an equity instrument granted could be exchanged between knowledgeable, willing parties in an arm’s length transaction.  This definition is different in some respects from the definition in Ind AS 113.

Ind AS 16– Property, Plant and Equipment:

Any item of property, plant or equipment which satisfies the recognition criteria as per the Standard shall be measured at acquisition cost.

An entity has an option of choosing the revaluation model for subsequent measurement of property, plant or equipment. However, for this purpose, the revaluations shall be done with sufficient regularity to ensure that the carrying value does not differ materiality from the fair value determined in accordance with Ind AS 113. Further, the entire class of property, plant or equipment shall be subjected to revaluation. The frequency of revaluation depends upon the changes in the fair value of the property, plant or equipment being revalued.

Whilst a detailed discussion of the valuation methods to be adopted for property, plant and equipment is beyond the scope of this study, the broad underlying principles are briefly touched upon hereunder.

– Market Value:– In case of real estate properties, the market approach is best suited by considering relevant information generated by market transactions for similar assets.

– Replacement Value:- In case of equipment, the replacement value is the most suitable method since that represents the price that an acquirer would pay after adjusting for obsolescence, physical wear and tear and other technological considerations.

Ind AS 40- Investment Property:
Any item of investment property which satisfies the recognition criteria as per the Standard shall be measured at acquisition cost.

Unlike in the case of property, plant and equipment and intangible assets, the subsequent measurement of investment property should be on the basis of the cost model. However, there is a mandatory requirement to disclose the fair value of investment property on the basis of a valuation by an independent valuer who holds a recognised and relevant professional qualification.
Whilst the fair value would need to be determined in accordance with the principles laid down in Ind AS 113, Ind AS 40 also lays down certain broad parameters, as under, for determining the fair value, which  valuers would need to keep in mind.

– When measuring the fair value of investment property in accordance with Ind AS 113, an entity shall ensure that the fair value reflects, among other things, rental income from current leases and other assumptions that market participants would use when pricing investment property under current market conditions.

– There is a rebuttable presumption that an entity can reliably measure the fair value of an investment property on a continuing basis. However, in exceptional cases when the fair value of the investment property is not reliably measurable on a continuing basis (e.g. there are few recent transactions, price quotations are not current or observed transaction prices indicate that the seller was forced to sell) and alternative reliable measurements of fair value (for example, based on discounted cash flow projections) are not available, or if an entity determines that the fair value of an investment property under construction is not reliably measurable but expects the fair value of the property to be reliably measurable when construction is complete, it shall measure the fair value of that investment property either when its fair value becomes reliably measurable or construction is completed (whichever is earlier). In such cases, specific disclosures need to be given.

– If an entity has previously measured the fair value of an investment property, it shall continue to measure the fair value of that property until disposal (or until the property becomes owner-occupied property or the entity begins to develop the property for subsequent sale in the ordinary course of business) even if comparable market transactions become less frequent or market prices become less readily available.

Ind AS 41 – Agriculture:

This Standard applies to biological assets, agricultural produce at the point of harvest and government grants related to biological assets.

The fair value of biological assets and agricultural produce at the point of harvest shall be measured in accordance with Ind AS 113.

A biological asset needs to be measured on initial recognition as well as at the end of each reporting period at its fair value less cost to sell, unless the same cannot be determined in which case it needs to be measured at cost less accumulated depreciation and accumulated impairment losses.

Any agricultural produce harvested from an entity’s biological assets should also be measured at its fair value less the cost to sell at the point of harvest.

BENEFITS AND PERILS OF FAIR VALUE ACCOUNTING:
As is the case with any journey, the journey of fair value accounting under Ind AS also has a smooth ride and at the same time there are several roadblocks. Let us now briefly review its benefits as well as understand its perils and challenges.

Benefits of Fair Value Accounting:

Some of the major benefits of fair value accounting are discussed below:

– Realistic Financial Statements – Companies reporting under this method have financial statements that are more accurate than those not using this method. When assets and liabilities are reported for their actual value, it results in more realistic financial statements. When using this method, companies are required to disclose information regarding changes made on their financial statements. These disclosures are done in the form of footnotes. Companies have an opportunity for examining their financial statements with actual fair values, allowing them to make wise choices regarding future business operations.

– Benefit to Investors – Fair value accounting offers benefits for investors as well, since fair value accounting lists assets and liabilities for their actual value. Accordingly, financial statements reflect a clearer picture of the company’s health. This allows investors to make wiser decisions regarding their investment options with the company. The required footnote disclosures allow investors a way of examining the effects of the changes in statements due to fair values of the assets and liabilities.

– Timely Information – Since fair value accounting utilises information specific for the time and current market conditions, it attempts to provide the most relevant estimates possible. It has a great informative value for a firm itself and encourages prompt corrective actions.

– More data than historical cost – Fair value accounting enhances the informative power of the financial statements vis–a-vis the historical cost. Fair value accounting requires an entity to disclose extensive information about the methodology used, the assumptions made, risk exposure, related sensitivities and other issues that result in a more thorough financial statement.

– Mirrors Economic Reality – Proponents of fair-value accounting argue that using fair-value measurements is necessary for financial records to represent the economic reality of the business. Since conventional accounting only allows for asset values to be written down, book values tend to underestimate the value of assets. Fair-value accounting allows the value of investments as well as other assets (subject to choices being exercised) to be written up and down as market values change. Perils and Challenges of Fair Value Accounting:

Though there are several benefits in adopting fair value accounting, it is not without its fair share of perils and challenges, some of which are discussed hereunder:

– Frequent Changes – In times of volatility, values can change quite frequently which would lead to major swings in a company’s value and earnings. Publicly held companies find this difficult as investors may find it difficult to value the company when such swings take place. Additionally, the potential for inaccurate valuations can lead to audit problems, which are discussed separately.

– Less Reliable – Traditional accountants may find fair value accounting less reliable than historical costs. When an item has different values across different regions and entities, accountants must make a judgement call on valuing items on their books. If a company with similar assets or investments values items differently than another, issues may arise because of the differences in valuation methods.

–Inability to value certain Assets – Businesses with specialised assets may find it difficult to value these items on the open market. When no market information is available, accountants must make a professional judgement on the item’s value. Accountants must also make sure that all valuation methods used are viable and take into account all technical aspects of the item.

– Subjectivity – For assets that are not actively traded on a public exchange, fair-value measurements are subjectively determined. While the Accounting Standards provide a hierarchy of inputs for fair-value measurements, only level 1 inputs are unadjusted quoted market prices in active markets for identical items. If these are not available, the company either has to look to similar items in active markets, inactive markets for identical items, or unobservable company-provided estimates. These level 2 and level 3 estimates can also be a bone of contention between auditors and management.

Challenges for Auditors:

Whilst there are several challenges in adopting fair value accounting, by far the greatest challenge in implementing fair value accounting is faced by the auditors since they cannot abdicate their responsibilities on the ground that the fair values are determined by specialists and experts. In this context, SA-540 on Auditing Accounting Estimates, Including Fair Value Estimates, makes it clear that the auditors should identify and assess the risk of material misstatements and perform appropriate procedures to mitigate the same. However, several challenges are likely to be encountered by auditors in the course of their audit of the fair value estimates whether determined by the Management or the experts / specialists, due to the following factors:

– Fair value accounting estimates are expressed in terms of the value of a current transaction or financial statement item based on conditions prevalent at the measurement date;

-The need to incorporate judgements concerning significant assumptions that may be made by others such as experts employed or engaged by the entity or the auditor;

– The availability (or lack thereof) of information or evidence and its reliability;

– The choice and sophistication of acceptable valuation techniques and models;

– The need for appropriate disclosure in the financial statements about measurement methods and uncertainty, especially when relevant markets are illiquid; and

– The possibility of Management Bias in making estimates, selection of the method of valuation and finally the valuer itself (if there is a conflict of interest)!

SA-540 deals with the overarching requirement for the auditor to obtain sufficient appropriate audit evidence that fair value measurements and disclosures are in accordance with the entity’s applicable financial reporting framework. Within the SA, additional requirements tailor the requirements in other SAs to the audit of fair value; in particular, those dealing with the following matters:

– SA-315 – Understanding the entity and its environment and assessing the risks of material misstatement,
–  SA-330 – Responding to assessed risks;
–  SA-240 – Responsibilities relating to fraud;
–  SA-570 – Going Concern;
–  SA-620 – Using the work of an expert;
–  SA-580 – Obtaining management representations; and
– SA-260 – Communicating with those charged with governance.

Thus it is imperative for the auditor to ensure that the requirements of the SAs are complied with by taking due care and exercising professional scepticism whilst auditing the fair value estimates and documenting the reasonableness of the management estimates and judgements regarding fair value, keeping in mind the principles laid down in Ind AS-113.

PRACTICAL CHALLENGES AND DECISIONS FOR IMPLEMENTATION BY PHASE II ENTITIES:

Key Learnings from Phase I Entities due to Adoption of Fair Value Accounting:

Some of the key learnings in the context of fair value accounting during the transition to Ind AS by phase I companies are of a net increase in the net worth of the top 100 listed entities due to adoption of fair value accounting in respect of investments (including in group companies) and property plant and equipment based on the options available on transition (which are discussed below) with a corresponding reduction in the Profit after Tax due to increased depreciation on property, plant and equipment as a result of fair value thereof.

Implementation Issues by Phase II Entities due to Adoption of Fair Value Accounting:

The transition to Ind AS by Phase II entities is already underway for the remaining listed entities and other entities having a net worth of more than Rs. 250 crores during the current financial year ending 31st March, 2018 and they would need to take certain decisions on the accounting choice from a fair value perspective keeping in mind the following matters, whilst transitioning to Ind AS.

Mandatory Fair Value Accounting:

In respect of the following areas fair value accounting would be mandatory, except that in certain cases an option has been given to adopt it either retrospectively or prospectively, as indicated there against, as provided for in Ind AS 101- First Time Adoption of Ind AS.

Area

Transition Applicability

Ind
AS 109 – Financial Instruments

Retrospectively
(optional)

Ind
AS 102  – Share Based Payments

Retrospectively
(optional)

Ind
AS 103 – Business Combinations

Retrospectively
(optional)

In respect of the first two items before taking any decision to adopt fair value retrospectively, the entity would need to take into account whether all the data and information is available to enable the computation of the fair value since origination, including but not limited to details of the cash flows and other data and assumptions required for valuation purposes. If the necessary data is not available or it is impractical and costly to reconstruct the same, the entity could adopt fair value prospectively from the date of transition. These decisions would accordingly have an impact on the net worth on the date of transition.

In respect of Ind AS 103, the entity has three options as under, to account for business combinations as per the acquisition method on a fair value basis, as provided in Ind AS 101:

a) To restate past business combinations retrospectively; or
b)  To restate past business combinations from any other earlier date,  in which case, all business combinations after that date would have to be restated; or
c) To apply Ind AS 103 prospectively.
This choice, like in the earlier two cases, would depend upon whether the necessary data and information is available as also the business rationale of the earlier acquisitions to enable fair values to be attributed to any intangibles especially against any goodwill which is accounted, whose amortisation would need to be reversed and it would need to be tested for impairment annually. Any such decisions could have a significant impact on the consolidated net worth.

Voluntary Fair Value Accounting:

The most significant decision for entities with regard to fair value on transition to Ind AS is whether to elect to measure an item of property, plant and equipment at the date of transition at its fair value and use that fair value as its deemed cost in accordance with para D5 of Ind AS 101.

Further, as per para D6 of Ind AS 101, a first-time adopter may elect to use a previous GAAP revaluation of an item of property, plant and equipment at, or before, the date of transition to Ind ASs as deemed cost at the date of the revaluation, if the revaluation was, at the date of the revaluation, broadly comparable to:
 
a) fair value; or
b) cost or depreciated cost in accordance with Ind ASs, adjusted to reflect, for example, changes in a general or specific price index.

The requirements discussed above also apply to intangible assets which meet the recognition and revaluation criteria as per Ind AS 38.

It needs to be noted that the above requirement is different from adopting the fair value model as laid down under Ind AS 16 and is a one-time decision to use the fair value as the new deemed cost which may have an immediate positive impact on the net worth but would impact the profitability on an ongoing basis if depreciation needs to be provided, unless the asset in question is land.

Finally, the above decisions on transition would have tax implications including under MAT, which have not been separately discussed but which would also need to be factored in before a final decision is taken.

CONCLUSION:
The above evaluation is just the tip of the ice-berg on a subject that is quite vast and complex. However, fair value accounting is here to stay and it would impact the way the financial statements are evaluated and also impact the auditors but prove to be a bonanza for valuation specialists who can laugh all the way to the bank!

Accounting For Uncertainty Over Income Tax Treatments

Background

IAS 12 (Ind AS 12) Income
Taxes specifies requirements for   
current   and   deferred  
tax   assets  and  
liabilities. However, there was no
clarity with respect to recognition and  
measurement   of   uncertain  
tax   treatments.  An‘uncertain tax treatment’
is a tax treatment for which there is uncertainty over whether the relevant
taxation authority will accept the entity’s tax treatment under tax law. For
example,   an   entity’s  
decision   not to include
particular income in taxable profit,
is an uncertain tax treatment if its acceptability   is  
uncertain   under  tax 
law. IFRIC 23 Uncertainty over Income Tax
Treatments is an interpretation of IAS 12 that deals with recognition and
measurement of uncertain tax treatments. A corresponding interpretation is not
yet issued under Ind AS, but is expected shortly.

 

Uncertainty over Income Tax Treatments

In assessing whether
uncertainty over income tax treatments exists, an entity may consider a number
of indicators including, but not limited to, the following:

 

–    Ambiguity in the drafting of relevant tax
laws and related guidelines (such as ordinances, circulars and letters) and
their interpretations

–    Income tax practices that are generally
applied by the taxation authorities in specific jurisdictions and situations

–    Results of past examinations by taxation
authorities on related issues

–    Rulings and decisions from courts or other
relevant authorities in addressing matters with a similar fact pattern

–    Tax memoranda prepared by qualified in-house
or external tax advisors

–    The quality of available documentation to
support a particular income tax treatment.

 

Unit of Account

The Interpretation requires
an entity to determine whether to consider each uncertain tax treatment
separately or together with one or more other uncertain tax treatments. This
determination is based on which approach better predicts the resolution of the
uncertainty. In determining the approach that better predicts the resolution of
the uncertainty, an entity might consider, for example, (a) how it prepares its
income tax filings and supports tax treatments; or (b) how the entity expects
the taxation authority to make its examination and resolve issues that might
arise from that examination. 

 

The author believes that
interdependent tax positions (i.e., where the outcomes of uncertain tax
treatments are mutually dependent) should be considered together. Significant
judgement may be required in the determination of the unit of account. In
making the judgement, entities would need to consider the approach expected to
be followed by the taxation authorities to resolve the uncertainty. The
judgement required in the selection of a unit of account may be particularly
challenging in groups of entities trading in various jurisdictions where the
relevant tax laws or taxation authority treat similar elements differently.

 

Example 1 – Unit of account

Entity A is part of a
multinational group and provides intra-group loans to affiliates. It is funded
through equity and deposits made by its parent. Whilst the entity can show that
its interest margin earned on many loans is at an appropriate market rate,
there are loans where the rate is open to challenge by the taxation
authorities. However, Entity A determines that, across the loan portfolio as a
whole, the existence of rates above and below a market comparator results in an
overall interest margin that is within a reasonable range accepted by the
taxation authorities.

 

Depending on the applicable
tax law and practice in a specific jurisdiction, a taxation authority may accept
a tax filing position on the basis of the overall interest margin if it is
within a reasonable range. However, there might be other taxation authorities
that would examine the interest rate separately for each loan receivable. In
considering whether uncertain tax treatments should be considered separately
for each loan receivable or combined with other loan receivables, Entity A
should adopt the approach that better reflects the way the taxation authority
would examine and resolve the issue.

 

Detection risk

The Interpretation requires
an entity to invariably assume that a taxation authority will examine amounts
it has a right to examine and have full knowledge of all related information
when making those examinations.

 

In some jurisdictions,
examination by taxation authorities is subject to a time limit, sometimes
referred to as a statute of limitations. In others, examination by taxation
authorities might not be subject to a statute of limitations, which means the
authorities can examine the amounts at any time in the future. Some respondents
to the draft Interpretation suggested in their comment letter that an
assessment of the probability of examination would be relevant in this latter
case. However, the IFRS Interpretation Committee (IC) decided not to change the
examination assumption, nor to create an exception to it, for circumstances in
which there is no time limit on the taxation authority’s right to examine
income tax filings.

 

The IC also noted that the
assumption of examination by the taxation authority, in isolation, would not
require an entity to reflect the effects of uncertainty. The threshold for
reflecting the effects of uncertainty is whether it is probable that the
taxation authority will accept an uncertain tax treatment. In other words, the
recognition of uncertainty is not determined based on whether a taxation
authority examines a tax treatment.

 

The Interpretation does not
explain what is meant by ‘results of examinations’. The examination procedures
vary by jurisdiction and, in some jurisdictions, an examination can have
multiple phases. In the author’s view, the communication between an entity and
the taxation authorities during the course of such examinations may provide
relevant information that could give rise to a change in facts and
circumstances before the actual ‘results’ of the examination are formally issued.

 

Example 2 – Detection risk

Entity A is based in
Country B. It is generally known that the taxation authorities in Country B
have limited resources. As a consequence, their examination procedures are
usually limited to a summary assessment of the income tax filings. Scrutiny tax
examinations are only performed in very rare circumstances and if there is a
clear indication of a tax fraud. Entity A has never been subjected to such a
scrutiny examination by the taxation authorities.

 

Prior to the application of
IFRIC 23, Entity A argued that it was unlikely that the taxation authorities
would identify any key income tax exposures not already identified through
their summary assessment, because they could be identified only by analysing
the underlying accounting records. Therefore, Entity A did not recognise any
uncertain tax treatments.

 

With the adoption of IFRIC
23, Entity A would need to consider underlying tax positions even though
scrutiny by the taxation authorities is unlikely. Entity A should assume that
the taxation authority can and will examine amounts it has a right to examine
and have full knowledge of all related information when making those
examinations.

 

Recognition and Measurement

Under IFRIC 23, the key
test is whether it’s probable that the taxation authority would accept the tax
treatment used or planned to be used by the entity in its income tax filings.
If yes, then the amount of taxes recognised in the financial statements would
be consistent with the entity’s income tax filings. Otherwise, the effect of
uncertainty should be estimated and reflected in the financial statements. This
would require the exercise of judgement by the entity. The recognition of
current and deferred taxes including uncertain tax treatments continues to be
on the underlying principle of “probability”. The measurement requirements in
IFRIC 23 do not distinguish between a probability of 51% and a probability of
100%. This is consistent with the objective of IAS 12 (Ind AS 12) that refers
to a probable threshold and with the Conceptual Framework for Financial
Reporting which refers to a probability threshold for the recognition of
assets and liabilities in general. It should be noted that deferred tax assets
on carry forward of losses can be recognised only if there is convincing
evidence that it will be utilised in future years.

 

Example 3 – Current and deferred tax impact

 

Entity C, constructs and
leases wooden chalet at hill stations, and claims 100% depreciation on the
basis that they are temporary structures. However, the tax laws may not
consider them as temporary structures and therefore there is a risk that the
100% depreciation claim may be disallowed. On application of IFRIC 23, Entity C
should reflect the impact of such uncertainties in the measurement of current
and deferred tax assets and liabilities as at the reporting date.

 

An entity may need to apply
judgement in concluding whether it is probable that a particular uncertain tax
treatment will be acceptable to the taxation authority. An entity may consider
the following:

 

–  Past experience related to similar tax
treatments

–   Legal advice or case law related to other
entities

–  Practice guidelines published by the taxation
authorities

–   The entity obtains a pre-clearance from the
taxation authority on an uncertain tax treatment.

 

In defining ‘uncertainty’,
the entity only needs to consider whether a particular tax treatment is probable,
rather than highly likely or certain, to be accepted by the taxation
authorities. If an entity concludes it is probable that the taxation authority
will accept an uncertain tax treatment, the entity shall determine the taxable
profit or loss, deferred taxes, unused tax losses, unused tax credits or tax
rates consistently with the tax treatment used or planned to be used in its
income tax filings. If an entity concludes it is not probable that the taxation
authority will accept an uncertain tax treatment, the entity shall reflect the
effect of uncertainty in determining the related taxable profit or loss,
deferred taxes, unused tax losses, unused tax credits or tax rates. An entity
shall reflect the effect of uncertainty for a unit of uncertain tax treatment
by using either of the following methods, depending on which method the entity
expects to better predict the resolution of the uncertainty:

 

a)   the
most likely amount—the single most likely amount in a range of possible
outcomes. The most likely amount may better predict the resolution of the
uncertainty if the possible outcomes are binary or are concentrated on one
value.

 

b)   the
expected value—the sum of the probability-weighted amounts in a range of
possible outcomes. The expected value may better predict the resolution of the
uncertainty if there is a range of possible outcomes that are neither binary
nor concentrated on one value.

 

If an uncertain tax
treatment affects current tax and deferred tax (for example, if it affects both
taxable profit used to determine current tax and tax bases used to determine
deferred tax), an entity shall make consistent judgements and estimates for
both current tax and deferred tax.

 

Example 4 – Application of Expected Value Method

 

–  Entity A’s income tax filing in a
jurisdiction includes deductions related to transfer pricing. The taxation
authority may challenge those tax treatments.

 

–  Entity A
notes that the taxation authority’s decision on one transfer pricing matter
would affect, or be affected by, the other transfer pricing matters. Entity A
concludes that considering the tax treatments of all transfer pricing matters
in the jurisdiction together better predicts the resolution of the uncertainty.
Entity A also concludes it is not probable that the taxation authority will
accept the tax treatments. Consequently, Entity A reflects the effect of the
uncertainty in determining its taxable profit.

 

–  Entity A estimates the probabilities of the
possible additional amounts that might be added to its taxable profit, as
follows:

 

 

Estimated additional amount, INR

Probability, %

Estimate of expected value, INR

Outcome 1

–

15%

–

Outcome 2

200

5%

10

Outcome 3

400

20%

80

Outcome 4

600

10%

60

Outcome 5

800

30%

240

Outcome 6

1,000

20%

200

 

 

100%

590

 

           

–   Outcome 5 is the most likely outcome.
However, Entity A observes that there is a range of possible outcomes that are
neither binary nor concentrated on one value. Consequently, Entity A concludes
that the expected value of INR 590 better predicts the resolution of the
uncertainty.

 

–  Accordingly, Entity A recognises and measures
its current tax liability that includes INR 650 to reflect the effect of the
uncertainty. The amount of INR 590 is in addition to the amount of taxable
profit reported in its income tax filing.

Example 5 – Application of the Most Likely Outcome Method

 

–  Entity B acquires for INR 100 a separately
identifiable intangible asset that has an indefinite life and, therefore, is
not amortised applying IAS 38 (Ind AS 38) Intangible Assets. The tax law
specifies that the full cost of the intangible asset is deductible for tax
purposes, but the timing of deductibility is uncertain. Entity B concludes that
considering this tax treatment separately better predicts the resolution of the
uncertainty.

–   Entity B deducts INR 100 (the cost of the
intangible asset) in calculating taxable profit for Year 1 in its income tax
filing. At the end of Year 1, Entity B concludes it is not probable that the
taxation authority will accept the tax treatment. Consequently, Entity B
reflects the effect of the uncertainty in determining its taxable profit and
the tax base of the intangible asset. Entity B concludes the most likely amount
that the taxation authority will accept as a deductible amount for Year 1 is
INR20 and that the most likely amount better predicts the resolution of the
uncertainty.

–   Accordingly, in recognising and measuring its
deferred tax liability at the end of Year 1, Entity B calculates a taxable
temporary difference based on the most likely amount of the tax base of INR 80
(INR 100 – INR 20) to reflect the effect of the uncertainty, instead of the tax
base calculated based on Entity B’s income tax filing (INR 0).

–   Entity B reflects the effect of the
uncertainty in determining taxable profit for Year 1 using judgements and
estimates that are consistent with those used to calculate the deferred tax
liability. Entity B recognises and measures its current tax liability based on
taxable profit that includes INR 80 (INR 100 – INR 20). The amount of INR80 is
in addition to the amount of taxable profit included in its income tax filing.
This is because Entity B deducted INR 100 in calculating taxable profit for
Year 1, whereas the most likely amount of the deduction is INR 20.

 

Changes in facts and circumstances

An entity shall reassess a
judgement or estimate required by this Interpretation, if the facts and circumstances
on which the judgement or estimate was based change or as a result of new
information that affects the judgement or estimate. For example, a change in
facts and circumstances might change an entity’s conclusions about the
acceptability of a tax treatment or the entity’s estimate of the effect of
uncertainty, or both. An entity shall reflect the effect of a change in facts
and circumstances or of new information as a change in accounting estimate
applying IAS 8 (Ind AS 8) Accounting Policies, Changes in Accounting
Estimates and Errors. An entity shall apply IAS 10 (Ind AS 10) Events
after the Reporting Period to determine whether a change that occurs after the
reporting period is an adjusting or non-adjusting event.

 

Examples of changes in
facts and circumstances or new information that, depending on the
circumstances, can result in the reassessment of a judgement or estimate
required by this Interpretation include, but are not limited to, the following:

 

(a)  examinations
or actions by a taxation authority. For example:

(i)  agreement
or disagreement by the taxation authority with the tax treatment or a similar
tax treatment used by the entity;

(ii) information
that the taxation authority has agreed or disagreed with a similar tax
treatment used by another entity; and

(iii) information
about the amount received or paid to settle a similar tax treatment.

(b)  changes
in rules established by a taxation authority.

(c)  the
expiry of a taxation authority’s right to examine or re-examine a tax
treatment.

 

Example 6 – Change in facts and circumstances

Entity A claimed a
tax-deduction for a particular expense item. In the prior year, Entity A had
concluded that it was probable that the taxation authority would accept the tax
deduction. However, during the current year, Entity A is alerted by a similar
issue where a tax deduction was denied in a ruling by the Supreme Court. The
recent court ruling is considered a change in facts and circumstances. As a
result, Entity A has to reassess the uncertain tax treatment, taking into
account the recent Supreme Court decision.

 

Example 7 – Events after the reporting date

 

Scenario A

Entity C had claimed a tax
deduction for a particular expense item in its tax return related to the
financial year ending 31st December 2018. However, for the purpose
of recognising current and deferred taxes in that year, Entity C had concluded
that it is not probable that the taxation authorities will accept the tax
deduction. Accordingly, Entity C had recognised an additional tax liability
relating to the uncertainty. In February 2020, before the approval of the
financial statements for the year ending 31st December 2019, Entity
C receives the final tax assessment for 2018. The tax assessment confirms the
full deductibility of the expense item. The confirmation of tax deduction
received after the reporting period and prior to authorisation of the financial
statements for 2019 is considered as an adjusting event after the reporting
period. Accordingly, the additional tax liability that was recognised in 2018
relating to the uncertainty is released in the 2019 period.

 

Scenario B

Entity B claimed a
tax-deduction pertaining to interest expense on a loan granted by an affiliated
company, amounting to INR 500,000 in its tax return related to the financial
statements for the year ending 31st December 2018. However, for the
purposes of recognising current and deferred taxes for that year, Entity B had
concluded that the taxation authorities will only accept a deduction of INR 100,000.
In March 2020, before the approval of the financial statements for the year
ending 31st December 2019, Entity B learns from its tax advisor that
the taxation authorities have confirmed that they will accept, on a
retrospective basis, another method of determining interest rate at arm’s
length that would lead to a tax deduction of INR 300,000 in year 2018. In this
example, it appears that the taxation authorities have issued a new guideline
on deductibility of interest expenses relating to a loan from an affiliated
company. Accordingly, in contrast to Scenario A above, the information received
in March 2020 is considered as a non-adjusting event after the reporting period
for the 2019 financial statements.

 

Absence of an explicit
agreement or disagreement by the taxation authorities on its own is unlikely to
represent a change in facts and circumstances, or new information that affects
the judgements and estimates made. In such situations, an entity has to
consider other available facts and circumstances before concluding that a
reassessment of the judgements and estimates is required.

 

An uncertain tax treatment
is resolved when the treatment is accepted or rejected by the taxation
authorities. The Interpretation does not discuss the manner of acceptance
(i.e., implicit or explicit) of an uncertain tax treatment by the taxation
authorities. In practice, a taxation authority might accept a tax return
without commenting explicitly on any particular treatment in it. Alternatively,
it might raise some questions in an examination of a tax return. Unless such
clearance is provided explicitly, it is not always clear if a taxation
authority has accepted an uncertain tax treatment. An entity may consider the
following to determine whether a taxation authority has implicitly or
explicitly accepted an uncertain tax treatment:

 

–   The tax treatment is explicitly mentioned in
a report issued by the taxation authorities following an examination

–   The treatment was specifically discussed with
the taxation authorities (e.g., during an on-site examination) and the taxation
authorities verbally agreed with the approach; or

–   The treatment was specifically highlighted in
the income tax filings, but not subsequently queried by the taxation
authorities in their examination.

 

Disclosures

There are no new disclosure
requirements in IFRIC 23. However, entities are reminded of the need to
disclose, in accordance with existing IFRS (Ind AS) standards. When there is
uncertainty over income tax treatments, an entity shall determine whether to
disclose: judgements made in determining taxable profit (tax loss), tax bases,
unused tax losses, unused tax credits and tax rates; and information about the
assumptions and estimates made in determining taxable profit (tax loss), tax
bases, unused tax losses, unused tax credits and tax rates under IAS 1 (Ind AS
1) Presentation of Financial Statements. If an entity concludes it is
probable that a taxation authority will accept an uncertain tax treatment, the
entity shall determine whether to disclose the potential effect of the
uncertainty as a tax-related contingency under IAS 12 (Ind AS 12).

 

Effective date and transition

IFRIC 23 applies to annual
reporting periods beginning on or after 1st January 2019. Earlier
application is permitted. Entities can apply the Interpretation using either of
the following approaches:

 

–   Full retrospective approach: this approach
can be used only if it is possible without the use of hindsight. The
application of the new Interpretation will be accounted for in accordance with
IAS 8, which means comparative information will have to be restated; or

 

–    Modified retrospective approach: no
restatement of comparative information is required or permitted under this
approach. The cumulative effect of initially applying the Interpretation will
be recognised in opening equity at the date of initial application, being the
beginning of the annual reporting period in which an entity first applies the
Interpretation.

     It
is not clear as to when this interpretation will apply under Ind AS. It is most
likely that this Interpretation may apply from annual reporting periods
beginning on or after 1st April 2019.

 

Key challenges

–    Applying the Interpretation could be
challenging for entities, particularly those that operate in more complex
multinational tax environments.

 

–    It would be challenging for entities to
estimate the income tax due with respect to tax inspections, when tax
authorities examine different types of taxes together and issue a report with a
single amount due therein.

 

–   Entities may also need to evaluate whether
they have established appropriate processes and procedures to obtain
information, on a timely basis, that is necessary to apply the requirements in
the Interpretation and make the required disclosures.

 

–    IFRIC 23 requires an entity to assume a
detection risk of 100%. An entity should not take any credit for the
possibility that uncertain tax treatments could be overlooked by the taxation
authority. This is a different approach compared to existing practice that may
lead to changes when the Interpretation is first applied. This could be a
challenging task in some cases.

 

Frequently Asked Questions

 

Will this
Interpretation apply to uncertain treatments of other taxes, for example GST?

 

Although uncertainty exists
in the determination of GST liability, IFRIC 23 is not applicable since GST is
not a tax on income and not in the scope of IAS 12 (Ind AS 12)/IFRIC 23. Rather
they would be covered under IAS 37 (Ind AS 37) Provisions, Contingent
Liabilities and Contingent Assets. It may be noted that whilst the
underlying principle for recognition in both standards is “probability”, the
measurement basis under the two standards are significantly different.

 

In a
particular jurisdiction, if tax is not deducted at source with respect to
royalty payments to non-resident the entity is subjected to penalty and also
disallowance of the royalty expenses in computation of taxable income. Is the
penalty and disallowance of the royalty expense covered under IFRIC 23?

 

Penalty is not a tax on
income and hence are not covered under IFRIC 23. Rather they would be covered
under IAS 37 (Ind AS 37) Provisions, Contingent Liabilities and Contingent
Assets. The disallowance of royalty expenses which is included in the
taxable income will be subjected to the requirements of IAS 12 (Ind AS 12) and
IFRIC 23.

 

Will
Interest and penalties levied by Income tax Authorities be covered under this
Interpretation?

 

IAS 12 (Ind AS 12) does not
explicitly refer to interest and penalties payable to, or receivable from, a
taxation authority, nor are they explicitly referred to in other IFRS
Standards. A number of respondents to the draft Interpretation suggested in
their comment letter that the Interpretation explicitly include interest and
penalties associated with uncertain tax treatments within its scope. Some said
that entities account for interest and penalties differently depending on
whether they apply IAS 12 (Ind AS 12) or IAS 37 (Ind AS 37) Provisions,
Contingent Liabilities and Contingent Assets to those amounts.

 

The IC decided not to add
to the Interpretation requirements relating to interest and penalties
associated with uncertain tax treatments. Rather, the IC noted that if an
entity considers a particular amount payable or receivable for interest and
penalties to be an income tax, then that amount is within the scope of IAS 12
and, when there is uncertainty, also within the scope of this Interpretation.
Conversely, if an entity does not apply IAS 12 to a particular amount payable
or receivable, then this Interpretation does not apply to that amount,
regardless of whether there is uncertainty.

 

An entity
determines that an uncertain tax treatment is not probable but is possible and
hence disclosure as contingent liability is required. Whether the contingent
liability disclosure will also include the consequential interest and penalty
amount?

 

Interest amount will be
included in the contingent liability amount if there is no or very little
likelihood of waiver. On the other hand, penalty amount may be waived by the
tax authorities. If it is probable that the penalties may be waived by the tax
authorities, they are not included in the contingent liability amount.

 

In evaluating
the detection risk, should an entity consider probability of detection by the
Income-tax authorities rather than assuming an examination will occur in all
cases?

 

The IC decided that an
entity should assume a taxation authority will examine amounts it has a right
to examine and have full knowledge of all related information. In making this
decision, the IC noted that IAS 12 (Ind
AS 12) requires an entity to measure tax assets and liabilities based on tax
laws that have been enacted or substantively enacted.

 

A few respondents to the
draft Interpretation suggested that an entity consider the probability of
examination, instead of assuming that an examination will occur. These
respondents said such a probability assessment would be particularly important
if there is no time limit on the taxation authority’s right to examine income
tax filings.

 

The IC decided not to
change the examination assumption, nor create an exception to it for
circumstances in which there is no time limit on the taxation authority’s right
to examine income tax filings. Almost all respondents to the draft
Interpretation supported the examination assumption. The IC also noted that the
assumption of examination by the taxation authority, in isolation, would not
require an entity to reflect the effects of uncertainty. The threshold for
reflecting the effects of uncertainty is whether it is probable that the
taxation authority will accept an uncertain tax treatment. In other words, the
recognition of uncertainty is not determined based on whether a taxation
authority examines a tax treatment.

 

Will the
principles of “virtual certainty” apply for recognition of current and deferred
tax assets in cases where there is uncertainty of tax treatments?

 

When the key test of the
Interpretation would result in the entity recognising tax assets (i.e. based on
the probability that the taxation authorities would accept the entity’s tax
treatment), the entity is not required to demonstrate the ‘virtual certainty’
of the tax authority accepting the entity’s tax treatment in order to recognise
such a tax asset. The underlying principle of “probability” will apply for
recognition of current and deferred tax asset arising from uncertain tax
treatments. Consider the example below.

 

Example 8 – Measurement of tax positions

The management of Entity B
decides to undertake a group-wide restructuring and records a restructuring
liability of INR 1,000,000. Entity B has tax loss carry-forwards of INR
1,200,000. Excluding the restructuring liability, taxable profit for the
current year is INR 2,000,000. Entity B is uncertain whether the local taxation
authorities will accept a deduction for the restructuring costs. However, it
analyses all available evidence and concludes that it is probable that the
taxation authorities will accept the deduction of the INR 1,000,000 in the year
when it is recorded.

 

Entity B therefore
estimates its taxable profit to be INR 1,000,000 and that this will be fully
offset with tax loss carry-forwards from the INR 1,200,000 available. As a
consequence, there is no current income tax charge in the period and Entity B
determines a remaining tax loss carry-forward balance of INR 200,000. As
management has convincing evidence that Entity B will realise sufficient
taxable profits in the future, it records a deferred tax asset for the unused
tax losses of INR 200,000. Though convincing evidence is required to record a
deferred tax asset on carry forward losses (INR 200,000), the acceptability of
uncertain tax treatments (INR 1,000,000) by the tax authorities is based on the
principle of “probability”.

 

Conclusion

For many large sized
entities or those with significant income tax litigations or complications,
this Interpretation may well be a significant change. Management and Audit
Committees should ensure that the Interpretation is properly understood and
complied with. Tax advisors too need to get upto speed on the standard, since
this standard may have significant impact on income tax computation and
assessments. _

Perspectives On Fair Value Under Ind As (Part 1)

INTRODUCTION
In line with the commitment made by our then Honourable Prime Minister, Shri Manmohan Singh at the G-20 summit nearly ten years back to adopt the International Financial Reporting Standards (IFRS), India has already begun its journey to converge with IFRS rather than adopt it. The roadmap by the Ministry of Corporate Affairs for adoption of International Financial IFRS converged Indian Accounting Standards (Ind AS) was announced in two phases for other than financial service entities, which is tabulated hereunder:

Phase

Entities Covered

Applicable Date

 

 

 

I

Entities
having net worth of more than Rs. 500 crores based on the audited Balance
Sheet as on 31st March, 2014 or any subsequent date

Financial
Year ending 31st March, 2017

 

 

 

II

All
other listed entities not covered in Phase I and unlisted entities having net
worth of more than Rs. 250 crores based on the audited Balance Sheet as on 31st
March, 2014 or any subsequent date

Financial
Year ending 31st March, 2018

The consolidated impact of the aforesaid convergence will result in significant differences in the preparation and presentation of financial statements thereby paving the way for greater transparency, enriched quality and enhanced comparability of the financial statements. Whilst there are several challenges consequent to adoption of Ind AS, the single most sweeping challenge would be a significant increase in the focus on fair value accounting which in turn is based on the principle of fair value measurement which is a fundamental concept and the underlying basis for the Ind AS framework. Keeping these factors in mind, this article aims to decipher the concept of fair value under Ind AS, its broad prescriptions, its benefits and perils coupled with certain practical challenges and decisions in its implementation especially on transition, for the Phase II entities tabulated above, keeping in mind the experience of the Phase I entities.
 
CONCEPT OF FAIR VALUE UNDER Ind AS
There are several Ind ASs as tabulated below, which permit or require entities to either measure or disclose the fair value of assets, liabilities or equity instruments.
 

Ind AS No.

Title

 

 

36

Impairment
of Assets

 

 

103

Business
Combinations

 

 

109

Financial
Instruments

 

 

28

Investments
in Associates and Joint Ventures

 

 

38

Intangible
Assets

 

 

102

Share
Based Payments

 

 

16

Property,
Plant and Equipment

 

 

40

Investment
Property

 

 

41

Agriculture

   

The primary purpose under Ind AS 113 is to increase the consistency and comparability of fair value measurement used in financial reporting and to provide a common framework whenever an Ind AS requires or permits fair value measurement irrespective of the type of asset, liability or the entity that holds the same. The basic objective of fair value measurement is to estimate the price at which an orderly transaction would take place between market participants under market conditions that exist at the measurement date. Let us now examine the key requirements of Ind AS 113 as well as each of the above Ind AS’s insofar as the fair value requirements are concerned.
 
Key Requirements of Ind AS 113:
Ind AS 113 addresses how to measure fair value but does not stipulate when fair value needs to be used which is determined by the other Ind ASs as indicated earlier. Further, Ind AS 113 applies to all fair value disclosures that are required or permitted by Ind AS, except for the following:
 
a)Share based payment transactions under Ind AS 102;
b)Leases under Ind AS 17; and
c)Measures that are similar to but are not fair value e.g.  net   realisable   value   under   Ind AS   2,
    Inventories, value in use under Ind AS 36, Impairment.
 
The disclosures required by this Standard are not required for the following:
 
a)Plan assets measured at fair value in accordance with Ind AS 19, Employee Benefits; and
b)Assets for which recoverable amount is fair value less costs of disposal in accordance with Ind AS 36, Impairment of Assets.
 
The fair value measurement framework described in this Standard applies to both initial and subsequent measurement, if fair value is required or permitted by other Ind ASs.
 
The basic objectives of Ind AS 113 are as under:
 
-To define the concept of fair value.
-To set out the framework for measuring the fair value.
-To lay down the disclosure requirements on fair value measurements.
 
Let us now proceed to briefly examine each of the above aspects.
 
Meaning of Fair Value:
IndAS 113 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”.
 
The basic premise which governs the determination and use of fair value is that it is always determined on a market based approach based on observable market prices or in its absence based on other appropriate valuation techniques which maximise the use of relevant observable inputs and minimise the use of unobservable inputs and is not entity specific. In other words, it means that the fair value has to be determined in accordance with use of the asset by market participants. A common example of such a situation is in the FMCG or Pharma industry when the acquirer acquires the business of a competitor with the objective of eliminating competing brands to promote his own brand. In such cases a fair value is attributed to the competing brand on the basis of its highest and best use (discussed later) by market participants, which principle is also laid down under Ind AS 103.
 
Before proceeding further, it is important to understand the concept of the term price in the context of fair value and also who are regarded as market participants since fair value is always to be determined on a market based approach.
 
The Price:
In keeping with its market based criteria as discussed earlier, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction in the principal (or most advantageous) market at the measurement date under current market conditions (i.e. an exit price) regardless of whether that price is directly observable or estimated using another valuation technique.Thus, under normal circumstances, the fair value is the exit price.
 
However, when an asset is acquired or a liability is assumed in an exchange transaction for that asset or liability, the transaction price is the price paid to acquire the asset or received to assume the liability (referred to as an entry price). An example could be a company which has an old truck having a book value of Rs.2,50,000 which acquires a boat in exchange whose transaction price assumed on the basis of similar transactions on an arm’s length basis is Rs. 10,00,000 which could be construed as its fair value. Accordingly the boat will be accounted for at Rs.10,00,000 and a loss of Rs.7,50,000 (10,00,000-2,50,000) would be simultaneously recorded.
 
In most cases, the transaction price will equal the fair value (e.g. when on the transaction date the transaction to buy an asset takes place in the market in which the asset would be sold).Though in practice there may not be various situations where the transaction price may not represent the fair value, Ind AS-113 does recognise that the transaction price might not represent the fair value of an asset or a liability at initial recognition if any of the following conditions exist:
 
a)The transaction is between related parties, unless it can be demonstrated that the transactions are on an arm’s length basis. Keeping in mind the requirements under the Companies Act, 2013 most related party transactions in practice would pass the arm’s length test.
 
b)The transaction takes place under duress or the seller is forced to accept the price in the transaction e.g. if the seller is experiencing financial difficulty. Similarly in the recent past the insolvency proceedings under the Bankruptcy Code may force the sellers to accept certain prices arrived at through the resolution process whichmay not always be fair.
 
c)The unit of account represented by the transaction price is different from the unit of account for the asset or liability measured at fair value e.g. if the asset or liability measured at fair value is only one of the elements in the transaction in a business combination or the transaction includes unstated rights and privileges that are measured separately in accordance with another Ind AS or the transaction price includes transaction costs.
 
d)The market in which the transaction takes place is different from the principal market (or most advantageous market) e.g. those markets might be different if the entity is a dealer that enters into transactions with customers in the retail market, but the principal (or most advantageous) market for the exit transaction is with other dealers in the dealer market.
 
Market Participants:
They represent buyers and sellers in the principal (or most advantageous) market for the asset or liability that have all of the following characteristics:
 
a)They are independent of each other and are not related parties as defined in Ind AS-24.

b)They are knowledgeable and have a reasonable understanding about the asset or liability and the transaction using all available information that might be obtained through due diligence efforts that are usual and customary.
c)They are able and willing to enter into a transaction for the asset or liability.
 
Measurement Date:
It represents a clear and specific date for a particular transaction and the fair value needs to be computed as of that date rather than for a period.
 
After having understood the meaning of certain critical terms let us now proceed to gain some insights into the overall framework for measuring the fair value as laid down in Ind AS 113
 
Framework for Measuring the Fair Value:
The fair value measurement framework as laid down under Ind AS 113 broadly requires a determination of the following:
 
a.The asset or liability being measured.
b.The highest and best use for a non-financial asset.
c.The principal or most advantageous market.
d.The fair value hierarchy.
e.The valuation techniques to be adopted (including the inputs to be used).
 
     a.The Asset or Liability being measured:
 
The asset or liability being measured at fair value could be either of the following:
 
a)A standalone asset or liability e.g. a financial instrument or a non-financial asset like land or equipment; or
 
b)A group of assets or liabilities e.g. a cash generating unit or valuation during the course of a business combination or restructuring transaction.
 
In either of the above situations, for the valuation under accounting depends on its unit of account, which is the level at which it is aggregated or disaggregated for accounting purposes.
 
When measuring fair value an entity shall take into account the following characteristics of the asset or liability which market participants would normally take into account when pricing the asset or liability at the measurement date.:
 
a)    the condition and location of the asset (an example thereof could be a Company which owns a licence only for selling a product in India, the value of the intangible asset represented by the licence cannot be measured by assuming or factoring in the cash flows from the sale of the products outside India); and
 
b)restrictions, if any, on the sale or use of the asset (an example could be a Company which has a land parcel that can be used only for industrial purposes in which case, the value of the land needs to be measured based on the current conditions as well as keeping in mind the restrictions on use).
 
b.Highest and Best Use for a Non-Financial Asset:
As we have discussed above, to arrive at the fair value of an asset or liability, its value needs to be taken from the perspectives of the market participants in an orderly transaction for sale or exchange of an asset. However, many non-financial assets may not always be liquid enough nor have specific contractual terms which the financial assets would normally have.
 
Accordingly, the fair value measurement of a non-financial asset depends upon the following two factors:
 
a)The ability of the market participants to generate economic benefit by using the asset in its highest and best use. This is also referred to as the in exchange valuation premise. In such cases, the asset would provide maximum value to market participants primarily on a standalone basis. Thus, the fair value of the asset would be the price which would be received in a current transaction to sell the asset to market participants who would use the asset on a standalone basis. An example could be the estimated amount at which a particular piece and parcel of land adjacent to an existing factory (for a proposed expansion) could be exchanged on the date of valuation between a willing buyer and a willing seller wherein both the parties have acted knowledgeably, prudently and without compulsion.
 
b)The sale value to another market participant who will use the asset to its highest and best use. This is also referred to as the in use valuation premise. In such cases, it is presumed that an entity’s current use of a non-financial asset is its highest and best use unless market or other factors suggest that a different use by market participants would maximise the value of the non-financial asset. An example could be an FMCG company which acquires another similar entity but intends to discontinue the brands acquired pursuant to the acquisition. In such a situation, the fair value of the brands would nevertheless be computed assuming it from a market participant’s perspective even if the acquirer intends to kill the brand(s).
 
Keeping this in mind, the Standard also specifically provides that the fair value of non-financial assets should be measured based on its highest and best use.
 
The highest and best use refers to the use of an asset by market participants that would maximise the value of the asset or group of assets and liabilities by taking into account the use of the asset, considering the following factors:
 

Factors

Examples
of Evaluation Criteria

Physical
Possibility

–     Size or location of the property

—       Technical feasibility for applying the
asset for producing different goods

 

 

Legal
Permissibility

–     Legal restrictions like zoning
restrictions

—       Entry restriction sin certain markets

 

 

Financial
Feasibility

– Generation of
adequate cash flows to provide the desired return  on investments to market participants to
put the asset to use

—       The costs of converting the asset for
the desired use from a marketparticipants perspective

   
c.The Principal or Most Advantageous Market:
 
The basic premise under Ind AS 113 is that the fair value needs to be determined based on orderly transactions that would take place in the principal or in its absence the most advantageous market as defined earlier. Identifying these markets is one of the key considerations in the entire valuation process.
 
Ind AS-113 provides that an entity need not undertake an exhaustive search of all possible markets to identify the principal market or, in the absence thereof, the most advantageous market, but it shall take into account all information that is reasonably available. In the absence of evidence to the contrary, the market in which the entity would normally enter into a transaction to sell the asset or to transfer the liability is presumed to be the principal market or, in the absence of a principal market, the most advantageous market.
 
Whilst it is easier to determine the principal market based on the observed volume or level of activity. Example: a stock exchange having more frequent trading or volume for a listed company’s equity shares, to determine the most advantageous market, in other casesone needs to take into account the transaction costs and transportation costs in the manner discussed below.
 
Transaction Costs and Transportation Costs:
Ind AS-113 defines transaction costs as those costs which are incurred to sell an asset or transfer a liability in the principal (or most advantageous) market (discussed earlier) for the asset or liability that are directly attributable to the disposal of the asset or the transfer of the liability and meet both of the following criteria:
 
a)They result directly from and are essential to that transaction.
 
b)They would not have been incurred by the entity had the decision to sell the asset or transfer the liability not been made (similar to costs to sell, as defined in Ind AS 105).
 
Ind AS-113 defines transportation costs as those costs that would be incurred to transport an asset from its current location to its principal (or most advantageous) market.
 
As per para 25 of Ind AS-113, the price in the principal (or most advantageous) market used to measure the fair value of the asset or liability shall not be adjusted for transaction costs since they are not a characteristic of an asset or a liability but they are specific to a transaction and will differ depending on how an entity enters into a transaction for the asset or liability. Transaction costs shall be accounted for in accordance with other Ind ASs. Further, as per para 26 of Ind AS-113, transaction costs do not include transport costs. If location is a characteristic of the asset (e.g. for a commodity), the price in the principal (or most advantageous) market shall be adjusted for the costs, if any, that would be incurred to transport the asset from its current location to that market.
 
However, as we have seen earlier, both the transaction and transportation costs should be taken into account to determine the most advantageous market for an asset or a liability.
The above is explained with the help of an example to determine the most advantageous market based on the transaction and transportation cost.
 
Determination of the Most Advantageous Market – Facts of the case:
An entity holds an asset which can be sold in two markets situated in different locations with different prices. It enters into transactions in both the markets since there is no principal market for the asset. Certain other details are tabulated below:

Amount in Rs.

Market

Price

Transport Cost

Transaction Cost

Net Price

 

 

 

 

 

X

950

100

100

750

 

 

 

 

 

Y

880

75

40

765

 
Determine the most advantageous market.
 
Solution:
Based on the net prices, the entity would maximise the net amount in market Y (Rs. 765) and hence it appears to be the most advantageous market.
 
However, on further analysis the fair value of market X and Y would be Rs. 850 and Rs. 805 after deducting the transportation cost as per the requirements of para 25 of Ind AS-113, discussed earlier, since location is a characteristic of the asset. However, even though the fair value of market X is greater, market Y remains most advantageous because of the overall greater net price. Accordingly, the fair value of the asset would be Rs. 805.
 
d.Fair Value Hierarchy:
The purpose of laying down a fair value hierarchy in the Standard is to increase consistency and comparability in the fair value measurements and disclosures. The basic premise of applying this hierarchy is to enable an entity to prioritise the observable inputs over those that are unobservable. Further, greater disclosures are mandated in respect of unobservable inputs adopted due to their inherent subjectivity.
 
The Standard establishes a fair value hierarchy that categorises into three levels, as discussed below, the inputs to valuation techniques used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities (Level 1 inputs) and the lowest priority to unobservable inputs (Level 3 inputs).
 
Level 1 inputs:
 
Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities that the entity can access at the measurement date and provides the most reliable evidence of fair value.
 
Level 1 inputs will be available for many financial assets and financial liabilities, some of which might be exchanged in multiple active markets (e.g. on different exchanges). Accordingly, the emphasis within Level 1 is on determining both of the following:
 
a)the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability; and
b)whether the entity can enter into a transaction for the asset or liability at the price in that market at the measurement date.
 
For example, if the equity shares are quoted on more than one exchange generally the price quoted on an exchange which has the maximum trading volume would be both the principal as well as the most advantageous market.
 
On the other hand, in respect of Government Securities, though they may be quoted, the market may not be very active or liquid and hence, the latest available quoted price may not be an appropriate level I input and may need to be adjusted.
 
Level 2 inputs:
 
Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable (those inputs that are developed using market data, such as publicly available information about actual events or transactions, and that reflect the assumptions that market participants would use when pricing the asset or liability) for the asset or liability, either directly or indirectly. If the asset or liability has a specified (contractual) term, a Level 2 input must be observable for substantially the full term of the asset or liability.
 
Level 2 inputs include the following:
 
a)quoted prices for similar assets or liabilities in active markets.
b)quoted prices for identical or similar assets or liabilities in markets that are not active.
c)inputs other than quoted prices that are observable for the asset or liability, for example:
i) interest rates and yield curves observable at commonly quoted intervals;
ii) implied volatilities; and
iii) credit spreads.
d)market-corroborated inputs.
 
Adjustments to Level 2 inputs will vary depending on the factors specific to the asset or liability, which include the following:
 
a)The condition or location of the asset;
b)The extent to which inputs relate to items which are comparable to the asset or liability; and
c)The volume and level of activity in the markets within which the inputs are observed.
 
An adjustment to a Level 2 input that is significant to the entire measurement might result in a fair value measurement categorized within Level 3 of the fair value hierarchy, if the adjustment uses significant unobservable inputs.
 
Some of the common examples of  Level 2 inputs used in valuation are:
 
a)Receive-fixed, pay-variable interest rate swap based on the Mumbai Interbank Offered Rate (MIBOR) swap rate.- A Level 2 input would be the MIBOR swap rate if that rate is observable at commonly quoted intervals for substantially the full term of the swap.

b)Licensing arrangement- For a licensing arrangement that is acquired in a business combination and was recently negotiated with an unrelated party by the acquired entity (the party to the licensing arrangement), a Level 2 input would be the royalty rate in the contract with the unrelated party at inception of the arrangement.

c)Finished goods inventory at a retail outlet – For finished goods inventory that is acquired in a business combination, a Level 2 input would be either a price to customers in a retail market or a price to retailers in a wholesale market, adjusted for differences between the condition and location of the inventory item and the comparable (i.e. similar) inventory items so that the fair value measurement reflects the price that would be received in a transaction to sell the inventory to another retailer that would complete the requisite selling efforts. Generally, the price that requires the least amount of subjective adjustments should be used for the fair value measurement.

d)Building held and used – A Level 2 input would be the price per square metre for the building (a valuation multiple) derived from observable market data, e.g. multiples derived from prices in observed transactions involving comparable (i.e. similar) buildings in similar locations.

e)Cash-generating unit- A Level 2 input would be a valuation multiple (e.g. a multiple of earnings or revenue or a similar performance measure) derived from observable market data (EV/ EBITDA multiple) e.g. multiples derived from prices in observed transactions involving comparable (i.e. similar) businesses, taking into account operational, market, financial and non-financial factors
 
Level 3 inputs:
 
Level 3 inputs are unobservable inputs (those inputs for which market data are not available and that are developed using the best information available about the assumptions that market participants would use when pricing the asset or liability) for the asset or liability. Unobservable inputs shall be used to measure fair value to the extent that relevant observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date. Accordingly, unobservable inputs shall reflect the assumptions that market participants would use when pricing the asset or liability, including assumptions about risk.
 
An entity shall develop unobservable inputs using the best information available in the circumstances, which might include the entity’s own data. In developing unobservable inputs, an entity may begin with its own data, but it shall adjust those data if reasonably available information indicates that other market participants would use different data or there is something particular to the entity that is not available to other market participants (e.g. an entity-specific synergy). An entity need not undertake exhaustive efforts to obtain information about market participant assumptions. However, an entity shall take into account all information about market participant assumptions that is reasonably available. Unobservable inputs developed in the manner described above are considered market participant assumptions and meet the objective of a fair value measurement.
 
Some of the common examples of Level 3 inputs used in valuation are:
 
a)Long-dated currency swap – A Level 3 input would be an interest rate in a specified currency that is not observable and cannot be corroborated by observable market data at commonly quoted intervals or otherwise for substantially the full term of the currency swap. The interest rates in a currency swap are the swap rates calculated from the respective countries’ yield curves.

b)Three-year option on exchange-traded shares – A Level 3 input would be historical volatility, i.e. the volatility for the shares derived from the shares’ historical prices. Historical volatility typically does not represent current market participants’ expectations about future volatility, even if it is the only information available to price an option.

c)Interest rate swap- A Level 3 input would be an adjustment to a mid-market consensus (non-binding) price for the swap developed using data that are not directly observable and cannot otherwise be corroborated by observable market data.

d)Cash-generating unit – A Level 3 input would be a financial forecast (e.g. of cash flows or profit or loss) developed using the entity’s own data if there is no reasonably available information that indicates that market participants would use different assumptions.
 
e.Valuation Techniques:
 
After having understood the broad principles underlying fair valuation, an entity would need to determine the valuation techniques which are appropriate in the circumstances and for which sufficient data are available to measure the fair value, whereby there is maximum use of observable inputs and minimum use of unobservable inputs, keeping in mind the overall objective of the valuation exercise to estimate the price at which an orderly transaction to sell an asset or transfer a liability would take place between market participants under current market conditions.
 
There are three widely used valuation techniques which are prescribed in Ind AS 113 as under:
 
-Market approach
-Cost approach
-Income approach
 
Each of these are briefly analysed hereunder:
 
The Market Approach:
 
This approach uses prices and other relevant information generated by market transactions involving identical or comparable assets, liabilities or group of assets or liabilities. The valuation techniques consistent with the market approach often use market multiples derived from a set of comparable assets, liabilities or business, as applicable. Multiples might be in ranges with a different multiple for each comparable. The selection of the appropriate multiple within the range requires judgement, considering qualitative and quantitative factors specific to the measurement. Some of the commonly used market multiples are EV/ EBIDTA, revenue or matrix pricing involving comparison with benchmark securities.
 
The Cost Approach:
 
This approach reflects the amount that would be required currently to replace the service capacity of the asset, which is often referred to as the current replacement cost. From the perspective of a market participant seller, the price that would be received for the asset is based on the cost to a market participant buyer to acquire or construct a substitute asset of comparable utility, adjusted for obsolescence (covering amongst others, physical deterioration, technological changes and changes economic conditions like interest rates, currency fluctuations), since a market participant buyer would not pay more for an asset than the amount for which it could replace the service capacity of that asset. For this purpose, the term obsolescence is much broader than depreciation which is provided for financial reporting or tax purposes.
 
The Income Approach:
 
This approach converts the future amounts comprising of cash flows, income or expenses to a single current (discounted) amount. The fair value measure so arrived at reflects the current market expectations of such future amounts. The following are the commonly used valuation techniques under this approach:
 
?????Present value technique
?Option pricing models
?Multi-period excess earnings method
 
Whilst a detailed discussion on each of these techniques is beyond the scope of this article, some broad principles underlying the same are covered hereunder.
 
Present Value Technique:
The present value technique is the most commonly used technique and is the only technique for which guidance is provided in Ind AS 113. This technique links the future estimates or amounts (e.g. cash flows or values) to a present amount using a discount rate. A fair value measurement of an asset or a liability using a present value technique captures all the following elements from the perspective of market participants at the measurement date:
 
a)An estimate of future cash flows for the asset or liability being measured.
b)Expectations about possible variations in the amount and timing of the cash flows representing the uncertainty inherent in the cash flows.
c)The time value of money, represented by the rate on risk-free monetary assets that have maturity dates or durations that coincide with the period covered by the cash flows and pose neither uncertainty in timing nor risk of default to the holder (i.e. a risk-free interest rate).
d)The price for bearing the uncertainty inherent in the cash flows (i.e.an illiquidity discount).
e)Any other factors that market participants would take into account in the circumstances.
f)For a liability, the non-performance risk relating to that liability, including the entity’s (i.e. the obligor’s) own credit risk.
 
Option Pricing Models:
 
These incorporate present value techniques and reflect both the intrinsic and time value of money of an option contract which represents a contract through which a seller gives a buyer the right, but not the obligation, to buy or sell a specified number of shares or other securities or commodities or foreign currency at a predetermined price within a set time period.Options are derivatives, which means that their value is derived from the value of an underlying investment or commodity or foreign currency, amongst others.
 
A further detailed discussion on the various option pricing models is beyond the scope of this article since it involves use of various statistical and other models, often quite complex, which are determined by valuation specialists taking into account various sophisticated models and tools.
 
Multi Period Excess Earnings Method:
 
The fundamental principle underlying this method is to isolate the net earnings attributable to the asset being measured. It is generally used to measure the fair value of intangible assets. Under this method, the estimate of an intangible assets fair value starts with an estimate of the expected net income of the enterprise or the group of assets. The other assets in the group are referred to as the contributory assets, which contribute to the realisation of the intangible assets value. Once the underlying value is determined, the contributory charges or economic rents, which represent the charges for the use of the assets based on their respective fair values, are deducted from the total net after tax cash flows projected from the combined group to obtain the “excess earnings” attributable to the intangible asset.
 
Use of Multiple Valuation Techniques:

If multiple valuation techniques are used to measure the fair value, the results thereof should be evaluated considering the reasonableness of the range of values. In such cases, the fair value is the point within the range that is most representative of the fair value in the given scenario.
 
Changes in Valuation Techniques:

As a general rule, valuation techniques shall be applied consistently. However, a change in the valuation technique or application of multiple valuation techniques is appropriate if the change results in a measurement that is equally or more representative of the fair value in the circumstances. Some examples of such circumstances are as under:
 
a)New markets develop or market conditions change.
b)New information is available.
c)Information previously used is no longer available.
d)The valuation techniques improve.
 
Inputs to Valuation Techniques:
 
General Principles:
 
As discussed above, valuation techniques used to measure fair value shall maximise the use of relevant observable inputs and minimise the use of unobservable inputs.
 
Inputs selected for fair value measurement shall be consistent with the characteristics of the asset or liability that market participants would take into account in a transaction for the asset or liability. In some cases those characteristics result in the application of an adjustment, such as a premium or discount (e.g. a control premium or non-controlling interest discount). When these characteristics reflect controlling shareholding, the share price would attract a premium and when it reflects a non-controlling interest, the share price would attract a discount.
 
In all cases, if there is a quoted price in an active market for an asset or a liability, an entity shall use that price without adjustment when measuring fair value, except in the following circumstances as specified in para 79 of Ind AS 113:
 
a)when an entity holds a large number of similar (but not identical) assets or liabilities (e.g. debt securities) that are measured at fair value and a quoted price in an active market is available but not readily accessible for each of those assets or liabilities individually. In such cases, as a practical expedient, an entity may measure fair value using an alternative pricing method that does not rely exclusively on quoted prices (e.g. matrix pricing). However, the use of an alternative pricing method would result in a fair value measurement categorised within a lower level of the fair value hierarchy.

b)    when a quoted price in an active market does not represent fair value at the measurement date. For example, if significant events (such as transactions in a principal-to-principal market, trades in a brokered market or announcements) take place after the close of a market but before the measurement date. An entity shall establish and consistently apply a policy for identifying those events that might affect fair value measurements. However, if the quoted price is adjusted for new information, the adjustment results in a fair value measurement categorised within a lower level of the fair value hierarchy.

c)when measuring the fair value of a liability or an entity’s own equity instrument using the quoted price for the identical item traded as an asset in an active market and that price needs to be adjusted for factors specific to the item or the asset.
 
Inputs based on Bid and Ask Prices:
 
If an asset or a liability measured at fair value has a bid price and an ask price, the price within the bid-ask spread that is most representative of fair value in the circumstances shall be used to measure fair value regardless of where the input is categorised within the fair value hierarchy as discussed above. The use of bid prices for asset positions and ask prices for liability positions is permitted, but is not required mandatorily.
 
Ind AS 113 does not preclude the use of mid-market pricing or other pricing conventions that are used by market participants as a practical expedient for fair value measurements within a bid-ask spread.
 
Fair Value Disclosures:
 
The disclosures under Ind AS 113 aims to equip the users of financial statements with greater transparency in respect of the following matters:
 
a)The extent of usage of fair value in the valuation of assets and liabilities.
b)The valuation techniques, inputs and assumptions used in measuring fair value.
c)The impact of level 3 fair value measurements on the profit and loss account or other comprehensive income.
 
The Standard also lays down the broad disclosure objectives and has stipulated certain minimum disclosure requirements especially in respect of Level 3 fair value measurements, since there is greater subjectivity and judgement involved in using them.
 
The disclosures broadly cover the following aspects:
 
a)Reasons  for non-recurring fair value measure-ments.
b)The fair value hierarchy adopted.
c)The reasons for transfer between the hierarchical levels for recurring fair value measurements.
d)The valuation techniques adopted,including any changes therein, for both recurring and non-recurring fair value measurements.
e)Quantitative information about significant unobservable inputs for recurring level 3 fair value measurements.
f)The amount of total gains and losses recognised in profit and loss and OCI, together withline items in which these are recognised, for recurring fair value measurements categorised within level 3 of the fair value hierarchy.
g)Sensitivity analysis, both narrative and with quantitative disclosures about the significant unobservable inputs. _
   (to be continued)
 

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.

 

Parent
accounting

Debit

Credit

Comments

 

 

 

 

On
transition date (TD)

 

 

 

Investment
in redeemable preference shares (Loan to Subsidiary)

600

 

Recorded
at discounted amount

Addition
to equity investment in Subsidiary

400

 

MAT
benefit available on sale or realization of the investment

Bank

 

1000

 

 

 

 

 

Going
forward over 10 years

 

 

 

Investment
in redeemable preference shares (Loan to Subsidiary)

400

 

 

Interest
income (P&L)

(unwinding
of interest on loan)

 

400

MAT
will be paid on the book profits over the 10 year period of interest income
recognition

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.

 

Impact on Ind AS results of FY March 2016
compared to Indian GAAP results for the same period

INR million

Approximate % of reduction

Reduction in revenues

68,000

50% reduction

Reduction in Property, Plant and Equipment (PPE)

79,000

57% reduction

Reduction in gross assets

38,000

15% reduction

 

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
6th 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

 

Particulars

INR

Consideration

1000

Fair value

650

Goodwill

350

 

 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.

 

Particulars

INR

Consideration

1000

Book value

600

Capital reserve (negative)

400

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.

 

Indian GAAP

Ind AS

PPE

100

Construction cost

100

 

 

Construction margin/ profit

20

 

 

Construction revenue

120

 

 

Intangible Asset or Receivables

120

 

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. _

Questions on GST

Issue 1: Should
the revenue be presented gross or net of GST under Ind AS?

 Paragraph 8 of Ind AS 18 Revenue states as below:

 “Revenue includes only the gross
inflows of economic benefits received and receivable by the entity on its own
account. Amounts collected on behalf of third parties such as sales taxes,
goods and services taxes and value added taxes are not economic benefits which
flow to the entity and do not result in increases in equity.”

An entity collects GST on behalf of the government and not on its own
account. Hence, it should be excluded from revenue, i.e., revenue should be net
of GST. This view is consistent with the guidance given in the Guidance note on
Ind AS Schedule III issued by ICAI and will apply irrespective of pricing
arrangement with customers, say, fixed prices inclusive or exclusive of GST. It
may be noted that GST net presentation does not impact the presentation of
excise collected from customers and paid to the government for periods till 30th
June 2017. Excise duty will be included in revenue and presented as an expense
in accordance with Ind AS principles.

Issue 2: How
should a company treat the GST paid on raw material/ finished goods inventory
purchased and available as GST input tax credit? Should it be included in
valuation of inventory at the quarter/ year-end?

Paragraph 11 of Ind AS 2 Inventories states as below for
refundable taxes:

“The costs of purchase of inventories
comprise the purchase price, import duties and other taxes (other than those
subsequently recoverable by the entity from the taxing authorities), and
transport, handling and other costs directly attributable to the acquisition of
finished goods, materials and services.”

Thus, only those taxes are included as costs of inventory which are not
subsequently recoverable by the company from taxation authorities. Since
GST paid on raw material/ finished goods inventory purchased is available for
set-off against the GST payable on sales or is refundable, it is in the nature
of taxes recoverable from taxation authorities. Accordingly, input tax paid
should not be included in the costs of purchase, to the extent
utilisable/refundable.

On similar lines, Ind AS 16 Property, Plant and Equipment (PPE)
requires that the cost of an item of PPE comprises – purchase price, including
import duties and non-refundable purchase taxes, after deducting trade
discounts and rebates (emphasis added). Hence, similar accounting will
apply to the GST Input Credit available on purchase of items of PPE. To the
extent not utilisable/refundable, the same may be included in cost of goods
sold, inventory or PPE as the case may be.

Issue 3: How is
GST paid on inter-branch transfers accounted for? It is assumed that sales
depots have obtained requisite registration and other documents. Hence, they
will be able to obtain full credit for GST paid on supply of goods.

For reasons already mentioned (refer issue 2), the valuation of
inventory at the branches should not include GST. The GST paid on branch
transfer of inventory should be reflected under an appropriate account such as
“GST Input Tax Credit (GITC) Receivable Account.”

Issue 4: As on
30th June 2017, the factory is holding substantial stock of
inventory on which no excise duty is paid, since those were not cleared from
the factory. How should the company value such inventory and the input tax
credit (ITC) on the inputs for manufacturing the inventory?

1.  Since excise duty is not payable on such inventory (as per
notification of CBEC), no provision for excise duty is required. Consequently,
the inventory valuation will not include excise duty.

 2.  After 30th June, the Company will pay GST on supply.

 3. The ITC credit on procurement for manufacturing the inventory will
be recorded as GST Input Tax Credit (GITC) Receivable Account, provided the
Company has adequate documentation and is reasonably certain of receiving the
ITC.

Issue 5: As on
30th June 2017, the sales depot of the entity is holding substantial
stock of inventory on which excise duty was paid, since those goods were
cleared from the factory. How should the company value such inventory and the
excise duty paid? The Company is entitled to ITC subject to submission of
proper documents. The Company has sufficient documentation available.

Paragraph 11 of Ind AS 2 Inventories states as below for
refundable taxes:

“The costs of purchase of inventories
comprise the purchase price, import duties and other taxes (other than those
subsequently recoverable by the entity from the taxing authorities), and
transport, handling and other costs directly attributable to the acquisition of
finished goods, materials and services.”

Since the tax is a recoverable tax, inventory lying at the depot should
be valued at net of excise duty paid to the extent the company will be able to
receive ITC. The corresponding ITC should be reflected under the other
appropriate account such as “GST Input Tax Credit (GITC) Receivable Account.”

Issue 6: After
initial recognition, how should the “GST Input Tax Credit (GITC) Receivable
Account” be treated in the financial statements?

Balances in the GITC Receivable Account, pertaining to both inputs and
PPE, should be reviewed at the end of each reporting period. If it is found
that the balances or a portion thereof are not likely to be used in the normal
course of business or not refundable (even in inverted duty structure), then,
notwithstanding the right to carry forward such excess credit under GST Law,
the non-useable excess credit should be adjusted in the financial statements.
The irrecoverable input credit should generally be added to COGS or inventory
or PPE, as applicable.

In some cases, it may so happen that the company is not able to avail
input credit for reasons such as: it has not got proper registration, not
maintained proper documentation or not filed proper returns or the vendor has
not uploaded credit. In such cases, GST Input Credit disallowance is in the
nature of expense for the company. The same should be written off to P&L
immediately.

It may be noted that GITC is not a financial
instrument; hence Ind
AS 109 Financial Instruments is not applicable. Though impairment rules
of Ind AS 109 do not apply, the impairment rules of Ind AS 36 Impairment
of Assets will apply. Therefore, GITC that may not be recovered or
recovered after significant time period should be impaired for
non-recoverability and time value of money under Ind AS 36.

Issue 7: How should
a company present the “GITC Receivable Account” in the balance sheet?

The GITC Receivable Account represents an amount receivable due to
statutory right and against contractual right. Hence, it is a non-financial
asset and should be presented as such in the balance sheet.

The amount should be classified as current and non-current asset
depending upon the classification criteria as laid down under paragraph 66 of
the Ind AS 1 Presentation of Financial Statements and Ind AS compliant
Schedule III, viz., the following criteria. Particularly, the criteria at (a)
and (c) will be more critical.

‘An entity shall classify an asset as current when:

(a) It expects to realise the asset, or intends to sell or consume it,
in its normal operating cycle,

(b) It holds the asset primarily for the purpose of trading,

(c) It expects to realise the asset within twelve months after the
reporting period, or

(d) The asset is cash or a cash equivalent (as defined in Ind AS 7 Statement
of Cash Flows) unless the asset is restricted from being exchanged or used
to settle a liability for at least twelve months after the reporting period.

 An entity shall classify all other assets as non-current.’

Issue 8: Under
the GST regime, dealers may face losses on their inventory at 30th
June; for example, ITC benefit may not be available with respect to certain
local taxes or cess. To compensate dealers for the losses, the manufacturing
company has decided to provide cash compensation to dealers. How should the
company treat such compensation to dealers, particularly whether it should be
reduced from revenue or shown as an expense?

Paragraphs 9 and 10 of Ind AS 18 provide as below:

“9. Revenue shall be measured at the
fair value of the consideration received or receivable.

 10. The amount of revenue arising on a
transaction is usually determined by agreement between the entity and the buyer
or user of the asset. It is measured at the fair value of the consideration
received or receivable taking into account the amount of any trade discounts
and volume rebates allowed by the entity.”

 Paragraph 18 of Ind AS 18 states as below:

 “18. Revenue is recognised only when it
is probable that the economic benefits associated with the transaction will
flow to the entity. In some cases, this may not be probable until the
consideration is received or until an uncertainty is removed. For example, it
may be uncertain that a foreign governmental authority will grant permission to
remit the consideration from a sale in a foreign country. When the permission
is granted, the uncertainty is removed and revenue is recognised. However, when
an uncertainty arises about the collectability of an amount already included in
revenue, the uncollectible amount or the amount in respect of which recovery
has ceased to be probable is recognised as an expense, rather than as an
adjustment of the amount of revenue originally recognised.”

 Based on the above, the following two views seem possible under Ind AS
18:

 (a) The cash compensation paid to dealer is effectively a cash incentive
paid by the company. This reduces consideration received/ receivable for sale
of goods and fair value thereof. Consequently, it should be reduced from
revenue since Ind AS 18 requires revenue to be recognised at fair value. This
would also be the view under Ind AS 115 Revenue from Contracts with
Customers, which requires any cash compensation paid to customer or
customer’s customer to be reduced from revenue.

 (b) The circumstances for compensation arising from the extraordinary
situation did not prevail at inception, when the original sale agreement was
signed between parties. At the time of recognition, there was no uncertainty
regarding the revenue receivable. Nor the company had any explicit/ implicit
obligation to provide cash compensation. Rather, the company has decided to
provide cash compensation to the dealer in exceptional circumstances arising
purely after recognition of the original sale transaction. This expense was
incurred to maintain harmony and good relationship with dealers and is not
reflective of the fair value of the revenue. The compensation should be seen as
a distinct activity from the original revenue. Thus,  it can be presented as an expense rather than
reduction from revenue.

The author believes that from an Ind AS 18 perspective, both the views
are acceptable.

Issue 9:
Consider that a company has entered into contract for supply of goods for INR
10,000 plus GST @ 18%, i.e., total invoice amount of INR 11,800. The sale
agreement involves deferred payment at the end of the 18th month. It
is a ‘zero percent’ financing arrangement. The management has determined that
the present value of sale consideration including GST amount discounted at
market rate of interest is INR 9,900. How will the company reflect this
transaction in the financial statements?

Though the company will recover the amount from the customer at a later
date, it needs to pay the GST immediately to the government. Consequently, the
company will pass the following entry to recognise sale/ supply of goods:

Debit
Receivable from customer

(discounted
amount)                       INR 9,900

Credit Sale of goods                       INR 8,100

Credit GST payable                         INR 1,800

Going forward, interest on receivable from customer will be recognised
using market rate of interest, i.e., the rate used for original discounting.

Issue 10:
Consider that the company has entered into fixed price construction contract
which includes all taxes at the rates prevailing when the agreement was signed.
No variation is allowed due to change in indirect tax rates. Due to
applicability of GST, the taxes applicable on the company have increased. How
should the company reflect such impact in its financial statements?

GST   is pass   through on the company, i.e., the company
collects GST on behalf of the government. Hence, revenue should be net of GST
Payable to the government, irrespective of the 
fact  that the company has signed
an all-inclusive  contract with its
customers. Consequently, the increase in tax rate due to the GST
applicability which cannot be absorbed by customer will reduce overall
construction revenue/margins. The company should reflect such reduction as
change in estimate while determining construction revenue/margins to be
recognised based on Ind AS 11 Construction Contracts principles. The
company will make Ind AS 8 Accounting Policies, Changes in Accounting
Estimates and Errors disclosures related to change in estimate. If due
to increase in the GST rate, the overall contract has become loss making, Ind
AS 11 would require an expected loss on the construction contract to be
recognised as an expense.

Issue 11: How
does the introduction of GST impact indirect tax incentive schemes such as
advance authorisation/ EPCG schemes and various export promotion schemes under
the foreign trade policy (FTP)? How should these schemes be accounted for under
Ind AS and GST regime?

At the time of writing this article, the status of indirect tax
incentive schemes under the GST regime is not very clear. It is expected that
the Government will introduce appropriate changes in the law/ foreign trade
policy to clarify these impact.

Based on non-authoritative FAQs issued by the Finance Ministry, the
following applies:

– As
the GST Law stands today, while the exporters will continue to get the benefit
of BCD (Basic Custom Duty) exemption, the Integrated GST (IGST) that has
replaced CVD (Countervailing duty) and SAD (Special Additional Duty) is not
exempt. This would mean the importer will have to pay IGST and claim refund or
utilise it against output liability, if any. Midterm review of the Foreign
Trade Policy is likely to align FTP with GST. Representation has been made to
allow IGST exemption in case of Advance Authorisation, EPCG and other such
benefits. IGST paid would be presented as GITC Receivable Account.

–  The benefit of Merchandise Exports from India
Scheme (MEIS) and Service Exports from India Scheme (SEIS) for its utilisation
against procurement tax (earlier Central excise and Service tax) is no longer
available under GST. However, they may be utilised to pay basic custom duty or
additional duties of customs not covered under GST.

   Therefore, MEIS and SEIS scripts at 30th June, may be
usable. The entity will have to evaluate the extent to which it can be used.
Since the scripts are also transferable, the possibility of utilisation is
high. To the extent it cannot be used, or refund is not available, the same
will have to be written off.

–  There
is no clarity in respect of State incentives or Package schemes and the
Area-based exemptions made available to industry, which had made investment in
the state. Fact remains that under GST, the exemption could be only by way of
refund or utilisation of tax credit after paying tax. For example, in a State,
the entity may be entitled to sales tax exemption for a certain number of
years. Under GST, the entity will have to pay GST, and claim refund of SGST
from the State Government. The entity will have to evaluate the extent to which
they will be able to receive refund; to the extent refund is not available,
impairment would be required.

This is an area where the companies should maintain a close watch.
Further clarity on this matter will emerge in the near future.

The author believes that accounting impact on such incentive schemes can
be analysed in detail only after clarity from the Government. In the interim,
the related principles in Ind AS 20 Accounting for Government Grants and
Disclosure of Government Assistance will continue to apply to these
schemes.

If the government does not provide incentive schemes which were
previously available to the company, then this may indicate an impairment of
assets/ onerous contracts. Consequently, it is imperative that the companies
evaluate the impact of applying Ind AS 36 Impairment of Assets and Ind
AS 37 Provisions, Contingent Liabilities and Contingent Assets carefully.

Issue 12: At
the time of dispatch of goods, a company raises an invoice and incurs GST
liability. Does that automatically result in revenue recognition under Ind AS?

Under Ind AS 18, revenue from the sale of goods shall be recognised when
all the following conditions have been satisfied:

(a) the entity has
transferred to the buyer the significant risks and rewards of ownership of the
goods;

(b) the entity retains
neither the continuing managerial involvement to the degree usually associated
with ownership nor the effective control over the goods sold;

(c) the amount of revenue
can be measured reliably;

(d) it is probable that the
economic benefits associated with the transaction will flow to the entity; and

(e) the costs incurred or
to be incurred in respect of the transaction can be measured reliably.

It may so happen that an
invoice is raised and GST liability is incurred, but because the above conditions are not fulfilled,
revenue cannot be recognised under Ind AS.

Voluntary Revision Of The Financial Statements

Background

With respect to voluntary
revision of financial statements, following is the provision of The Companies
Act, 2013 (as amended). 


131.(1)
If it appears to the directors of a company that— (a) the financial statement
of the company; or (b) the report of the Board, do not comply with the
provisions of section 129 or section 134, they may prepare revised financial
statement or a revised report in respect of any of the three preceding
financial years after obtaining approval of the Tribunal on an application made
by the company in such form and manner as may be prescribed and a copy of the
order passed by the Tribunal shall be filed with the Registrar…….


The MCA notified section
131 of the Act dealing with voluntary revision of financial statements on 1
June 2016 and the section is applicable from the notification date. In
accordance with the section, if it appears to the directors of a company that
its financial statement or the board report do not comply with the requirements
of section 129 (dealing with preparation of financial statements, including
compliance with accounting standards) or section 134 (dealing with aspects such
as signing of financial statements and preparation of the board report), then
directors may prepare revised financial statements or a revised report for any
of the three preceding financial years after obtaining the National Company Law
Tribunal (NCLT) approval. The section and related rules prescribe the procedure
to be followed in such cases. The procedure include:


– The company will make an application to the NCLT in prescribed
manner.

– Before passing any orders for revision, the NCLT will notify the
Central Government and the Income tax authorities and will consider
representations received, if any.

– The company will file a copy of the NCLT order with the
Registrar.

 –  Detailed reasons for revision of financial statements or report
will also be disclosed in the board’s report in the relevant financial year in which such revision is being made.


Ind AS 1 Presentation of
financial statement and Ind AS 8 Accounting Policies, Changes in Accounting Estimates and Errors


A company may decide to
change one or more accounting policies followed in the preparation of financial
statements or change classification of certain items or correct an error in
previously issued financial statements. In these cases, Ind AS 8/ 1 requires
that comparative amounts appearing in the current period financial statements
should be restated.


In the case of an error,
there may be rare circumstances when the impact of error in financial
statements is so overwhelming that they may become completely unreliable. In
such cases, the company may need to withdraw the issued financial statements
and reissue the same after correction. The auditor may also choose to withdraw
their audit report. However, in majority of cases, the impact of error will not
be so overwhelming requiring withdrawal of already issued financial statements.
Rather, the company will correct the error in subsequent financial statements.
Ind AS 8 requires that comparative information presented in subsequent
financial statements will not be the same as originally published. Those
numbers will be restated/ updated to give effect to the correction of the
error. Similar treatment applies for change in accounting policy or
reclassification. The subsequent financial statements in which correction is
made will also include appropriate disclosures to explain impact of the
changes.


Issue


Whether restatement of
comparative amounts in subsequent financial statements is tantamount to
revision of financial statements? Consequently, whether such restatement will
trigger compliance with section 131 of the Act?


Author’s View


Section 131 of the Act is
triggered only in cases where the company needs to withdraw previously issued
financial statements and re-issue the same. For example, this will be required
when the impact of error on previously issued financial statements is so
overwhelming that they have become completely unreliable.


Section 131 will not be
triggered in cases related to restatement of comparative information appearing
in the current period financial statements. This view can be supported by the
following key arguments:


– Restatement of comparative information appearing in subsequent financial
statements is not tantamount to change or revision or reissuance of
previously issued financial statements. If one reads section 131 carefully, it
is about preparing (and consequently reissuing) revised financial statements,
at the behest of the board of directors. It cannot be equated to restating
comparative numbers for errors or changes in accounting policies where there is
no revision or reissuance of already issued financial statements. There
is a change in the comparative numbers in subsequent financial statements; but
there is no revision or reissuance of already issued financial
statements.


– Section 131 can be triggered only if
the previously issued financial statements were not in compliance with section
129. In the case of a change in accounting policy or reclassification, there
was no such non-compliance in previously issued financial statements. Hence,
section 131 does not apply. The Ind AS 8 requirement to restate an error in
subsequent financial statements is the same as change in accounting
policy/reclassification. Hence, section 131 should apply in the same manner for
correction of errors as well.

ICDS – Post Delhi High Court Decision

The Central Government (CG)
has notified 10 Income Computation and Disclosure Standards (ICDS) u/s. 145(2)
of the Income-tax Act (ITA). Section 145 of the ITA provides that the taxable
income of a taxpayer falling under the heads “Profits and Gains from Business
and Profession” (PGBP) or “Income from Other Sources” (IFOS) shall be computed
in accordance with either the cash or mercantile system of accounting,
whichever is regularly employed by the taxpayer. Section145(2) grants power to
the CG to prescribe the ICDS to be followed by any class of taxpayers or in
respect of any class of income. The notified ICDS are applicable from 1st
April, 2016, (financial year 2016-17) to taxpayers following the mercantile
system of accounting and for the computation of income chargeable under the
heads PGBP or IFOS. They do not apply to taxpayers who are individuals or Hindu
Undivided Families, which are not liable for tax audit under the provisions of
the ITA.

 

A writ petition was filed
by The Chamber of Tax Consultants (Chamber) on the constitutional validity of
section 145(2) as also the validity of notified ICDS, to the extent they are in
conflict with the principles laid down in binding judicial precedents rendered
prior to ICDS. The Chamber urged that while section 145(2) of the ITA permits
the CG, as a delegate of the Legislature, to notify ICDS, it cannot be read as
granting unfettered powers to the CG, in the guise of delegated legislation, to
notify ICDS modifying the basis of taxation which can, if at all, be done only
by the Parliament by amending the ITA. The notified ICDS, to the extent they
seek to unsettle binding judicial precedents and modify the basis of
chargeability and computation of taxable income, are ultra vires the ITA
and the Constitution of India.

 

The Chamber further argued
that “the accounting standards (AS) issued by the ICAI were applicable to all
corporate entities and non-corporate entities following the mercantile system
of accounting. ICDS was applicable only to taxpayers following mercantile
system of accounting (i.e. to all assesses except individuals and HUFs whose
accounts are not required to be audited u/s. 44B of the Act). There was no
reasonable basis on which such differentiation or classification can be made
for the applicability of the ICDS, since the Assessee following the cash system
of accounting would escape from the implications and compliance requirements of
the ICDS. This is violative of Article 14 of the Constitution.”

 

The Delhi High Court (HC)
upheld the constitutional validity of section145(2), but struck down several
contentious provisions of individual ICDS. In a landmark ruling, the HC held
that ICDS cannot override binding judicial precedents or statutory provisions.
It held that the force of judicial precedents can be overridden only by a valid
law passed by the Parliament. Such power cannot be exercised by the Executive.
The provisions of ICDS, being a delegated legislation, have to be so read down
such that they do not modify the basis for computation of taxable income as
recognised by the provisions of the ITA or the binding judicial precedents laid
down by the Supreme Court (SC) or High Courts.

 

In the following
paragraphs, we discuss the provisions of individual ICDS that are struck down
by the HC.

 

ICDS I on Accounting Policies

–  ICDS I provides that expected or mark to
market (MTM) losses are not to be allowed as deduction, unless specifically
permitted by any other ICDS and, thus, does away with the concept of
“prudence”, which was present in the earlier Tax Accounting Standard (TAS) I.

–  The provision of ICDS I is contrary to the
settled judicial position. Many High Court rulings have recognised the
principle of ”prudence” by allowing deduction for provision for expected losses
on contracts recognised in the books of account by the taxpayer in compliance
with GAAP.

–  The ITA also grants deduction for revenue
expenses “laid out” or “expended” for the purpose of business in which the
concept of “prudence” is inherent.

–   The removal of the concept of prudence is
also not consistent with the prudence principles inherent in other ICDSs. A few
examples are given below.

•    Inventory
valuation at lower of cost and market price (ICDS II).

•    Provision
for expected losses on contracts in ICDS III, with the only modification that
the said loss will be allowed in proportion of completion of the contract,
rather than allowing the same for the unfinished portion of the contract. This
was primarily for bringing horizontal equity of treating the contract profit
and contract loss on the same principle.

•    The
principle of reasonable certainty is adopted for recognising revenue in ICDS
IV.

•    Provision
for the losses on forward cover transactions in the nature of hedging (except
to the extent the same pertains to highly probable transactions or firm
commitment) in ICDS VI.

•    Valuation
of inventory (of investments) under ICDS VIII at lower of cost and market price

•    Recognising
provisions for present obligation of future liabilities in ICDS X.

–  Accepting the above contentions, the HC held
that non-acceptance of the “prudence” concept is contrary to the ITA and,
hence, ICDS I is unsustainable to that extent.

–   It may be noted that the CBDT Circular (No 10
dated 23rd March, 2017) provides horizontal equity by not taxing MTM
gains.

 

ICDS II on Valuation of Inventory

–   As per the settled judicial position, if the
business of a partnership firm continues after dissolution of the firm, then
the inventory has to be valued at lower of the cost and the market price. On
the other hand, if the business is discontinued on dissolution of the firm,
then the inventory has to be valued at market price.

–   ICDS II requires that inventory, as on the
date of dissolution of the firm, is to be valued at market price, irrespective
of continuance or discontinuance of the business. This leads to notional
taxation of income contrary to the judicial position.

–   Furthermore, there is a specific provision of
the ITA [section 145A], which provides that the inventory shall be valued as
per the method of accounting regularly employed by the taxpayer.

–   The HC held that: (a.) It is not permissible
for ICDS II to override the settled judicial position. (b.) Where the taxpayer
follows a certain method of accounting for valuation of inventory, the same
shall override ICDS II by virtue of the specific provision in the ITA. Thus,
the HC held that ICDS II is ultra vires the ITA and, to that extent, it
is struck down.

 

ICDS III on Construction Contracts –
Retention money

–  ICDS III provides that retention money should
form part of the contract revenue and taxed on the basis of percentage of
completion method (POCM). The CBDT Circular reiterates this position.

–  However, as per the settled judicial
position, retention money accrues to the taxpayer only when the defect
liability period is over and the Engineer-in-Charge certifies that no liability
is attached to the tax payer. Retention money cannot form part of the revenue
unless the same has accrued as “income” as per the charging provisions of the
ITA.

–   The HC held that taxation of retention money
would need to be seen on a case-to-case basis depending upon the contractual
terms, conditions attached to such amount and keeping in mind the settled tax
principles of accrual of income. ICDS III, to the extent it seeks to bring
retention money to tax at the earliest stage even when the receipt is uncertain
or conditional, is contrary to the settled position. Therefore, to that extent
ICDS III was struck down.

–   Whilst as per law, retention money is taxable
on completion of defect liability period, in practice, many companies prefer to
offer it for tax on its recognition in the accounts, which is much earlier than
completion of the defect liability period. This is done predominantly because
it is the method of accounting regularly followed by the tax payer (section
145) and to avoid any possible litigation. Since the item involves mere timing
difference, tax payers find it convenient to offer retention money for tax as
per accounts, and thereby avoid cumbersome offline calculation for tax
purposes. It also meets the Tax Officers’ intent of taxing it at the earliest
point of time. Therefore, the risks and consequences to the tax payer of
continuing with its existing practice is very limited.

 

ICDS III on Construction Contracts –
Incidental income

 

–   The SC, in the case of CIT vs. Bokaro
Steel Ltd., held that receipts which are inextricably linked to the setting
up of plant or machinery can be reduced from the cost of asset.

–   However,
ICDS III, read with the provisions of ICDS IX on Borrowing Cost, provides that
incidental income earned cannot be reduced from the borrowing cost forming part
of the cost of the asset.

–   The
HC held that, to the extent the provisions of ICDS III are contrary to the settled
judicial position, they are not sustainable.

 

ICDS IV on Revenue Recognition – Export
incentives

 

–   As
per the SC ruling in the case of CIT vs. Excel Industries Ltd., export
incentives are taxable only in the year in which the claim is accepted by the
Government, as the right to receive the payment accrues in favour of the
taxpayer when the corresponding obligation to pay arises for the Government.

–   However,
ICDS IV requires recognition of such income in the year of making claim if
there is a reasonable certainty of ultimate collection.

–   ICDS
IV, being contrary to the SC ruling, is ultra vires the ITA provisions
and, hence, struck down to that extent.

–  In
the case of Excel Industries, exports were made in Year 1, which
entitled the tax payer to duty free imports. The benefit arising to the tax
payer on exports was recognised in the books in Year 1 and duty free imports
were made in Year 2. In other words, from an accounting parlance, the incentive
was earned in Year 1 and utilised in Year 2. Taxpayer claimed that for tax
purposes, the benefit is taxable in Year 2 when there is corresponding
liability on Government to pay which was upheld by the SC. In more complicated
export incentives or Government grants, the taxability will depend upon facts
and circumstances and may not be straight-forward. As already explained in the
context of retention monies, most tax payers may be offering these incentives
for tax in the year in which it is accrued in the accounts.

 

ICDS IV on Revenue Recognition –
Completed contract method (CCM)

–   Accounting
principles (AS-9) permit the taxpayer with respect to service related contracts
to follow either CCM or POCM for revenue recognition. As per AS-9, the choice between CCM and POCM is
dependent on whether there is only a single act in performance of service
contract or more than one act. It may be noted that the AS are not binding on
all categories of assesses, firms, etc. Such assessees are free to
follow any method of accounting.

–   Judicial
precedents have recognised both methods as valid for tax purposes under the
mercantile system of accounting.

–   ICDS
IV, which only permits POCM, is contrary to the above judicial position and,
hence, liable to be struck down to that extent.

–   It
may be noted that with respect to construction contracts (not service contracts,
covered under AS-9), AS-7, permits only POCM. ICDS III on Construction
Contracts also allows only POCM. The HC did not strike down ICDS III, on this
account, probably because the POCM method is the only acceptable method
provided under AS-7 for construction contracts.

 

ICDS IV on Revenue Recognition – Interest
Income

–   The
Chamber contended that under ICDS IV, interest income on non-performing assets
(NPAs) of Non-banking Financial Companies (NBFCs) would become taxable on time
basis even though such interest is not recoverable.

–  The
HC noted that the CBDT Circular clarifies that while interest income is to be
taxed on time basis alone, bad debt deduction, if any, can be claimed under the
provisions of the ITA. Furthermore, the Parliament has inserted a specific
provision in the ITA to grant bad debt deduction for incomes recognised under
ICDS (without recognition in the books) in the year in which they become
irrecoverable.

–  The
HC held that this provision of ICDS IV cannot be held to be ultra vires
since a corresponding bad debt deduction can be claimed by the taxpayer if the
amount of interest is irrecoverable. Also, the Chamber has not demonstrated
that ICDS IV is contrary to any ruling of the SC or any other Court.

–  The
HC further observed that once interest income is offered to tax on time basis
by claiming corresponding bad debt deduction, if the amount is not recoverable,
ICDS creates a mechanism to track unrecognised interest amounts for future
taxability, if so accrued.

 

ICDS VI on Foreign Exchange Fluctuations

–   The
SC held, in the case of Sutlej Cotton Mills Ltd .vs. CIT, that exchange
fluctuation gain/loss in relation to loan utilised for acquiring a capital item
would be capital in nature.

–   ICDS
VI provides that exchange fluctuation loss/gain in case of foreign currency
derivatives held for trading or speculation purposes shall be allowed on actual
settlement, and not on MTM basis. The HC held that this is not consonant with
the ratio laid down by the SC in the Sutlej Cotton Mills ruling and,
therefore, struck it down.

–   The
CBDT Circular clarifies that the opening balance of Foreign Currency
Translation Reserve Account as on 1 April 2016 (i.e., on the date ICDS first
became applicable), which comprises of accumulated balance of exchange
fluctuation gains/losses in relation to non-integral foreign operations, is
taxable to the extent it relates to monetary items.

–   In
line with the SC decision in the case of Godhra Electric Supply Company Ltd
vs. CIT, the HC held that valuation of monetary assets and liabilities of
the foreign operations as at the end of the year cannot be treated as real
income as it is only in the nature of notional or hypothetical income which
cannot be subjected to tax.

 

ICDS VII on Government Grants

–   ICDS
VII provides that recognition of government grants cannot be postponed beyond
the date of actual receipt. This is in conflict with the accrual system of
accounting since, many times, conditions are attached to the receipt of
government grant which need to be fulfilled in the future. In such instance, it
cannot be said that there is any accrual of income although the money has been
received in advance.

–   Therefore,
the HC struck down ICDS VII to that extent.

 

ICDS VIII on Securities held as Inventory

–   ICDS
VIII provides for valuation of securities held as inventory and is divided into
two parts.

–   Part
B of ICDS VIII, which applies to banks and public financial institutions,
provides that recognition of securities should be in accordance with the RBI guidelines.

–   Part
A applies to taxpayers other than banks and public financial institutions. It
requires valuation of inventory on “bucket approach” i.e., category-wise
application of lower of cost and market instead of individual valuation of each
security. However, this is different from the normal accounting principles and,
thus, taxpayers will need to maintain separate records for tax purposes every
year.

–  The
HC held that Part A of ICDS VIII, which prescribes “bucket approach”, differs
from ICDS II on valuation of inventory which, under similar circumstances, does
not prescribe the ”bucket approach”. This shows that ICDS has adopted separate
approaches at different places for valuation of inventory. This change is not
possible without a corresponding amendment in the ITA. Hence, to that extent,
Part A of ICDS VIII is ultra vires the ITA.

 

Comparison between Indian GAAP, ICDS and Delhi HC Decision

Point  of Difference

Indian GAAP

ICDS

Delhi HC Decision/Judicial pronouncements

Revenue
during early stage of construction, when outcome cannot be estimated
reliably.

Revenue
recognised to the extent costs are recoverable. No threshold is prescribed
for early stage.

Same
as Indian GAAP. However, the early stage shall not extend beyond 25%
completion. (ICDS III – Construction Contracts).

No
change.

Retention
money.

Forms
part of contract revenue and POCM is applied to entire contract revenue.

Same
as Indian GAAP (ICDS III – Construction Contracts).

Retention
money accrues to the taxpayer only when the related performance conditions
are fulfilled, for eg. when the defect liability period is over and the
Engineer-in-Charge certifies that no liability is attached to the tax payer.
Retention money cannot form part of the revenue unless the same has accrued.

Export
incentive.

When
it is reasonably certain that all conditions will be fulfilled and the
ultimate collection will be made.

In
the year of making claim, if there is a reasonable certainty of ultimate
collection. (ICDS VII – Government Grants).

Income
will not accrue, till the time conditions attached to it are fulfilled and
there is corresponding liability on Government to pay the benefit. (SC in Excel
Industries case).

Revenue
from construction contracts.

POCM

POCM

Not
discussed.

Revenue
from service contracts.

POCM
or CCM

u  Only POCM for long duration contracts (>
90 days).

u   CCM permitted for short duration contracts (< 90 days) (ICDS
IV – Revenue Recognition).

Accounting
principles and Judicial precedents permit, both POCM and CCM.

Real
estate developers.

As
per Guidance Note on Accounting for Real Estate Transactions, only
POCM is allowed.

No
ICDS for real estate developers. 
Judicial precedents will apply. 
Therefore, POCM or CCM will be allowed per the method of accounting
regularly employed by the taxpayer. 
The acceptance of CCM by the tax authorities for real estate
developers is a contentious issue and generally resisted by the Tax
Department. There are also cases where CCM has been disallowed by courts.
Currently, if taxpayer is following POCM in books, it would be bound u/s.145,
which requires income to be computed as per method of accounting regularly
followed by the taxpayers in its books. Most corporate real estate developers
follow POCM. A few corporates and non-corporates that followed CCM had to
face severe litigations and an audit qualification from the auditor on the
financial statements.

Not
discussed.

Onerous
Contract.

Expected
losses are recognised as an expense immediately.

Losses
incurred on a contract will be allowed only in proportion to the stage of
completion (ICDS III – Construction Contracts).

Prudence
is inherent in section 37(1) and hence expected losses allowable as per
judicial precedents.

Borrowing
Cost capitalisation – whether substantial period of time is required.

Applies
only when assets require substantial period of time for completion.

No
condition w.r.t substantial period of time except for inventory and general
borrowing costs ( 12 months) (ICDS IX – Borrowing Costs).

No
change.

Capitalisation
of specific borrowing cost.

Actual
borrowing cost.

Actual
borrowing cost.

No
change.

Capitalisation
of general borrowing cost.

Weighted
average cost of borrowing is applied on funds that are borrowed generally and
used for obtaining a qualifying assets.

Allocation
is based on average cost of qualifying asset to average total assets (ICDS IX
– Borrowing Costs).

No
change.

Borrowings
– Income on temporary investments.

Reduced
from the borrowing costs eligible for capitalisation.

Not
to be reduced from the borrowing costs eligible for capitalisation. Thus, it
will be taxable income (ICDS IX – Borrowing Costs).

Accounting
principles and Judicial precedents permit reduction of incidental income
where it has close nexus with construction activity. (SC in Bokaro Steel).

Contingent
Assets.

Recognition
is based on virtual certainty.

Recognition
is based on reasonable certainty (ICDS X – Provisions, Contingent Liabilities
and Contingent Assets).

Test
of ‘reasonable certain’ is not in accordance with S. 4/5 of ITA. Hypothetical
income not creating enforceable right cannot be taxed.

Government
Grant
classification.

u   Income related grant

u   Assets related grant

u   Grant in the nature of promoter’s contribution (credited to
capital reserve).

u     Income related grant

u     Assets related grant

     (ICDS VII – Government Grant).

 

No
change.

Government
Grant – recognition.

Not
recognised until there is a reasonable assurance that the entity shall comply
with the conditions attached to them and the grants will be received.

Similar
to Indian GAAP, except recognition is not postponed beyond the date of actual
receipt. (ICDS VII – Government Grant).

Taxable
when conditions attached to the receipt of government grant are fulfilled
and, there is corresponding liability on Government to pay.

Capitalisation
of exchange differences on long term foreign currency monetary item for
acquisition of fixed assets
(AS 11.46A).

Paragraph
46/ 46A of AS 11 provides option for capitalisation.

u   On imported assets S43A allows capitalisation

u   On local assets S43A does not apply.

u     With respect to local assets, all MTM exchange differences are included
in taxable income (ICDS VI – Foreign Exchange)

Distinguish
between capital and revenue nature of exchange fluctuation (Sutlej Cotton Mills).  Thus, exchange
differences on local capital assets, are not revenue in nature; nor, are
capitalisable under 43A.

Forward
contracts under AS 11 for hedging purpose.

Premium/
discount to be amortised over the contract period. Spot-to-spot gains/ losses
are recognised in P&L.

Same
as Indian GAAP. (ICDS VI – Foreign Exchange).

No
change.

Foreign
currency risk of a firm commitment or a highly probable forecast transaction.

As
per Guidance Note on Accounting for Derivative Contracts (GN)
derivatives are measured at fair value through P&L, if hedge accounting
is not applied.

Premium,
discount or exchange difference, shall be recognised at the time of
settlement. (ICDS VI – Foreign Exchange).

ICDS
cannot override judicial precedents (which will implicitly include SC ruling
in Woodward Governor’s case (312 ITR 254) which upheld MTM treatment
as per accounting principles). Thus MTM losses/gains are deductible/taxable.

Foreign
currency risk on contract for trading or speculative purposes.

As
per GN, derivatives are measured at fair value through P&L.

Premium,
discount or exchange difference shall be recognised at the time of
settlement. (ICDS VI – Foreign Exchange).

MTM
losses are tax deductible

[SC
in Sutlej Cotton Mills].

MTM
gains – No clarity but on principles, it is taxable.

MTM
losses on commodity derivatives.

As
per GN, derivatives are measured at fair value through P&L, if hedge
accounting is not applied.

u   MTM losses are not tax deductible. (ICDS I – Disclosure of
Accounting Policies)

u     CBDT Circular – MTM Gains are not taxable.

u     Consequently, tax will apply on settlement.

ICDS
cannot override judicial precedents (which will implicitly include SC ruling
in Woodward Governor’s case (312 ITR 254) which
permitted MTM treatment as per accounting principles).  Thus MTM losses/gains are
deductible/taxable.

 

The Road Ahead

The ICDS has far-reaching implications on tax
liability of assessees, which are debilitating. The introduction of Ind AS
should have been tax neutral, with minimal or no impact on tax liability. It is
unfortunate that Ind AS was used as an excuse to introduce ICDS that had severe
tax consequences on tax payers, which were mostly negative. The standards were
framed by a part time committee and that too in a great hurry. The ICDS
standards appear to be one sided, determined to maximise tax collection, rather
than routed in sound accounting principles. Such a backhanded and concealed
manner of bringing in an important piece of legislation, many of the provisions
of which were in conflict with the ITA or judicial precedents was deservedly
struck down by the HC. To the extent, the provisions were in conflict with the
ITA, the ICDS itself provided that those would prevail over ICDS. However,
there was no such exemption for ICDS provisions that were in conflict with
judicial precedents. The CBDT’s clarification in the Circular that ICDS shall
prevail over judicial precedents on ‘transactional issues’ was also highly
unsatisfactory.

 

There were also many interpretative
challenges that could have created a very litigious environment. Consider this;
the preamble of the ICDS states that where there is conflict between the
provisions of the ITA and ICDS, the provisions of the ITA shall prevail to that
extent. If a company has claimed mark-to-market losses on derivatives as
deductible expenditure u/s. 37(1) of the ITA – Can the company argue that this
is a deductible expenditure under the ITA (though the matter may be sub
judice) and hence should prevail over ICDS which prohibits mark-to-market
losses to be considered as deductible expenditure?

 

Some of the transitional provisions in ICDS
had significant unanticipated effect. For example, the ICDS requires contingent
assets to be recognised based on reasonable certainty as compared to the
existing norm of virtual certainty. Consider a company has filed several
claims, where there is reasonable certainty that it would be awarded
compensation. However, it has never recognised such claims as income, since it
did not meet the virtual certainty test under AS 29 Provisions, Contingent
Liabilities and Contingent Assets. Under the transitional provision, it
will recognise all such claims in the first transition year 2016-17. If the
claim amounts are significant, the tax outflow could be devastating. This could
negatively impact companies that have these claims. The interpretation of “reasonable
certainty” and “virtual certainty” would also come under huge stress and
debate.  This may well be another
potential area of uncertainty and litigation.

 

The struck down ones of some contentious
provisions of ICDS by the HC is a huge relief to tax payers. It will not only
bring fairness and tax neutrality but will also avoid a litigious environment,
provided the HC decision is upheld by the SC and not contested by the
Government.

 

Taxpayers which have already filed returns
for tax year 2016-17 can explore revising their returns on the basis of the law
laid down by the present ruling. While there may be no difficulty in case of
the SC ruling which is binding on all lower Courts in India, there could be
difficulties in the case of a High Court ruling. A High Court ruling would be
binding on a lower judicial authority in the jurisdictional area of the High
Court. Whether a High Court ruling would bind lower judicial authority in other
jurisdictional areas is a highly contentious and debatable matter.

 

In this respect, different High Courts have
taken different views. If other High Courts step into this issue, the situation
can get very muddy and complicated, particularly if they take a conflicting
position from that taken by the Delhi HC. Therefore, it is natural to expect
that the CG may intervene, either by filing a special leave petition with the
SC for stay of the HC decision or alternatively, incorporating the ICDS as part
of the Act. _

Ind AS – Learings from Phase 1 Implementation – Tips for a Smooth implementation (Part 1)

Introduction

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. Below are some important tips.


Use the right people in the Ind  AS conversion process

The existing accounting staff may not be Ind
AS literate, and therefore will need to be trained under Ind AS. However,
expertise does not come from mere training. Expertise comes from several years
of engagement in working on IFRS/Ind AS. Therefore, it will be worthwhile to
consider external help or recruit someone with Ind AS knowledge, expertise and
implementation experience.

 

Align all stake holders

Phase 1 entities have experienced that Ind
AS is not a mere accounting change, but has significant business impact.
Therefore, the CFO should be significantly involved in the Ind AS conversion
process, and also keep the CEO in the loop. The conversion process entails
taking numerous business decisions, which only the CFO or the CEO can take.

Other stakeholders that may need to be
aligned are regulators, investors and analysts, audit committee, board of
directors and various business heads of the organisation. In one particular
instance which the author is aware of, the Ind AS financial statements were
quite delayed, because the independent directors did not want to identify
themselves as key management personnel (KMP) in the financial
statements. It may be noted that independent directors are not KMPs under
Indian GAAP, but under Ind AS they would be disclosed as KMPs. It took the
CFO and the auditors quite some time to convince the Independent directors that
they were indeed KMPs for Ind AS disclosure purposes.

Consider impact on debt/equity ratio

Many
instruments that are classified as equity under Indian GAAP could be a
liability under Ind AS. Consider a simple scenario, where a PE firm has made
investments in the preference shares of a company, and has a put option of
those shares on the Company, if exit is not achieved within the specified
period through a successful IPO. This instrument would be classified by the
Company within the shareholder’s fund under Indian GAAP. However, under Ind AS
such an instrument is classified as financial liability, because the issuer
Company has no unconditional right to avoid payment of cash, if the IPO is not
successful. Further, a successful IPO is beyond the control of the issuer
Company as it is dependent on numerous factors, which the issuer Company cannot
change, for example, the stock market condition. This is a case where equity
under Indian GAAP is reclassified as loan under Ind AS.

In this
scenario, some Phase 1 companies have changed the arrangements with the PE,
such that the put option is not on the Company, but on the promoters of the Company.
In such a case, the financial liability is that of the promoter and not of the
Company. However, this change could be a very time consuming process as the PE
investor would need to be convinced. Therefore, it is important for Phase 2
companies to start early, in order to avoid last minute hiccups.


Consider income tax implications

One of the biggest impact areas of Ind AS
conversion is income-tax, which could be either positive or negative. Consider
a company that is restructuring its debts with the bank, wherein the bank takes
a hair-cut. The sacrifice the bank makes, is a gain for the borrower company,
and will be credited to the profit and loss account. A huge credit to the
P&L account, may result in a MAT liability even for a company that was otherwise
making book losses.

Besides the impact of Ind AS on income tax
on an ongoing basis, the Company also needs to consider the impact of first
time adoption adjustments. Phase 2 entities have a clear advantage over phase 1
companies in this regard. Phase 2 entities have a clear visibility on the
various requirements, which were available to phase 1 entities only at the last
minute. This is elaborated in the following paragraph. Phase 2 entities should
therefore have a clear plan and not waste any time in making the right first
time adoption choices.

Finding the sweet spot was not easy for
phase 1 entities. Consider a company which wants to reflect a better net worth
and therefore, used the Ind AS deemed cost option of fair valuing the fixed
assets. As MAT provisions were not clear at that point in time, these companies
were afraid of what the MAT implications would be, and hence the choice of fair
valuation was only tentative. Eventually, fair valuation of fixed assets on
first time adoption was made MAT neutral in the budget, which led to the
tentative decision becoming a final decision. Next, phase 1 Companies wanted to
fairvalue only land, since it does not entail any depreciation, and avoid higher
depreciation due to fair value uplift on plant and machinery. However, as per
Ind AS 101 selective fair valuation was not allowed, though there is a proposed
amendment to allow selective fair valuation which may help phase 2 companies.
Phase 2 companies should take benefit of the same. However, it is important
that all these choices are made in time and after careful consideration and
planning.

 

Presentation AND Disclosures can be a big
hurdle

Ind AS presentation and disclosures are
numerous running into several more pages than Indian GAAP. Many phase 1
companies were more focused on the Ind AS adjustments, and left presentation
and disclosures towards the end. These companies struggled to publish their Ind
AS financial statements on time.

The presentation and disclosure requirements
under Ind AS are highly onerous and time consuming, particularly the fair value
and various risk disclosures under Ind AS 107 Financial Instruments:
Disclosures. Consider, for example, the liquidity risk disclosures. Companies
have to provide a maturity analysis of their financial liability based on a
worse-case scenario. To provide these disclosures on a worse-case basis,
companies will have to consider potential debt covenant violation, treat demand
liabilities as immediately payable, etc.

Companies have to disclose sensitivity
analysis for each significant risk (for e.g. foreign exchange) applicable to
them. In providing these disclosures, entities operating in multiple currency
environment, will have more difficulty because of the correlation between the
various foreign currencies. Companies will also have to ensure that an
appropriate control process is in place to prepare and review such information,
including a formal process for audit committee review.

Phase 2 companies should therefore prepare
in advance and not delay their effort on presentation and disclosures till the
eleventh hour.

 

Conclusion

Phase 2 entities should use the benefit of
lessons learnt in Phase 1 implementation and avoid any pitfalls. Part 2 of this
article, will be included in the next edition. _

 

Impact of Ind AS 115 on Real Estate Companies

An Exposure draft namely Ind AS 115 Revenue from Contracts with
Customers is awaiting approval by the Ministry of Corporate Affairs.  There is uncertainty on the effective date of
the Standard, but it may apply as early as from accounting periods beginning on
or after 1 April, 2018.  In this article,
we discuss the impact of Ind AS 115 on real estate companies, particularly in
the context of development and sale of multi-unit residential or commercial
property before the entity constructs the property.

 

Ind AS 115 specifies the requirements an entity must apply to measure
and recognise revenue and the associated costs. The core principle of the
standard is that an entity will recognise revenue when it transfers control of
the underlying goods and services to a customer. The principles in Ind AS 115
are applied using the following five steps:

1.  Identify the contract with a customer

2.  Identify the performance obligations in the contract

3.  Determine the transaction price

4.  Allocate the transaction price to the performance obligations

5.  Recognise revenue when or as the entity satisfies each performance
obligation.

 

Ind AS 115 requires recognition of revenue when or as the entity
satisfies each performance obligation. This requirement is one of the key
hurdles for real estate companies. Currently, the Guidance Note on
Accounting for Real Estate Transactions (GN) requires real estate companies
to apply the percentage of completion method.

 

Under Ind AS 115, an entity will have to evaluate whether it satisfies
the performance obligation to its customer at the time of delivery of the real
estate unit or over time as the construction is in progress. If an entity
cannot demonstrate that the performance obligation is satisfied over time, it
will not be able to recognis e revenue over time. In simpler terms, the entity
will have to record real estate sales on the completed contract method, instead
of the percentage of completion method (POCM).

 

Satisfaction of
performance obligations

An entity recognises revenue only when it satisfies a performance
obligation by transferring control of a promised good or service to a customer.
Control may be transferred at a point in time or over time. Control of the good
or service refers to the ability to direct its use and to obtain substantially
all of its remaining benefits. Control also means the ability to prevent other
entities from directing the use of and receiving the benefit from a good or
service. The benefits of an asset are the potential cash flows (inflows or
savings in outflows) that can be obtained directly or indirectly in many ways,
such as by:

 

a)  using the asset to produce goods or provide services;

b)  using the asset to enhance the value of other assets;

c)  using the asset to settle liabilities or reduce expenses;

d)  selling or exchanging the asset;

e)  pledging the asset to secure a loan; and

f)   holding the asset.

 

The control model is different from the ‘risks and rewards’ model in
current Ind AS 18 and the GN. As per the GN, the completion of revenue
recognition process is usually identified when the following conditions are
satisfied.

 

a)  the entity has transferred to the buyer the significant risks and
rewards of ownership of the real estate;

b)  the entity retains neither
continuing managerial involvement to the degree usually associated with
ownership nor effective control over the real estate sold;

c)  the amount of revenue can be measured reliably;

d)  it is probable that the economic benefits associated with the
transaction will flow to the entity; and

e)  the costs incurred or to be incurred in respect of the transaction
can be measured reliably.

 

The differences in the model may result in different accounting
outcomes.

 

Performance
obligations satisfied over time

An entity transfers control of a good or service over time, rather than
at a point in time when any of the following criteria are met:

 

1)  The customer simultaneously receives and consumes the benefits
provided by the entity’s performance as the entity performs. For example, when
cleaning services are provided, the customer simultaneously receives and
consumes the benefits.

 

2)  The entity’s performance creates or enhances an asset that the
customer controls as the asset is created or enhanced. For example, an entity
constructs an equipment for the customer at the customer’s site.

 

3)  The entity’s performance does not create an asset with an
alternative use to the entity and the entity has an enforceable right to
payment for performance completed to date.

 

The first criterion is not applicable because the entity’s performance
creates an asset, i.e., the real estate unit that is not consumed immediately.
The second and the third criteria are discussed below. The Standard contains
requirements on when performance obligations are satisfied over time. When a
performance obligation is not satisfied over time, it will be deemed to have
been satisfied at a point in time.

 

Customer
controls asset as it is created or enhanced

The second criterion in which control of a good or service is
transferred over time, is where the customer controls the asset as it is being
created or enhanced. For example, many construction contracts contain clauses
indicating that the customer owns any work-in-progress as the contracted item
is being built. In many jurisdictions, the individual units of an apartment
block are only accessible by the purchaser on completion or near completion.
However, the standard does not restrict the definition of control to the
purchaser’s ability to access and use (i.e., live in) the apartment. In Ind AS
115.33, the standard specifies: The benefits of an asset are the potential cash
flows (inflows or savings in outflows) that can be obtained directly or
indirectly in many ways, such as by:

a)  using the asset to produce goods or provide services (including
public services);

b)  using the asset to enhance the value of other assets;

c)  using the asset to settle liabilities or reduce expenses;

d)  selling or exchanging the asset;

e)  pledging the asset to secure a loan; and

f)   holding the asset.

 

In some jurisdictions, it may be possible to pledge, sell or exchange
the unfinished apartment. Careful consideration will be required of the
specific facts and circumstances. The September 2017 Update of IFRIC, discusses
this issue in detail, and concluded that the second criterion is not fulfilled
in most developments of a multi-unit complex. Consequently, PCOM cannot be
applied in such cases. Particularly, the IFRIC emphasised the following:

 

1)  In applying the second criterion, it is important to apply the
requirements for control to the asset that the entity’s performance creates or
enhances. In a contract for the sale of a real estate unit that the entity
constructs, the asset created is the real estate unit itself. It is not, for
example, the right to obtain the real estate unit in the future. The right to
sell or pledge this right is not evidence of control of the real estate unit
itself.

 

2)  The entity’s performance creates the real estate unit under
construction. Accordingly, the entity assesses whether, as the unit is being
constructed, the customer has the ability to direct the use of, and obtain
substantially all of the remaining benefits from, the part-constructed real estate
unit. The Committee observed the following:

 

a)  although the customer can resell or pledge its contractual right to
the real estate unit under construction, it is unable to sell the real estate
unit itself without holding legal title to it;

b)  the customer has no ability to direct the construction or
structural design of the real estate unit as the unit is constructed, nor can
it use the part-constructed real estate unit in any other way;

c)  the customer’s legal title (together with other customers) to replace
the entity, only in the event of the entity’s failure to perform as promised,
is protective in nature and is not indicative of control.

d)  the customer’s exposure to changes in the market value of the real
estate unit may indicate that the customer has the ability to obtain
substantially all of the remaining benefits from the real estate unit. However,
it does not give the customer the ability to direct use of the unit as it is
constructed.

 

Thus, the customer does not control the part-constructed unit. In
simpler terms, the performance obligation is satisfied when the real estate
entity delivers the constructed unit to the customer. At that point in time the
real estate entity recognises revenue.

 

Asset with no
alternative use and right to payment

The third situation in which control is transferred over time has the
following two requirements that must both be met:

–The
entity’s performance does not create an asset with alternative use to the
entity.

–  The
entity has an enforceable right to payment for performance completed to date.

 

Asset with no
alternative use

An asset created by an entity has no alternative use if the entity is
either restricted contractually or practically from readily directing the asset
to another use (e.g., selling it to a different customer). A contractual
restriction on an entity’s ability to direct an asset for another use must be
substantive. In other words, a buyer could enforce its rights to the promised
asset if the entity sought to sell the unit to a different buyer. In contrast,
a contractual restriction may not be substantive if the entity could instead
sell a different unit to the buyer without breaching the contract or incurring
significant additional costs. Furthermore, a practical limitation exists if an
entity would incur significant economic losses to direct the unit for another
use. A significant economic loss may arise when significant costs are incurred
to redesign or modify a unit or when the unit is sold at a significantly
reduced price.

 

Enforceable
right to payment for performance completed to date

An entity has an enforceable right to payment for performance completed
to date if, at any time during the contract term, the entity would be entitled
to an amount that at least compensates it for work already performed. This
right to payment, whether by contract or by law, must be present, even in
instances in which the buyer can terminate the contract for reasons other than
the entity’s failure to perform as promised. The entity’s right to payment by
contract should not be contradictory to any law of the land.

 

Many real estate companies sell real estate on a small down payment,
followed by the rest of the payment being made at the time of delivery of the
real estate; for example, a 20:80 scheme, wherein 20% of the consideration is
paid upfront on booking, followed by 80% payment on delivery of the unit. The
customer can walk away without making the rest of the payment, if he is not
interested in taking delivery of the unit. Such real estate contracts do not
meet the criterion of enforceable right to payment for performance completed to
date.

 

To meet this criterion, the amount to which an entity is entitled must
approximate the selling price of the goods or services transferred to date,
including a reasonable profit margin. The standard clarifies that including a
payment schedule in a contract does not, by itself, indicate that the entity
has an enforceable right to payment for performance completed to date. The
entity needs to examine information that may contradict the payment schedule
and may represent the entity’s actual right to payment for performance
completed to date (e.g., an entity’s legal right to continue to perform and
enforce payment by the buyer if a contract is terminated without cause).

 

In some contracts, a customer may have a right to terminate the contract
only at specified times during the life of the contract or the customer might
not have any right to terminate the contract. If a customer acts to terminate a
contract without having the right to terminate the contract at that time
(including when a customer fails to perform its obligations as promised), the
contract (or other laws) might entitle the entity to continue to transfer to
the customer the goods or services promised in the contract and require the
customer to pay the consideration promised in exchange for those goods or
services. In those circumstances, an entity has a right to payment for
performance completed to date, because the entity has a right to continue to
perform its obligations in accordance with the contract and to require the
customer to perform its obligations (which include paying the promised
consideration).

 

Conclusion

In light of the requirements of Ind AS 115, many real estate companies
in India may not qualify for POCM. However, the third criterion discussed above
is a small window available for real estate companies in India to achieve POCM
recognition. To qualify for POCM recognition, real estate companies should
ensure that they have a contractual right to collect payment from the customer
for work completed to date and that the contractual right is not in
contradiction with any law of the land.  _

 

Artificial Intelligence Embracing Technology – New Age Audit Approach

With technology becoming a disruptor across
businesses, the issues facing the auditors in the current environment are:

Are we setting ourselves up for
redundancy with cognitive technology driving audits in future? 

                                   or         
          

Would the proliferation of technology
push the auditor to innovate and augment the value accreted through audit?

Cutting across the ‘black box’

Not so long ago, audits were performed
manually scouring reams of financial information. Data and records back then
were less complex, generated and maintained mostly in physical form, which
facilitated the traditional approach of vouching to deliver a robust audit.
Over time, growth of business operations both in terms of volume and across
geographies compelled organisations to embrace technology and automation as a
means to reduce cost and introduce operational efficiencies. The introduction
of ERP systems and straight through transaction processing application systems
ushered in a change in the way business was run, accounts were maintained and
audits were executed. The audit approach primarily entailed ‘audit around’
the proverbial ‘black box’. With the ever changing business dynamics,
steadily increasing operational complexities including the wave of centralised
operations and the consequential shift in the epicenter of audit from branches/
factories to ‘shared service centres’, the sheer expansiveness of data
generated and the rapid changes in the IT landscape, it has become
imperative for the auditor to execute an ever more scrupulous audit which is
only possible by auditing ‘through’ the proverbial ‘black box’.
Artificial intelligence based programmes aids in auditing through the black
box.

The changing regulatory and governance
landscape

It is pertinent to note that, much of the
above transition has happened against the backdrop of a continually changing
business and regulatory environment, where stakeholders have become more
empowered by stepped up laws and regulations and the heightened standards of
governance, resulting in increased expectations from auditors. As an example,
the Board of Directors, under the Companies Act, 2013, are responsible not only
for the preparation of financial statements that provide a true and fair view
of the financial position and performance of a Company, but also safeguarding
the assets of the company, implementing effective internal controls for
ensuring the propriety of business and looking after the interests of all
stakeholders. Audit committees, as a result, are far more involved in their
interaction and engagement with auditors. Moreover, the game changer, mandatory
auditor rotation, has increased the degree of competitiveness and left the
auditor with no choice but to deliver not only a highly effective and efficient
audit but also a value accretive audit. Auditors’ effectiveness is often
measured by the value they bring to the table, their ability to partner in the
progress of companies they audit, help management see around the bend, identify
risks and provide incisive business insights and do all of this whilst
upholding the highest ethical and professional standards. Further, with the
quarterly reporting and ever-crashing deadlines every quarter, the time at the
disposal of the auditor is ever-reducing.

Very little of the above may realistically
be achieved by merely deploying additional resources in an audit. The logical
and sustainable (and perhaps the only) solution is through increased
integration of technology into the audit approach. Embedding technology into
audit can help enhance productivity and reduce response time to clients.
Digital innovations in audit will help rebalance and redirect resources to more complex and higher risk areas e.g. areas
entailing judgement and use of management estimates.

Auditing with technology

Technology enables an auditor in:

–  Risk
assessment

–  Control
testing

–  Performance
of substantive analytical procedures;

–  Substantive
audit procedures;

And offer benefits as more fully explained
below:

Greater assurance- Moving away from
samples to testing the entire population

Under the traditional method, the auditor
would more often than not, select samples to test, based on a quantitative
materiality threshold, for example, vouching ‘top 20 instances’ of operating
expenditure incurred during the period under audit, representing a defined
coverage of the general ledger account or vouching all individual instances
above a specific threshold by value. Such samples were then tested as per
planned audit procedures and conclusions reached based upon these tested
samples. One of the potential areas of redundancy linked with increased use
of technology in audit is that of using a sample-based method in audit testing.

The new age technology tools subject
the entire population of the selected general ledger account to testing. These
tools are capable of analysing (literally scrubbing) the entire population and
highlighting outliers or exceptions e.g., a routine could highlight all
instances of breaks in a ‘three-way match’ (i.e. relationship between purchase
order, goods inward note and supplier’s invoice) in respect of purchases. With
a 100% test of the population, the level of assurance an auditor obtains is far
greater than that achieved through the traditional method of sample testing.

Deeper insights: There’s more to it than
meets the eye

Cognitive technology embedded in audit tools
and routines are capable of correlating data and in identifying patterns,
trends and outliers that may otherwise go unnoticed in a traditional auditing
technique (including those entailing 100% sample testing manually or through
vouching). For example, an unusual spike in orders from a particular geography
or during a particular time of the year, transactions recorded by seldom users
and/ or transactions recorded not in conformity with normal procedure, could
potentially raise a red flag for the auditor to investigate. Such insights may
often go undetected through implementation of traditional methods of vouching,
which primarily focus on agreeing the vouchers to the general ledger entries
and the underlying supporting documents.

The ability to correlate and analyse varied
data points within the population helps the auditor to have deeper insight into
business operations, which enables him to provide greater assurance to the
management and the audit committees. It also provides direction to the auditor
in terms of focus areas and indicates where effort should be focused.

Cognitive abilities in new age technology
tools enable assimilation of data and help provide value accretive insights to
management e.g., we as auditors examine ‘goods returned’ and ‘issue of credit
notes’ for return of goods or defects in a product. With technology, the
auditor could catalogue reasons for return of goods, which could be a useful
insight for management and form the basis for either an internal review or an
external specialist to be consulted so as to improve the product, reduce costs
or enhance employee productivity.

Efficient audits: Delivering more with
less

The auditor often faces a conundrum in
testing manual journal entries for the risk of override of controls. It
is almost impossible to scrutinise ?manual journal entities,’ recorded through
an audit period, due to inherent time and resource constraints. Technology
tools can instead slice and dice the population and highlight manual
journal entries which seem more vulnerable to fraud risk e.g., journal
entries posted on a public holiday or directly by the CXOs or by super users in
the IT department, or journal entries in an accounting caption where one would
normally expect only automated entries etc.

Further, with the expansive data available
at one’s fingertips and capable of being combed through cognitive technology
tools, the auditor could even reduce the frequency of branch or factory visits.

With technology tools doing much of the
‘heavy lifting’ of planned audit procedures, auditors may be able to redirect
their time and focus on areas that entail judgement, or contain high level of
management estimation and assumptions based on unobservable inputs.
Technology at times makes unobservable – observable.

All of the above, lends itself to a more
effective and efficient audit.

The ask

Auditing ‘with’ technology seems to be an
imperative and not an option. The transition needs to be meticulously planned
and seamlessly implemented through timely involvement of all constituents. What
will it take to embrace this change? The answer is:

u  Investment-
of both time and money;

u  Extensive
training and adapting new skillsets; and

u  Educating
all constituencies including regulators.

The cost of initial investment, including
the time taken for careful selection or development of relevant technology
tools and the continual availability of resources for upgradation of such tools
should not be overlooked.

The effectiveness of the output generated by
the technology tools is determined by the relevance and appropriateness of data
that is input into the tools and the management assertions that it helps
address. The old adage persists `garbage in – garbage out’. Hence, selection of
inputs is imperative.

The tools may have to be tailored to
auditee’s ERP systems, so as to render them capable of ‘talking to IT systems’
at the client. Developing a bespoke tool so as to efficiently extract data, on
a timely basis, from the client organisation could be an option.

The rising popularity of cyber currency and
block chain technology in consummating transactions and sharing information
amongst peers will leave auditors with no choice, but to embrace the change,
update their business understanding and risks associated with it. For example:
accepting the risk of cybercrime in designing audit procedures will be an
imperative and auditors will have to be more receptive towards accepting
contemporary basis of audit evidence. Auditors will need to upgrade their
skillsets through focused trainings. They would also need to develop the
ability to read, analyse and interpret the results produced by `technology
tools’. Similarly, regulators may need to be educated, so as to embrace audit
procedures driven by technology tools and routines as acceptable in reaching
audit conclusions.

Whilst the benefits of using technology in
an audit far outnumber the challenges associated with it, the pitfalls should
be identified and catalogued and not be overlooked.

Today’s students and the future professionals
are more tech-savvy than their predecessors. They take easily to a
technology-based audit. The audit fraternity needs to embrace technology also
to attract and retain talent. However, that said, over-dependency on
technology in an audit has its own perils. Whilst cognitive technology may
shore up an audit, its use should not lead to complacency and preclude an
auditor from applying his mind and questioning e.g., instead of relying
completely on the output from audit tests performed by automated routines, an intuitive
auditor would always question, for example, the existence of coffee
plantations in the State of Punjab! The auditor should always guard and not
become a victim of technology where we are susceptible to miss the ‘woods for
the trees’. Technology is a tool – it is not a substitute for human
intelligence.

Embracing technology as a proponent to
differentiate

The changing role of a CFO from someone who
whips out timely financial and regulatory reports, to someone who lends a
perspective and participates in active decision making in the Boardroom, casts
an increased expectation upon the auditor to remain in-step and transform into
a value accretive and trusted business advisor.

We’re witnessing CFOs convincing Boards to
embrace digitisation and use innovative technology in enhancing customer
experience and as a cost efficient means to propel business growth. It goes
without a doubt that this expectation of using more of technology to deliver
results, is also extended to all those constituents for whom the CFO is a
stakeholder. The key lies in how quickly the auditor accepts, adapts and
embraces technology to enhance the audit experience and leverage upon it as a
differentiator to deliver a value accretive audit.

technology enabled Audit: will there be a human touch, after all?

Machines can at best only mimic the human
mind, however, they cannot entirely replace it. What will not be taken away
by proliferation of technology tools in audit is the application of
professional skepticism and the use of professional judgment in areas such
as:

–  In
critically evaluating purchase price allocation in a business combination;

– In
reviewing underlying assumptions in respect of valuation of an unlisted
subsidiary and testing the same
for impairment;

– In
reviewing reasonableness of cash flows and assumptions while testing impairment
of Goodwill, etc.

In short, learnings from cumulative
experience, understanding varying perspectives and nuances, application of
rationale and reasoning whilst making decisions based qualitative, quantitative
and subjective determinants, the human mind, no doubt, is supported and
supplemented by the technology tool.

Technology tools will take away the
monotony from audit, facilitate efficiency and bring the focus onto
analytics by highlighting outliers such as:

 u  Debit
entries in revenue accounts such as interest income;

u  Credit/Negative
balances in expenditure accounts;

u  Entries
inconsistent with an organisation’s authority matrix, etc.

Undoubtedly, the future of audit seems much
different than what it is today as technology will become central to the
planning, execution and delivery of an effective audit. Those who try to
obviate technology and resist change may risk their relevance in the commercial
arena. In the future, an auditor will have to be a combination of an
Accountant, an investigator(forensic skills) and a Data Scientist!! _

Disclosures in Standalone Ind As Financial Statements For The Year Ended 31st March 2017 Regarding Current Tax And Reconciliation Of Tax Expense

TATA CONSULTANCY SERVICES LTD

The income tax expense consists of the following:

(Rs. crores)

 

2017

2016

Current tax:

 

 

Current
tax expense for current year

6,762

6,344

Current
tax expense/(benefit) pertaining to prior years

(119)

32

 

6,643

6,376

Deferred
tax benefit

(230)

(112)

Total income tax expense recognised in the current year

6,413

6,264

The reconciliation of estimated income tax
expense at statutory income tax rate to income tax expense reported in
statement of profit and loss is as follows:

 

Year ended March 31, 2017

Year ended March 31,
2016

Profit
before income taxes

30,066

29,339

Indian
statutory income tax rate

34.61%

34.61%

Expected
income tax expense

10,406

10,154

Tax effect of adjustments to reconcile expected income tax
expense to reported income tax expense:

 

 

Tax
holidays

(4,134)

(4,468)

Income
exempt from tax

(27)

(34)

Undistributed
earnings in branches and subsidiaries

(60)

90

Tax
on income at different rates

166

285

Tax
pertaining to prior years

(218)

32

Others
(net)

280

205

Total income tax expense

6,413

6,264

The Company benefits from the tax holiday available for units
set up under the Special Economic Zone Act, 2005. These tax holidays are
available for a period of fifteen years from the date of commencement of
operations. Under the SEZ scheme, the unit which begins providing services on
or after April 1, 2005 will be eligible for deductions of 100% of profits or
gains derived from export of services for the first five years, 50% of such
profits or gains for a further period of five years and 50% of such profits or
gains for the balance period of five years subject to fulfilment of certain
conditions. From April 1, 2011 units set up under SEZ scheme are subject to
Minimum Alternate Tax (MAT).

Significant components of net deferred tax assets and
liabilities for the year ended March 31, 2017 are as follows:

 

Opening
balance

Recognised /reversed through profit and loss

Recognised in/
reclassified from other comprehensive income

Closing
balance

Deferred tax assets / (liabilities) in relation to:

 

 

 

 

Property,
plant and equipment and Intangible assets

(22)

(62)

–

(84)

Provision
for employee benefits

238

58

–

296

Cash
flow hedges

(7)

–

(5)

(12)

Receivables,
loans and advances

183

22

–

205

MAT
credit entitlement

1,960

102

–

2,062

Branch
profit tax

(346)

60

–

(286)

Unrealised
gain/loss on securities carried at fair value through statement of profit and
loss/OCI

(27)

(2)

(256)

(285)

Others

185

52

–

237

Net deferred tax assets / (liabilities)

2,164

230

(261)

2,133

Gross deferred tax assets and liabilities are as follows:

 

(Rs. crores)

As at March 31, 2017

Assets

Liabilities

Net

Deferred tax assets/
(liabilities) in relation to:

 

 

 

Property,
plant and equipment and Intangible assets

(56)

(28)

(84)

Provision
for employee benefits

296

–

296

Cash
flow hedges

(12)

–

(12)

Receivables,
loans and advances

205

–

205

MAT
credit entitlement

2,062

–

2,062

Branch
profit tax

–

(286)

(286)

Unrealised
gain/loss on securities carried at fair value through statement of profit and
loss/OCI

(285)

–

(285)

Others

237

–

237

Net deferred tax assets/
(liabilities)

2,447

(314)

2,133

Significant components of net deferred tax assets and
liabilities for the year ended March 31, 2016 are as follows: (not
reproduced as similar to 31-3-2017)

Under
the Indian Income Tax Act, 1961, the Company is liable to pay Minimum Alternate
Tax in the tax holiday period. MAT paid can be carried forward for a period of
15 years and can be set off against the future tax liabilities. MAT is
recognised as a deferred tax asset only when the asset can be measured reliably
and it is probable that the future economic benefit associated with the asset
will be realised. Accordingly, the Company has recognised a deferred tax asset
of Rs. 2,062 crores and has not recognised a deferred tax asset of Rs. 1,108
crores as at March 31, 2017.

The
Company has ongoing disputes with Income Tax authorities relating to tax
treatment of certain items. These mainly include disallowed expenses, tax
treatment of certain expenses claimed by the Company as deductions, and
computation of, or eligibility of, certain tax incentives or allowances. As at
March 31, 2017, the Company has contingent liability in respect of demands from
direct tax authorities in India, which are being contested by the Company on
appeal amounting Rs. 2,688 crores. In respect of tax contingencies of Rs. 318
crores, not included above, the Company is entitled to an indemnification from
the seller of TCS e-Serve Limited.

The
Company periodically receives notices and inquiries from income tax authorities
related to the Company’s operations in the jurisdictions it operates in. The
Company has evaluated these notices and inquiries and has concluded that any
consequent income tax claims or demands by the income tax authorities will not
succeed on ultimate resolution.

The
number of years that are subject to tax assessments varies depending on tax
jurisdiction. The major tax jurisdictions of Tata Consultancy Services Limited
include India, United States of America and United Kingdom.  In India, tax filings from fiscal 2014 are
generally subject to examination by the tax authorities. In United States of
America, the federal statute of limitation applies to fiscals 2013 and earlier
and applicable state statutes of limitation vary by state. In United Kingdom,
the statute of limitation generally applies to fiscal 2014 and earlier.

RELIANCE INDUSTRIES LTD

The income tax expense consists of the following:

(Rs. crores)

 

Year Ended31st March, 2017

Year Ended 31st
March, 2016

TAXATION

 

 

Income tax recognised in Statement of Profit and Loss

 

 

Current
tax

8,333

7,801

Deferred
tax

1,019

831

Total income tax expenses recognised in the current year

9,352

8,632

 

The
income tax expenses for the year can be reconciled to the accounting profit
as follows:

Profit
before tax

40,777

36,016

Applicable
Tax Rate

34.608%

34.608%

Computed
Tax Expense

14,112

12,464

Tax
effect of :

 

 

Exempted
income

(2,707)

(5,306)

Expenses
disallowed

3,044

3,378

Additional
allowances net of MAT Credit

(6,116)

(2,735)

Current Tax Provision (A)

8,333

7,801

Incremental
Deferred Tax Liability on account of Tangible and Intangible Assets

1,229

824

Incremental
Deferred Tax Asset on account of Financial Assets and Other Items

(210)

7

Deferred tax Provision (B)

1,019

831

Tax Expenses recognised in Statement of Profit and Loss (A+B)

9,352

8,632

Effective
Tax Rate

22.93%

23.97%

STERLITE TECHNOLOGIES LTD

The major components of income tax expense for the years
ended 31 March 2017 and 31 March 2016 are:

 

31 March 2017

31 March 2016

(Rs. in crores)

(Rs. in crores)

Profit or loss section

 

 

Current Income Tax

 

 

Current income tax charge

51.55

52.77

Adjustment of tax relating to earlier
periods

3.22

(5.93)

Deferred Tax

 

 

Relating to origination and reversal of
temporary differences

2.47

19.35

Income tax expenses reported in the
statement of profit or loss

57.24

66.19

OCI Section

 

 

Deferred tax related to items recognised
in OCI during in the year:

 

 

Net (gain)/loss on revaluation of cash
flow hedges

0.29

(0.69)

Re-measurement loss defined benefit
plans

0.28

1.16

Income tax credit through OCI

0.57

0.47

Reconciliation of tax expense and the accounting profit
multiplied by India’s domestic tax rate for 31 March 2017 and 31 March 2016:

 

31 March 2017

31 March 2016

(Rs. in  crores)

(Rs. in crores)

Accounting profit before income tax

197.98

247.61

At India’s statutory income tax rate of
34.61% (31 March 2016: 34.61%)

68.52

85.70

Adjustments in respect of current income
tax of previous years

3.22

(5.93)

Tax benefits under various sections of
Income tax Act

(16.84)

(15.98)

Others

2.35

2.41

At the effective income tax rate of
28.91% (31 March 2016: 26.73%)

57.24

66.19

Income tax expense reported in the
statement of profit and loss

57.24

66.19

RAYMONDs LIMITED

Tax expense recognized in the Statement of Profit and Loss

(Rs. in lakhs)

Particulars

Year ended

31st March, 2017

Year ended

31st March, 2016

Current tax

 

 

Current Tax on taxable income for the
year

945.42

2,704.59

Total current tax expense

945.42

2,704.59

 

 

 

Deferred tax

 

 

Deferred tax charge/(credit)

(559.87)

3,121.19

MAT Credit (taken)/utilized

925.89

(1,961.21)

 

 

 

Total deferred income tax
expense/(benefit)

366.02

1,159.98

 

 

 

Tax in respect of earlier years

15.20

–

Total income tax expense

1,326.64

3,864.57

Reconciliation of the income tax expenses to the amount
computed by applying the statutory income tax rate to the profit before income
taxes is summarized below:

(Rs in lakhs)

Particulars

Year ended

31st March, 2017

Year ended

31st March, 2016

Enacted income tax rate in India
applicable to the Company

34.608%

34.608%

Profit before tax

4,709.47

11,239.84

Current
tax expenses on Profit before tax expenses at the enacted income tax rate in
India

1,629.85

3,889.88

 

 

 

Tax effect of the amounts which are not
deductible/(taxable) in calculating taxable income

 

 

Permanent Disallowances

167.85

363.38

Deduction under section 24 of the Income
Tax Act

(42.62)

(52.14)

Interest income from Joint Venture on
liability element of compound financial instrument

(233.06)

(210.00)

Tax in respect of earlier years

15.20

–

Income exempted from income taxes

(273.04)

(91.24)

Other items

62.46

(35.31)

Total income tax expense/(credit)

1,326.64

3,864.57

Consequent to reconciliation items shown above, the
effective tax rate is 28.17% (2015-16: 34.38%).

Significant Estimates: In calculation of tax expense
for the current year and earlier years, the group has disallowed certain
expenditure pertaining to exempt income based on previous tax assessments,
matter is pending before various tax authorities.

IDEA CELLULAR LTD

Tax Reconciliation

(a) Income Tax Expense

Rs.
Mn

Particulars

For the year

ended

March 31, 2017

For the year

ended

March 31, 2016

Current
Tax

 

 

Current
Tax on profits for the year

–

8,621.82

Total Current Tax Expense (A)

–

8,621.82

Deferred
Tax

 

 

Relating
to addition & reversal of temporary differences

(4,825.95)

5,623.81

Relating
to effect of previously unrecognised tax credits, no recorded

(1,053.33)

–

Total Deferred Tax Expense (B)

(5,879.28)

5,623.81

Income Tax Expense (A+B)

(5,879.28)

14,245.63

Income tax impact of re-measurement gains/losses on defined
benefit plans taken to other comprehensive income

(17.13)

(71.11)

(b) Reconciliation of average effective tax rate
and applicable tax rate

Rs. Mn

Particulars

For the year ended

March 31, 2017

For the year

ended

March 31, 2016

Profit
/ (Loss) from continuing operation before Income tax expense

(14,190.03)

40,708.51

Applicable Tax Rate

34.61%

34.61%

Increase
/ reduction in taxes on account of:

 

 

Effect
of unrecognised deductible temporary differences

–

0.25%

Effect
of previously unrecognised tax credits, now recorded

7.42%

–

Effects
of expenses that are not deductible in determining the taxable profits

(0.64)%

0.24%

Other
Items

0.04%

(0.11)%

Effective Tax Rate

41.43%

34.99%

(c) Deferred tax assets are recognised to the
extent that it is probable that taxable profit will be against which the
deductible temporary differences, carry forward of unabsorbed depreciation and
tax losses can be utilised.  Accordingly,
in view of uncertainty the Company has not recognized deferred tax assets in
respect of temporary differences arising out of effects of assessments and
unused tax losses/credits of Rs. 4,612.09 Mn, Rs. 3,738.82 Mn, and Rs. 3,442.47
Mn.  as of March 31, 2017, March 31, 2016
and April 1, 2015 respectively.

ASIAN PAINTS LTD

( Rs. in Crores)

NOTE
18: INCOME TAXES

Year 2016-17

Year 2015-16

A.

The
major components of income tax expense for the year are as under:

 

 

(i)

Income
tax recognised in the Statement of Profit and Loss

Current
tax

 

 

 

In
respect of current year

817.22

743.74

 

Adjustments
in respect of previous year

(3.60)

(3.33)

 

Deferred
tax:

 

 

 

In
respect of current year

41.33

39.88

 

Income
tax expense recognised in the Statement of Profit and Loss

854.95

780.29

(ii)

Income
tax expense recognised in OCI

 

 

 

Deferred
tax:

 

 

 

Deferred
tax benefit on fair value gain on investments in debt instruments through OCI

0.17

0.34

 

Deferred
tax expense on re-measurements of defined benefit plans

(2.84)

(0.91)

 

Income
tax expense recognised in OCI

(2.67)

(0.57)

B

Reconciliation
of tax expense and the accounting profit for the year is as under:

 

 

Profit
before tax

2,658.05

2,403.10

Income
tax expense calculated at 34.608%

919.90

831.67

Tax
effect on non-deductible expenses

22.62

38.81

Incentive
tax credits

(34.70)

(46.23)

Effect
of Income which is taxed at special rates

(19.70)

(14.12)

Effect
of Income that is exempted from tax

(26.66)

(24.26)

Others

(2.91)

(2.25)

Total

858.55

783.62

Adjustments
in respect of current income tax of previous year

(3.60)

(3.33)

Tax
expense as per
Statement of Profit and Loss

854.95

780.29

The Company has the following unused tax losses which arose
on incurrence of capital losses under the Income Tax Act, 1961, for which no
deferred tax asset has been recognized in the Balance Sheet.

(Rs.
in Crores)

Financial Year

As at 31.03.2017

Expiry Date

As at 31.03.2016

Expiry Date

2009-10

–

–

3.73

31st March, 2019

2011-12

1.07

31st March, 2021

9.93

31st March, 2021

2013-14

2.03

31st March, 2023

2.03

31st March, 2023

2014-15

8.64

31st March, 2024

8.64

31st March, 2024

TOTAL

11.74

 

24.33

 

Business Combinations of Entities under Common Control

Background

Appendix C, Business
Combinations of Entities under Common Control of Ind AS 103, Business
Combinations, deals with accounting of common control business
combinations. The assets and liabilities of the combining entities in a common
control business transaction are reflected at their carrying amounts. This is
commonly known as “The pooling of interest method”.  Paragraph 9 of Appendix C is reproduced
below.

“9 The pooling of interest method is considered to involve
the following:

(i) The assets and liabilities of the combining entities
are reflected at their carrying amounts.

(ii) No adjustments are made to reflect fair values, or
recognise any new assets or liabilities. The only adjustments that are made are
to harmonise accounting policies.

(iii) ………… “

Issue

An interesting question arises on
the application of the pooling of interest method. The question is whether
the carrying amount of assets and liabilities of the combining entities should
be reflected as per the books of the entities transferred/merged or the
ultimate parent. The standard requires reflecting the business combination
under common control at carrying value of the combining entities. However the
standard is silent about whether the carrying amounts should be those as
reflected in the standalone financial statements of the combining entities or
those as reflected in the consolidated financial statements (CFS) of the parent
or the ultimate parent.

Consider a basic fact pattern. A Ltd. is the parent company
of two subsidiaries, viz., B Ltd. & C Ltd. Consider the following two
Scenarios.

Scenario 1: B Ltd. merges with C Ltd.

Scenario 2: B Ltd. merges with A Ltd.

The question is raised from the perspective of how C Ltd. in
Scenario 1 and A Ltd in Scenario 2 will prepare their post combination
standalone financial statements. 

It
may be noted that as far as A Ltd / parent’s CFS is concerned; the merger will
have absolutely no effect. This is because all intra-group transactions should
be eliminated in preparing CFS in accordance with Ind AS 110. The legal merger
of a subsidiary with the parent or legal merger of fellow subsidiaries is an
intra-group transaction and accordingly, will have to be eliminated in the CFS
of the parent or the ultimate parent.

Response

A similar question was raised to
the Ind AS Transition Facilitation Group (ITFG). In responding to the query,
the ITFG made a distinction between Scenario 1 and Scenario 2. The ITFG’s view
is given below.

Scenario 1

Assets and liabilities of
the combining entities are reflected at their carrying amounts. Accordingly, in
the separate financial statements of C Ltd., the carrying values of the assets
and liabilities as appearing in the standalone financial statements of the
entities being combined i.e B Ltd. & C Ltd. shall be recognised.

Scenario 2

In this case, since B Ltd. is merging with A Ltd.
(i.e. parent) nothing has changed and the transaction only means that the
assets, liabilities and reserves of B Ltd. which were appearing in the CFS of
Group A immediately before the merger would now be a part of the separate
financial statements of A Ltd. Accordingly, it would be appropriate to
recognise the carrying value of the assets, liabilities and reserves pertaining
to B Ltd. as appearing in the CFS of A Ltd. Separate financial statements to
the extent of this common control transaction shall be considered as a
continuation of the consolidated group.

Author’s View

The
ITFG has made a distinction between Scenario 1 and Scenario 2. In Scenario 1,
since the parent is not a party to the combination, the standalone financial
statements of C will combine carrying value of assets and liabilities of B and
C as appearing in their standalone financial statements. In Scenario 2, since
the parent is a party to the combination, A Ltd./ the parent’s post combination
financial statements will combine carrying values of A and carrying value of B
as appearing in A’s CFS. In other words, in Scenario 2, the accounting for the
combination is accounted as if, A had acquired B, and merged it with itself
from the very inception.

The logic of two different
approaches for accounting common control business combination based on whether
the parent is a party to the business combination is not absolutely clear.
Further, the logic does not emanate from a reading of the standard. In both
Scenario’s, business under common control are merging. Since the standard is
not clear on which carrying values to be used, the author believes that in both
Scenarios, there should be a clear accounting policy choice of either using
standalone carrying values or those that are reflected in the CFS of the parent
or ultimate parent.

The continuation of the
consolidation group approach should be an accounting policy choice and should
not be made conditional to the parent being a party to the business
combination. Globally under IFRS too,
either methods are acceptable, irrespective of whether a parent is party to the
business combination. Giving up the shares for the underlying assets is
essentially a change in perspective of the parent of its investment, from a
‘direct equity interest’ to ‘the reported results and net assets.’ Hence, the
values recognised in the CFS becomes the cost of these assets for the parent.

If the author’s approach is
considered, other relevant questions as detailed below, and not addressed by
ITFG, may not need any further clarification:

–   In Scenario 2, B Ltd does not merge with A
Ltd, but A Ltd. merges with B Ltd.

–   In Scenario 2, it is not absolutely clear
whether it is mandatory to use the carrying values of B Ltd as appearing in the
CFS of A or there is a choice to use the carrying values of B Ltd. as appearing
in the standalone financial statements of B Ltd.

The ITFG may provide appropriate clarification.

Goodwill In Common Control Transactions Under Ind AS ­ Whether Capital Reserve Can Be Negative?

Background

White
Goods Ltd. (WGL) and Electronic Items Ltd. (EIL) are companies under common
control. WGL is in phase 1 of Ind AS. Its transition date (TD) is 1st
April, 2015, comparative year is 2015-16, and first year of Ind AS is 2016-17.
The last statutory accounts under Indian GAAP was 2015-16; which will be a
comparative year under Ind AS.

In the last year of Indian GAAP
and comparative year of Ind-AS; i.e., 2015-16, WGL acquired through a slump
sale the business of EIL and paid a cash consideration. The acquisition was by
way of a slump sale and did not require any court approval.

WGL applied AS 10 Accounting
for Fixed Assets to record for the slump sale under Indian GAAP.
Consequently, the excess of consideration over the fair value of assets and
liabilities taken over was recorded as goodwill. For simplicity, let’s assume,
the fair value of the net assets was equal to the book value of the net assets
taken over.

For purposes of Ind AS, WGL
chooses to restate the business combination in accordance with Ind AS 103.
Appendix C, Business Combinations of Entities under Common Control of Ind AS
103, Business Combinations would apply. In accordance with the said
standard, this would be accounted as a business combination under common
control and consequently WGL would record the assets and liabilities at their
book values and will not record any goodwill.

Issue

Paragraph 12 of Appendix C
(referred to above), requires the following treatment to account for difference
between the consideration amount and the book value of the net assets taken
over.

“The
identity of the reserves shall be preserved and shall appear in the financial
statements of the transferee in the same form in which they appeared in the
financial statements of the transferor. Thus, for example, the General Reserve
of the transferor entity becomes the General Reserve of the transferee, the
Capital Reserve of the transferor becomes the Capital Reserve of the transferee
and the Revaluation Reserve of the transferor becomes the Revaluation Reserve
of the transferee. As a result of preserving the identity, reserves which are
available for distribution as dividend before the business combination would
also be available for distribution as dividend after the business combination.
The difference, if any, between the amounts recorded as share capital issued
plus any additional consideration in the form of cash or other assets and the
amount of share capital of the transferor shall be transferred to capital
reserve and should be presented separately from other capital reserves with
disclosure of its nature and purpose in the notes.”

In Ind AS financial statements,
can the goodwill recognised under Indian GAAP be adjusted against retained
earnings/other equity or whether the goodwill has to be presented as a negative
capital reserve?

The above question becomes very
important because of section 115JB (2C). In accordance with section 115JB (2C),
the book profits of the year of convergence and each of the following four
previous years, shall be further increased or decreased, as the case may be, by
one-fifth of the transition amount adjustments. Explanation (iii) defines
“transition amount” as the amount or the aggregate of the amounts adjusted in
the other equity (excluding capital reserve and securities premium reserve) on
the convergence date. Consequently, Ind AS transitional adjustments in retained
earnings/other equity are included in book profit for determining MAT liability
equally over 5 years beginning from the year of Ind AS adoption. Transitional
adjustments to capital reserve and securities premium are excluded from book
profit.

Author’s View

The following two assumptions
appear implicit in Paragraph 12 referred to above.

–   Paragraph 12
envisages a situation where two companies are merging, and in order to preserve
the identity of the reserves, the difference between the share capital issued
plus other consideration and the share capital of the transferor is recorded as
an adjustment to capital reserves.

–   Paragraph 12
envisages a situation where the consideration is lower than the book value of
the acquired assets and consequently it results in a capital reserve, which is
a positive amount.

In the fact pattern under
discussion, neither of the above two assumptions apply. Consequently the amount
recorded as goodwill under Indian GAAP, can only be eliminated as an adjustment
to retained earnings/other equity under Ind-AS, rather than presented as a
negative capital reserve amount. In the author ‘s view, any reserve under the
standards can only be a positive number. Therefore, it would be more
appropriate to eliminate the goodwill against retained earnings/other equity.

The above treatment will have a
positive income-tax implication. The goodwill debited to retained
earnings/other equity under Ind AS will provide a five year straight line
deduction for the determination of book profits for MAT purposes. This
deduction is not available if the goodwill was debited to capital reserves.
Further, since the goodwill was recorded under Indian GAAP statutory accounts,
the benefit of depreciation going forward would be available for purposes of
normal income tax computations, subject to fulfilment of other conditions.

If the Company had continued to be
in the Indian GAAP regime, it would have amortised goodwill and have lower book
profits for MAT purposes. The Company would also receive the benefit of normal
income tax deduction on account of goodwill depreciation.

Since the Ind AS outcome is the
same as would have been the case if the Company would have continued under
Indian GAAP, it does not provide any undue tax advantage to the Company.

Conclusion

Capital reserve cannot be a
negative number. Consequently, goodwill will be eliminated against retained
earnings/other equity. This could be an acceptable view and will ensure income
tax neutrality between Indian GAAP and Ind AS treatment of goodwill.

Proposed Amendment

The MAT Committee has recommended
an amendment to 115JB [2A]. If the section is amended, it will change the way
book profits are determined under Ind AS on a go forward basis (not
transitional amounts). As per this amendment, items debited or credited to
other equity will be included in determination of book profits barring certain
exceptions. One of the exceptions is capital reserve in respect of business
combination of entities under common control.

In the author’s opinion, capital reserve cannot
be a negative number. Therefore, in a slump sale if the consideration paid is
greater than net assets, the excess will be debited to retained earnings. Since
the amount is not debited to capital reserves, it will not be covered by the
above exception, and should be allowed as a deduction of book profits for the
purposes of MAT in that year.

Ind AS 115 – Revenue From Contracts With Customers

Identifying the customer

Ind AS 115 defines a customer as a
party that has contracted with an entity to obtain goods or services that are
an output of the entity’s ordinary activities in exchange for consideration.
Beyond that, Ind AS 115 does not contain any definition of a customer. In many
transactions, a customer is easily identifiable. However, in transactions
involving multiple parties, for example, in the credit card business, it may be
less clear which counterparties are customers of the entity. For some
arrangements, multiple parties could all be considered customers of the entity.
However, for other arrangements, only some of the parties involved are
considered as customers. The identification of the performance obligations in a
contract can also have a significant effect on the determination of which party
is the entity’s customer.

 

Identifying the customer becomes
very important under Ind AS 115, because depending on who and how many
customers are identified, it will determine, the performance obligations in a
contract, the presentation and accounting of sales incentives, determination
and presentation of negative revenue, etc. The example below shows how the
party considered to be the customer may differ, depending on the specific facts
and circumstances.

 

Example — Travel Agents

An entity provides internet-based
airline ticket booking services. In any transaction, there are three parties
involved, the airline is the principal, the entity is an agent, and the
end-customer who purchases the ticket on the entity’s website. The entity gets
its majority of the income from the airline, to whom it charges a commission
(say INR 500 per ticket). The entity also receives a small convenience fee from
the end-customer (INR 20). To attract customers, the entity provides a cash
back of INR 120 to each end-customer.

 

If the entity considers, the
airline and the end-customer as two customers in a transaction, it will
determine revenue to be INR 400 (500+20-120). On the other hand, if the entity
had not received any convenience fees from the end-customer, and reduced the
cash back to INR 100, the entity will determine revenue to be INR 500. The
entity will also present INR 100 paid to third parties (end-customers) as a
selling cost.

 

Consideration paid to Customers’ Customer

Consideration payable to a customer
includes cash amounts that an entity pays, or expects to pay, to the customer.
Such amounts are reduced from revenue. This requirement also applies to
payments made to other parties that purchase the entity’s goods or services
from the customer. In other words, consideration paid to customers’ customer is
also reduced from revenue. For example, if a lubricant entity pays a
consideration to mechanics that purchases lubricants from the entity’s customer
(distributor), that amount will be reduced from the revenue of the lubricant
entity.

 

In some cases, entities provide
cash or other incentives to end consumers that are neither their direct
customers nor purchase the entities’ goods or services within the distribution
chain. One such example is depicted below. In such cases, the entity will need
to identify whether the end consumer is the entity’s customer under Ind AS 115.
This assessment could require significant judgment. The management should also
consider whether a payment to an end consumer is contractually required
pursuant to the arrangement between the entity and its customer (e.g., the
merchant in the example below) in the transaction. If this is the case, the
payment to the end consumer is treated as consideration payable to a customer
as it is being made on the customer’s behalf.

 

Example – Consideration paid to other
than customers

An entity provides internet-based
airline ticket booking services. In any transaction, there are three parties
involved, the airline is the principal, the entity is an agent, and the
end-customer who purchases the ticket on the entity’s website. The entity gets
its income from the airline, to whom it charges a commission (say INR 500 per
ticket). To attract users, the entity provides a cash back of INR 100 to each
end-customer on its own (i.e. without any contractual requirement from the
airline company).

 

If the entity considers, the
airline and the end-customer as two customers in a transaction, it will
determine revenue to be INR 400 (500-100). On the other hand, if the entity
determines that the end-customer is not its customer (because convenience fee is
not charge to the end-customer), the entity will determine revenue to be INR
500 and present INR 100 paid to third parties (end-customers) as a selling
cost. In case, the cash back to end user is paid because of a contractual
requirement between the airline and the entity, then such cash back paid will
be deducted from revenue, even when it is concluded that the end-user is not a
customer.  This is because, the entity is
making a payment on behalf of the customer as per agreement.

 

Both examples in the article are economically
the same; however, they provide different accounting consequences, based on how
a customer is identified. In the second example, a convenience fee is not paid
to end-customer, and hence it is concluded that the end-customer is not the
customer of the entity.


Impact of Ind AS on Demerger Transactions

Demerger
is a business reorganisation where one or more business unit is hived off into
a separate entity. There could be a number of reasons why a demerger is done;
for example, to unlock the value in a business, to focus on a particular
business or to seek external participation in the transferor or resulting
company. It involves separation of business, unlike an amalgamation, which
entails consolidation or merger of businesses.

Demerger
is generally achieved through a scheme of compromise or arrangement in a court
process u/s. 391 to 394 of the Companies act, 1956. The demerged company
(transfer or company, referred to as TCO in this article) transfers a business
unit on a going concern basis to a resulting company (transferee company
referred to as RCO in this article).

In
order to become a tax neutral or tax compliant scheme, the demerger should be
compliant with section 2(19AA) of the income-tax act, which, inter alia,
requires that the demerger should be pursuant to a scheme u/s. 391 to 394 of
the Companies act,  1956 and that the
transfer of assets and liabilities should take place at the book values of the
transferor company by ignoring revaluation, if 
any. The   tax neutrality  provisions 
provide  neutrality to all parties
concerned, viz., the transferor company, the transferee company and the
shareholders of the transferor and transferee company. From the transferor
company perspective, there will be no capital gains on the transfer. Further
there will be no deemed divided nor dividend distribution tax with respect to
the distribution to the shareholders. The shareholders of the transferor
company too will not have to bear the incidence of capital gains tax.

Appendix
a Distribution of Non-cash Assets to Owners of Ind AS 10 Events after the
Reporting Period deals with accounting for distribution of assets other than
cash (non­ cash assets) as dividends to its owners (shareholders) acting in
their capacity as owners. The appendix applies to the non-reciprocal
distributions of non-cash assets (e.g. items of property, plant and equipment,
intangible assets, businesses as defined in Ind AS 103, ownership interests in
another entity or disposal groups as defined in Ind AS 105) by an entity to its
owners acting in their capacity as owners. The appendix addresses only the
accounting by the entity that makes a non-cash asset distribution, not the
accounting by recipients.

The   appendix 
does  not  apply 
to  a  distribution 
of  a non-cash  asset 
that  is  ultimately 
controlled  by  the same party or parties before and after
the distribution. This exclusion applies to the separate, individual and
consolidated financial statements of an entity that makes the distribution. A
group of individuals shall be regarded as controlling an entity when, as a
result of contractual arrangements, they collectively have the power to govern
its financial and operating policies so as to obtain benefits from its
activities, and that ultimate collective power is not transitory.
therefore,  for a distribution to be
outside the scope of this appendix on the basis that the same parties control
the asset both before and after the distribution, a group of individual
shareholders receiving the distribution must 
have,  as  a 
result  of  contractual 
arrangements, such ultimate collective power over the entity making the
distribution.

The
Appendix does not apply when an entity distributes some of its ownership
interests in a subsidiary but retains control of the subsidiary. The entity
making a distribution that results in the entity recognising a non-controlling
interest in its subsidiary accounts for the distribution in accordance with Ind
AS 110.

When
an entity declares a distribution and has an obligation to distribute the
assets concerned to its owners, it must recognise a liability for the dividend
payable. Consequently, this appendix addresses the following issues:

(a)
When should the entity recognise the dividend payable?

(b)
How should an entity measure the dividend payable?

(c)
When an entity settles the dividend payable, how should it account for any
difference between the carrying amount of the assets distributed and the
carrying amount of the dividend payable?

When to Recognise a Dividend Payable

The
liability to pay a dividend shall be recognised when the dividend is
appropriately authorised and is no longer at the discretion of the entity,
which is the date:

(a)   When declaration of the dividend, e.g. by
management or the board of directors, is approved by the relevant authority,
e.g. the shareholders, if the jurisdiction requires such approval, or

(b)   When the dividend is declared, e.g. by
management or the board of directors, if the jurisdiction does not require
further approval.

Since
the demerger is to be approved by the court, a question may emerge as to
whether the dividend liability is accounted when the demerger is approved by
the shareholders or when finally approved by the court. If the court approval
is substantive and not a mere formality, then the dividend liability shall be
recorded when the final court approval is received. If the court approval is
treated as a mere formality, then dividend liability should be recognized on
approval from shareholders. Under the indian jurisdiction, the court order
would generally be treated as substantive and determine the acquisition date.
However, this issue is not very relevant for the purposes of this article.

Measurement
of a Dividend Payable

An
entity shall measure a liability to distribute non-cash assets as a dividend to
its owners at the fair value of the assets to be distributed. At the end of
each reporting period and at the date of settlement, the entity shall review
and adjust the carrying amount of the dividend payable, with any changes in the
carrying amount of the dividend payable recognised in equity as adjustments to
the amount of the distribution.

Accounting For Any Difference between the Carrying Amount of
the Assets Distributed and the Carrying Amount of the Dividend Payable when an
Entity Settles the Dividend Payable

When
an entity settles the dividend payable, it shall recognise the difference, if
any, between the carrying amount of the assets distributed and the carrying
amount of the dividend payable in profit or loss.

Example:   Non – Cash Asset Distributed To Shareholders

TCO
is an Ind-AS and a listed company. TCO has two divisions, hardware
manufacturing and software. TCO is professionally managed and has a widely
dispersed shareholding. There is no group of shareholders that controls TCO.
TCO’s accounting period ends at 31st march 2017. On 29th march 2017, the
shareholders of TCO approve a non-cash dividend in the form of demerger of the
hardware division. The hardware division will be hived off into a resultant
company (RCO). The shareholders of TCO shall become the shareholders of RCO in
the same proportion. The court approves the demerger scheme on 20th July 2017,
and the demerger is executed.

In
TCO’s separate  financial  statements at 29th march 2017 and 31st march
2017, the net assets of the hardware division, is  carried 
at INR 250. The   fair  value of the hardware  division 
at 29th march and 31st  march 2017
is INR 350. The fair value increases to INR 400 when the non-cash asset is distributed
on 20th July  2017. For simplicity, it is
assumed that there is no change in the carrying amount of the net assets of the
hardware division from 29th march 2017 to 20th july 2017.

In
this example, for illustration purposes only, we have assumed that the court
order is a mere formality1 and hence the dividend liability is recognised on
approval of the demerger by the shareholders. On that basis, the dividend is a
liability in the books of TCO when the annual financial statements are prepared
as at 31st march 2017. At 31st march 2017 TCO would record a dividend liability
of INR 350 with a corresponding debit to its equity. In TCO’s separate
financial statements, the net assets in hardware division of INR 250 are
classified as held for distribution to owners. When the non-cash asset is
distributed on 20th July 2017, the fair value has increased by INR 50. At that
date, TCO shall record an additional dividend liability of INR 50 with a
corresponding debit to equity.

The
non-cash asset is distributed on 20th July 2017 at which point the fair value
of the division is INR 400. The difference between the carrying amount of the
net assets distributed (INR 250) and the liability (INR 400) which is INR 150,
is recognised as a gain in profit or loss of TCO.

———————————————————————————————-

1    Under the Indian Jurisdiction, the court
order would generally be treated as substantive and determine the acquisition
date.

The
above example included the following assumptions:

1.  TCO is an Ind-AS and a listed company. TCO
needs to provide an auditor’s certificate of compliance with Ind AS, in order
for the court to approve the demerger scheme. Effectively,  this means that TCO needs to comply with
Ind-AS  standards. RCO is the resulting
company.

2.  TCO and RCO are not controlled by the same
party or parties before and after the demerger.

TCO
needs to address  the  following challenges from an income-tax angle
arising from the above demerger scheme:

1.  TCO is a listed company and hence should
comply with the accounting standards in a court scheme, as per SEBI
requirements. If TCO was a non-listed entity, to which Ind AS was applicable,
SEBI  requirements for providing an
auditor’s certificate with respect to Ind AS compliance would not apply.
Therefore, if TCO is a non-listed entity, there is a possibility, not to comply
with Ind AS to account for the demerger. However, additional consequence may
have to be examined, such as, the registrar of Companies, enforcing compliance
with Ind AS or auditors providing a matter of emphasis in the audit report.

2.
Under Ind AS the transfer of the non-cash asset is recorded  at 
fair  value  and 
the  resultant  gain/loss is taken to the P&l.  Would this be considered as a revaluation and
hence not meet the condition of section 2(19AA)?  one 
view is that TCO records a gain/loss on distribution of the assets,
which is not the same as revaluation of assets in the books of TCO. Therefore
with respect to this matter it may be argued that section 2(19AA) is not
violated.

3.  On the other hand, if it is concluded that
the scheme is not in compliance with section 2(19AA), there could be an issue
of dividend distribution tax (DDT) on the distribution of non-cash assets.
arguments  against this possibility would
be (a) Companies act 2013, prohibits any dividend distribution in kind – hence
the demerger cannot be treated as dividend for income- tax purposes also (b)
the legal form of the transaction as a ‘demerger’ cannot be disregarded.

4.  Fair valuation is at the core of Ind AS. TCO
may have used the fair value option to determine the deemed cost at the
transition date to Ind AS for certain assets such as PPE or investments.
Alternatively, TCO may have used fair value option as a regular basis of
accounting for certain assets, where such a basis is allowed/ required. Fair
valuation may have resulted in an upwards or downwards adjustment. When TCO has
used such fair valuation under Ind AS, compliance with the condition u/s. 2(19AA)
to consummate the demerger transaction at book value will become challenging.

5.  In our example, TCO records a profit of INR
150 on the distribution of non-cash assets. Whilst this would not be taxable
from a normal income tax computation perspective, if  TCO is under mat, this credit would be counted
for the purposes of determining the profits for MAT purposes.

From
the perspective of RCO, the following aspects need to be considered:

1.  Under Ind AS, from an RCO perspective, this
would be treated as a business restructuring transaction. RCO will have to
account for the assets and liabilities at book value, because under Ind AS, a
change in the geography of assets, arising from the restructuring, does not on
its own result in accounting for the exchange at fair value. The difference
between the fair value of shares issued by RCO to the shareholders and the book
value of assets and liabilities received from TCO will be debited to equity.
Assuming the fair value of shares issued by RCO to the shareholders is INR 445;
the amount to be debited to equity would be INR 195 (INR 445 – INR 250).

2.  In other words, RCO will not be able to
create a goodwill for INR 195, and hence will not be able to derive any tax
benefits from goodwill.

Conclusion

It  does 
not  appear  fair 
that  Ind  AS 
should  result  in an unintended consequence for TCO with
respect to demerger  schemes  under 
the  income-tax  act. 
At the same time, it is not appropriate to try and meddle with Ind AS
and create more differences between IASB IFRS and Ind AS. The finance  ministry and the Income-tax authorities
should move into swift action to resolve these issues by making suitable
changes in the income-tax act. If this is not done, the restructuring of
businesses will be hampered. Consequently, all this will have a negative impact
on the indian economy in the long run.

Accounting and ‘Brexit’ the World’s Most Complex Divorce

Introduction

The
UK  voters’ decision to exit the EU came
as a surprise to many observers, as well as the markets, and the vote has
triggered political, economic and financial uncertainty which is likely to
impact Indian entities having operations in the UK . There has been an
immediate impact on the financial markets, both in the UK  and across the world, with the pound
significantly weakening against other currencies and share prices fluctuating
as the market reacts to the decision. The decision is expected to risk upto
75,000 jobs in EUROpe and a loss upto 10 billion pounds in tax revenue as per a
recent article in the  financial  express.

From
the time of announcement of Brexit till current date, the exchange rates in relation
to the pound have been volatile as given below:­

–   The pound to EURO rate has moved from
1.31099 in June 2016 to 1.10846 in October 2016.

–   The pound to dollar rate has moved from
1.46079 in June 2016 to 1.22144 in October 2016.

–   The pound to INR rate has moved from 98.07
in June 2016 to 81.40 in October 2016.

In
fact, the pound to EURO rate post June 2016 has never touched such lower levels
in the past two and half years. Further, 
the Bank of England has cut the interest rate to a historic low of 0.25%
post the Brexit announcement.

In
view of this volatility, let us see the possible impact on some of the key
captions in the financial statements from an Ind-AS perspective for Indian
entities having operations in the UK :­

Foreign Currency Transactions

Ind-AS
21, the  effects of Changes in
foreign  exchange rates allows, for
practical reasons, entities to use an appropriately average exchange rate for a
reporting period if it approximates the actual rate. In case of entities who
have operations in the UK  which use a
weighted average rate, a sudden and significant change in foreign currency
exchange  rates,  may 
affect  the  way 
the  average  is calculated.

As
per Ind-AS 21, foreign currency monetary items shall be translated using the
closing exchange rate i.e assets and liabilities to be received or paid in a
fixed or determinable number of units of currency. e.g., entities in India will
have to restate their debtors, creditors, borrowings etc. held in GBP and this
could have volatility in the profit and loss account due to the exchange rate
movement.

Ind-AS
21 defines the concept of functional currency as the currency of the primary
economic environment in which the entity operates. An entity would record all
transactions in its books of accounts in the functional currency. Some factors
which determine the functional currency of an entity include:­

Currency
in which sales prices for its goods and services are denominated and settled;
and

Currency
of the country whose competitive forces and regulations mainly determine the
sale prices of its goods and services.

For
Indian entities, with functional currency as INR, the same is not expected to
change. however,  if such an entity has a
subsidiary in the UK , it may have to monitor and reassess the UK   subsidiary functional currency in light  of 
the  BreXit.  this  
is  because,  going 
forward, entities may adjust their trading relationships with entities
in the EU  and the rest of the world, as
a result of trade negotiation and trade agreements between the UK  and other 
countries.  In these  circumstances,  entities 
need to monitor the primary economic environment in which they operated,
and assess if there is a change in the functional currency.

Investment in Subsidiaries, Associates and Joint Ventures

Entities
in India may have investments in subsidiaries, associates and joint ventures in
the UK. Under Ind-AS, these investments will be carried at cost or at fair
value as  per  Ind-AS 109. 
The   volatility  in 
exchange  rates and interest rates
could have a possible impact on the separate financial statements of the Indian
entity from an impairment perspective. e.g., the entity may have to re-build
the underlying cash flow projections for the UK 
business considering any change expected in the business outcomes due to
the Brexit. These cash flow projections will have to be further adjusted for
the exchange rate/ discount rate assumptions. Accordingly, this may trigger an
impairment provision in the separate financial statements of the Indian entity.

In
case of consolidated financial statements, the impact of the translation from
the functional currency of the UK 
subsidiary (e.g. GBP) to the reporting currency of the parent Indian
entity (e.g. INR) is recognised in other comprehensive income and accumulated
as a separate component of the equity. This is reclassified from equity to the
profit and loss on disposal of the subsidiary investment. As per the standard,
a write-down of the carrying amount either because of losses / impairment does
not trigger any reclass from equity. However, 
there could be a possible impairment to the goodwill on consolidation of
the subsidiary/net investment in the associate or the joint venture in the
consolidated financial statements of the Indian entity.

Impairment of assets with indefinite/ finite useful life

Entities
are expected to have at least a high-level overview on what the effects of
Brexit might be on the key financial assumptions  used 
to  determine  recoverable 
amounts and  other potential  consequences for the entity. Cash flow
projections used in impairment assessment should be adjusted for changes in
possible business outcomes due to Brexit. Further,  discount rates used should also be reassessed
to reflect the current market assessment of the time value of money considering
the change in the interest rates. Accordingly, recoverable amounts may undergo
a change, resulting in impairment provisions in certain cases.

Similarly,
property, plant and equipment and intangible assets with a finite useful life are
tested for impairment when  factors  are 
present  that  indicate 
the  recorded value of a
non-current asset (or asset group) may not be recoverable. This may require
appropriate re-assessment.

Defined benefit plans

Market
volatility could have implications for the measurement of the pension asset or
liability under defined benefit schemes. For example, decline in equity markets
and  potential  changes 
in  interest  rates 
as  explained above could have a
significant effect on the fair value of plan assets and the funded status of
plans, as well as the defined benefit obligation. This would have an impact
especially in case of Indian entities having subsidiaries / plan assets for its
branches located in the UK.

Entities/Groups
operating cross border pension schemes within the EU will also need to closely
watch the changes, if any, that could make such schemes no longer operational
e.g., an entity may have UK -based cross-border pension schemes for employees
across the EU may find that those schemes can no longer operate in EU member
states. Conversely, it may be that a cross-border pension scheme that is based
in an EU member state can no longer be used for UK  employees. The replacement or relocation of
these pension arrangements will then become necessary and may bring about
change in the pension liabilities recorded.

Income Taxes

Determining
whether deferred tax assets qualify for recognition under Ind-AS12 income taxes
often requires an extensive analysis of the positive and negative evidence for
the realisation of the related deductible temporary differences and an
assessment of the likelihood of sufficient future   taxable  
income.   Volatile   economic  
conditions add complexity to this analysis and may be a source of
negative evidence.

Provisions

Ind-AS37
Provisions, Contingent liabilities and Contingent assets requires the discount
rate that is used to calculate the present value of expected expenditures to
reflect current market assessments of the time value of money and risks
specific to the liability. Changes in interest rates and other economic
indicators following the outcome of the referendum may well affect the
estimates of future cash flows inherent in the provision. Accordingly,
provisions may be required to be restated.

Due
to stability in exchange rates in the past, entities in the UK  may have entered into long term purchase and
sales contracts which may now become onerous due to the significant fall in the
exchange rates. Consequently, losses on such contracts will be required to be
provided for.

Business Combination

Para
45 – 49 of Ind-AS103 deals with the concept of measurement period which states
that, post the acquisition date, if there is any change in the fair value of
assets and  liabilities,  the 
same  can  be  adjusted 
back  to  the purchase price allocation on the
acquisition date only if the adjustment / change takes place during the
measurement period. However, the measurement period shall not exceed one year
from the acquisition date. In case of business combinations which have taken
place in the pre-vote period and where measurement period is over, any further
change in the fair value of assets and liabilities may have an impact in the
profit or loss in the period of change.

Financial Reporting Considerations

As
per Ind-AS1 (para 125) – ‘an entity should disclose information   about  
the assumptions   it   makes  
about the future, and other major sources of estimation uncertainty at
the end of the reporting period, that have a significant risk of resulting in a
material adjustment to the carrying amounts of assets and liabilities within
the next financial year.’

Entities
should  consider  whether 
the  potential  effects of Brexit materially change their
previously disclosed judgements and sources of estimation uncertainty, or
whether an entity is exposed to any new factors resulting from the vote. These
disclosures should be tailored to an entity’s facts and circumstances,
including a discussion of the entity’s affected operations and the specific
effects on its operations, liquidity and financial condition.

E.g.,
Changes in the sensitivity of reasonably possible outcomes related to goodwill
impairment assumptions.

Ensuring
valuation methodologies are adequately explained due to market volatility, key
assumptions are disclosed and appropriate consideration is given to the use of
sensitivity analysis e.g. impact due to change in exchange rate by 1%, change
in interest rate by 1% etc.

Reassessment
of going concern assumption for entities exporting significantly to the UK  or UK 
entities with a high level of import from the EU who do not have
adequate risk management processes in place.

Entities
in India will need to consider some of the above accounting  and 
financial  reporting  implications 
of  this exit and monitor and
assess how subsequent events / government decisions in the UK  and the EU may possibly bring a change to
their own operations and/or investment strategies.

Capital Subsidies and Accounting

It is well settled for the last
many years, that the question as to whether subsidies are income receipts or
capital receipts depends upon whether they are intended to supplement
the trade receipts or received otherwise {see Seaham harbour dock Co.
Crook 16 tC 333 (hl) and CIT vs. Poona Electric Supply 14 ITR 622 (Bom).} it
would depend upon the nature and content of the subsidy, the scheme, its
objective and the purpose for which subsidy is given. In other words, the ‘purpose’
test is decisive and not the mode or manner or time or source of payment.

In Sadichha Chitra vs. CIT 189 ITR
774, the Bombay high Court referred to the decision in CIT vs. Ruby Rubber
Works 178 ITR 181 and held that nature of the subsidy depends on the purpose
for which it is granted. In that case, the subsidy was in the form of refund of
entertainment tax  already  collected 
as  income.  It agreed 
with  the opinion of the M.P. high
Court in CIT vs. Dusad Industrial 162 ITR 784.

Following observations by the
Bombay high Court are apposite. “In a given case, subsidy may be granted with
the object of supplementing trade receipts and profits of the recipient.
In another case, the scheme of subsidy may have been formulated by the
authority concerned to assist the assessee in acquiring a capital asset or for
the growth of the industry generally in public interest without any objective
of supplementing trade receipts or recoupment of revenue expenses. Whether the
receipt of subsidy amount is a capital receipt or revenue receipt would depend
upon the nature and content of the subsidy the scheme, its objective and the
purpose for which subsidy is given.”

In CIT vs. Chaphalkar Brot. 351 ITR
309, the Bombay high Court held that subsidy granted to encourage setting up of
multiplexes (a capital asset) was a capital receipt.

The following observations of the
Supreme Court in Ponni Sugars case 306 ITR 392 at page 401 are extremely
relevant.

“The judgement of the house of
lords shows that the source of payment or the form in which the subsidy
is paid, or the mechanism through which it is paid is immaterial and
that what is relevant is the purpose for payment of assistance. Ordinarily,
such payments would have been on revenue account, but since the purpose of the
payment was to curtail obliterate unemployment and since the purpose was dock
extension, the house  of lords  held that payment was of capital nature.

In the above case 306 ITR 392,
the Supreme Court reviewed the entire case law on the subject and reiterated
that the character of the receipt of the subsidy under a scheme has to be
determined with respect to the purpose for which the subsidy is granted. In
other words, one has to apply the purpose test. The point of time at which the
subsidy is paid is not relevant. The source is not material. If the object of
the subsidy is to enable the assessee to run the business more profitably, then
the receipt is on revenue account. On the other hand, if the object of the
assistance under the subsidy scheme is to enable the assessee to set up a new
unit or to expand an existing unit, the receipt of subsidy would be on capital
account. See also CIT vs. Reliance Industries Ltd. 339 ITR 632 (Bom.)

Same view was taken by CBDT in
its Circular no.142 dated 1st   august,
1974 in respect of 10% Central outright Grant Subsidy Scheme. In the said
circular, it is stated that since the scheme is framed by the Govt. for the
growth of industries and not for supplementing the trade profits, it is a
capital receipt.

The following parapraphs from
different chapters of a report on industrial dispersal by Planning Commission
in the year 1980 for a similar Central Government subsidy introduced in the
fourth  five  year plan for backward areas, where the
quantum of subsidy was linked to capital investment is relevant and confirm
that such Government subsidies are not for acquiring fixed assets but for
locating projects in backward areas and level of capital investment is merely
used for calculating the quantum of subsidy.

Para 3.15 and 3.16 of the Report
……………..

“3.15 The approach to industrial
dispersal followed in the first three plans had some effect, but the results
achieved were   not   considered  
satisfactory.   Thus    the  
fourth Plan states:

“In terms of regional development, there has
been a natural tendency for new enterprises and investments to gravitate
towards the already overcrowded metropolitan areas because they are better
endowed with economic and social infrastructure. Not enough has been done to
restrain this process. While a certain measure of dispersal has been achieved,
a much larger-effort is necessary to bring about greater dispersal of
industrial activity.

(fourth five year Plan, page 11,
para 1.23)”

3.16 In its approach to industrial
development, the fourth Plan lays great stress on the need for industrial
dispersal:

“The requirement of non-farm
employment is so large and so widely spread throughout the country that a
greater dispersal of industrial development is a matter of necessity. Even from
the narrow and immediate economic view point, the society stands to gain by
dispersed development.

The cost of providing necessary
infrastructure for further expansion of existing large urban and industrial
centres is often much larger than what it might be if development was
purposefully directed to occur in smaller towns and rural areas.”

Thus,  it is certain that the primary condition for
this Government  subsidy  is  not  acquisition 
of  fixed  assets and hence, this is not a grant related
to assets in terms of Ind AS 20.

Since, as mentioned above, the
Grant is not supposed to compensate any particular cost of any particular asset
and is a capital receipt which when invested in business generates income to
compensate for higher costs of operations in backward region, in accordance
with Ind AS 10, no amount of Government Grant can be taken to profit and loss
account of any year.

In the following paragraph, the Ind
AS 20 seems to suggest that Government Grant results in a benefit for an entity
when compared to other entries which do not get the grant while the fact for
this Grant is exactly the opposite. The Government Grant, in this case, is
given to compensate for the benefits which other entities enjoy by virtue of
operating in developed regions.

“5. the  receipt of government assistance by an entity
may be significant for the preparation of the financial statement for two
reasons. Firstly,  if resources have been
transferred, an appropriate method of accounting for the transfer must be
found. Secondly, it is desirable to give an indication of the extent to which
the entity has benefited from such assistance during the reporting period. This
facilitates comparison of an entity’s financial statements with those of prior
periods and with those of other entities.”

Guidance note under Indian GAAP
states that it is generally considered appropriate that accounting for Govt.
grants should be based on the nature of the relevant grant. Grants which have
the characteristics similar to those of promoters’ contribution should be
treated as part of shareholders’ funds. Income approach may be more appropriate
in cases of other grants. (as.12-Para 5-4).

This paragraph which supports the
view that when subsidy granted is for capital purposes, it should be treated as
shareholder funds i.e. part of reserves. But this para is not there in ind. AS/IFRS. Para 12 of Ind AS-20”. (Accounting for Government grants and
disclosures of Govt. assistance) clearly states that. “Govt. grants shall be
recognized in profit and loss a/c. on a systematic basis over the periods in
which the entity recognises as expenses the related costs for which the grants
are intended to compensate. (Emphasis Supplied). Thus matching
concept/principle is adopted and it can apply to grants of a revenue nature
which seek to compensate revenue expenses incurred over a period.

Ind AS-20, however suddenly takes
a U-turn. Definition of Govt. grant says that grants related to assets are
Govt. grants whose primary condition is that an entity qualifying
for them should purchase, construct or otherwise acquire long term assets.
Subsidiary conditions may be attached restricting the type or location of the
asset. This makes it amply clear that the definition is merely talking of
qualifying or eligibility condition. It is significant to note that it uses the
expression ‘primary or subsidiary conditions for eligibility’ and not primary
purpose of giving the grant. then  it
talks of  transfer  of 
resources,  but  recognises 
in  para  4  that
Govt. grants take many forms varying both in the nature of the assistance and
in the conditions attached to it. (Emphasis supplied).

Then after citing capital
approach and income approach in para 14 and 15, para 19 states that “Grants are
sometimes received as part of a package of financial or fiscal aids to which
number of conditions may be attached. In such cases, care is needed in
identifying conditions giving rise to costs and expenses which determine
period over which, the grant will be earned. It may be appropriate to
allocate a part of a grant on one basis and part on another? (emphasis
supplied).

There can be no dispute that
revenue grants given to compensate for costs and expenses (such as employee
expenses, interest, waiver of taxes) can be treated as on revenue account.

However, it appears that para 20
takes a complete u-turn from the established principles and says that “a Govt.
grant that becomes receivable as compensation  for expenses or losses already incurred or for
the purpose and giving immediate financial 
support with no further related costs (?) (without defining or
specifying the purpose or nature of the financial support) shall be recognised
in profit and loss of the period in which it becomes receivable. the expression
‘giving immediate financial support’ is too vague and cannot be read in
derogation to the basic principles laid down by the Supreme Court and old
accounting standards and CBDT‘s own view held earlier. It will be against the
principles of commercial accounting adopted by the accounting community so far.

Para 21, surprisingly still
recognises this doctrine of making distinction between grants awarded for the
purpose of giving immediate financial support rather than as an incentive to
undertake specific expenditure. Para 22 again speaks of expenses or
losses.

By para 34 read with appendix –
i, confusion is worst confounded. it talks of “grants related to costs” being
deferred income and appendix –a which really deals with Govt. assistance which
are not to be related to specific operating activity, quietly takes them into
account as ‘transfer of resources’ to start or continue to run their business
in underdeveloped area.

It is respectfully submitted that
there is an urgent need to clarify this confusion and make it clear whether the
accounting standards advocate or support the view of treating all subsidies as
revenue receipts to be treated as income–immediate or deferred in derogation
with established principles laid down by the S.C. or reason for departure, if
any, which means that the distinction between capital receipts and revenue
receipts are no longer relevant in accounting. Also whether article 265 of the
constitution of india is no longer relevant or valid. it may be noted that
income computation and disclosure standards, which have to be now mandatorily
followed u/s.145 also make an exception in the preamble to the effect that if
the legal position is different from that adopted in the ICDS, legal position
is to be followed. Some view is taken in Accounting Standards for SMC notified
on 7th December 2006 by ministry of Corporate affairs. Para 4.1.1 of
the preface to the accounting Standards issued by ICAI States as under:

“However, if a particular
accounting standard is found to be not in accordance with law, the provision of
the said law will prevail and the financial statements should be prepared in
conformity with such law.

Para 4.2 says

“The accounting  Standards 
by their very nature cannot and do not override the local regulation
which govern the preparation and presentation of financial statements in the
country.

Before parting with the subject,
it is necessary to deal with one important aspect. The finance  act, 2015 has inserted sub cl.(xviii) in
s.2(24) defining ‘income’ inclusive–wise to include within its sweep
‘assistance in the form of a subsidy or grant. But it also excludes those
subsidies and grants which are deducted while calculating actual cost under
explanation10 to section 43(1), thus indirectly recognising the distinction
between capital subsidy and income subsidy. But it may be argued that this is
the later law and hence, even otherwise, there is no conflict between AS 20 and
legal provision.

But the words “assistance”
clearly supports the reasoning of the Supreme Court cited above. The word
‘assistance’ means the provision of money, resources or information to help
someone. Thus the word ‘assistance’ seems to have been used in the sense of
supplement (the trade receipts). At least, it is capable of being interpreted
so. if two interpretations are possible, the courts have always adopted that
interpretation which is in favour of the taxpayer and which will uphold the
constitutional validity of the taxing provision (see 131 ITR 597 S.C).

If the amendment in section
(24(xviii) is taken to mean that it includes each and every kind of subsidy –
whether capital or revenue – it will be clearly violative of the constitution –
both article 265 and entry 82 and 86 – leave alone the Supreme Court decisions.
Thus, the provision will have to be read down to cover only income subsidies.
object of Govt. assistance can never be to take away something given by the
Govt. by one hand and taken away by the other hand.

Thus,  both in equity and law, capital subsidies can
in no sense and no manner be treated as income liable to tax. Equity and law or
accounting may be strangers, but they need not be sworn enemies!

Accounting For Loss of Control in Subsidiary

Issue

Consider the following example.
Parent (P) sells wholly owned Subsidiary (S) to Associate (A).  The structure before and after sale is given
below.

In P’s CFS, the carrying amount of
the net assets of S at the date of the sale is INR 10,000.  For simplicity, assume S has no accumulated
balance of OCI. The fair value of S and the selling price is INR 18,000, which
is the consideration received by P in cash. P recognises a profit of INR 8,000
on the sale of S in CFS.

The next step is to determine how
much of this profit of INR 8,000 is required to be eliminated on
consolidation.  Essentially, there are
two approaches, which are explained below.

Ind AS 110 Approach

Paragraph 25 of Ind AS 110 –
Consolidated Financial Statements states as follows: 

If a parent loses control of a
subsidiary, the parent:

a)  Derecognises the assets and
liabilities of the former subsidiary from the consolidated balance sheet.

b)  Recognises any investment
retained in the former subsidiary at its fair value when control is lost and
subsequently accounts for it and for any amounts owed by or to the former
subsidiary in accordance with relevant Ind ASs. That fair value shall be
regarded as the fair value on initial recognition of a financial asset in
accordance with Ind AS 109 or, when appropriate, the cost on initial
recognition of an investment in an associate or joint venture.

c)  Recognises the gain or loss associated
with the loss of control attributable to the former controlling interest.

If P applies the Ind AS 110
approach, then it recognizes the full profit on the sale of S. The amount
included in the carrying amount of A for the sale of S in P’s CFS is INR 4,500
(18,000 x 25%)

Ind AS 28 Approach

Paragraph 28 of Ind AS 28 – Investments
in Associates and Joint Ventures states as follows:

Gains and losses resulting from
‘upstream’ and ‘downstream’ transactions between an entity (including its
consolidated subsidiaries) and its associate or joint venture are recognised in
the entity’s financial statements only to the extent of unrelated investors’
interests in the associate or joint venture. ‘Upstream’ transactions are, for
example, sales of assets from an associate or a joint venture to the investor.
‘Downstream’ transactions are, for example, sales or contributions of assets
from the investor to its associate or its joint venture. The investor’s share
in the associate’s or joint venture’s gains or losses resulting from these
transactions is eliminated.

If P applies the Ind AS 28
approach, then it eliminates 25% of the profit recognised on the sale of S
against the carrying amount of the investment in A. The amount included in the
carrying amount of A for the sale of S in P’s CFS is INR 2,500 [(18,000 x 25%)
– (8000 x 25%)]

P records the following entries in
its CFS for the transaction and the subsequent elimination

 

Debit

Credit

Cash

Net assets of S

Gain on sale ( P & L)

(To recognise sale of S)

18,000

 

10,000

8,000

Gain on sale (P & L) 8000 x 25%

Investment in associate

(To recognise elimination of 25% of profit on sale of $

2,000

 

2,000

The
amount included in the carrying amount of A for the net assets of S in P’s
consolidated financial statements, after elimination. is INR 2,500 (18,000 x
25% – 2,000). This equals to the carrying amount of the net assets of S in P’s
CFS before the sale, which was INR 2,500 (10,000 x 25%).

Author’s view

Both approaches discussed above
are acceptable, as both are supported by the respective standards. 

In September 2014, the IASB issued
amendments to IFRS 10 and IAS 28: Sale or Contribution of Assets between an
Investor and its Associate or Joint Venture. The amendments address the
conflict between the requirements of IAS 28 and IFRS 10 Consolidated
Financial Statements regarding non-monetary contributions in exchange for
an interest in an equity-method investee.

The September 2014 amendments are
designed to address this conflict and eliminate the inconsistency; by requiring
different treatments for the sale or contribution of assets that constitute a
business and of those that do not.

When a non-monetary asset that
does not constitute a business as defined in IFRS 3 Business Combinations,
is contributed to an associate or a joint venture in exchange for an equity
interest in that associate or joint venture:

–  The
transaction should be accounted for in accordance with IAS28.28, except when
the contribution lacks commercial substance; and

–   Unrealised
gains and losses should be eliminated against the investment accounted for
using the equity method and should not be presented as deferred gains or losses
in the entity’s CFS in which investments are accounted for using the equity
method.

The gain or loss resulting from a
downstream transaction involving assets that constitute a business, as defined
in IFRS 3, between an entity and its associate or joint venture is recognised
in full in the investor’s CFS.

However, the IASB identified
several practical challenges with the implementation of the amendments.  Consequently, the IASB has issued a proposal
to defer the effective date of the September 2014 amendments pending
finalisation of a larger research project on the equity method of accounting.

Conclusion

Till such time the IASB takes a final decision,
and is followed up by appropriate amendments in Ind AS’s, both approaches
discussed above with respect to elimination of profits on sale of subsidiary to
the associate are acceptable under Ind AS.

What Will Constitute A Service Concession Arrangement?

Fact pattern

As per an arrangement with the Civil Aviation Department
(CAD), Airport Co Ltd (ACO) shall construct an airport and provide Aeronautical
& Non-Aeronautical Services. The Aeronautical services are regulated by the
CAD, but Non-Aeronautical services are unregulated.

Aeronautical services (“Regulated activity”) include:

a)  Provision of flight operation
assistance and crew support systems

b)  Ensuring the safe and secure
operation of the Airport, excluding national security interest

c)  Movement and parking of aircraft
and control facilities

d)  Cleaning, heating, lighting and
air conditioning of public areas

e)  Customs and immigration halls

f)   Flight information and
public-address systems

g)  X-Ray service for carry on and
checked-in luggage

h)  VIP / special lounges

i)   Aerodrome control services

j)   Arrivals concourses and meeting
areas

k)  Baggage systems including
outbound and reclaim

Non-Aeronautical Services (“Unregulated activity”) include:

a)  Aircraft cleaning services

b)  Duty free sales

c)  Airline Lounges

d)  Hotels and Motels

e)  Car Park rentals

f)   Bank/ ATMs

g)  Telecom

h)  Advertisement

i)   Parking

j)   Flight kitchen

k)  Land and space

l)   Ground handling 

–   ACO shall
recover charges for aeronautical services as determined or regulated by CAD
under an agreed mechanism i.e. “price cap mechanism” which is substantive in
nature. Thus, income from aeronautical services is considered as Regulated
income.

–   ACO is free
to fix the charges for Non-Aeronautical Services, thus income earned on this
account is unregulated.  

–   ACO has
subcontracted/outsourced certain specialised non-aeronautical services to
separate entities i.e. joint ventures (between ACO and those specialised
service providers e.g. Duty free, parking and IT equipment operations) and for
certain services like shops, pharmacy, restaurant etc. directly to third
parties. ACO earns revenue share from these entities/concessionaires. ACO,
being the airport operator, continues to remain responsible for all the
activities at the Airport including the ones sub-contracted.

Revenue from Aeronautical and Non-aeronautical services

–   To achieve
the overall purpose CAD allows non-aeronautical services, and that too at an
unregulated price to make the airport project as a whole viable for the
government, users and the operator. In light of the non-aeronautical services,
the government seeks to make the user charges for aeronautical services
affordable to the users (public).

–   ACO
estimates that over the entire concession period, total non-aeronautical
revenue (unregulated) will be very significant and even greater than the
aeronautical revenue (regulated).

Is this arrangement a service concession arrangement (“SCA”)
under Ind-AS?

–   Appendix A
to Ind AS 11 (“Appendix A”) contains provisions regarding what constitutes a
service concession arrangement (“SCA”) and accounting for the same.

–  As per Para
5 of Appendix A an arrangement is a SCA if:

–    The grantor
controls or regulates what services the operator must provide with the
infrastructure, to whom it must provide them, and at what price; and

–  the grantor controls—through
ownership, beneficial entitlement or otherwise—any significant residual
interest in the infrastructure at the end of the term of the arrangement

–   Para AG7 of
Application Guidance on Appendix A deals with scenario where the use of
infrastructure is partly regulated and partly un-regulated and provides
guidance on the application of control assessment principles as enunciated in
Para 5 above in such scenarios.

–   It provides:

(a) Any infrastructure that is
physically separable and capable of being operated independently and meets the
definition of a cash-generating unit (CGU) as defined in Ind AS 36 shall be
analysed separately if it is used wholly for unregulated purposes. For example,
this might apply to a private wing of a hospital, where the remainder of the
hospital is used by the grantor to treat public patients. 

(b) when purely ancillary
activities (such as a hospital shop) are unregulated, the control tests shall
be applied as if those services did not exist, because in cases in which the
grantor controls the services in the manner described in paragraph 5 of
Appendix A, the existence of ancillary activities does not detract from the
grantor’s control of the infrastructure. 

Author’s Analysis

  The
condition with regard to control over the price of service that is provided
using the infrastructure asset is an important condition. If CAD does not
control the price of the services, the infrastructure asset will not be
subjected to SCA accounting.

–  Para AG7 (a)
discussed above requires regulated activity and non-regulated activity to be
accounted separately if the separability test is met. In the above case, the
infrastructure i.e. Airport premises is being used both for regulated services
(aeronautical) and for providing unregulated services (non-aeronautical). There
is no distinct or separate infrastructure for providing regulated and
unregulated services. The regulated and unregulated services are highly
dependent on each other, and do not constitute separate CGU’s, thus failing the
separability test. The aeronautical and non-aeronautical services are
substantially interdependent and cannot be offered in isolation e.g. operations
like Duty free, IT services, foods and shops and Hotel around airport etc.
are dependent upon the passenger traffic generated by the aeronautical
activities. The sustainability of aeronautical and non-aeronautical services
gets significantly impacted by non-existence of the other. Thus, in the given
fact pattern, control test as enunciated above (Para 5 of Appendix A) needs to
be applied on the infrastructure as a whole.

–   Para AG7 (b)
requires purely ancillary activities that are unregulated to be ignored, and
the control test should be applied as if those services did not exist.
Therefore, if the unregulated services are interpreted to be purely ancillary,
and control test is applied on that basis, CAD would have control over the
infrastructure and consequently SCA accounting would apply for the operator.
However, in the given fact pattern, the unregulated activities are very
significant and not “purely ancillary”.

–   Appendix A
does not define the term “purely ancillary”, however, in normal parlance it is
understood to be an ‘activity that provides necessary support to the main
activity of an organisation. Some of the synonyms for the term “ancillary”
include, additional, auxiliary, supporting, helping, assisting, extra,
supplementary, supplemental, accessory, contributory, attendant, incidental,
less important, etc. One may argue that a user needs an airport to
travel from Point A to Point B. Seen from this perspective, the unregulated
activity is ancillary because it is only supporting the main activity of air
travel. However, if seen from the perspective of importance, the unregulated
activity is very important and should not be seen as ancillary and certainly
not as “purely ancillary”. This is because the unregulated activity
drives the airport feasibility, and is therefore very important from the
perspective of the public (users), government and the operator. Besides in the
given fact pattern, the unregulated income is very significant and estimated to
exceed regulated income over the concession period.

–  As
discussed above since the separability test is not met, the regulated and
unregulated activity and the related infrastructure cannot be accounted for
separately.

     Further, the unregulated
activity is not purely ancillary and hence cannot be ignored. Thus in the fact
pattern, the condition as mentioned above in para 5 that grantor control or
regulates the prices for services should be analysed considering the entire
infrastructure. This control criterion is not met for the entire
airport, and hence this is not a SCA.

–   Also,
Appendix A does not deal with a situation where the separability test is not
met and the unregulated activity is not purely ancillary. Consequently, one
could argue that it is scoped out of Appendix A, and should be accounted as
Property, plant and equipment (PPE). On the other hand, one may argue that
since neither Ind AS 16 nor Appendix A prescribes any accounting in these
situations, one may voluntarily decide to apply Appendix A. Therefore the
author believes that there would be an accounting policy choice, which when
selected, should be consistently applied.

Whilst this discussion has been made in the context of modern
airports which have significant unregulated activity, it may be applied by
analogy to several other SCA which entail significant unregulated activity and
revenue.  In most cases, careful analysis
would be required to determine if the arrangement is a SCA or not.

Author is of the view that either the Institute
or the National Financial Reporting Authority should issue guidance to avoid
use of alteration accounting.

Deferred Tax under Ind AS On Exchange Differences Capitalised

Background

Under Indian GAAP, Para 46A of AS
11 The Effects of Changes in Foreign Exchange Rates, allowed an option
to companies to capitalise exchange differences arising on borrowings for
acquisition of fixed assets. The exchange differences arising on reporting of
long-term foreign currency monetary items at rates different from those at
which they were initially recorded during the period, or reported in previous
financial statements, insofar as they related to the acquisition of a
depreciable capital asset, can be added to or deducted from the cost of the
asset and shall be depreciated over the balance life of the asset.

Paragraph D13AA of Ind AS 101 First
Time Adoption of Ind AS provides an option on first time adoption of Ind
AS, to continue with the above accounting. A first-time adopter may continue
the policy adopted for accounting for exchange differences arising from
translation of long-term foreign currency monetary items recognised in the
financial statements for the period ending immediately before the beginning of
the first Ind AS financial reporting.

Paragraph 15 of Ind-AS 12 Income
Taxes states as follows: A deferred tax liability shall be recognised for
all taxable temporary differences, except to the extent that the deferred tax
liability arises from:

a)  the initial recognition of
goodwill; or

b)  the initial recognition of an
asset or liability in a transaction which:

i.   is not a business combination;
and

ii.  at the time of the transaction,
affects neither accounting profit nor taxable
profit (tax loss).

The exchange differences on
foreign currency borrowings used to purchase assets indigenously are not
allowed as deduction under the Income-tax Act either by way of depreciation or
otherwise. Under Income Tax Act, such expenditure is treated as capital
expenditure. Section 43A of the Income-tax Act contains special provision to
provide for depreciation allowance to the assessee in respect of imported
capital assets whose actual cost is affected by the changes in the exchange
rate. However, section 43A does not allow similar benefit for assets purchased
indigenously out of foreign exchange borrowings.

Issue

A company chooses to continue with
the option of capitalising exchange differences. On first time adoption of Ind
AS and thereafter, whether the Company should create deferred taxes on the
exchange differences capitalised?

Author’s Response

Paragraph 15 requires that no
deferred taxes are recognised on temporary differences that arise on initial
recognition of an asset or liability, which neither affects accounting profit
nor taxable profit. This is commonly referred to as ‘Initial recognition
exception (IRE).’ When IRE applies, deferred taxes are neither recognised
initially nor subsequently as the carrying amount of the asset is depreciated
or impaired.

There is no precise guidance in
the standards on this issue. Based on the above requirements of Ind AS, the
following two views need to be examined:

View 1: IRE exception does not apply and deferred tax needs to
be recognised

–   IRE applies
only at the time of initial recognition of an asset or liability. In this case,
difference between tax base and carrying amount is arising subsequent to
initial recognition of the asset. Hence, IRE does not apply and deferred tax
needs to be recognised on amount of exchange differences capitalised (both
increases and decreases) to the asset in this manner. The corresponding
adjustment is made to P&L. With regard to exchange difference arising
before the transition date, adjustment is made to retained earnings. The
reversal of deferred tax will be recognised in P&L as the exchange
difference is depreciated.

–  Since
exchange differences do not have an identity independent of the underlying
asset, IRE will not apply (since it is not a new asset) and deferred tax will
need to be created on temporary differences attributable to exchange difference
adjustments.

–   An analogy
can be drawn to revaluation reserve (an item that too does not have an identity
independent of the underlying asset) on which Ind AS 12 specifically requires
creation of deferred taxes. A deferred tax liability is created on the
revaluation of fixed asset. Subsequently, the depreciation on the revalued
portion is debited to P&L. Recoupment out of revaluation reserve is not permitted
under Ind AS. As and when depreciation on revaluation is debited to P&L,
the deferred tax liability is debited and a tax credit is taken to P&L.

–  An analogy
can also be drawn from land indexation benefit. A temporary difference is
created between book value and tax value of land, because of indexation
benefits allowed under the Income-tax Act for land. On such indexation amounts,
a deferred tax asset is created subject to the probability criterion being met.

–   View 1 is
also supported by the fact that the additional capitaliation is not reflected
as a separate asset in the accounting records of the Company (for example, the
fixed asset register).

View 2: IRE exception applies and deferred taxes need not be
recognised

–  When the
company adjusts exchange differences to the carrying amount of the asset, the
entry passed is Debit Asset, Credit Borrowings – that affects neither taxable
profit nor accounting profit. One may argue that each addition to the cost of
asset is in substance a new asset. This requires IRE to be applied at the time
of each capitalisation (which may include increase to the fixed assets due to
exchange loss or decreases to the fixed assets if there is exchange gain).
Consequently, IRE applies and no deferred tax should be recognised on difference
between the carrying amount and the tax base of the asset arising due to
capitalisation of exchange differences. The reversal of this portion of
exchange differences will also have no impact.

–   Support for
view 2 can be drawn from the requirement of paragraph 46A to depreciate each
period’s capitalisation over the remaining useful life of the underlying asset.
In other words, the additional capitalisation is treated as a separate item to
be depreciated over the remaining useful life of the asset. If it was treated
as the original asset itself, there would be a need to provide for depreciation
on a catch up basis, as if the exchange difference capitalisation had happened
immediately on purchase of the asset.

–   View 2 can
also be articulated differently. 
Assuming that the capitalisation requirements were slightly tweaked to
require the exchange difference to be capitalised each time as a separate
intangible item, the IRE exception would certainly apply in that case.

Conclusion

Considering the above discussions, the author
believes that View 1 is more credible.

Section A: Adverse Conclusion on Interim Ind AS Results

Surana industries Ltd. (results for quarter ended 30th
June 2016 as filed with the Bombay Stock Exchange)

From Auditors’ Review report

Basis
of adverse conclusion

3.  i.  We
refer to note no.6 relating to investment in its subsidiary Surana Power
limited  (SPL).  The carrying value of the investment in
SPL  as at 30th June,  2016 was Rs.41,850 lakh. In addition, the
Company has also issued a financial guarantee of Rs.10,000 lakh to the lenders
against the loans taken by SPL.  
The   net worth of this subsidiary
had fully eroded and its current liabilities exceed its current assets. The
independent auditor of the subsidiary had given an adverse audit opinion on its
financial statements for the year ended 31st march, 2016 stating that the going
concern assumption is not appropriate and the carrying value of the assets of
the subsidiary may also be impaired.

No
provision has been considered by the management for the diminution in the value
of the investments in this subsidiary and for the likelihood of the devolvement
of the guarantee on the Company.

ii.
Attention is invited to note no 5 regarding certain investments in subsidiaries
(having a carrying value aggregating to Rs.11,463.62 lakh) that were approved
for divestment due to continuing adverse market scenario which was impacting
the survival of the parent company. These investments are carried at cost and
have not been assessed for any impairment to the carrying values.

iii.
Inventory as at 30th  June,  2016 aggregated to Rs.16,428.37 1akh, for
which the quantity, quality and 
realisable  value  were 
not  assessed  and determined by the management. in the
absence of  evidence  for 
physical  existence  of 
inventory as  at 30th   June, 
2016  and  net realisable value of inventory, we are
unable to comment on the adjustments that may be required to the carrying
values of the inventory.

iv.
The Company has not recognised recompense interest expense amounting to rs,
1,396 lakh for the quarter ended 30th June, 
2016. Further,  during the year
ended 31st  March, 2016, the Company had
not recognised recompense interest expense amounting to Rs.5,148.36 lakh for
the year then ended and had reversed recompense interest expense amounting to
Rs.7,630.28 lakh recognised in earlier years.

v.
We refer to note no 4 relating to the non­ compliance with the repayment of the
loans as per the debt covenants agreed in the CDR package and paragraph (iv)
above relating to the non­ recognition of recompense interest for the quarter
ended 30th June, 2016 and the period then ended.

The
financial results for the quarter ended 30th June,  2016 have been prepared on a going
concern  basis  in 
spite  of  negative 
net  worth after considering the
impact of the modifications mentioned in paragraphs (i) and (iv) above.

The
ability of the Company to continue as a going concern is significantly
dependent on the bringing in of new investor to revive the operations of the Company
and successful outcome of the ongoing negotiations with the lenders and
therefore, we are unable to comment if the going concern assumption is
appropriate and any effect it may have on the financial results for the quarter
ended 30th June, 2016.

vi.
We refer to note 7 of the results wherein it is stated that the Company has
adopted Indian accounting Standards (Ind AS) notified under the Companies (Indian
accounting Standards) rules, 2015 as amended by the Companies (Indian
accounting Standards) (amendment) rules, 2016 and is implementing the same in a
phased manner and that in the opinion of the Company, the presentation of the
results under Ind AS will not have any material impact on the recorded amounts
of income and expenditure for the quarters ended june  30, 2016 and 30th june,  2015. In the absence of adequate information
and completion of transition to Ind AS, we are unable to determine if these
results comply with the recognition and measurement principles of Ind AS 34
(“interim financial  reporting”)

Paragraph
3(i) to 3(v) were matters of adverse opinion in the Audit Report issued by us
for the year ended 31st  march, 2016
under the previous GAAP (in accordance with the accounting Standards specified
in the Annexure to the Companies (Accounting Standards Rules, 2006).

Adverse Conclusion

4.  Based 
on  our  review 
conducted  as  stated 
above, due to the significance and the possible effects of the matters
described in paragraph 3 above, the accompanying  Statement 
has  not  been 
prepared in accordance with Ind AS and other accounting principles
generally accepted in India and has not disclosed the information required to
be disclosed in terms of regulation 33 of the SEBI (listing obligations and
disclosure requirements) regulations, 2015, as modified by Circular No.
CIR/CFD/FAC/62/2016 dated 5th July, 2016, including the manner in which it is
to be disclosed and the Statement may contain material misstatements.

From Notes below Unaudited Financial Results

The
auditors have modified their limited review report on the above results. The
management responses are as under:

i. Observation

As
above

Our Submission:

Based
on the preliminary negotiations with prospective buyers, the company currently
is of the opinion that actual realisable value of the current assets of the
subsidiary company will be sufficient to discharge its current liabilities. The
company is also in discussions with some financial institutions who have
evinced interest in restarting the project by pumping in additional equity and
debt required for completing the project. These 
discussions are being held at tripartite level between the prospective
financial institution, leader  of the
Consortium and the Company. Consequently, the company does not envisage any
prospective devolvement of liability on account of revocation of guarantee.
Accordingly, the company has not made any provision in this regard.

In
view of the ongoing negotiations with the prospective buyers and the lenders
and also considering the expected realisable value of the assets the Company
will be able to realise the carrying value of the said investment.

The
audit  report for the year ended
31st  march, 2016 was also modified in
respect of the above matter under the previous GAAP  (in accordance with the accounting Standards
specified in the Annexure to the Companies (Accounting Standards) Rules, 2006).

ii. Observation

As
above

Our Submission:

In
view of the ongoing negotiations with the prospective buyers and the lenders
and also considering the expected realizable value of the assets the Company
will be able to realize the carrying value of the said investments in SGPL and
SMML.

The
Audit  Report for the year ended
31st  march, 2016 was also modified in
respect of the above matter under the previous GAAP  (in accordance with the accounting Standards
specified in the Annexure to the Companies (Accounting Standards) Rules, 2006).

iii.  Observation

As
above

Our Submission

During
the previous year the physical verification of stock has been carried out by
the stock auditors appointed by the lenders based on which the stocks have been
provided to the extent of deterioration identified on a scientific basis.

With
regard to the balance stock, the same shall be assessed at the time of
resumption of production and appropriate adjustments as required shall be done.
We are of the opinion that any such adjustment so arising will not be material.

The
audit  report for the year ended
31st   march, 2016 was also modified in
respect of the above matter under the previous GAAP  (in accordance with the accounting Standards
specified in the Annexure to the Companies (Accounting Standards) Rules, 2006).

iv. Observation:

As
above

Our Submission

The  Company has not provided for recompense
interest of Rs. 14,174.64 lakh (including Rs. 1,396 lakh for the quarter ended
30th June 30, 2016) because as per master circular of RBI on CDR and also as
per the MRA occurs only when the company has generated cash surplus after
paying out all its obligations.

Further,   as 
per  the  master 
restructuring  agreement under
article viii para 8.1

“Right
to Recompense

If
in the opinion of the lenders, the profitability and the cash flows of the
Borrower so warrant, the Lenders shall be entitled to receive recompense for
the reliefs and sacrifices extended by them within the CDR parameters with the
approval of the CDR-Empowered Group.”

Accordingly,
as the lenders have not formed any opinion about the profitability and cash
flows of the company to service the recompense interest as on date, the need to
recognize the recompense interest does not arise.

Also
considering the factors stated in note 
(2) above, the Company is of the opinion that the going concern
assumption is appropriate.

The
Audit Report for the year ended 31st 
march, 2016 was also modified in respect of the above matter under the
previous GAAP”  (in accordance with
the Accounting Standards Specified in the Annexure to the Companies (Accounting
Standards) Rules, 2006)

v. Observation:

As
above

Our Submission:

Company
could not comply with debt repayment schedule as embedded in the CDR package
for want of non release of sufficient working capital funding by the lenders as
per the package. Consequently, the company was not in a position to restart its
operations in Raichur in time and could not adhere to the debt repayment
schedule.

As
mentioned in response to observation (v), there is no non-compliance of debt
covenants as per the CDR package and the need to recognize recompense interest
does not arise.

The
negotiations with the concerned parties, including the consortium of lenders,
are on for restarting the operations of the Raichur Plant and further the
operational capabilities of the Gummidipoondi Plant have been improving over
the past years. Accordingly, the company is of the opinion that the assumption
of going concern is appropriate.

The
Audit Report for the year ended 31st March, 2016 was also modified in respect
of the above matter under the previous GAAP 
(in Accordance with the Accounting Standards specified in the Annexure
to the Companies (Accounting Standards) Rules, 2006).

vi. Observation:

As
above

Our Submission:

Covered
by note 7 above and the responses to the individual items as mentioned above.

vii. Observation:

As
above

Our Submission

Covered
by responses to the individual items as mentioned above.

Impact on Mat from First Time Adoption (FTA) Of Ind As

As the book profit based on Ind AS
compliant financial statement is likely to be different from the book profit
based on existing Indian GAAP, the Central Board of Direct Taxes (CBDT)
constituted a committee in June, 2015 for suggesting the framework for
computation of minimum alternate tax (MAT) liability u/s. 115JB for Ind AS
compliant companies in the year of adoption and thereafter. The Committee
submitted first interim report on 18th March, 2016 which was placed
in public domain by the CBDT for wider public consultations. The Committee
submitted the second interim report on 5th August, 2016 which was
also placed in public domain. The comments/ suggestions received in respect of
the first and second interim report were examined by the Committee. After
taking into account all the suggestions/comments received, the Committee
submitted its final report on 22nd December, 2016. Based on the
final recommendation of the committee, the Finance Bill, 2017 prescribes
framework for levy of MAT on Ind-AS companies.

Reference Year for FTA  adjustments

Among other matters, the reference
year for FTA adjustments is clarified in the proposed final provisions. In the
first year of adoption of Ind AS, the companies would prepare Ind AS financial
statement for reporting year with a comparative financial statement for
immediately preceding year. As per Ind AS 101, a company would make all Ind AS
adjustments on the opening date of the comparative financial year. The entity
is also required to present an equity reconciliation between previous Indian
GAAP and Ind AS amounts, both on the opening date of preceding year as well as
on the closing date of the preceding year. It is proposed that for the purposes
of computation of book profits of the year of adoption and the proposed
adjustments, the amounts adjusted as of the opening date of the first year of
adoption shall be considered. For example, companies which adopt Ind AS with
effect from 1st April 2016 are required to prepare their financial
statements for the year 2016-17 as per requirements of Ind AS. Such companies
are also required to prepare an opening balance sheet as of 1st April
2015 and restate the financial statements for the comparative period 2015-16.
In such a case, the first time adoption adjustments as of 31st March
2016 shall be considered for computation of MAT liability for previous year
2016-17 (Assessment year 2017-18) and thereafter. Further, in this case, the
period of five years proposed above shall be previous years 2016-17, 2017-18,
2018-19, 2019-20 and 2020-21.

The above provisions are slightly
confusing because, the FTA adjustments are made at 1st April 2015,
whereas the final provisions allude to FTA adjustments at 31 March 2016 to be
considered for computation of MAT. Does that mean that the FTA adjustments made
at 1st April, 2015 are trued up for any changes upto the end of the
comparative year, i.e, 31st March 2016?

This article provides
clarification on how this provision needs to be interpreted.

Impact of Ind AS FTA Adjustments on MAT

The accounting policies that an
entity uses in its opening Ind AS balance sheet at the time of FTA may differ
from those that it previously used in its Indian GAAP financial statements. An
entity is required to record these adjustments directly in retained
earnings/reserves at the date of transition to Ind AS. The Committee noted that
several of these items would subsequently never be reclassified to the
statement of P&L or included in the computation of book profits.

The final provisions on MAT for
FTA adjustments in Ind AS retained earnings on the opening balance sheet date
that are subsequently never reclassified to the statement of P&L are
summarised below. It may be noted that those adjustments recorded in other
comprehensive income and which would subsequently be reclassified to the profit
and loss, shall be included in book profits in the year in which these are
reclassified to the profit and loss.

Items

The point of time it will be
included in book profits

Changes in revaluation surplus of Property, Plant or Equipment
(PPE) and Intangible assets (Ind AS 16 and Ind AS 38). An entity may use fair
value in its opening Ind AS Balance Sheet as deemed cost for an item of PPE
or an intangible asset as mentioned in paragraphs D5 and D7 of Ind AS 101.

This item is completely kept MAT neutral based on the existing
principles for computation of book profits u/s. 115JB of the Act.  It provides that in case of revaluation of
assets, any impact on account of such revaluation shall be ignored for the
purposes of computation of book profits.

 

Therefore changes in revaluation surplus will be included in
book profits at the time of realisation/ disposal/ retirement or otherwise
transfer of the asset. Consequently, depreciation shall be computed ignoring
the amount of aforesaid retained earnings adjustment.  Similarly, gain/loss on realisation/
disposal/ retirement of such assets shall be computed ignoring the aforesaid
retained earnings adjustment.

Investments in subsidiaries, 
joint ventures and associates at fair value as deemed cost

An entity may use fair value in its opening Ind AS Balance Sheet
as deemed cost for investment in a subsidiary, joint venture or associate in
its separate financial statements as mentioned in paragraph D15 of Ind AS
101. In such cases retained earnings adjustment shall be included in the book
profit at the time of realisation of such investment.

 

Therefore this item is also completely kept MAT neutral from the
perspective of existing treatment.

Cumulative translation differences

An entity may elect a choice whereby the cumulative translation
differences for all foreign operations are deemed to be zero at the date of
transition to Ind AS. Further, the gain or loss on a subsequent disposal of
any foreign operation shall exclude translation differences that arose before
the date of transition to Ind AS and shall include only the translation
differences after the date of transition.

 

In such cases, to ensure that such Cumulative translation
differences on the date of transition which have been transferred to retained
earnings, are taken into account, these shall be included in the book profits
at the time of disposal of foreign operations as mentioned in paragraph 48 of
Ind AS 21.

 

Therefore this item is also completely kept MAT neutral from the
perspective of existing treatment.

Any other item such as remeasurements of defined benefit plans,
decommissioning liability, asset retirement obligations, foreign exchange
capitalisation/ decapitalization, borrowing costs adjustments, etc

To be included in book
profits equally over a period of five years starting from the year of first
time adoption of Ind AS.

 

Section 115JB of the Act
already provides for adjustments on account of deferred tax and its
provision. Any deferred tax adjustments recorded in Reserves and Surplus on
account of transition to Ind AS shall also be ignored.

Examples clarifying how the MAT
adjustments will be made

The Company is in Phase 1. It’s
transition date is April 1, 2015. The year of Ind AS adoption is financial year
2016-17 and the comparative period is financial year 2015-16. On the transition
date the company makes the following adjustments in the opening retained
earnings.

1.  The Company applies the fair
value as deemed cost exemption and revalues the fixed assets from Rs 100
million to Rs. 150 million. On a go forward basis the Company will apply the
cost measurements basis for accounting purposes and the opening cost of fixed
assets will be Rs.150 million under Ind AS.

2.  The Company has investment in two
subsidiaries, whose cost at  April 1,
2015 is Rs. 60 million (Subsidiary 1) and 70 million (Subsidiary 2). On the
transition date the Company records the investments at fair value, Rs. 80
million and Rs. 85 million, respectively, which is the new deemed cost. On a go
forward basis, the investments will be recorded at the deemed cost. During the
financial year, 2015-16, the Company sells Subsidiary 1 at Rs. 82 million.

3.  The Company has investments in
equity mutual funds. Under Ind AS, investments in equity mutual funds are
marked to market and the gains/losses are recognized in P&L. Under Indian
GAAP, the book value of investments in the mutual funds is Rs. 215 million. The
fair value at transition date (1st April, 2015) is Rs. 220 million
and at the end of comparative period (31st March 2016) is Rs 225
million.

4.  The fair value of the above
equity mutual fund at end of 31st March 17 increased by Rs. 7
million and at end of 31st March 18 decreased by Rs. 3 million.

Solution

1.  The fair value uplift of fixed
assets of Rs. 50 million will be completely MAT neutral. For MAT purposes, the
same will be ignored for computing future book depreciation, as well as
gains/losses on sale or final disposal of the fixed assets.

2.  With respect to Subsidiary 2, there
is a fair value uplift of Rs. 15 million. The adjustment to retained earnings
is completely MAT neutral vis-à-vis existing provisions. For the purpose
of MAT, retained earnings adjustment of Rs. 15 million shall be included in the
book profit at the time of realisation of such investment.

3.  With respect to Subsidiary 1,
there is a fair value uplift of Rs. 20 million. However, it is sold in the
comparative period. For the purpose of MAT, retained earnings adjustment of Rs.
20 million as well as fair value uplift of Rs. 2 million in the comparative
period are completely ignored, since the same has already been realised in the
comparative period, on which MAT was applied under Indian GAAP.

4.  The fair value uplift on the
mutual fund of Rs. 5 million is to be included in the book profits for purposes
of determining MAT over the next five years. However, firstly this needs to be
trued up at 31st March ’16. The trued up uplift is Rs. 10 million. For the next five years, Rs. 10 million
would be equally spread, for determining book profits for MAT, in accordance
with the Table below.

           

Previous year

Assessment year

Amount to be added to book profits

 

 

Rs (million)

2016-17

2017-18

2

2017-18

2018-19

2

2018-19

2019-20

2

2019-20

2020-21

2

2020-21

2021-22

2

 5.  The upward fair
valuation in the mutual fund of Rs. 7 million for the year 16-17, will be
included in the Ind AS book profits and MAT profits as well. The downward fair
valuation of Rs. 3 million will be included as loss in the Ind AS book profits.
However, in accordance with the requirements of 115 JB, the same will be added
back to the Ind AS book profits, for purposes of calculating MAT book profits.
This results in a double whammy for companies.

Clarifications on Security Deposits And Key Management Personnel

Presentation of Security
Deposits

An
electricity distribution company collects security deposit at the time of issue
of electricity connection, which is refundable when the connection is
surrendered. The entity expects that most of the customers will not surrender
their connection. A question was raised to the Ind AS Transition Facilitation
Group (ITFG) whether such a security deposit shall be classified as a ‘current
liability’ or a ‘non-current liability’ in the books of the electricity
company?

The
ITFG at the first instance concluded that the security deposit should be
presented as current liability on the basis of Paragraph 69 of Ind AS 1,
Presentation of Financial Statement, which states as under:

“An
entity shall classify a liability as current when:

a)  it
expects to settle the liability in its normal operating cycle;

b)  it
holds the liability primarily for the purpose of trading;

c)  the
liability is due to be settled within twelve months after the reporting period;
or

d)  it
does not have an unconditional right to defer settlement of the liability for
at least twelve months after the reporting period”

The
ITFG opined “Although it is expected that most of the customers will not
surrender their connection and the deposit need not be refunded, but
surrendering of the connection is a condition that is not within the control of
the entity. Hence, the electricity company does not have a right to defer the
refund of deposit. The expectation of the company that it will not be settled
within 12 months is not relevant to classify the liability as a non-current
liability. Accordingly, the said security deposits should be classified as a
current liability in the books of the electricity company.”

However,
subsequently the ITFG withdrew the above guidance. Among other matters, the
ITFG stated that the concept of current and non-current classification already
existed under Indian GAAP and is not new to Ind AS. Hence, there is no need for
transition group guidance on the matter. Rather, the classification should be
based on Ind AS 1 and Ind AS compliant Schedule III principles. Some may argue
that by withdrawing the guidance, ITFG is permitting electricity companies to
present the security deposit as non-current. The supporters of this view
believe that in withdrawing the guidance, the ITFG must have focussed on the
substance of the arrangement, and the redemption pattern, which indicates that
the security deposit was non-current.

Author’s
View on some related matters

Pursuant
to the above change, electricity and similar companies, for example, a company
that provides gas connection or water supply, would classify security deposits
received from the customers as current or non-current liability based on
estimated redemption pattern. This view would generally apply in limited
circumstances such as in monopolistic or oligopolistic situations where choices
available to the consumer to change the service provider are highly limited.
This view should not apply by analogy in all cases. For example, in the case of
security deposit received by a consumer goods company from
retailers/distributors, the classification of security deposits would continue
to be current.

The
other question not addressed by the ITFG is whether the security deposits, once
presented as non-current needs to be discounted to its present value followed
by subsequent unwinding of the discount. One view is that discounting would be
required. On initial discounting, the security deposit would be stated at its
present value. The difference between the amount of security deposit received
and the present value will be treated as deferred income. The deferred income
will be credited to the P&L income, generally on a straight line basis to
reflect the true value of the goods or services provided to the customer. On
the other hand, the unwinding of the discounting will result in the security
deposit being reflected at its original value just before redemption. The
unwinding will be done on an effective interest rate method and the consequent
financial expense will be debited to P&L. The accounting will result in a
mis-match in the P&L as the deferred income is recognised on a straight
line basis whereas the financial expense is recognised on an effective interest
rate basis.

The
author’s view is that the new guidance (viz., non-current presentation of
deposit by electricity and similar companies) arising from withdrawal of old
ITFG view is relevant only for presentation in the balance sheet. Recognition
and measurement of security deposits, including those accepted by the
electricity and similar companies, would continue to be governed by Ind AS 109 Financial
Instruments principles. Consequently, the author believes that there is no
need to discount the security deposits.

WHETHER INDEPENDENT DIRECTORS ARE KEY MANAGEMENT
PERSONNEL?

Whether
independent directors should be considered as key management personnel (KMP)
under Ind AS 24 Related Party Disclosures?

Authors’
View

Ind
AS 24 defines the term ‘key management personnel’ as “the persons having
authority and responsibility for planning, directing and controlling the
activities of the entity directly or indirectly, including any director (whether
executive or otherwise) of that entity.”

Under
Indian GAAP, AS 18 Related Party Disclosures excludes non-executive
directors from the definition of KMP. However, under Ind AS, it is quite clear
that all directors  whether  Executive or Non-executive will generally be
considered as KMP. Furthermore, the Companies Act, 2013, prescribes very
onerous responsibilities for independent directors. These responsibilities
include taking executive responsibilities. This includes authority and
responsibility for planning, directing and controlling the activities of the
entity. Hence, independent directors are KMP under Ind AS 24.

ITFG may provide
appropriate guidance on this matter.

SECTION B: REVISED AS 10 ‘PROPERTY, PLANT & EQUIPMENT’ APPLICABLE FROM ACCOUNTING YEARS COMMENCING FROM 1ST APRIL 2016 ONWARDS FOLLOWED IN FY 2015-16

NHPC Ltd. (31-3-2016)

From Notes to Financial Statements

Note 29, para 15:

The Ministry of Corporate Affairs has notified revised AS-10,
“Property, Plant & Equipment” on 30.03.2016, to be applicable for
accounting periods commencing on or after that date. Para 9 of revised AS-10 permits
Unit of Measure Approach which allows capitalisation of expenditure of capital
nature incurred for creation of facilities, over which the company does not
have control but the creation of which is essential principally for
construction of the project.  Further,
the transitional provision in revised AS-10 allows retrospective capitalisation
of costs charged earlier to the statement of profit and loss but eligible to be
included as a part of the cost of a project for construction of property, plant
and equipment in accordance with the requirements of paragraph 9. The Unit of
Measure Approach also exists in Para 9 of Ind AS-16, “Property, Plant &
Equipment.” It strengthens the accounting policy no.2.3.4 on capital work in
progress. Had this policy not been adopted but implemented from 01.04.2016, the
para 88 of Revised AS-10 on transitional provision would automatically take
care of capitalisation of such expenditure. 
As such, significant accounting policy no.2.3.4 and consequential
accounting treatment of enabling assets as followed in FY 2014-15 has been
continued. Accordingly, an amount of Rs.176.21 crore (Previous year Rs.173.61
crore) has been included in Fixed Assets as Tangible Assets/CWIP.

From Auditors’ Report

Emphasis of Matters

We draw attention to the following matters in the Notes to
the financial statements:

a)    
to e) … not reproduced

f)

Auditor’s Comment tor’s
Comment

Management’s reply

 

Accounting policy no.2.3.4 On capital work in progress read with
note no. 29 Para 15 to the financial statements about the capital expenditure
incurred for creation of facilities over which the company does not have
control but the creation of which is essential principally for construction
of the project is charged to “expenditure attributable to construction (eac)”
as the same is in line with revised as-10 notified on 30.03.2016 As para 88
of the revised accounting standard which stated about transitional provision
that shall result into the same treatment.

Disclosure through note is a statement of fact.

 

DEEMED COST EXEMPTION ON FIXED ASSETS AND INTANGIBLES

Introduction

The application of the deemed cost
exemption to fixed assets and intangible assets has led to peculiar issues and
challenges. Let us first consider the wording of the exemption followed by the
clarifications provided by the Ind AS Transition Facilitation Group (ITFG).

Paragraph D7AA of Ind AS 101

D7AA – Where there is no change in
its functional currency on the date of transition to Ind ASs, a first-time
adopter to Ind ASs may elect to continue with the carrying value for all of its
property, plant and equipment as recognised in the financial statements as at
the date of transition to Ind ASs, measured as per the previous GAAP and use
that as its deemed cost as at the date of transition after making necessary
adjustments for decommissioning liabilities. If an entity avails the option, no
further adjustments to the deemed cost of the property, plant and equipment so
determined in the opening balance sheet shall be made for transition
adjustments that might arise from the application of other Ind ASs. This option
can also be availed for intangible assets covered by Ind AS 38, Intangible
Assets and investment property covered by Ind AS 40 Investment Property.

Salient features of the exemption

1.  The
entity can continue with the carrying amount under previous GAAP for all of its
fixed assets, investment property and intangible assets after making necessary
adjustment for decommissioning liabilities. The ITFG opined that if a first
time adopter chooses the D7AA option, then the option of applying this on
selective basis to some of the items of property, plant and equipment and using
fair value for others is not available.

2.  The exemption is
available to an entity only where there is no change in the functional currency
on the date of transition to Ind AS.

3.  No further adjustments to
the deemed cost so determined in the opening balance sheet shall be made for
transition adjustments that might arise from the application of other Ind ASs

4.  The exemption is an
additional option under Ind AS. An entity may choose not to use this option,
and instead use other first time adoption options. For example, in the case of
fixed assets, an entity may choose to:

a.  state retrospectively all
the fixed assets in accordance with Ind AS principles

b.  selectively choose to
fair value some fixed assets and use Ind AS principles for other fixed assets.

ITFG Clarification Bulletin 3 – Issue 9

The Company has chosen to continue
with the carrying value for all of its property, plant and equipment as recognised
in the financial statements as at the date of transition to Ind AS, measured as
per the previous GAAP. The Company has recorded capital spares in its previous
GAAP financial statements as a part of inventory, which under Ind AS would
qualify to be classified as fixed assets. Would such a reclassification be
required under Ind AS? Would such a reclassification taint the deemed
cost exemption?

As per paragraph D7AA, once the
company chooses previous GAAP as deemed cost as provided in paragraph D7AA of Ind
AS 101, it is not allowed to adjust the carrying value of property, plant and
equipment for any adjustments other than decommissioning costs. In this case, a
question arises whether the company may capitalise spares as a part of
property, plant and equipment on the date of transition to Ind AS. It may be
noted deemed cost exemption as the previous GAAP is in respect of carrying
value of property, plant and equipment capitalised under previous GAAP on the
date of transition to Ind AS. The ITFG opined that this condition does not
prevent a company to recognise an asset whose recognition is required by Ind AS
on the date of transition. The ITFG opined that the Company should recognise
‘capital spares’ if they meet definition of PPE as on the date of transition,
in addition to continuing carrying value of PPE as per paragraph D7AA of Ind AS
101.

ITFG Clarification Bulletin 5 – Issue 4

The Company has chosen to continue
with the carrying value for all of its property, plant and equipment as
recognised in the financial statements as at the date of transition to Ind AS,
measured as per the previous GAAP. The company has previously taken a loan for
construction of fixed assets and paid processing fee thereon. The entire
processing fees on the loan were upfront capitalised as part of the relevant
fixed assets as per the previous GAAP. The loan needs to be accounted for as
per amortised cost method in accordance with Ind AS 109, Financial
Instruments. Whether the Company is required to adjust the carrying amount
of fixed assets as per the previous GAAP to reflect accounting treatment of
processing fees as per Ind AS 109?

When the option of deemed cost
exemption is availed for property, plant and equipment under paragraph D7AA of
Ind AS 101, no further adjustments to the deemed cost of the property, plant
and equipment shall be made for transition adjustments that might arise from
the application of other Ind AS. Thus, once the entity avails the exemption
provided in paragraph D7AA, it will be carrying forward the previous GAAP
carrying amount.

Paragraph 10 of Ind AS 101, inter
alia, provides that Ind AS will be applied in measuring all recognised
assets and liabilities except for mandatory exceptions and voluntary exemptions
other Ind AS. Processing fees is required to be deducted from loan amount to
arrive at the amortised cost as per the requirements of Ind AS 109. In view of
this, with respect to property, plant and equipment, the company shall continue
the carrying amount of PPE as per previous GAAP on the date of transition to
Ind AS since it has availed the deemed cost option provided in paragraph D7AA
of Ind AS 101 for PPE. In the given case, the Company need to apply the
requirements of Ind AS 109 retrospectively for loans outstanding on the date of
transition to Ind AS at amortised cost. The ITFG opined that the adjustments
related to the outstanding loans to bring these in conformity with Ind AS 109
shall be recognised in the retained earnings on the date of transition. Consequently,
the carrying value of PPE as per previous GAAP cannot be adjusted to reflect
accounting treatment of processing fees.

ITFG Clarification Bulletin 5 – Issue 5 

The Company received government
grant to purchase a fixed asset prior to Ind AS transition date. The grant
received from the Government was deducted from the carrying amount of fixed
asset as permitted under previous GAAP, i.e. AS 12, Accounting for Government
Grants. The Company has chosen to continue with carrying value of property,
plant and equipment as per the previous GAAP as provided in paragraph D7AA of
Ind AS 101. As per Ind AS 20, Accounting for Government Grants and
Disclosure of Government Assistance, such a grant is required to be
accounted by setting up the grant as deferred income on the date of transition
and deducting the grant in arriving at the carrying amount of the asset is not
allowed.

In this situation, whether the
Company is required to add to the carrying amount of fixed assets as per
previous GAAP and reflect the addition as deferred income in accordance with
Ind AS 20?

The ITFG opined that when the
option of deemed cost exemption under paragraph D7AA is availed for property,
plant and equipment, no further adjustments to the deemed cost of the property,
plant and equipment shall be made for transition adjustments that might arise
from the application of other Ind AS. Accordingly, once an entity avails the
exemption provided in paragraph D7AA, it will have to be carry forward the
previous GAAP carrying amounts of PPE. Consequently, the company shall
recognise the asset related government grants outstanding on the transition
date as deferred income in accordance with the requirements of Ind AS 20, with
corresponding adjustment to retained earnings.

Salient feature of the ITFG responses

The ITFG has provided conflicting
responses. In the context of accounting for the government grants and
processing fees, the ITFG opined that the impact of accounting for government
grants and processing fees should be adjusted against retained earnings.
Consequently, the previous GAAP carrying amount of fixed assets should not be
tampered with in order to comply with the requirements of D7AA. On the other
hand, the ITFG in the context of reclassification between inventory and fixed
assets, opined that the reclassification was necessary, and that such
reclassification would not result in non-compliance of D7AA.

The author also feels that too much
focus has been put on complying with the technical requirement of D7AA rather
than on the substance and the spirit of the exemption. This has led to a very
absurd interpretation. For example, in the case of fixed asset related
government grants, the grant amount was deducted from fixed assets under Indian
GAAP. However, the ITFG requires an entity to ignore the same and recreate the
deferred income on grant by adjusting the retained earnings. In subsequent
years, the deferred income would be released to the P&L account under Ind
AS. This effectively means that the government grant gets accounted twice; once
under Indian GAAP by deducting the grant amount from fixed assets and again
under Ind AS through creation of deferred income on Ind AS transition date.
Similarly the ITFGs response in the case of processing fee results in its being
treated as borrowing cost twice – once under Indian GAAP and again under Ind
AS.

Practical issue not dealt with by ITFG

Whether D7AA exemption is available
to service concession arrangements (SCA)?

Paragraph D22 of Ind AS 101
requires an operator of SCA to apply SCA accounting retrospectively. If it is
not practical to apply SCA accounting retrospectively, then the operator may
use the previous GAAP carrying amounts as the carrying amount at that date.
Assuming that there is no change in functional currency, whether in addition to
the above exemption, D7AA option is available?

One argument is that since
paragraph D22 contains specific requirements for intangible assets recognised
in accordance with the standard, the transitional provisions in D22 will apply
to intangible assets arising under the SCA. For all other intangible assets,
exemption in paragraph D7AA may be used.

The second argument is that there
is nothing in paragraph D7AA to suggest that it does not apply to SCAs. Hence,
the company can apply exemption under paragraph D7AA to all intangible assets,
i.e., SCA related intangible assets as well as all other intangible assets
covered within the scope of Ind AS 38.

The application of second view will
give rise the following additional issues:

–  While the company continues the same carrying
amount as under previous GAAP, it will need to reclassify those amounts based
on requirements of Ind AS. For e.g., toll road classified as PPE under Indian
GAAP will be reclassified as intangible or financial asset, as applicable, at
the Indian GAAP carrying amount.

–   Accounting for premium payable by operator to
grantor (negative grant): Companies may have followed one of the following
treatment under Indian GAAP:

•    Certain companies have
created liability at undiscounted amount.

•    Certain companies have
not created liability for negative grant under Indian GAAP.

In both the above cases, the
related question would be when the financial liability amount is reflected as
per Ind AS 109, whether the corresponding adjustment should be made to retained
earnings or to the intangible asset. Some may even argue that the strict
requirements of D7AA means that no adjustment is made to the financial
liability amount and consequently the corresponding adjustment is also not
made.

Conclusion

There are numerous questions around
the practical application of D7AA. These issues were not probably conceived
when D7AA was hurriedly introduced in Ind AS 101. The drafting of D7AA has
resulted in numerous unanswered questions. The ITFG has also provided
conflicting guidance on the subject. Besides some of the recommendations, for
example, in the case of processing fees and government grant accounting are
counter-intuitive and are against the spirit and intention of the exemptions.
In light of the above, the author would recommend that a broader view may be
taken on this issue, and in light of the lack of clarity arising from a not so
clear drafting of D7AA, companies may be allowed more room for different
interpretations. _

Accounting for MAT

The Finance Bill 2017 sets out the requirement of determining how Ind AS will impact Minimum Alternate Tax (MAT) on first time adoption (FTA) and on an ongoing basis.  This article discusses a few issues with respect to MAT implications on FTA.

FINANCE BILL 2017 PROVISIONS ON MAT IMPACT ON FTA OF Ind-AS

The broad provisions are set out below:

1.    Ind AS adjustments in reserves/ retained earnings (RE) are included in 115 JB book profit equally over 5 years beginning from the year of Ind AS adoption, except:

–    Other Comprehensive Income (OCI) items recyclable to P&L are included in book profits, when those are recycled to P&L

–    Adjustments to capital reserve, securities premium and equity component of compound financial instruments are excluded from book profit

–    Use of fair value as deemed cost exemption for PPE/ Intangible Asset will be MAT neutral
•    To be ignored for computing book profit
•    Depreciation is computed ignoring the amount of fair value adjustment
•    Gains/ losses on transfer/realisation/disposal/ retirement are computed ignoring fair value adjustment (as per Memorandum to the Finance Bill)

–    Gains/losses on investments in equity instruments classified as fair value through other comprehensive income (FVTOCI) will be included in
book profit on realisation/disposal/transfer of
investment
–    Use of fair value as deemed cost exemption for investments in subsidiaries, associates and joint ventures will be MAT neutral. Gains/ losses to be included in book profit on realisation/disposal/ transfer of investment

–    Use of option to make Indian GAAP Foreign Currency Translation Reserve (FCTR) Zero will be MAT neutral
•    To be included in book profit at the time of disposal of foreign operation.

2.    FTA adjustments made at transition date (TD) are trued up for any changes upto the end of the comparative year. For example, for a phase 1 Company the TD will be 1 April 2015. The FTA adjustments on 1st April 2015 will be trued up for any changes upto the end of the comparative year end, i.e., 31st March 2016. This is illustrated below.

3.    Consider a company that has only one adjustment at TD. The investments in mutual fund were measured at cost less impairment (assume INR 100) on an ongoing basis under Indian GAAP. On TD the company will have to measure the investments in mutual funds at fair value (assume INR 180). At 1st April, 2015, the company has included the fair value uplift INR 80 in RE. At 31st March, 2016, the fair value of the mutual fund was INR 240. For purposes of section 115 JB book profits, the company will include INR 28 each year for the next 5 years (INR 140 in aggregate), starting from the financial year 2016-17.

MAT IMPACT ON FTA OF Ind-AS
On the TD to Ind AS, the company makes adjustments to align Indian GAAP accounting policies with Ind AS. The impact of these items may end up in different adjustments being made. An asset or liability is recorded or derecognised or measured differently and the corresponding impact is directly adjusted in either:
(a)    RE or reserves
(b)    Another asset or liability
(c)    OCI
(d)    Capital reserve
(e)    Equity

(I)    Corresponding Adjustment made to RE or Reserves
Some examples of adjustment in this category and the corresponding impact on MAT are as follows:

Adjustments

Impact on MAT

Property, Plant
and Equipment (PPE) or Intangible Assets is fair valued on TD, as the new
deemed cost under Ind AS.  The
corresponding impact is recorded in RE on the TD

This is MAT
neutral.

Investment in
subsidiaries, associates and joint ventures is fair valued on TD, as the new
deemed cost under Ind AS.  The
corresponding impact is recorded in RE on the TD

This is MAT
neutral.

The amount of
deferred tax asset or liability (DTA/DTL) is changed due to TD adjustments of
various assets and liabilities. The corresponding debit or credit impact is
recorded in RE on the TD

While the
Memorandum to Finance Bill states that it should be MAT neutral, the text of
the Finance Bill 2017 does not contain any such clause.
Hence, based on the text of the Finance Bill 2017, one may argue that for
purposes of determining book profits the debit or credit adjustment in RE
after true-up impact will be recognized over 5 years.

Receivables are
provided for based on Expected Credit Loss (ECL). The corresponding debit
impact is recorded in RE on the TD

For purposes of
determining book profits the debit adjustment in RE after true-up impact will
be recognized over 5 years.

Fair value gains
on derivative assets were not recognized under Indian GAAP.  On TD a derivative asset is created with a
corresponding impact on RE

For purposes of
determining book profits the credit adjustment in RE after true-up impact
will be recognized over 5 years.

With respect to
Service Concession Arrangements, the Intangible assets were recorded at cost
under Indian GAAP.  Under Ind AS these
are recorded at fair value (cost plus margin).  On TD, the amount of Intangible Assets will
be increased with a corresponding impact on RE.

For purposes of
determining book profits the credit adjustment in RE after true-up impact
will be recognized over 5 years.

Under Indian
GAAP, Investments in mutual fund is measured at cost.  Under Ind AS at each reporting date it is
fair valued with gains/losses recognized in the P&L account. On TD, the
amount of Investments will be increased or decreased for fair value gains/losses
with a corresponding impact on RE.

For purposes of
determining book profits the credit or debit adjustment in RE after true-up
impact will be recognized over 5 years.

(II)   Corresponding Adjustment made to another
Asset or Liability

Some examples of adjustment in this category and the corresponding
impact on MAT are as follows:

Adjustments

Impact on MAT

(a)   A
day before the TD the parent issues to a bank a financial guarantee (FG) on
behalf of its subsidiary.  The parent
will not cross charge the subsidiary for the FG.  On TD the parent will record a FG liability
(INR 100) and a corresponding investment in the subsidiary.

(b)   Indian
GAAP book value of investment is INR 250. 
The Company uses fair value of INR 400 as deemed cost on TD.  The investment is sold after four years at
INR 700.

(a)   No
Impact on MAT since an asset and a liability is recorded with no
corresponding impact on RE or reserves. However, true-up impact will have to
be adjusted.

(b)   The
fair value uplift of INR 50 (400-(250+100)) is MAT neutral.  When the investment is sold, the profit of
INR 300 (700-400) + the fair value uplift INR 50, will be included in book
profits for MAT purposes.

 

(a)   Two
years before the TD the parent issues to a bank a FG on behalf of its
subsidiary for a 5 year period.  The
parent will not cross charge the subsidiary for the FG.  Under Ind AS, on the date of issue of the
FG the parent will record a FG liability and a corresponding investment in
the subsidiary.  Assuming the
subsidiary is financially capable and the bank does not have to invoke the
FG, the FG would be amortized over a 5 year period with a corresponding
credit to the profit and loss.  On TD,
the FG would be amortized for a two year period with a corresponding credit
to RE.

(b)   Indian
GAAP investment value is INR 100. 
Assume the FG liability on initial recognition is INR 20, and that the
entity uses previous GAAP carrying value (INR 100) on TD for investment.

(a)   For
purposes of determining book profits u/s 115 JB the credit adjustment in RE
on account of FG amortization after true-up impact will be recognized over 5
years.

(b)   With
respect to investment, for purposes of determining book profit u/s 115 JB, RE
will be debited by INR 20 which after true up impact will be recognized over
5 years

 

A day before the
TD the entity enters into a long term service arrangement, which has an
embedded lease.  The entity is a lessee
and lease is finance lease.  On TD the
entity will record an asset and a corresponding lease liability of equal
amount.

No Impact on MAT
since an asset and a liability is recorded with no corresponding impact on RE
or reserves. However, true-up impact during the comparative period will be
recognized over 5 years.

Two years before the TD the lessee entity enters into a 30 year long
term service arrangement, which has an embedded lease. The entity is a lessee
and lease is finance lease.   Under Ind
AS the entity will record an asset and a corresponding lease liability of
equal amount on the date of entering into a lease arrangement. On TD the
amount of asset and lease liability recognized would not be equal because the
asset depreciation and the loan amortization will happen at different
amounts.  Therefore on TD, there would
be a debit or credit adjustment to RE.

For purposes of
determining book profits u/s 115 JB the debit or credit adjustment in RE
after true-up impact will be recognized over 5 years.

(III) Corresponding Adjustment made to OCI

Adjustments

Impact on MAT

The entity
applies hedge accounting under Indian GAAP, which is fully aligned with the
Ind AS principles.  On that basis it
has recorded a cash flow hedge reserve in OCI.  Under Ind AS it will continue with the
hedge accounting, therefore, the cash flow hedge reserve recorded under
Indian GAAP will be continued as it is.

This is MAT
neutral, i.e, the consequences under Indian GAAP and Ind AS will be the
same.  The cash flow hedge reserve will
be included in book profits u/s. 115 JB as and when the hedge reserve is
recycled to the P&L account.

Adjustments

Impact on MAT

The Company has a
foreign branch.  It recognizes a FCTR
on translation of foreign branch.  The
Company chooses the FTA option of restating the FCTR to zero under Ind AS.  Subsequently the FCTR is accumulated afresh

This is MAT
neutral, i.e, the consequences under Indian GAAP and Ind AS will be the
same.  The Indian GAAP FCTR and the
fresh accumulated Ind AS FCTR is recognized when the branch is finally
disposed off.

Adjustments

Impact on MAT

The entity
applies hedge accounting under Indian GAAP, which is fully aligned with the
Ind AS principles.  On that basis it
has recorded a cash flow hedge reserve in OCI.  Under Ind AS it will continue with the
hedge accounting, therefore, the cash flow hedge reserve recorded under
Indian GAAP will be continued as it is.

This is MAT
neutral, i.e, the consequences under Indian GAAP and Ind AS will be the
same.  The cash flow hedge reserve will
be included in book profits u/s. 115 JB as and when the hedge reserve is
recycled to the P&L account.

Adjustments

Impact on MAT

The Company has a
foreign branch.  It recognizes a FCTR
on translation of foreign branch.  The
Company chooses the FTA option of restating the FCTR to zero under Ind AS.  Subsequently the FCTR is accumulated afresh

This is MAT
neutral, i.e, the consequences under Indian GAAP and Ind AS will be the
same.  The Indian GAAP FCTR and the
fresh accumulated Ind AS FCTR is recognized when the branch is finally
disposed off.

(IV) Corresponding Adjustment made to Capital
Reserves

Adjustments

Impact on MAT

Prior to the TD
the Company has applied acquisition accounting for a common control
transaction.  The consideration paid
was lower than the fair value of assets and liabilities taken over.  The difference was recorded as capital
reserves. The Company chooses to restate the accounting of the common control
transaction on the TD in accordance with Ind AS 103.  Under Ind AS the assets and liabilities in
a common control transaction are recorded at book value, and the excess of
book values over the consideration is recorded as capital reserves.  Whilst in both Indian GAAP and Ind AS, a
capital reserve is recorded, the amount of capital reserve recognized is
different.

Any adjustment to
capital reserves is MAT neutral.

Prior to the TD
the Company has applied acquisition accounting for a common control
transaction and recognized goodwill in accordance with Indian GAAP.  The Company chooses to restate the
accounting of the common control transaction on the TD in accordance with Ind
AS 103.  Under Ind AS common control
transaction does not lead to recognition of goodwill.  The said amount is adjusted against RE.

For purposes of
determining book profits u/s. 115 JB the debit adjustment in RE will be
recognized over 5 years.

(V)   Corresponding Adjustment made to Equity

Adjustments

Impact on MAT

A day prior to
the TD the Company has issued a compound financial instrument that is
classified as liability under Indian GAAP. 
On TD under Ind AS, the Company does split accounting and records the
instrument partly as a liability and partly an equity.  The equity represents the option under the
instrument to convert to shares at a future date and at a fixed predetermined
ratio.

Equity component
of compound financial instruments is MAT neutral.

Two
years prior to the TD the Company has issued a compound financial instrument
that is classified as liability under Indian GAAP.  On TD under Ind AS, the Company does split
accounting and records the instrument as a liability and an equity amount. 

The
equity component is MAT neutral. 
However, subsequent to the issue of the compound financial instrument,
the liability would have under gone a change under Ind AS due to the
amortization effect. RE would be debited to the extent of the amortization
for the two year period prior to TD. 

Adjustments

Impact on MAT

The equity
represents the option under the instrument to convert to shares at the end of
5 years at a fixed predetermined ratio.

The debit
adjustment to the RE after true-up impact, would be allocated over 5 years
for the purposes of determining book profits u/s 115 JB.

       QUESTION
As explained above, the Finance Bill 2017 requires FTA adjustments in specific cases to be included in determining book profits under section 115 JB over a period of 5 years.  For such adjustments that are not MAT neutral and have a MAT impact over a period of 5 years, would a provision for MAT liability or a credit for MAT asset be required on TD under Ind AS 12 Income Taxes?

RESPONSE
As a first step a company determines it’s income tax liability based on normal income tax provisions.  However, this is subject to the provisions of section 115 JB of the Income tax Act, which requires a company to pay atleast a minimum tax on the basis of the book profits as determined under Indian GAAP or Ind AS as applicable.  If a company pays higher tax during any financial year due to applicability of MAT, the excess tax paid is carried forward for offset against tax payable in future years when the company will be paying normal income tax.

As per the current Income-tax Act, the MAT credit can be carried forward for set-off for ten succeeding assessment years from the year in which MAT credit becomes allowable. The Finance Bill 2017 proposes that credit in respect of MAT paid u/s. 115JB can be carried forward upto fifteen succeeding assessment years.  MAT is an additional tax payable to authorities based on the comparison of book profit and taxable profit for the year, albeit the company may be required to make certain adjustments (additions or deductions) to accounting profit for arriving at the 115 JB book profit.

For accounting purposes, the author believes that a MAT provision or a MAT asset should not be created on TD adjustments for the following reasons:

–    The trigger for MAT is a higher book profit compared to a lower income computed under normal income tax computation provisions.  The relationship between future book profits and income computed under normal income tax provisions will determine the MAT in future periods.  Therefore MAT is like a current tax liability/asset that is accounted in each year.  The possibility of the future book profits being higher or lower due to TD adjustments, is not a relevant factor for creating a MAT liability or MAT asset for TD adjustments.  In other words, MAT is a current tax based on book profits in each year, and the liability for MAT arises only once the financial year commences.  MAT is not triggered by FTA adjustments, though those are taken into consideration for determining MAT book profits for the relevant year.

–    Absent tax holidays and few tax exempt income/ expenses, differences between the normal tax and the MAT are primarily due to deductible and taxable temporary differences. Those temporary differences result in deferred taxes being recognized on the basis that they will eventually reverse subject to application of prudence for recognition of DTA. Thus, the MAT is effectively a mechanism to bridge/ reduce gap between the carrying amount and tax base of assets and liabilities. On its own the MAT does not create any new differences. Since Ind AS 12 requires an entity to recognise DTA/ DTL for temporary differences between the carrying amount and tax base of assets and liabilities, it may be argued that MAT itself should not result in recognition of any new/ additional DTA/ DTL.  Else, it may be tantamount to double counting.  This is explained with the help of a small example.

EXAMPLE
The Company enjoys an accelerated depreciation under the Income-tax provisions, but charges lower depreciation for accounting purposes.  This has resulted in the Company being subjected to MAT.  The Company has created a DTL for the accelerated depreciation at normal income tax rates.  The Company also records a MAT liability in the financial year.

On TD the Company records the fixed assets at Indian GAAP carrying value and also creates a provision for decommissioning liability of INR 100 with a corresponding adjustment to RE.  For 115 JB book profits the RE adjustment will be spread over 5 years.

As a result of recording the decommissioning liability in Ind AS, the DTL amount will also correspondingly reduce on TD.  It would be inappropriate to record a MAT asset on TD, for the RE credit of INR 100, since that would tantamount to double counting.

MAT is effectively a mechanism to bridge/ reduce gap between the carrying amount and tax base of assets and liabilities. On its own the MAT does not create any new differences. Since Ind AS 12 requires an entity to recognise DTA/ DTL for temporary differences between the carrying amount and tax base of assets and liabilities, it may be argued that MAT itself should not result in recognition of any new/ additional DTA/ DTL

Considering the above arguments, MAT payment is only an event of the relevant period, viz., the period during which MAT obligation arises under the Income-tax Act. Hence, it should be recognised in the relevant period and no upfront DTA/ DTL should be created towards amount to be adjusted in book profit of future years.  The ICAI may issue appropriate guidance on the matter.

Treatment of Capital Expenditure on Assets Not Owned by the Company

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Sometimes, circumstances force an entity to incur capital expenditure which is not represented by any specific or tangible assets. For example, an entity may agree with a local authority to pay the cost or part of the cost of roads to be built by the authority. In this case also, the roads will remain the property of the Municipal body. Whether such expenditure should be capitalised or not, is a matter of debate and the solution will depend on facts and circumstances of each case. Consider two scenario’s as given below. The discussion is based on Indian GAAP, but would be equally relevant for Ind-AS purposes as well.

Scenario 1
The Company had to incur expenditure on the construction/ development of certain assets, like electricity transmission lines, railway sidings, roads, culverts, bridges, etc. (hereinafter referred to as enabling assets) for setting up a new refinery. This was required in order to facilitate construction of project and subsequently to facilitate its operations. The ownership of these enabling assets does not vest with the company. The moot question is whether such expenditure can be capitalised or has to be charged to the profit and loss account immediately. This question was raised in 2011 with the Expert Advisory Committee (EAC), and its view and the basis of conclusion was as follows:

View of EAC along with the basis of conclusion [published in CA Journal January 2011]

The expenditure on enabling assets should be expensed by way of charge to the profit and loss account of the period in which the same is incurred. As per the Committee, an expenditure incurred by an enterprise can be recognised as an asset only if it is a resource controlled by an enterprise. For example, the entity having control of an asset can exchange it for other assets, employ it to produce goods or services, charge a price for others to use it, use it to settle liabilities, hold it, or distribute it to owners.

Further, an indicator of control of an item of fixed asset would be that the entity can restrict the access of others to the benefits derived from that asset. In the given case the entity does not have control over the enabling assets and should therefore charge the same as an expense in the profit and loss account.

Author’s comments

In the author’s view, there is sufficient justification in existing literature to support capitalisation of the enabling assets as part of the overall cost of the refinery. This is discussed below.

As per paragraph 9.1 of AS-10, “The cost of an item of fixed asset comprises its purchase price, including import duties and other non-refundable taxes or levies and any directly attributable cost of bringing the asset to its working condition for its intended use; any trade discounts and rebates are deducted in arriving at the purchase price. Examples of directly attributable costs are: (a) site preparation; (b) initial delivery and handling costs; (c) installation cost, such as special foundations for plant; and (d) professional fees, for example fees of architects and engineers. Further paragraph 10.1 states, “Included in the gross book value are costs of construction that relate directly to the specific asset and costs that are attributable to the construction activity in general and can be allocated to the specific asset.”

Paragraph 8 of AS-16 states, “The borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset are those borrowing costs that would have been avoided if the expenditure on the qualifying asset had not been made. When an enterprise borrows funds specifically for the purpose of obtaining a particular qualifying asset, the borrowing costs that directly relate to that qualifying asset can be readily identified.” In the given case, the costs incurred on the enabling assets is directly related to the construction of the refinery. The expenses on the enabling assets are required solely for the purpose of bringing the refinery to its working condition for its intended use. For example, without the electricity transmission lines, the refinery will not be ready for its intended purpose.

Interestingly, the EAC [Volume 24 – Query no. 9] had dealt with a similar issue in 2004 with regards to the expenditure incurred on the catchment area of a hydroelectric power project. In the said matter, a dam was being constructed across a river for the purpose of creation of a reservoir so that water is stored and used for the purpose of generating electricity. The reservoir is dependent upon the catchment area for water. Continuous soil erosion results in sedimentation, and reduces the capacity of the reservoir and efficiency of the project (emphasised). Substantial expenditure was incurred towards extensive catchment area treatment measures. In the said matter, EAC opined that the expenditure on the catchment area treatment is capitalised with the cost of the dam. For determining which expenditure is directly attributable to bring the asset to its working condition for its intended use, factors such as whether the concerned expenditure directly benefits or is related to that asset may be considered. In other words, there has to be some nexus between the expenditure and the benefit/relationship with the asset.

The ‘unit of account’ (should not be confused with component accounting) concept is another interesting concept in accounting. Under this concept, it would be argued that what is being constructed is the refinery, and not the roads, culverts, etc. which are all required to construct the refinery. The enabling assets are required not for their own individual purposes but for the purposes of the refinery. The expenditure on the enabling assets is required as part of the cost of constructing the refinery. Therefore the entire project cost including those incurred on the enabling assets will be captured as cost of constructing the refinery. Once that is done, the refinery itself will be bifurcated into various components, so that component accounting can be applied.

In the EAC opinion it is argued that, the entity having control of an asset can exchange it for other assets, employ it to produce goods or services, charge a price for others to use it, use it to settle liabilities, hold it, or distribute it to owners. Further, an indicator of control of an item of fixed asset would be that the entity can restrict the access of others to the benefits derived from that asset. Unfortunately, the argument presupposes the refinery and enabling assets as separate unit of accounts (should not be confused with component accounting). In the author’s view, the unit of account or the asset under construction is the refinery (and not the enabling assets), and all the costs (including on the enabling assets) are related to constructing the refinery. The entity has control over the refinery and restrict the access of others to the benefits derived from the refinery. Thus by looking at the refinery as the unit of account, it is argued that all expenses directly related to constructing the refinery (including costs on enabling assets) should be capitalised.

The EAC opinion will have significant implications for a lot of companies that are in the process of constructing huge projects. In light of the various submissions above, the EAC may reconsider its position. The author is aware that this gap is likely to be plugged in the revised AS 10 under Indian GAAP.

Scenario 2
A mining company has to transport coal through road transport to the nearest railway siding which is around 40 k.m. away from the mines. The existing two lane road is also extensively used by local villagers causing inconvenience, traffic jams and accidents due to which blockage of roads and delay in delivery is a common phenomena. Hence, there was a business necessity and compulsion to widen this road to liquidate the coal stock and to maintain continuity of production. To find a solution to the management problem of transporting the coal, the company widened the two lane road to four lane. The road belongs to and is owned by the State Government. The question is whether expenses incurred for widening of two lanes road to four lanes which is not owned by the company can be recognised as intangible asset.

The appropriate standard would be AS 26 Intangible Assets. As per paragraph 14 of AS 26, an enterprise controls an asset if the enterprise has the power to obtain the future economic benefits flowing from the underlying resource and also can restrict the access of others to those benefits. From the facts of the case neither the land to be acquired for widening the road nor the road will be the property of the company. These will remain the property of the State Government. Further, it is noted that the nearby villagers will also be beneficiaries. From this, it appears that although the work of widening the road will facilitate unrestricted movement of coal for the company, the company does not enjoy control in terms of restriction of access of others to the benefits arising from the widened road facility. Therefore, one may argue that the ex penditure incurred on widening and construction of road on the land which is not owned by the company does not meet the definitions of the terms ‘asset’ and ‘intangible asset’. Accordingly, some may argue that such expenditure cannot be capitalised as an intangible asset.

However the author believes, similar to Scenario 1, the unit of account is not the road but the mine. Hence the above argument of control is not a valid argument. Nonetheless, this fact pattern is different from the one in Scenario 1. In Scenario 1, the expenditure was incurred for and incidental to the construction of an asset (the refinery). The company controls the refinery and hence the capital expenditure including the incidental expenditure incurred for construction should be capitalised as cost of refinery. In Scenario 2, no new asset is created and the expenditure incurred on widening the lane is with respect to an already functioning mine. Paragraph 60 of AS 26 is relevant here, which states “Subsequent expenditure on a recognised intangible asset is recognised as an expense if the expenditure is required to maintain the asset at its originally assessed standard of performance.” This is a matter of judgement. The company should carefully evaluate whether the expenditure incurred on widening the road has increased the originally assessed standard of performance of the mine. If for example, substantially more coal can be produced and transported, because transportation bottlenecks have been removed, one may argue that the originally assessed standard of performance of the mine is increased, and therefore the cost of widening the road will be capitalised as an intangible asset. One will have to make this assessment very carefully.

INTERNAL FINANCIAL CONTROLS – COMMON MISCONCEPTIONS

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Introduction
In a paradigm shift, Section 143(3)(i) of the Companies Act, 2013 (“the Act”), has for the first time introduced the requirement of reporting by the statutory auditors on, whether the Company has an adequate internal financial controls system in place and the operating effectiveness of such controls. This requirement, which was optional for the financial years beginning 1st April, 2014, is mandatory for the financial years beginning 1st April, 2015.

The reporting requirements are modelled on the lines of the SOX requirements for US listed entities, which were notified by the Securities and Exchange Commission of the USA in June 2003. The trigger for the introduction of the same were various corporate scandals like Enron, Worldcom, Parmalat etc. Similarly in June 2006, the Financial Instruments and Exchange Act (J-SOX) was passed by Diet, which is the Japanese Parliament/ National Legislature. In the United Kingdom, the UK Corporate Governance Code specified the matters which the Boards of listed companies have to comply with, which inter alia includes matters relating to oversight and review of internal controls in the Company. Just as the various corporate scandals like Enron prompted the introduction of the SOX requirements, the Satyam saga which unfolded in January 2009 has been the prime driver for the introduction of the reporting requirements on Internal Controls over Financial Reporting in India.

The reporting by auditors on internal controls is not entirely new for auditors in India. As all of you would be aware, the auditors in the course of their reporting under CARO 2003 and CARO 2015 were required to report on whether the Company has an adequate internal control system which is commensurate with the size of the Company and the nature of its activities in respect of purchase of inventory and fixed assets and sale of goods and services and whether there is a continuing failure to correct major weaknesses in respect thereof. Thus, the scope of reporting which is envisaged under the Act ,is substantially larger than what was required under CARO 2003 and 2015, which is limited to reporting on the adequacy of internal controls on specific matters. Further, Clause 49 of the Equity Listing Agreement, which has now been substituted by the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 requires an evaluation by listed companies of the internal financial controls and risk management systems by the Board and also a specific assertion by the CEO and CFO that they accept responsibility for establishing and maintaining internal controls for financial reporting and the operating effectiveness thereof. Accordingly, the scope and objectives of Internal Financial Control and the reporting thereof has increased substantially for all classes of companies, which brings along with it various misconceptions and myths in the minds of both the management and the auditors.

Before discussing certain common misconceptions with regard to the reporting on Internal Financial Controls, both from the point of view of both the Management and the Auditors, it would be pertinent to examine the statutory provisions dealing with Internal Financial Controls and Internal Financial Control System from the point of view of the management and the auditors.

Statutory Provisions
The statutory provisions emanate from the Act, and place separate responsibilities on the Management and Statutory Auditors, which are discussed hereunder.

Management’s Responsibility
The Management’s responsibility towards Internal Financial Controls can be examined separately with respect to the following stakeholders:

• Board of Directors
• Audit Committee
• Independent Directors

The statutory provisions in the context of each of the above are analysed hereunder:

Board of Directors
Section 134(5)(e) of the Act requires the Director’s Responsibility Statement in case of a Listed Company, to state whether the Company has laid down internal financial controls[IFC] and whether the same are adequate and operating effectively. It may be noted that listed companies would also cover those where only the debt securities are listed.

Further, explanation to Section134(5)(e) defines IFC as the policies and procedures adopted by the Company for ensuring orderly and efficient conduct of its business including adherence to company’s policies, the safeguarding of assets, the prevention and detection of frauds and errors, accuracy and completeness of the accounting records and timely preparation of reliable financial information.The aforesaid definition encompasses both operational and financial reporting controls, and is much broader in scope than internal financial control systems.

Further, Rule 8(5)(viii) of the Companies (Accounts) Rules, 2014 requires the Board Report of all companies to state the details in respect of the adequacy of internal financial controls with reference to the financial statements.This requirement is much more restricted as compared to that for listed companies since it covers only the controls impacting financial statements and also does not cover the operating adequacy thereof.

Audit Committee
Section177(4) requires that the terms of reference of every Audit Committee shall include an evaluation of the Internal Financial Controls and Risk Management Systems.

Independent Directors
The Code of Independent Directors under Schedule IV emphasises that Independent Directors have to satisfy themselves about the integrity of the financial reporting system and on the strength of financial controls and risk management systems

Misconceptions on the part of Management

There is a common misconception on the part of the Management in many cases, as to whether there is anything new which has cropped up as a result of the aforesaid reporting responsibilities which are specified under the Act and whether anything has really changed?

In this context, two common questions are normally asked, as under:

a) The first question which top managements including CEOs ask is, whether anything has changed and are we saying that the entity did not have controls earlier?

b) Further, as an off shoot of the above, the second question which is asked is, were not the auditors checking and reporting on controls earlier?

More often than not, these questions need to be answered by the auditors (both internal and external) and/or other external consultants.

The answer to the first question is not very direct or simple, and depends upon a variety of factors including the size and complexity of the entity, the nature and extent of existing documentation which is available, the management philosophy and operating style etc., since the fundamental foundation of an Internal Financial Control system is the existence of a documented framework. For the purpose of explaining to the top management including the CEO, an assessment needs to be done in respect of the following matters or should we say ground realities!), amongst others, as deemed necessary:

Is the Code of Conduct documented and even if so, whether the same is communicated.

Are Board meetings actually held or are minutes written just to cover the required agenda matters.

Is quality time spent by the Board on important/critical matters having a material impact on the risk.

The Audit Committee does not allot sufficient time to discuss the interim results or Internal Audit Reports.

The Company has a turnover of over Rs. 500 crore, but does not have a qualified CA in its Accounts/Finance Department.

The Organisational structure is not formalised even though the Company has 500 employees and the job profiles are not documented/reviewed periodically.

Though there is a documented Risk Management Framework and SOPs, the same operate on a standalone basis and the actual activities are conducted based on neither of them. Further, the control points/ activities may not be specifically documented therein. Also, policies and procedures and/or authority levels/ matrices remain undocumented for many key areas/ operations/processes.

The ERP/IT system is changed/modified regularly without proper justification/UATs and no IT system audit has been undertaken for the past several years. Also, the Company uses a Tally package, even though it has multi-locational activities which involve processing of numerous transactions at various points of data entry, which are also modified/changed without proper oversight.

The process of generating MIS is not robust and is based on incomplete data.

Policies and procedures for period end closure of financial statements are not adequately documented, especially in case of multi-location/multiple activity entities and for preparation of consolidated financial statements. Also, unusual events/transactions are not captured, escalated or approved appropriately.

The information/communication system is not adequate /deficient resulting in non-escalation of problems from the lower levels to the middle/top management, lack of open communication, ineffective whistle blower mechanism etc.

Lack of documented controls over preparation and generation of spreadsheets.

An adverse answer to any one or more of the above matters, based on either a Self-Assessment / introspection by the top management or by an external party, would prima-facie indicate lack of or absence of internal controls depending upon the nature, severity, criticality and materiality of the deficiency/deviation which in turn would need to be factored in whilst discharging the statutory reporting responsibilities in the Board Report under the Act as discussed earlier, and could also result in an adverse opinion on ICFR by the statutory auditors under the Act. Accordingly, there should be a comprehensive introspection on the part of the Management with regard to the existence and documentation of Internal Financial controls.

With regard to the second question regarding the change in the responsibility of the statutory auditors vis-à-vis controls, as discussed earlier, the reporting responsibility has broadened/widened. Further, upto last year, the auditors could adopt a non-reliance on controls strategy, by performing more extensive and focussed substantive testing and accordingly opine on the truth and fairness of the financial statements, even if adequate internal controls were not prevelant or documented.

To conclude in one sentence, what the top Management requires is a cultural change rather than a compliance change!

Auditors’ Responsibilities
As discussed above, the auditors responsibility to report in terms of section 143(3)(i) covers all companies. Further, consistent with global practices and based on the Guidance Note issued by the ICAI, internal financial controls as referred to above only relates to Internal Financial Controls over Financial Reporting (‘ICFR’) and thus auditors reporting on Internal Financial Controls is only in the context of the audit of the financial statements.

The following are certain matters which are relevant in this regard:

The definition IFC as per explanation to section 134(5)(e) above is relevant only on the context of the reporting under the same and is not relevant for the reporting u/s. 143(3(i) by the auditor.

Unlisted companies are not required to affirm the operating effectiveness of controls, whereas the auditor is required to report on the adequacy and operating effectiveness of all companies. This would present greater challenges to the auditor in respect of unlisted companies.

Misconceptions/Myths in the Minds of auditors
Whilst discharging their attest responsibilities with regard to reporting on ICFR, the auditors should be aware of certain common and practical misconceptions, which are discussed hereunder.

Concept of Control and Process
Wikipedia defines Control, or controlling, “is one of the managerial functions like planning, organizing, staffing and directing. It is an important function because it helps to check the errors and to take the corrective action so that deviation from standards are minimized and stated goals of the organisation are achieved in a desired manner.

According to modern concepts, control is a foreseeing action whereas earlier concept of control was used only when errors were detected. Control in management means setting standards, measuring actual performance and taking corrective actions.”

Henri Fayol, a French Mining Engineer who had developed a general theory of business administration which was popularly referred to as Fayolism, formulated one of the first definitions of control as it pertains to management as under:

“Control of an undertaking consists of seeing that everything is being carried out in accordance with the plan which has been adopted, the orders which have been given, and the principles which have been laid down. Its object is to point out mistakes in order that they may be rectified and prevented from recurring”.

According to E. F. L. Brech, who was a British Management consultant and an author of several management books, “control is checking current performance against predetermined standards contained in the plans, with a view to ensure adequate progress and satisfactory performance”.

According to Harold Koontz, an American organisational theorist, professor of business management at the University of California, Los Angeles and a consultant for many of America’s largest business organisations, “Controlling is the measurement and correction of performance in order to make sure that enterprise objectives and the plans devised to attain them are accomplished”.

Some of the common characteristics which emerge from the above definitions are summarised hereunder:

Control is a continuous process
Control is a management process
Control is embedded in each level of organisational hierarchy
Control is closely linked with planning
Control is a tool for achieving organisational activities
Control is an end process
Control compares actual performance with planned performance
Control points out errors in the execution process
Control helps in achieving standards of performance.

From the point of view of ICFR, the term control is often used synonymously with the term process, which is a misconception. Both these terms are different even though they may be inter-connected, since one of the characteristics of controls is evaluating the adequacy of or monitoring of the processes within an entity. Process describes the action of taking a transaction or event through an established and usually routine set of procedures, whereas a control is an action or an activity taken to prevent or detect misstatements within the process.

It would be relevant at this stage to understand the difference between process and control, with the help of a few examples.

Some of the important points which are relevant based on the above examples, are discussed hereunder:

a) The distinction between a process or a control is more important in case of predominantly manual activities.

b) In case of activities/processes performed in a predominantly IT environment, a lot of the controls are automated and may not always be visible but get evidenced by exception reports/logs/audit trails. Whilst in such cases the review of IT general and application controls by an IT specialist would give an assurance on the operating effectiveness, these by itself may not always be adequate and may need to be supplemented by high level review controls.

c) In many entities, the control activities indicated above may be actually performed but not specifically documented in the SOPS, flow charts, policy manuals, authority matrix etc. This could be one of the common misconceptions on the part of the top management, who already assume that controls are prevalent and nothing has changed. In such cases, it is important for the auditors and/or other external consultants to advise the Management to document the existing controls as well identify controls for processes or activities where none

Key Factors for Identifying Controls (5WH analysis)

The key factors to assist in identifying controls and differentiating the same from a process can be summarised as the 5WH analysis, which can be explained by considering the following questions, all of which should normally be present for an activity/process to be considered as a control.

Information Produced by the Entity (IPE)
Though the term IPE is referred to in the auditing standards (primarily SA-315 dealing with Risk Assessment and SA- 500 dealing with Audit Evidence), there is no precise definition given therein.

IPE is primarily used by auditors as a source of evidence both for control testing, which includes ICFR as well as substantive testing. Hence, it is important to understand the nature thereof.

IPE is basically in the form of various reports which are generated either through the system or manually or in combination. They may take different forms as under:

Used by the entity – These are used by the entity in performing the relevant controls. These normally take one or more of the following forms:

– Standard “out of the box” or default reports or templates with or without configuration e.g. debtors ageing report

– Custom developed reports which are not a part of the standard application but which are defined and generated by user operated tools like scripts, report writers, query tools etc. e.g. sales by region

– Outputs from end user applications

– Analysis, schedules, spreadsheets etc. which are manually prepared from system generated information or from other internal or external sources.

A lot of information/IPEs may be generated by the Management for its own use all of which may not be relevant and used as audit evidence.

Used by/relevant for the auditor – The IPE which can be used by/relevant for the auditors can be in either of the following forms:

– used by the entity when performing relevant controls

– used by the auditor when testing operating effectiveness of ICFR and substantive testing

It is of utmost importance to test of the accuracy and completeness of the data generated through the IPE. This is a common short coming which needs to be remedied.

The elements of IPE which are relevant from the auditor’s point of view are as follows:

– Source Data which represents information from which the IPE is generated and which can be system generated or manual.

– Report Logic which represents the computer code, algorithms, formulae, query parameters etc.

– Report Parameters which define the report structure, filtering of data, connecting of related reports.

The following considerations govern the testing of the accuracy and completeness of the data generated by IPEs:

– Not all data is captured
– Data is incorrectly input
– Report logic is incorrect
– Inappropriate or unauthorised change of the report logic or source data
– Use of incorrect parameters

The above may involve the help of IT specialists.

Testing of IPE
The testing of IPEs can be undertaken in one or more of the following ways:

Direct Testing – This method can be adopted only in respect of standard parameter driven reports, which are generated directly from the system. It primarily involves the testing of the completeness and logic of the reports and benchmarking may be adopted.

Testing of controls that address the accuracy and completeness of the IPE – This method involves performing the tests on certain specific aspects such as system setting like access, passwords etc. as well as on the parameter settings like interest rates, prices etc.

More often than not, the entity generates various spread sheets which represent IPE to be used by the auditors, which are normally not specifically tested for accuracy and completeness. Hence, it is important to understand the considerations governing the same.

Testing of Spreadsheets
As indicated above, spreadsheets are an important component of IPEs in many enterprises and hence, it is imperative to test the accuracy and completeness thereof. The following are certain controls which can be adopted in respect of spreadsheets:

Change Controls – These involve controls over tracking of version changes and testing and approval of updates prior to deployment.

Access Controls – The spreadsheets should be stored in files or directories whose access is restricted. Further, formula fields should use cell protection measures, to restrict the possibilities of making changes in formulae.

Input Controls – Inputs to the spreadsheets should be validated for accuracy and completeness, when manually entering the data or importing the same. Control totals should be reconciled during data extraction with the source data/system prior to uploading to the spreadsheet

Calculation Controls –Automated algorithms should be used with access and change controls discussed earlier. Important formulae should be periodically reviewed to evaluate their continued relevance.

Testing of controls over spreadsheets would be an important consideration in assessing the effectiveness of ICFR and would involve interaction with the management at an early stage, since there is generally a lack of awareness of assessing and documenting formalised controls in this area as discussed earlier, whilst identifying certain common myths on the part of the top management/CEOs.

Spreadsheets could be used either to generate information to enable monitoring by the Management of various activities/processes as well as for preparation of financial statements. Accordingly, the documentation of the controls therein should be done as a part of the RCM for the individual processes or the financial closing and reporting process as discussed subsequently.

Documentation of the Internal Control Framework
To enable the auditors to report on ICFR, it is necessary for them to base their report on a specific framework, which needs to be documented by the Management. A question which is often raised is, whether there is any standard format for documenting the framework and whether the same needs to be captured in a single document.

In this context, it may be noted that since companies are free to adopt any framework, it would be difficult to lay down a standard format for documenting the same nor is it possible to have the same in one document, since the individual components of the framework would be different for each entity and may involve various documents.

From a practical perspective, it would be advisable to have a Summarised Master Policy Framework document, especially for the smaller and less complex entities, which captures the essence of the framework proposed to be adopted together with the various components and get the same adopted by the Board and/or Those Charged with Governance, if the same is not already done.The Master document may in turn refer to the various other documents/policies at the appropriate place, which would then constitute the comprehensive framework on which the auditors can base their report. These documents can comprise of the following, amongst others depending upon the size of the entity and the nature of its activities:

a) Risk Management Policy
b) Vision and Mission Statement / Ethics Policy
c) Code of Conduct
d) Whistle Blower Policy
e) Internal Audit Charter
f) Audit Committee Charter
g) Anti-Fraud Programme/Policy
h) Budgeting Policy/Process
i) Legal Compliance Framework
j) IT Security Policy
k) Business Continuity Plan
l) Disaster Recovery Plan
m) Outsourcing Policy
n) Succession Policy
o) Authority Matrix
p) SOPs for various processes
q) Process Flow Diagrams
r) Risk Control Matrix (RCM) for each business cycle / process

The following are some of the points which need to be kept in mind:

a) Some of the documents indicated above have to be mandatorily prepared by companies in terms of the Act or the Listing Agreement with the Stock Exchanges e.g. code of conduct, risk management policy, succession policy etc.

b) Whilst the above is a comprehensive list which addresses Internal Financial Controls from the point of view of the Board Reporting responsibilities indicated earlier, the auditors need to consider the same only to the extent relevant for ICFR reporting.

Conclusion:
Whilst every attempt has been made to decode some of the common myths/misconceptions of this new kid on the block, like all kids, this kid would in time become a grown up and responsible adult and have many more of its own challenges!

OVERVIEW OF TRANSITION TO AND ADOPTION OF IND-AS

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INTRODUCTION
With the notification of the roadmap by the
Ministry of Corporate Affairs for adoption of International Financial
Reporting Standards (IFRS) converged Indian Accounting Standards (Ind
AS) by all listed companies and large unlisted companies, the adoption
of the same will lead to many changes in the financial statements of
companies, both in terms of presentation and numbers.

Apart from
changes in the accounting, there are several other areas where there
would be an impact, some of which are highlighted hereunder:

Impact of transition on the profit/loss, financial position and net worth of the entity.

Communication with the Board and/or Audit Committee.

Increased volatility in the results.

Increased
disclosure requirements, both quantitative and qualitative which would
result in greater transparency. There would be significantly detailed
disclosures about management judgements and estimates.

Changes in existing information systems requirements.

Impact on reporting on Internal Financial Controls.

Need for increased availability of and enhanced capability of resources.

Greater
alignment with business operations due to increased focus on substance
rather than legal form. There would be greater emphasis on the
underlying business rationale and true economics of various transaction.

Tax implications of and the cost associated with the transition

Loan covenants

Dividend distribution

Investor relations.

An
attempt has been made in the foregoing paragraphs to briefly examine
the various practical considerations in the transition to and adoption
of Ind AS by corporates.

PREPARA TION OF IND-AS OPENING BALANCE SHEET
The
first and foremost consideration in the transition to Ind-AS is the
preparation of the opening Balance sheet. Whilst preparing the Opening
Ind-AS Balance Sheet, subject to the mandatory exceptions and
exemptions, an entity would normally require to ascertain the
adjustments under the following broad headings:

Not to recognise items as assets and liabilities, if Ind-AS does not permit their recognition.

Recognise all assets and liabilities whose recognition is required by Ind-AS.

Reclassify assets, liabilities, and items of equity as per Ind-As requirements.

Measure all assets and liabilities in accordance with Ind-AS.

Let us now examine some of the common adjustments which may be required under each of the above heads.

Not to recognise items as assets and liabilities if Ind- AS does not permit their recognition:

Some of the common adjustments which may be required in this respect are briefly discussed hereunder:

Ind-AS-10 Events after the Reporting Period does not permit recognition of proposed dividends as
an adjusting event and hence the same is not to be presented as a
liability as is the case with AS-4. The proposed dividend is only
required to be disclosed as a note.

Any deferred income or expenditure
such as premium/discount on issue/redemption of debentures / bonds or
expenses on issue of debentures or bonds recognised in terms of the
special dispensation under AS-26, and which are an integral part of the
amortised cost of financial assets and liabilities should be factored in
to determine the effective interest rate and reversed in the opening
balance sheet.

The carried forward balance of any share issue expenses
which are amortised in terms of the special dispensation under AS-26
are required to be eliminated whilst preparing the opening balance
sheet. (The treatment to be adopted if already adjusted against Securities premium Account is not clear).

Any contingent assets or reimbursements like insurance or other claims which are not virtually certain and do not meet the recognition criteria under Ind-AS-37 should be reversed in the opening balance sheet.

In the opening consolidated financial statements, assets and liabilities of joint ventures which are included under the Proportionate Consolidated method should be reversed since the same is no longer permissible

Any held for sale subsidiary, associate or joint venture should be eliminated from consolidation and disclosed as a separate disposal group.

Recognise all assets and liabilities whose recognition is required by Ind-AS.

Some of the common adjustments which may be required in this respect are briefly discussed hereunder:

All derivative financial assets and liabilities and embedded derivatives shall be recognised if not done earlier.

Certain
provisions in the nature of restructuring obligations, onerous
contracts, decommissioning liabilities, site restoration, warranties,
litigation etc. need to be recognised based on constructive obligations, which may not have been recognised earlier or were disclosed as contingent liabilities.

Various intangible assets
like brands, customer lists etc. acquired in a business combination,
which earlier were part of goodwill need to be recognised if
retrospective application of Ind-AS 103 is opted for.

Recognition of certain new investment properties
in view of the differences in the recognition criteria e.g land held
for long term capital appreciation, building that is vacant but is held
to be leased under one or more operating leases etc.

Deferred tax assets and liabilities would need to be recognised based on the Balance sheet approach.

In the consolidated financial statements investments in joint ventures need to be recognised based on the equity method.

Assets
and liabilities of any held for sale subsidiary, associate or joint
venture would need to be recognised and presented as a disposal group.

Reclassify assets, liabilities, and items of equity as per Ind-As requirements.

Some of the common adjustments which may be required in this respect are briefly discussed hereunder:

Classification of financial liabilities and equity should be based on the substance
rather than legal form e.g. redeemable preference shares would need to
be reclassified as debt, fully convertible debentures would need to be
reclassified as equity etc.

Compound financial instruments need to be split into debt and equity components e.g. partly / optionally convertible bonds.

Financial assets, notably investments, need to be reclassified into amortised cost, fair value through profit and loss, fair value through other comprehensive income etc.

Certain intangible assets acquired as part of earlier business combinations may not meet the definition of intangible assets and hence need to be included as part of goodwill e.g. certain acquisition cost, promotional cost etc.

An entity preparing consolidated financial statements
for the first time or which has not consolidated any subsidiary under
AS-21 e.g. where the control is exercised through the power to govern
the operating policies and business decisions rather than through
shareholding alone would need to incorporate the relevant assets and
liabilities.

Measure all assets and liabilities in accordance with Ind-AS.

Some of the common adjustments which may be required in this respect are briefly discussed hereunder:

In case of purchase of inventories, fixed assets and intangible assets on deferred settlement terms, the interest element would need to be segregated.

In case of fixed assets, if the fair value model is opted for, it would necessitate a remeasurement.

Government grants in the form of non-monetary assets or concessional loans are to be measured at the fair value.

Borrowing cost are to be calculated using the effective interest rate method.

Where the time value of money is material, provisions should be on a discounted basis.

Share based payment transactions need to be recognised on a fair value basis.

Assets and liabilities acquired in a business combination need to be measured at fair value.

Non-current assets held for sale and Discontinued Operations need to be measured at fair value less costs to sell.

All
Financial assets and liabilities to be initially recognised at fair
value and subsequently measured based on their classification as above.

As
part of the transition to Ind-AS entities are also required to evaluate
the various exemptions, both mandatory and voluntary, which are
provided for under Ind-AS-101, the important ones of which are briefly
discussed hereunder:

MANDATORY EXEMPTIONS TO RETRO – SPECTIVE APPLICATION OF IND-AS
A first time adopter is provided with the following key mandatory exemptions to retrospective application of certain Ind-AS:

Derecognition of Financial Assets and Liabilities

There
is no need to recognise any financial asset or liability which is
already derocognised under local GAAP. Alternatively, the entity may
apply derecognition criteria retrospectively by choosing a cut off date.


Hedge Accounting

Any transactions entered into before the date of transition are not to be retrospectively designated as hedges.

Classification and Measurement of Financial Assets and Liabilities

The
determination of cash flows for time value measurement of financial
assets on the date of transition is not required when it is
impracticable to assess the same retrospectively, subject to adequate
disclosures being made till their derecognition.

For measurement
of existing financial assets and liabilities on the date of transition,
if it is impracticable to determine effective interest rate
retrospectively, the fair value on the date of transition shall be the
new gross carrying amount or the new amortised cost for applying the
effective interest method.

Embedded Derivatives

A
first time adopter shall assess whether an embedded derivative is
required to be separated from the host contract on the basis of
conditions that existed at the later of the date it first became a party
to the contract and the date of reassessment.

Government Loans

The
benefit of a government loan at below market rate of interest is not
required to be recognised as a government grant on the date of
transition.

VOLUNTARY EXEMPTIONS TO RETRO – SPECTIVE APPLICATION OF IND-AS
A
first time adopter is provided with the following key voluntary
exemptions to retrospective application of certain Ind-AS. Understanding
the same is of critical importance since it could impact comparability
of results of entities in the same sector.

Share based Payment Transactions

Voluntary
retrospective application of fair valuation in respect of equity
instruments granted, vested and not settled or any modification made
before the date of transition is available. Similar considerations apply
to any liabilities arising out of such transactions which are settled
before the date of transition. However, an entity may adopt earlier
application if fair value disclosures have been publicly made.

Deemed Cost of Property, Plant and Equipment and Intangible Assets

The
entity can opt for the previous GAAP carrying amount as deemed cost.
Alternatively, the fair value on the date of transition can also be
considered as the deemed cost provided it is comparable with what is
required under Ind-AS. In certain cases, an event driven fair value used
during a privatisation, IPO etc. can also be considered as a deemed
cost. In case fair value is taken as deemed cost, the same should be
allocated component wise and depreciation shall be calculated
accordingly.

Deemed Cost of Investment Property

These
may be identified on the date of transition based on Ind-AS criteria of
these being used to earn rentals or for capital appreciation as against
the AS-13 criteria of it not being intended to be used or occupied
substantially in the operations of the enterprise.

Leases

Separate
classification where lease includes both land and building into the
finance (normally for land) and operating lease, as applicable on the
date of transition is permissible where there is a composite lease of
land and building.

Determining whether an arrangement contains a lease on the date of transition based on the specific assets test – fulfilment of the arrangement is dependent on the use of a specific asset or right to use of an asset.

Cumulative Translation Differences

Cumulative
translation differences for all foreign operations (Ind-AS does not
distinguish between integral and non-integral operations) on the date of
translation shall be zero; and

Gains and losses on subsequent
disposal of foreign operations shall exclude translation differences
prior to the date of transition.

Long Term Foreign Currency Monetary Items

If these are reflected under FCMDTA account, similar treatment can continue on the date of transition.

In
case these are adjusted against the carrying value of the fixed assets,
similar treatment can continue only if the entity adopts the deemed
cost model as discussed above.

Investments in Subsidiaries, Associates and Joint Ventures

Deemed
cost as per previous GAAP (i.e. fair value in the separate financial
statements on date of transition or previous GAAP carrying amount) on
the date of transition can be used.

Assets and Liabilities of Subsidiaries, Associates and Joint Ventures

If
an entity adopts Ind-AS before or simultaneously with the
parent/investor, no adjustments required. However, if the entity adopts
Ind-AS later than the parent/investor, respective carrying amounts on
the date of the investor’s/ parent’s transition can be considered.

Compound Financial Instruments

An
entity is required to split into liability and equity components
retrospectively unless liability component is no longer outstanding on
date of transition.

Designation of Previously Recognised Financial Instruments

All Financial assets are required to be classified into three types, as under:

Fair value through Profit and Loss in
cases where the holding of the financial asset helps to eliminate or
significantly reduce measurement or recognition uncertainty or holding
period is less than 12 months. It can be used irrespective of the
business model discussed below.

Fair value through other comprehensive income in
cases where the business model involves collection of contractual cash
flows either through selling the asset or through principal and interest
payments.

Amortised cost, in cases where the business model involves collection of contractual cash flows of interest and principal.

All Financial liabilities are required to be classified into two types, as under:

1. Fair value through Profit and Loss (very selectively)
2. A mortised cost.

The above designations can be either at initial recognition or on the date of transition.

The
amortised cost of financial assets and liabilities shall be determined
on the basis of the benchmark interest rate on the date of transition,
if it is impractical to determine the same retrospectively.

All
Equity instruments always to be classified at fair value – either
through Profit & Loss or through Other Comprehensive Income and no
recycling permissible if option of classifying through OCI is selected –
No specific impairment analysis required

Fair Value Measurement of Financial Assets and Liabilities on Initial Recognition

This may be applied prospectively to transactions entered into on or after the date of transition.

Decommissioning Liabilities included in Cost of Fixed Assets

Where exemption from retrospective application is sought, following needs to be done:

Measure the liability on the date of transition as per Ind-AS 37.

To
the extent it is to be included in the cost of the asset, the amount
should be estimated based on the assumption that it would be included
when the liability first arose and then discounted accordingly, using
historical risk adjusted discount rates (based on average annual
inflation, and incremental borrowing rates).

Calculate accumulated depreciation on the above amount using current estimated useful life.

Service Concession Arrangements

Recognise financial assets and intangible assets on the date of transition.

Use the previous GAAP carrying amounts.

Test for impairment at the date of transition unless impractical to do so.

Joint Venture Accounting – Transition from Proportionate Consolidation to Equity Method

Business Combinations

An entity may choose not to apply Ind-AS-3 to business combinations that occurred before the date of transition.

However, if it decides to restate any past business combinations, it should restate all business combinations after that date.

Apart from the various exemptions, certain other key considerations under various Ind-AS are discussed hereunder:

OTHER KEY CONSIDERATIONS IN TRANSITION Ind-AS-2 Inventories

In
respect of inventories acquired on deferred settlement basis, the
interest element thereon shall be excluded. This needs to be adjusted on
the date of transition.

Sale of inventories after the reporting
period would be an adjusting event under Ind-AS 10 discussed below
which would need to be adjusted on the date of transition.

Ind-AS10 Events After Reporting Period

Any
provision for proposed dividend and related dividend distribution tax
after the reporting period shall be reversed and added back to retained
earnings.

Settlement of a court case after reporting period
confirms the existence of a present obligation and accordingly the
previously created provision needs to be adjusted or fresh provision
need to be created in terms of Ind-AS-37.

An entity shall adjust
cost of assets purchased based on information available after reporting
period if it opts for carrying value as the deemed cost.

On the
date of transition any legal and/or constructive obligations after the
reporting period shall be taken into account if not considered under
previous GAAP. (see discussion on Ind-AS 19 on Employee Benefits below)

Ind-AS 19 on Employee Benefits

Actuarial
gains and losses arising on defined benefit plans and other long term
employee benefits should be recognised in the Statement of Other
Comprehensive Income and cannot be recycled to the Profit and Loss
Account.

All past service costs need to be immediately expensed off.

Instead
of recognising interest cost in the Profit and Loss Account, Ind- AS-19
requires recognition of net interest cost based on the net defined
benefit asset or liability and the discount rate at the beginning of the
year.

Other miscellaneous adjustments in the actuarial assumptions.

Revised actuarial valuation would be required.

More
specific guidance on accounting for constructive obligations i.e. as a
result of informal practices. These would need to be henceforth
recognised in the financial statements

Ind-AS 23 on Borrowing Costs

Inventories
which are manufactured or otherwise produced in large quantities on a
repetitive basis are not considered as qualifying assets even if they
take a substantial period of time to get ready for their intended use or
sale. e.g wines, cheese etc.

Borrowing costs shall be measured
applying effective interest rate method from the date transition date.
Accordingly, ancillary borrowing cost written off earlier need to be
amortised. Earlier period borrowing costs should not be restated.

Dividend payable in respect of compulsorily redeemable preference shares
would also need to be considered as borrowing costs eligible for
capitalisation depending on the specific circumstances.

Ind-AS 12 Income
Taxes

Balance Sheet method to be adopted for computation of deferred
tax asset or liability by which the tax base is compared with accounting
base. Primary impact would be in respect of business combinations and
consolidation adjustments.

Tax base of an asset is the amount
deductible for tax purposes against any taxable economic benefits that
would flow to the entity when it recovers the carrying amount of the
asset. e.g depreciable assets, uncollected income taxed on a cash basis,
assets measured at fair value where the fair value gain is not taxed or
fair value loss is disallowed.

Tax base of a liability is its
carrying amount, less any amount deductible for tax purposes. E.g.
income received in advance taxed at a later date, loan payable having an
amortised cost.

A first time adopter would have to establish the
history of items that give rise to temporary differences and adopt
retrospective application.

Implications vis-à-vis ICDS needs to be
considered?

Ind-AS 38 Intangible Assets

Unamortised share issue
expenses need to be charged off. Amounts in the nature of transaction
cost need to be reduced from equity.

Any unamortised borrowing costs
need to be analysed. Initial transaction cost need to be reduced from
the borrowings and any ancillary cost needs to be considered in the
calculating the effective interest rate.

Revenue based amortisation
of toll roads would not be permitted for toll roads arising after the
transition date.

Amortisation of intangible assets with indefinite
useful life not permitted. E.g., Right of Way, Stock Exchange broking
card etc. These would however need to be tested for impairment.

Implications vis-à-vis adjustment against Securities Premium Account to be considered.

Ind-AS 21 Effects of Changes in Foreign Exchange Rates

The concept of functional currency introduced for the first time. No first time exemption provided. It is the currency of the primary economic environment
in which the entity operates. It is normally the currency which
influences the income and expenses the most. e. g. shipping company.

Ind-AS 37 Provisions, Contingent Liabilities and Contingent Assets

Specific
requirement to recognise provisions in respect of constructive
obligations. AS-29 does not specifically refer to the same. It only
refers to creation of provisions arising out of normal business customs
and practices, to maintain business relations etc.

Restructuring provisions need to be made based on constructive obligations as against legal obligations in terms of AS-29.

Discounting of provisions where effect of time value of money is material.

OTHER AREAS HAVING SIGNIFICANT IMPACT

FINANCIAL INSTRUMENTS

Recognition and Measurement

Greater use of fair value – use of judgement and valuation tools in many cases.

Impairment to be calculated on the Expected Credit Loss Model.

–
Assessment of whether there is a significant increase in the credit
risk since initial inception or there is a low credit risk; in which case
12 months expected credit losses are recognised.

– Where
significant increase in credit risk since initial inception and no
objective evidence of impairment, in which case life time expected
credit losses to be recognised on a PD basis

– Where there is
objective evidence of impairment, life time expected credit losses are
recognised and interest income is computed on the net basis (i.e. net of
credit allowances)

– The above will have a big impact on financial institutions and NBFCs which are covered at a later date. However, in the interim any loans granted by non- financial entities would still need to be evaluated since currently they are not even covered by the prudential guidelines. Financing of group entities would need closer scrutiny.

Derivative Instruments- Currently, there are diverse practices adopted. Whilst some entities were adopting AS-30 (which is recommendatory in nature), other entities are following the ICAI announcement which requires only losses to be recognised. Post adoption of Ind-AS, consistency would creep in and recognition of both gains and losses either through Profit and Loss or OCI (where hedge accounting is adopted) would be required. The impact would be greater for entities who were hitherto following the ICAI announcement and recognising only losses.

Transaction Costs
– In respect of long term borrowings, these will be recognised over the tenor of the borrowing using the effective interest rate method as against the current practice of charging off.

– In respect of financial assets, these would need to be charged off as against the current practice of capitalising the same, unless these are in respect of financial assets recorded on amortised cost basis, in which case they would need to be adjusted against the carrying value.

BUSINESS COMBINATIONS

Recognition and Measurement

Acquisition Value
– Assets and liabilities to be recognised at fair value.
– Contingent Liabilities and Intangible Assets not recognised in the acquiree’s financial statements would also need to be recognised at fair value.

– Non controlling interests to be measured at fair value.

– Significant changes in the value of goodwill reflecting a more accurate depiction of the premium paid on acquisition even though the legal form of the acquisition has not changed.

– Recording of assets at fair value will normally result in higher depreciation and amortisation – In case of intangibles with indefinite useful life or with higher useful life lower or no amortisation.

– Goodwill will not have to be amortised but tested for impairment.

– In case of a business combination in stages, the previously held equity interest to be measured at acquisition date fair value, with resultant gain or loss recognised in the Profit and Loss resulting in greater volatility in the Income Statement.

Accounting for Transaction Costs
– These need to be charged off as against the current practice of generally capitalising them.

Accounting vis-à-vis High Court Orders
– Under the Companies Act, 2013, certificate from the auditors required whether scheme is in accordance with the Accounting Standards thereby doing away with the leeway provided under the Companies Act, 1956.

– Position in the intervening period till the notification of the relevant sections under the Companies Act, 2013, especially for non-listed companies not clear.

CONSOLIDATED/GROUP ACCOUNTS

Recognition and Measurement

Preparation of Consolidated Financial statements – Many additional SPEs would get consolidated and there could be deconsolidation of certain subsidiaries since two companies cannot consolidate the same subsidiary since control can be exercised only by one entity. Investment entities are also not required to be consolidated.

– Consolidation mandated under the Companies Act, 2013 of associates and joint ventures even if there are no subsidiaries.

– Proportionate consolidation method no longer permissible.

– Definition of control is different. An investor is deemed to control an enterprise only when he has the power over the entity or when he has exposure or rights to variable returns from its involvement with the investee and has the ability/power the affect these returns. Such powers can be exercise even when there is no majority ownership. Even potential voting rights are relevant.

– Changes in ownership interest that do not result in loss of control should be adjusted against equity. No guidance under current GAAP and hence differing practices were adopted.

– Losses incurred by the subsidiary to be allocated between the controlling and non-controlling interest as against the practice under Indian GAAP of adjusting these against the majority, unless there is a binding obligation to make good the losses.

Uniform Accounting Policies
– Not very rigid and strictly enforceable under current GAAP. – Challenges could be encountered especially in case of associates over which control is not exercised.

– Many group entities would be required to change their policies, the individual impact of which would need to be evaluated.

Uniform Financial Year
– Maximum gap reduced to three months as against six months. – On adoption many entities would be compelled to change their year ends.

INCOME TAXES

Recognition and Measurement

Recognition based on Balance Sheet method for taxable temporary differences as against timing differences under the current GAAP.

Recognition of deferred tax on business combinations.

Recognition of deferred tax assets on losses is not very stringent.

Deferred tax liability required to be recognised in consolidated financial statements for all taxable temporary differences in connection with group investments unless the investor is able to control the timing of the reversal in the foreseeable future.

Significantly detailed disclosures and reconciliations.

EMPLOYEE BENEFITS AND SHARE BASED PAYMENTS

Recognition and Measurement

Actuarial gains and losses to be taken to Other Comprehensive Income which will reduce volatility.

Employee benefits are required to be recognised based on constructive obligation as against the current practice of generally recognising the same based on legal obligation.

ESOPS to be mandatorily recorded on a fair value basis which would result in increased charges and hence have a significant impact on key performance indicators like EPS.

Share based payments to non-employees like vendors against supply of goods and services would need to be recorded on a fair value basis in all cases, which is currently missing. Only fixed assets so acquired are accounted for at fair value in terms of AS-10. This could have a negative impact on the financial results and other performance indices, dividend servicing abilities and loans covenants, amongst others.

PROPERTY, PLANT AND EQUIPMENT

Recognition and Measurement

Mandatory Component Accounting

– Any cost which is significant in relation to the total cost and has a separately defined useful life need to be separately identified and depreciated accordingly.
– Residual value calculations and estimates need to be evaluated afresh.
– Even companies not adopting Ind-AS need to adopt the same in terms of the Companies Act, 2013.
– Expected to a have a material and significant impact on highly capitalised manufacturing entities and IT technology companies.
– Could have a significant impact on insurance, asset backed financing, amongst other matters.

Revaluation of Assets
– No selective revaluation permitted.
– Updation of revaluation on a regular basis.

– Depreciation charge to be charged off to Income Statement. Even companies not adopting Ind- AS need to follow the same in terms of the Companies Act, 2013

– Since it is an option it can affect comparability of results of the same class of companies and hence uniformity in terms of loan covenants including security cover etc. would be an issue.

–For companies adopting the revaluation route whilst the asset base would be higher, there would also be a higher corresponding depreciation charge

Repairs and Overhaul expenditure
– Needs to be capitalised if it satisfies the recognition criteria.

– Corresponding decapitalisation of the replaced parts.

– Closer scrutiny of the renewal and asset maintenance policies of companies, especially those which are asset heavy.

Unrealised Exchange Differences
– These are required to be charged off in all cases prospectively.
– Companies who have opted for the transitional relief for continuing treatment of capitalisation in terms of para 46A of AS-11 till the tenor of the loans or till FY 2020. This would impact comparability of results.
– Greater volatility in the results of companies who have large overseas borrowings.

INTANGIBLE ASSETS

Recognition and Measurement

Intangible assets can have indefinite useful lives, identification of which should be adequately and appropriately demonstrated and justified. Such assets need to be subjected to an annual impairment assessment.

Fair valuation is now permissible especially if an active market exists.

CONCLUSION
The above assessment is just the tip of the ice-berg and in actual practice there could be many other issues, challenges and implications which would merit a detailed assessment.

ACCOUNTING FOR COURT SCHEMES UNDER IND-AS & ON TRANSITION DATE

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Accounting for business combinations under Indian GAAP is significantly different to that under Ind-AS. Retrospective application of Ind-AS 103 Business Combinations may be difficult and in certain cases impossible, for past business combinations. Against this background, the business combinations exemption in Ind-AS 101 First Time Adoption of Indian Accounting Standards is probably the most important exemption, as it provides a firsttime adopter of Ind-AS an exemption from restating business combinations prior to its date of transition to Ind-AS, subject to certain requirements.

A first-time adopter choosing to apply this exemption is not required to restate business combinations to comply with Ind-AS 103, if control was obtained before the transition date. A first-time adopter taking advantage of this exemption will not have to revisit past business combinations to establish fair values and amounts of goodwill under Ind-AS. However, the application of the exemption is complex, and certain adjustments to transactions under Indian GAAP may still be required.

A first-time adopter may also choose not to use the exemption and restate previous combinations in accordance with Ind-AS 103. If a first-time adopter restates any business combination prior to its date of transition to comply with Ind-AS 103, it must restate all business combinations under Ind-AS 103 which occur after the date of that combination. In simple words, a first time adopter may choose a date and restate all business combinations from that date. Business combinations before that date are not restated by using the exemption.

Using the exemption not to restate business combinations under Ind-AS 103, does not mean that the entire accounting under Indian GAAP is kosher. The exemption is only with respect to fair value accounting. Thus, if a proper asset or liability was not recognised or written off in Indian GAAP, then the same will have to be properly accounted at the transition date and on a go forward basis in the Ind AS financial statements.

On 16th February 2015, the Ministry of Corporate Affairs (MCA) notified the Companies (Indian Accounting Standards) Rules, 2015 laying down the roadmap for application of IFRS converged standards (Ind-AS). As per general instructions in the MCA notification, notified Ind AS’s are intended to be in conformity with the provisions of applicable laws. However, if due to subsequent amendments in the law, a particular Ind AS is found to be not in conformity with such law, the provisions of the said law will prevail and the financial statements will be prepared in conformity with such law. Therefore, as per the Framework, law shall override the provisions of Ind-AS, unless clarified otherwise.

With the above background, let us consider two simple scenarios, for an acquirer company that is in phase 1, and has a transition date of 1st April, 2015. Prior to this transition date, the acquirer has made three acquisitions of businesses. Only Acquisition 2 was under a court scheme, in which two accounting concessions were made by the court. Acquisition 2 happened in 2009; when SEBI requirement to comply with accounting standards in a court scheme was not yet legislated. Since those acquisitions were of business divisions, rather than acquisition of an investment, those were accounted in the separate financial statements of the acquirer. The two scenarios are as follows:

1. Acquirer does not wish to restate past business combinations.

2. Acquirer wants to restate business combinations starting from acquisition 1.

Commentary on Scenario 1: Acquirer does not wish to restate past business combinations There is no issue with Acquisition 1 & 3. However, the question is with respect to Acquisition 2. Can the accounting ordered by the court be retained as it is both at the transition date and on a go forward basis? View 1 Yes, the court order is supreme and therefore it will trump the requirements of Ind-AS 101 and Ind-AS 103. Thus indefinite life intangible assets will not be resurrected in Ind-AS financial statements and impairment losses will be adjusted against reserves under Ind-AS on transition date and on a go forward basis. The court order is applicable to all statutory financial statements prepared under Indian law; and would be applicable to both Indian GAAP and Ind-AS financial statements. View 2 The court scheme was applicable to Indian GAAP financial statements and hence is not relevant for the purposes of preparing Ind AS financial statements. Therefore, on transition date the company will have to recognize intangible assets under Ind AS. Further any future impairment losses will be adjusted to P&L a/c rather than directly to reserves.

Commentary on Scenario 2: Acquirer wants to restate business combinations starting from acquisition 1

View 1
The acquirer can restate Acquisitions 1, 2 & 3. Though acquisition 2 was under a court scheme it can be restated under Ind-AS. This is on basis that the court scheme applied to Indian GAAP financial statements and not Ind-AS financial statements. When Acquisition 2 is restated in accordance with Ind AS 103, the accounting concessions provided by the court will have to be disregarded.

View 2
The acquirer can restate Acquisitions 1 & 3. However, Acquisition 2 cannot be restated because it is under a court scheme, and the court mandated accounting cannot be changed. This is on the basis that the court scheme is applicable to all statutory financial statements, and it does not matter whether those are prepared under Indian GAAP or Ind-AS.

View 3
The acquirer cannot restate acquisition 2, because it is under a court scheme. As a result, restating of Scquisition 1 is also tainted. This is because under Ind AS 101, if a first-time adopter restates any business combination prior to its date of transition to comply with Ind-AS 103, it must restate all business combinations under Ind-AS 103 which occur after the date of that combination. Therefore the acquirer can only restate acquisition 3. Acquisition 1 & 2, along with the court concession on the accounting will have to be retained under Ind AS.

Conclusion
The author believes that the current drafting of Ind AS and the MCA circular, provides a flexibility in the views that can be taken. However, the ICAI along with MCA may provide a more clear guidance and way forward on this major dilemma.

Discounting of Retention money under Ind-AS

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Query
A consulting company provides
project management and design services to customers on very large
projects that take significant time to complete. The company raises
monthly bills for work done, which are promptly paid by the customers.
However, the customers retain 10% as retention money, which is released
one year after the contract is satisfactorily completed. The 10%
retention money is a normal feature in the industry, and is more akin to
providing a security to the customer rather than a financing
transaction. Under Ind-AS, is the consulting company required to discount retention monies?

Response

Technical Literature

1.
Under Ind AS 18 Revenue is measured at the fair value of consideration
received or receivable. Further, Ind AS 18 states as below:

“In
most cases, the consideration is in the form of cash or cash equivalents
and the amount of revenue is the amount of cash or cash equivalents
received or receivable. However, when the inflow of cash or cash
equivalents is deferred, the fair value of the consideration may be less
than the nominal amount of cash received or receivable. For example, an
entity may provide interest-free credit to the buyer or accept a note
receivable bearing a below-market interest rate from the buyer as
consideration for the sale of goods. When the arrangement effectively
constitutes a financing transaction, the fair value of the consideration
is determined by discounting all future receipts using an imputed rate
of interest…………….The difference between the fair value and the nominal
amount of the consideration is recognised as interest revenue in
accordance with Ind AS 109.”

2. Further IAS 18 provides an example with respect to instalment sales when consideration is receivable in instalments.

“Revenue
attributable to the sales price, exclusive of interest, is recognised
at the date of sale. The sale price is the present value of the
consideration, determined by discounting the instalments receivable at
the imputed rate of interest. The interest element is recognised as
revenue as it is earned, using the effective interest method.”

3.
Ind AS 115 Revenue from Contracts with Customers prohibits discounting
of retention monies when the retention monies do not reflect a financing
arrangement. For example, the retention money provides the customer
with protection from the supplier failing to adequately complete some or
all of its obligations under the contract. Further even in arrangements
where there is significant financing component, practical expediency
not to discount was allowed, provided the financing was for a period
less than one year. Ind AS 109 Financial Instruments was aligned to Ind
AS 115, and did not require any discounting if the trade receivables did
not contain a significant financing component or when the practical
expediency was available.

4. On withdrawal of Ind AS 115, the alignment paragraph in Ind AS 109 discussed above was also removed.

Possible Views

View 1: No discounting is required

The
arrangement does not entail instalment payments nor is a financing
transaction under Ind AS 18, and hence discounting of retention money is
not required. Though Ind AS 18 does not provide further elaboration on
what constitutes a financing arrangement, guidance is available in Ind
AS 115. Based on this guidance, retention money is on normal terms and
common to the industry and represents a source of protection with
respect to contract performance rather than a source of financing.
Though Ind AS 115 is withdrawn, the guidance on what constitutes a
financing transaction, in the absence of any guidance in Ind AS 18, is
useful and may be applied.

Though Ind AS 109 requires discounting of retention money, one may argue that Ind AS 18 should be allowed to trump Ind AS 109.

View 2: Discounting is required

The
requirement in Ind AS 18 to determine revenue at the fair value of
consideration received or receivable would necessitate the discounting
of retention money. The provisions in IFRS 13 Fair Value, and Ind AS 109
Financial Instruments would also require discounting of retention
money. In essence, in any arrangement where money is not paid
instantly, there will be a time value of money, which needs to be
recognized. The reason for which the payment is not made instantly or delayed is not relevant.

Author’s View

View
2 is the preferred view. However, View 1 should not be ruled out
because Ind AS 18 does not require discounting when the arrangement does
not effectively constitute a financing arrangement. View 1 can be ruled
out, only if Ind AS 18 is suitably amended to remove the reference to
financing arrangements. Suggest Institute should issue a clarification.

Presentation of Government Grant

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Background
For sustained agricultural growth and to promote balanced nutrient application, it is imperative that fertilisers are made available to farmers at affordable prices. With this objective, urea being the only controlled fertiliser, is sold at statutory notified uniform sale price, and decontrolled Phosphatic and Potassic fertilisers are sold at indicative maximum retail prices (MRPs). The problems faced by the manufacturers in earning a reasonable return on their investment with reference to controlled prices, are mitigated by providing support under the New Pricing Scheme for Urea units and the concession Scheme for decontrolled Phosphatic and Potassic fertilisers. The statutorily notified sale price and indicative MRP is generally less than the cost of production of the irrespective manufacturing unit. The difference between the cost of production and the selling price/MRP is paid as subsidy/concession to manufacturers.

Query
Whether subsidy received by the manufacturers should be presented as ‘other income’ or as ‘revenue’?

Response
Theoretically, there could be two views.

View 1
Paragraph 29 of Ind AS 20 Accounting for Government Grants and Disclosure of Government Assistance states “Grants related to income are presented as part of profit or loss, either separately or under a general heading such as ‘Other income’; alternatively, they are deducted in reporting the related expense.” Since the subsidies are paid to the manufacturer, the same cannot be reflected as revenue of the manufacturer. It should be presented as ‘other income’. Further, since the subsidy is not related to providing relief on specific expenditure, the same cannot be deducted from expenses.

View 2
The benefit of the subsidy is meant for the farmers not for the manufacturer of fertilisers. This is a government grant to the farmers, not to the manufacturers. As far as the manufacturer company is concerned, it is receiving revenue at fair value from the farmers and the government. In other words, the government is paying the subsidy (part of sale proceeds) to the manufacturer on behalf of the farmer. Therefore, the government should be seen more as a customer, rather than as a provider of grant to the manufacturer.

Consider the following definitions under Ind AS 20:

Government assistance is action by government designed to provide an economic benefit specific to an entity or range of entities qualifying under certain criteria. Government assistance for the purpose of this Standard does not include benefits provided only indirectly through action affecting general trading conditions, such as the provision of infrastructure in development areas or the imposition of trading constraints on competitors.

Government grants are assistance by government in the form of transfers of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity. They exclude those forms of government assistance which cannot reasonably have a value placed upon them and transactions with government which cannot be distinguished from the normal trading transactions of the entity.

Both the above definitions entail compliance with past and future onerous conditions by the manufacturer to become eligible for the subsidy. For example, this is clearly seen in the Capital Investment Subsidy Scheme, which requires the manufacturer to make investments in plant and machinery of a specified value in backward regions and also imposes other conditions, such as, with respect to setting up social infrastructure and employment generation.

In the fertiliser subsidy, the manufacturers do not have to comply with such onerous conditions, and hence it is not a government grant from the manufacturer perspective.

Conclusion
The author believes View 2 is more appropriate for reasons already mentioned above. A simple analogy is the subsidy on cooking gas cylinders. In the past, the subsidy was paid to the manufacturer on behalf of the consumers (who paid a subsidised price for the cylinder). Now the consumers have to pay full fair price to the manufacturers, and the Government directly credits the subsidy to the consumers. Similarly, with respect to fertilisers, it can be argued that the subsidy is to the farmer, and not to the fertiliser manufacturer.

Effect given for amalgamation of another large company and integration of accounting policies for accounting of derivative instruments

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48. Pursuant to the Scheme of Arrangement u/s. 391 to 394 of the Companies Act 1956 for amalgamation of erstwhile Ranbaxy Laboratories Ltd. (RLL) with the Company as sanctioned by the Hon’ble High Court of Gujarat and Hon’ble High Court of Punjab and Haryana on March 24, 2015 (effective date) all the assets, liabilities and reserves of RLL were transferred to and vested in the Company with effect from 1st April 2014, the appointed date. RLL along with its subsidiaries and associates was operating as an integrated international pharmaceutical organisation with business encompassing the entire value chain in the production, marketing and distribution of pharmaceutical products. The scheme has accordingly been given effect to in these financial statements.

The amalgamation has been accounted for under the “Pooling of Interest Method” as prescribed under Accounting Standard 14-“Accounting for Amalgamations” (AS 14) issued by the Institute of Chartered Accountants of India and as notified u/s. 133 of the Companies Act 2013 read with Rule 7 of the Companies Accounts Rules 2014. Accordingly and giving effect in compliance of the Scheme of Arrangement all the assets, liabilities and reserves of RLL, now considered a division of the Company, were recorded in the books of the Company at their carrying amounts and the form as at the appointed date in the books of RLL.

On April 10, 2015, in terms of the Scheme of Arrangement 0.80 equity share of Re. 1 each (Number of Shares 334,956,764 including 187,583 Shares held by ESOP trust) of the Company has been allotted to the shareholders of RLL for every 1 share of Rs. 5 each (Number of Shares 418,461,476 including 234,479 shares held by ESOP trust) held by them in the share capital of RLL, after cancellation of 6,967,542 shares of RLL. These shares have been considered for the purpose of calculation of earnings per share appropriately. An amount of Rs. 1,792.4 Million being the excess of the amount recorded as share capital to be issued by the Company over the amount of the share capital of erstwhile RLL has been credited to Capital Reserve.

49. RLL had earlier adopted Accounting Standard (AS) 30 “Financial Instruments: Recognition and Measurement” and AS 31 “Financial Instruments: Presentation” for accounting of derivative instruments which are outside the scope of Accounting Standard 11 ‘The Effects of Changes in Foreign Exchange Rates’ such as forward contracts to hedge highly probable forecast transactions, option contracts, currency swaps, interest rate swaps etc. In order to align with the Company’s policy, derivative instruments are now accounted for in accordance with the announcement issued by the Institute of Chartered Accountants of India dated March 28, 2008. On the principles of prudence as enunciated in Accounting Standard 1 “Disclosure of Accounting Policies” which requires to provide losses in respect of all outstanding derivative instruments at the balance sheet date by marking them to market. Accordingly, the unrealised MTM gain of Rs. 905.4 Million as at April 1, 2014 has been reversed and MTM gain as at March 31, 2015 amounting to Rs. 1,121.0 Million has not been recognised in these financial statements.

50. Out of a MAT credit of Rs. 8,222.7 Million which was written down by the erstwhile RLL during the quarter ended December 31, 2014, an amount of Rs. 7,517.0 Million has been recognised by the Company, on a reassessment by the Management at the year-end, based on convincing evidence that the combined amalgamated entity would pay normal income tax during the specified period and would therefore be able to utilise the MAT credit so recognised. Current tax for the year also includes Rs. 284.7 Million pertaining to earlier years.

Re-adoption of financial statements to give effect to scheme of arrangement

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51. Pursuant to the Scheme of Amalgamation u/s. 391 to 394 of the
Companies Act, 1956 and u/s. 52 of the Companies Act, 2013 for
amalgamation of erstwhile Sun Pharma Global Inc.(Transferor Company)
with the Company, with effect from January 1, 2015 (appointed date), as
sanctioned by the Hon’ble High Court of Gujarat, filed with the
Registrar of Companies on August 6, 2015 (effective date), all the
assets, liabilities, reserves and surplus of Transferor Company were
transferred to and vested in the Company without any consideration, on a
going concern basis. Transferor Company is a wholly owned subsidiary of
the company and was engaged in the business activities of strategic and
non-strategic investments and financing mainly to its group subsidiary
or associate companies worldwide. The amalgamation has been accounted
for under the “Pooling of Interest Method” as prescribed under
Accounting Standard 14 – “Accounting for Amalgamations” (AS 14) issued
by the Institute of Chartered Accountants of India and as notified u/s.
133 of the Companies Act, 2013 read with Rule 7 of the Companies
Accounts Rules 2014.

The scheme has been given effect to in these
financial statements and accordingly;

(i) The Financial Statements for
the year ended March 31, 2015 which were earlier approved by Board of
Directors on May 29, 2015 and audited by the statutory auditors of the
Company have been revised.

(ii) All the assets, liabilities, reserves
and surplus of Transferor Company were recorded in the books of the
Company at their carrying amounts and in the same form as at the
appointed date. Transferor Company being a wholly owned subsidiary of
the Company neither any shares are required to be issued nor any
consideration is paid. The Equity Share Capital, Preference Share
Capital, Share application money pending allotment and securities
premium account of the Transferor Company and the carrying value of
investment in Equity Shares, Preference Shares and Share application
money of the Transferor Company in the books of the Transferee Company
stands cancelled. Accordingly, the difference of Rs. 6,498.8 Million
between the amount of share capital of the Transferor Company and the
consideration being Nil, after adjusting for the carrying value of
Investments in the books of the Company is credited to Capital Reserve.

From Auditors’ Report Emphasis of Matter

We draw attention to Note 51 to
the standalone financial statements. As referred to in the said Note,
the financial statements of the Company for the year ended 31st March,
2015 were earlier approved by the Board of Directors at their meeting
held on 29th May, 2015 which were subject to revision by the Management
of the Company so as to give effect to the Scheme of Arrangement for
amalgamation of Sun Pharma Global Inc., a wholly owned subsidiary, into
the Company w.e.f 1st January, 2015. Those financial statements were
audited by us and our report dated 29th May, 2015, addressed to the
Members of the Company, expressed an unqualified opinion on those
financial statements and included an Emphasis of Matter paragraph
drawing attention to the foregoing matter. Consequent to the Company
obtaining the required approvals, the aforesaid financial statements are
revised by the Company to give effect to the said Scheme of
Arrangement.

Apart from the foregoing matter and the provision for
proposed dividend, the attached financial statements do not take into
account any events subsequent to the date on which the financial
statements referred to in paragraph 1 above were earlier approved by the
Board of Directors and reported upon by us as aforesaid.

Accounting by Real Estate Companies

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Accounting for real estate construction under Indian GAAP was covered
under the Guidance Note on Accounting for Real Estate Transactions
(Revised 2012). Under Ind AS real estate construction accounting is
specifically scoped into Ind AS 11 Construction Contracts. In this
article, Dolphy D’Souza discusses the similarities and dissimilarities
of accounting between the Guidance Note and Ind AS 11.

Scoping – Ind AS 18 or Ind AS 11?

Under
IFRS, IFRIC Interpretation 15 Agreements for the Construction of Real
Estate deals with accounting of real estate contracts. Determining
whether an agreement for the construction of real estate is within the
scope of IAS 11 (Ind AS 11) Construction Contracts or IAS 18 (Ind AS 18)
Revenue depends on the terms of the agreement and all the surrounding
facts and circumstances. Such a determination requires judgement with
respect to each agreement.

IAS 11 applies when the agreement
meets the definition of a construction contract set out in paragraph 3
of IAS 11: ‘a contract specifically negotiated for the construction of
an asset or a combination of assets …’ An agreement for the construction
of real estate meets the definition of a construction contract when the
buyer is able to specify the major structural elements of the design of
the real estate before construction begins and/or specify major
structural changes once construction is in progress (whether or not it
exercises that ability). Thus, a customer may ask a real estate
contractor to construct a villa (a) on a land owned by the customer and
(b) as per design and specification approved by the customer. The
customer controls the work-in-progress on an ongoing basis, and can
generally sack the contractor (albeit by payment of penalty) and hire a
new contractor. In situations such as this, the contractor will have to
apply IAS 11.

In contrast, an agreement for the construction of
real estate in which buyers have only limited ability to influence the
design of the real estate, e.g. to select a design from a range of
options specified by the entity, or to specify only minor variations to
the basic design, is an agreement for the sale of goods within the scope
of IAS 18. The entity may transfer to the buyer control and the
significant risks and rewards of ownership of the work in progress in
its current state as construction progresses. In this case, if all the
criteria in paragraph 14 of IAS 18 are met continuously as construction
progresses, the entity shall recognise revenue by reference to the stage
of completion using the percentage of completion method. The
requirements of IAS 11 are generally applicable to the recognition of
revenue and the associated expenses for such a transaction. The entity
may transfer to the buyer control and the significant risks and rewards
of ownership of the real estate in its entirety at a single time (e.g.
at completion, upon or after delivery). In this case, the entity shall
recognise revenue only when all the criteria in paragraph 14 of IAS 18
are satisfied. Thus, consider a scenario where a real estate developer
own a piece of land in which it constructs a building with about 100
flats. In this scenario, the risk and rewards are transferred to the 100
customers, when the building construction is complete and the flats are
ultimately delivered to the customers. It is inconceivable that the
risk and rewards are transferred to the 100 customers on an ongoing
basis. If that was the case, each customer would own the work in
progress and have the ability to hire another contractor to construct
his/her individual flat. That is neither legally nor practically
possible, for example, it is not possible that 100 different contractors
representing 100 different customers could possibly complete the
construction of the building.

In the Indian situation,
considering the demand of the real estate developers the standard
setters decided to carve out IFRIC 15. Further, a real estate contract
was specifically scoped in Ind AS 11. In accordance with Ind AS 11
Construction Contracts, the standard would apply to accounting in the
financial statements of contractors including the financial statements
of real estate developers. The definition of construction contracts in
Ind AS 11 also includes agreement of real estate development to provide
services together with construction material in order to perform
contractual obligation to deliver the real estate to the buyer.

Thus,
real estate construction contracts would be accounted for in accordance
with Ind AS 11, like any other construction contract. Therefore, in the
above example, the sale of 100 flats would be treated like a
construction contract to be accounted for using the percentage of
completion method (POCM) rather than accounting for them as sale of
goods, wherein, revenue is recognised when the completed flat is
ultimately delivered to the customer.

The carve in to Ind AS 11
is somewhat nebulously drafted. As per this carve in, Ind AS 11 would
apply to accounting in the financial statements of contractors including
the financial statements of real estate developers. Does that mean Ind
AS 11 would apply to contractors other than real estate contractors
also? For example, it is not absolutely clear, whether Ind AS 11 or Ind
AS 18 would apply to construction of a standard equipment such as a ship
or aircraft or windmill. The author believes that Ind AS 18 should
apply to these items, since the buyer is unable to specify the major
structural elements of the design of the equipment before construction
begins and/ or specify major structural changes once construction is in
progress whether or not it exercises that ability. In other words, the
author believes that the above items should be treated like a sale of
goods. This can also be supported by the intention of the ICAI to allow
construction contract accounting to real estate development only.

Ind AS 11 vs Guidance Note on Accounting for Real Estate Transactions (Revised 2012)

On
account of the diverse practices under Indian GAAP, the ICAI felt it
necessary to issue a revised Guidance Note titled Guidance Note on
Accounting for Real Estate Transactions (Revised 2012) to harmonise the
accounting practices followed by real estate companies in India. Under
Ind AS 11, accounting for real estate development would be accounted for
as a construction contract in accordance with Ind AS 11. An interesting
point to note is that the requirements of Ind AS 11, may or may not be
the same as those contained in the Guidance Note. This section deals
with some critical areas of similarities and differences that exist
between Ind AS 11 and the Guidance Note. Under both Ind AS 11 and the
Guidance Note, completed contract method would be prohibited. However,
there are significant dissimilarities in the way POC method is applied.

Question 1: Is the scope of the Guidance Note and Ind AS 11 the same?

The
revised Guidance Note would apply to any enterprise dealing in real
estate as sellers or developers. The term ‘real estate’ refers to land
as well as buildings and rights in relation thereto. The Guidance Note
provides an illustrative list of transactions which are in scope. The
Guidance Note applies not only to development and sale of residential
and commercial units, row houses, independent houses, with or without an
undivided share in land, but to many other real estate transactions.
These are sale of plots of land with or without any development. The
development may be in the form of common facilities like laying of
roads, drainage lines, water pipelines, electrical lines, sewage tanks,
water storage tanks, club house, landscaping etc. The sale of plots of
land, include long term sale type leases. What is a long term sale type
lease is not defined. Typically a 99 year lease would generally fulfill
the definition of a sale type lease. However, whether a 50 year lease
would be a sale type lease is a matter of conjecture and judgment will
have to be applied. However, the principles that would be used to apply
the judgment are not contained in the Guidance Note. In the author’s
view, conditions that establish whether a lease is a finance lease or
operating lease may serve as a good basis for making that decision. For
example, in the case of a 99 year lease, if the present value of the
minimum lease payments is atleast 90% or higher of the fair value of the
land, it could be construed, subject to other requirements that the
lease in substance is a sale type lease. Another example, which may be
construed as a sale type lease is a 50 year lease of land, where the
ownership is transferred to the lessee at the end of the lease period.
Whether a lease is a sale type lease or not, will have a significant
impact on the accounting. In the case of a lease, the revenue is
recognised over the lease period; whereas in a sale type lease the
revenue is accounted for when the sale type lease is executed.

The
revised Guidance Note also scopes in the acquisition, utilisation and
transfer of development rights, redevelopment of existing buildings and
structures and joint development agreements for real estate activities.

Other
than scoping in joint development agreements, the revised Guidance Note
does not provide any guidance on how to account for such agreements.
Real estate transactions of the nature covered by Accounting Standard
(AS) 10, Accounting for Fixed Assets, Accounting Standard (AS) 12,
Accounting for Government Grants, Accounting Standard (AS) 19, Leases,
and Accounting Standard (AS) 26, Intangible Assets, are outside the
scope of the Guidance Note. For example if a real estate contract was
being constructed for own administrative use, AS-10 principles rather
than this Guidance Note would apply. Similarly short-term leasing of
real estate would be covered by AS-19; however, a long term sale type
lease would be covered under the Guidance Note.

Ind AS 11 would
apply to accounting in the financial statements of contractors including
the financial statements of real estate developers. Under Ind AS 11,
there is no definition of what constitutes a real estate developer or
real estate development. Generally, the guidance in the Guidance Note
with respect to scoping may be used for Ind AS 11 purposes.

Question 2: How are transactions which are in substance delivery of goods accounted for under Ind AS and the Guidance Note?

Requirement under the Guidance Note

In
respect of transactions of real estate which are in substance similar
to delivery of goods, principles enunciated in Accounting Standard (AS)
9, Revenue Recognition, are applied. For example, sale of plots of land
without any development would be covered by the principles of AS-9.
These transactions are treated similar to delivery of goods where the
revenues, costs and profits are recognised when the revenue process is
completed. For recognition of revenue in case of real estate sales, it
is necessary that the conditions specified in paragraph 10 and 11 of
AS-9 are satisfied. Those conditions are enumerated below.

10.
Revenue from sales or service transactions should be recognised when the
requirements as to performance set out in paragraphs 11 ……. are
satisfied, provided that at the time of performance it is not
unreasonable to expect ultimate collection. If at the time of raising of
any claim it is unreasonable to expect ultimate collection, revenue
recognition should be postponed.

11. In a transaction involving
the sale of goods, performance should be regarded as being achieved when
the following conditions have been fulfilled:

i. the seller of
goods has transferred to the buyer the property in the goods for a price
or all significant risks and rewards of ownership have been transferred
to the buyer and the seller retains no effective control of the goods
transferred to a degree usually associated with ownership; and

ii.
no significant uncertainty exists regarding the amount of the
consideration that will be derived from the sale of the goods.

In
accordance with the above, the point of time at which all significant
risks and rewards of ownership can be considered as transferred, is
required to be determined on the basis of the terms and conditions of
the agreement for sale. The completion of the revenue recognition
process is usually identified when the following conditions are
satisfied:

(a) The seller has transferred to the buyer all
significant risks and rewards of ownership and the seller retains no
effective control of the real estate to a degree usually associated with
ownership;

(b) The seller has effectively handed over possession of the real estate unit to the buyer forming part of the transaction;

(c) No significant uncertainty exists regarding the amount of consideration that will be derived from the real estate sales; and

(d) It is not unreasonable to expect ultimate collection of revenue from buyers.

Revenue
from sale of lands or plots without any development is recognised when
the above conditions are satisfied. In the case of sale of developed
plots, where the development activity is significant, these would be
treated as transactions which are in substance construction type
contracts and accounted for accordingly. The Guidance Note does not
elaborate further as to when development activity would be treated as
significant or insignificant. This may have a material impact on revenue
recognition in some cases. Consider an example, where at the end of
reporting period a company sells plots of land, which will entail start
and completion of development activity subsequent to the reporting
period. If the development activity is considered significant, entire
revenue will be recognised in the subsequent reporting period, because
the 25% threshold criterion in the Guidance Note for revenue recognition
under POCM will be met only in the subsequent reporting period. If the
development activity is considered insignificant, revenue on the plot
will be recognised in the current reporting period, and revenue on the
development (to be allocated on market value basis) will be recognised
in the following reporting period. Requirement under Ind AS 18/Ind AS 11
Revenue from sale of lands or plots without any development is
recognised like a sale of goods under Ind AS 18. This is similar to the
requirement in the Guidance Note. In the case of sale of developed
plots, where the development activity is significant, these may be
treated in accordance with the Guidance Note which is to treat them as
construction type contracts. However it is questionable whether the 25%
revenue recognition threshold criterion in the Guidance Note would apply
under Ind AS. The author believes that the 25% threshold in the
Guidance Note is not relevant under Ind AS and entities will have to
apply judgement to assess whether the general revenue recognition
criteria are fulfilled.

Question 3: What are in substance
construction type contracts and how are they accounted for under the
Guidance Note and Ind AS?

Requirement in the Guidance Note

In
the case of real estate transaction which has the same economic
substance as construction contracts, the Guidance Note draws upon the
principles enunciated in Accounting Standard (AS) 7, Construction
Contracts and Accounting Standard (AS) 9, Revenue Recognition. Some
indicators of construction type contracts are:

(a) The duration
of such projects is beyond 12 months and the project commencement date
and project completion date fall into different accounting periods.

(b)
Most features of the project are common to construction contracts,
viz., land development, structural engineering, architectural design,
construction, etc.

(c) While individual units of the project are
contracted to be delivered to different buyers these are interdependent
upon or interrelated to completion of a number of common activities
and/or provision of common amenities.

(d) The construction or development activities form a significant proportion of the project activity.

For
example, construction and sale of units in a residential complex would
be covered by the principles of AS-7 and AS-9. The
construction/development of commercial and residential units has all
features of a construction contract – land development, structural
engineering, architectural design and construction are all present. The
natures of these activities are such that often the date when the
activity is commenced and the date when the activity is completed
usually fall into different accounting periods.

In case of real
estate sales, which are in substance construction type contracts, a two
step approach is followed for accounting purposes. Firstly, it is
assessed whether significant risks and rewards are transferred to the
buyer. The seller usually enters into an agreement for sale with the
buyer at initial stages of construction. This agreement for sale is also
considered to have the effect of transferring all significant risks and
rewards of ownership to the buyer provided the agreement is legally
enforceable and subject to the satisfaction of conditions which signify
transferring of significant risks and rewards even though the legal
title is not transferred or the possession of the real estate is not
given to the buyer. After satisfaction of step one, the second step is
applied, which involves the application of the POCM method. Once the
seller has transferred all the significant risks and rewards to the
buyer, any acts on the real estate performed by the seller are, in
substance, performed on behalf of the buyer in the manner similar to a
contractor. Accordingly, revenue in such cases is recognized by applying
the POCM method on the basis of the broad methodology explained in AS
7, Construction Contracts and detailed in the Guidance Note.

Paragraph
3.3 of the 2012 Guidance Note states as follows: “The point of time at
which all significant risks and rewards of ownership can be considered
as transferred, is required to be determined on the basis of the terms
and conditions of the agreement for sale. In the case of real estate
sales, the seller usually enters into an agreement for sale with the
buyer at initial stages of construction. This agreement for sale is also
considered to have the effect of transferring all significant risks and
rewards of ownership to the buyer provided the agreement is legally
enforceable and subject to the satisfaction of conditions which signify
transferring of significant risks and rewards even though the legal
title is not transferred or the possession of the real estate is not
given to the buyer.”

The 2012 Guidance note contains an
anti-abuse clause to prevent companies from recognising revenue in
certain circumstances. Paragraph 3.4 of the Guidance Note states that
“The application of the methods described above requires a careful
analysis of the elements of the transaction, agreement, understanding
and conduct of the parties to the transaction to determine the economic
substance of the transaction. The economic substance of the transaction
is not influenced or affected by the structure and/or legal form of the
transaction or agreement.” Though this appears to be an anti-abuse
clause the full meaning of this paragraph is not clear and hence,
judgement would be required in many situations.

The anti-abuse
clause was more clearly spelt out in paragraph 9 of the 2006 Guidance
Note which required the nature and extent of continuing involvement of
the seller to be assessed to determine whether the seller retains
effective control. In some cases, real estate may be sold with a degree
of continuing involvement by the seller such that the risks and rewards
of ownership are not transferred; for example, this may happen in the
case of a sale and repurchase agreements which include put and call
options, and agreements whereby the seller guarantees occupancy of the
property for a specified period. The anti-abuse clause in the 2012
Guidance Note is more broadly drafted and some may argue that it
encompasses many other situations. For example, a real estate company
may be precluded from considering real estate sales made to related
parties that are not genuine for the purposes of determining whether it
has satisfied the various threshold limits prescribed in the Guidance
Note for recognising revenue.

Paragraph 4.3 of the 2012 Guidance
Note sets out a very interesting perspective on the linkage between the
transfer of a legal title and the transfer of risks and rewards of
ownership. Paragraph 4.3 states “Where transfer of legal title is a
condition precedent to the buyer taking on the significant risks and
rewards of ownership and accepting significant completion of the
seller’s obligation, revenue should not be recognised till such time
legal title is validly transferred to the buyer”. For example, a real
estate company may have entered into a sale contract with a customer, of
a flat in a building that would take two years to complete. The
customer prefers to register the contract and pay stamp duty after two
years at the time of receiving possession of the flat to postpone the
cash outflow and thereby save on interest. On the other hand, another
customer that is availing a bank loan may have to register the sale
deed, pay stamp duty and obtain legal title immediately on entering into
the contract. In the former case, just because the customer is
obtaining legal title only at the time of possession, should not
preclude revenue recognition in the books of the real estate company. In
many cases, legal title would be deemed to be transferred to the
customer on entering into an agreement for sale, and registration with
the local authority may be seen as a formality that could be completed
at a later date. What is important is the agreement for sale, has to be
legally enforceable. In addition to selling to end users, real estate
companies often sell units to investors. In such cases, real estate
companies should be able to recognise revenue as long as there is a
legally enforceable contract between the real estate company and the
investor and the real estate company has no obligation to buy back the
unit or provide any other form of guarantee.

Requirement under Ind AS 11

The
above guidance may be applied under Ind AS 11, as it may not be
inconsistent with the intention of the ICAI. The Guidance Note applies
to projects where the duration of such projects is beyond 12 months and
the project commencement date and project completion date fall into
different accounting periods. There is no such restriction under Ind AS
11, and even projects below 12 months duration may qualify for
“construction type contracts”.

Question 4: For applying POCM how is “project” defined under Ind AS 11 and the Guidance Note?

Requirement under the Guidance Note

Project
is the smallest group of units/plots/saleable spaces which are linked
with a common set of amenities in such a manner that unless the common
amenities are made available and functional, these units/plots /
saleable spaces cannot be put to their intended effective use. The
definition of a project is very critical under the Guidance Note,
because that determines when the threshold for recognising revenue is
achieved and also the manner in which the POCM is applied. In other
words, the manner in which the project is defined by a company may have a
significant impact on the revenue, cost and profit that is recognised.
If the entire township is considered as a project then it is likely that
the threshold limit for recognising revenue is achieved much later as
compared to when each building in the township is identified as a
project.

Consider an example where two buildings are being
constructed adjacent to each other. Both these buildings would have a
common underground water tank that will supply water to the two
buildings. As either of the building cannot be put to effective use
without the water tank, the project would be the two buildings together
(including the water tank). Consider another example, where each of
those two buildings have their own underground water tank and other
facilities and are not dependant on any common facilities. In this
example, the two buildings would be treated as two different projects.
Consider a third variation to the example, where each of those two
buildings has their own facilities, and the only common facility is a
swimming pool. In this example, judgment would be required, as to how
critical the swimming pool is, to make the buildings ready for their
intended use. If it is concluded that the swimming pool is not critical
to the occupancy of either of those two buildings, then each of those
two buildings would be separate projects. Where it is concluded that the
swimming pool is critical to put the two buildings to its intended
effective use, the two buildings together would constitute a project.

The
definition of the term ‘project’ in the Guidance Note is somewhat
nebulous. Firstly, it is defined as a smallest group of dependant units.
This is followed by the following sentence in the Guidance Note “A
larger venture can be split into smaller projects if the basic
conditions as set out above are fulfilled. For example, a project may
comprise a cluster of towers or each tower can also be designated as a
project. Similarly a complete township can be a project or it can be
broken down into smaller projects.” Once the term ‘project’ is defined
as the smallest group of dependant units, it is not clear why the word
‘can’ is used instead of ‘should’. Does it mean that there is a
limitation on how small a project can be, but no limitation on how big a
project could be? In the example, where two buildings are being
constructed adjacently, and each have their own independent facilities
and are not dependant on common facilities, there is a choice to cut
this as either a project comprising two buildings or two projects
comprising one building each. If this is indeed the case, the manner in
which this choice is exercised is not a matter of an accounting policy
choice but rather a choice that is exercised on a project by project
basis.

Requirement under Ind AS 11

The requirement under
Ind AS 11 with respect to combining or separating contracts for
accounting purposes is irrelevant in the context of accounting for real
estate. For example, under Ind AS 11, two contracts need to be combined
together for accounting purposes if they are negotiated as a single
package; the contracts are so closely interrelated that they are, in
effect, part of a single project with an overall profit margin; and the
contracts are performed concurrently or in a continuous sequence. This
guidance is inapplicable to real estate development as they involve
multiple customers. Therefore the definition of the term “project” under
the Guidance Note may well be applied under Ind AS 11.

Question 5: For applying POCM how is “project cost” defined under Ind AS 11 and the Guidance Note?

Requirement
under the Guidance Note Project cost includes cost of land,
construction costs and borrowing costs. Cost of land may include cost of
land itself or development rights and other related costs such as stamp
duty, registration and brokerage. It also includes rehabilitation
costs. For example, when land is acquired, companies have an obligation
towards rehabilitating the displaced people by providing alternative
property and/or incurring various other social obligations.

Construction
and development costs include costs that are related directly to a
specific project such as cost of designing, labour, material, equipment
hiring or depreciation costs, but would exclude depreciation of idle
plant and equipment. It would include site supervision and site
administration costs and cost of obtaining municipal sanction or
building permissions, but would exclude head office general
administration costs. Construction costs would include expected warranty
costs/provisions, that may be incurred during or post the completion of
the construction. It may be noted that real estate companies were
accounting for warranties in numerous ways. By treating warranties as
any other input cost, this Guidance Note will bring consistency in the
treatment of warranty costs. Costs that may be attributable to a project
activity in general and can be allocated are also included as
construction and development costs; for example, insurance, cost of the
technical, architecture or supervision department, construction or
development overheads, etc. Such costs are allocated using methods that
are systematic and rational and are applied consistently to all costs
having similar characteristics. Construction overheads include costs
such as the preparation and processing of construction personnel
payroll. The allocation is based on the normal level of project
activity, similar to overhead absorption in the case of inventories.
Therefore in periods of low activity, not all of the general
construction overheads would be absorbed on the fewer projects that may
be in progress.

Borrowing costs are capitalized in accordance
with AS-16 Borrowing Costs. The borrowing costs incurred towards
purchase of land forming part of construction of a commercial or
residential project are eligible for capitalisation since it does not
represent an asset in itself, but forms part of the project, which
requires substantial period of time to get ready for its intended use or
sale. However, borrowing costs incurred while land acquired for
building purposes is held without any associated development activity do
not qualify for capitalisation [Para 16 of AS 16]. Interest
capitalisation will be based on utilisation of funds, i.e., on the basis
of actual cash flow, and not on the accrual of liability. Thus,
warranty expenses that are included as project cost would be excluded
for the purposes of borrowing cost capitalisation, unless it involved an
actual cash flow. Sometimes real estate companies have to place
security deposits for the purposes of securing land or development
rights. EAC has opined that borrowing cost on the cash outflow on
security deposit cannot be capitalised, as the security deposit is not
part of the project cost.

Certain costs should not be considered
as part of the project cost, such as selling costs, costs of unconsumed
or uninstalled material delivered at site; and payment made to
sub-contractors in advance of work performed. Payment made to
sub-contractors for work performed will be considered as part of the
project cost. Further, accrual made for work done by sub-contractor will
also be considered as part of the project cost, but will be excluded
for the purposes of borrowing cost capitalisation, unless it results in
actual cash flows.

Requirement under Ind AS 11

The
above requirements of the Guidance Note would generally apply to Ind AS
11 as well. However, there is a significant difference. Under the
Guidance Note, the EAC had opined that borrowing cost on security
deposit paid for securing land cannot be capitalised. Under Ind AS,
security amount paid for land by the contractor is an advance
consideration for land. If the security amount was paid out of borrowed
funds, then borrowing cost should be capitalised provided the
construction on that land is taking place.

Question 6: How is Percentage of completion method (POCM) applied under Ind AS 11 and the Guidance Note?

Requirement under the Guidance Note

POCM
method is applied when the outcome of a real estate project can be
estimated reliably and when all the following conditions are satisfied:

(a) total project revenues can be estimated reliably;

(b) it is probable that the economic benefits associated with the project will flow to the enterprise;

(c)
the project costs to complete the project and the stage of project
completion at the reporting date can be measured reliably; and

(d)
the project costs attributable to the project can be clearly identified
and measured reliably so that actual project costs incurred can be
compared with prior estimates. Further to the above conditions, there is
a rebuttable presumption that the outcome of a real estate project can
be estimated reliably and that revenue should be recognized under the
POCM method only when the following events are completed:

  • All
    critical approvals necessary for commencement of the project have been
    obtained; for example, environmental and other clearances, approval of
    plans, designs, etc., title to land or other rights to development/
    construction and change in land use
  • When the stage
    of completion of the project reaches a reasonable level of development.
    A reasonable level of development is not achieved if the expenditure
    incurred on construction and development costs is less than 25 % of the
    construction and development costs. Such costs would exclude land cost
    but include borrowing costs.
  • Atleast 25% of the saleable project area is secured by contracts or agreements with buyers.
  • Atleast
    10 % of the total revenue as per the agreements of sale or any other
    legally enforceable documents are realised at the reporting date in
    respect of each of the contracts and it is reasonable to expect that the
    parties to such contracts will comply with the payment terms as defined
    in the contracts.

When POCM is applied, project revenue
and project costs associated with the real estate project should be
recognised as revenue and expenses by reference to the stage of
completion of the project activity at the reporting date. For
computation of revenue the stage of completion is arrived at with
reference to the entire project costs incurred including land costs,
borrowing costs and construction and development costs. Interestingly,
land cost is not included to determine whether the threshold for
recognizing revenue is reached. But once the threshold is reached land
cost is included for the purposes of determining the stage of completion
and is included in revenue and costs accordingly. As mentioned earlier,
costs incurred that relate to future activity on the project and
payments made to sub-contractors in advance of work performed under the
sub-contract are excluded and matched with revenues when the activity or
work is performed. The recognition of project revenue by reference to
the stage of completion of the project activity should not at any point
exceed the estimated total revenues from ‘eligible contracts’/other
legally enforceable agreements for sale. ‘Eligible contracts’ means
contracts/ agreements where at least 10% of the contracted amounts have
been realised and there are no outstanding defaults of the payment terms
in such contracts. To illustrate – if there are 10 Agreements of sale
and 10 % of gross amount is realised in case of 8 agreements, revenue
can be recognised with respect to these 8 agreements.

The
Guidance Note does not prohibit other methods of determination of stage
of completion, e.g., surveys of work done, technical estimation, etc.
However, computation of revenue with reference to other methods of
determination of stage of completion should not, in any case, exceed the
revenue computed with reference to the ‘project costs incurred’ method.
When it is probable that total project costs will exceed total eligible
project revenues, the expected loss should be recognised as an expense
immediately. The amount of such a loss is determined irrespective of
commencement of project work; or the stage of completion of project
activity.

The percentage of completion method is applied on a
cumulative basis in each reporting period to the current estimates of
project revenues and project costs. Therefore, the effect of a change in
the estimate of project costs, or the effect of a change in the
estimate of the outcome of a project, is accounted for as a change in
accounting estimate. The changed estimates are used in determination of
the amount of revenue and expenses recognised in the statement of profit
and loss in the period in which the change is made and in subsequent
periods. The changes to estimates include changes arising out of
cancellation of contracts and cases where the property or part thereof
is subsequently earmarked for own use or for rental purposes. In such
cases any revenues attributable to such contracts previously recognized
should be reversed and the costs in relation thereto shall be carried
forward and accounted in accordance with AS 10, Accounting for Fixed
Assets. A contract that was an eligible contract (10% of the contract
value is realised and there are no outstanding defaults) may become an
ineligible contract on subsequent default in payment by the customer.
The Guidance Note does not prescribe any requirements with respect to
the same. However, it appears logical that the guidance contained above
of treating the same as a change in accounting estimate is applied.
Thus, revenue recognized previously is reversed, and the associated
costs are transferred to inventory.

Requirement under Ind AS 11

When
the outcome of a construction contract can be estimated reliably,
contract revenue and contract costs associated with the construction
contract should be recognised as revenue and expenses respectively by
reference to the stage of completion of the contract activity at the
balance sheet date. An expected loss on the construction contract should
be recognised as an expense immediately. In the case of a fixed price
contract, the outcome of a construction contract can be estimated
reliably when all the following conditions are satisfied:

  • total contract revenue can be measured reliably;
  • it is probable that the economic benefits associated with the contract will flow to the enterprise;
  • both
    the contract costs to complete the contract and the stage of contract
    completion at the balance sheet date can be measured reliably; and
  • the
    contract costs attributable to the contract can be clearly identified
    and measured reliably so that actual contract costs incurred can be
    compared with prior estimates. In making a judgment about reliability of
    measurement, the following requirements under the Guidance Note may
    appear consistent with the overall Ind AS framework:
  • All
    critical approvals necessary for commencement of the project have been
    obtained; for example, environmental and other clearances, approval of
    plans, designs, etc., title to land or other rights to development/
    construction and change in land use. However the following requirement
    in the Guidance Note appears inconsistent with the overall Ind AS
    framework:
  • When the stage of completion of the project
    reaches a reasonable level of development. A reasonable level of
    development is not achieved if the expenditure incurred on construction
    and development costs is less than 25 % of the construction and
    development costs. Such costs would exclude land cost but include
    borrowing costs.

This requirement appears inconsistent
with Ind AS because a threshold of 25% for a real estate company that
routinely constructs real estate appears very arbitrary. Real estate
entities therefore should make their own judgment based on the
particular facts and circumstances.

In accordance with the
Guidance Note, a real estate developer will start recognising revenue
from constructiontype contracts only after it satisfies the prescribed
criteria, e.g., the project has reached a reasonable level of
development and minimum 25% of the estimated revenues are secured by
contracts. Apparently, Ind AS 11 does not allow deferral of revenue in
this manner. Rather, it requires a company to start recognising revenue
from a construction contract immediately. In cases where the outcome of
the contract cannot be estimated reliably, the recognition of revenue is
restricted to the extent of costs incurred, which are probable of
recovery.

An interesting question that is often asked is the
treatment of land in a real estate construction contract. Some may argue
that under Ind AS 11 the cost of land does not represent “contract
activity” or “work performed” and therefore is not to be considered in
determining the stage of completion. In addition, when the percentage of
completion is based on physical inspection, no activity will be
measured if land has been acquired but the actual construction has not
yet commenced. In the Guidance Note, land is included as an input cost
and in the application of the POCM method for recognizing revenue, costs
and profits. However, land cost is not included to determine if the 25%
threshold is reached to start applying the POCM method.

Question 7: How are multiple elements accounted for under the Guidance Note and Ind AS 11?

Requirement
under the Guidance Note An enterprise may contract with a buyer to
deliver goods or services in addition to the construction/development of
real estate [e.g. property management services, sale of decorative
fittings (excluding fittings which are an integral part of the unit to
be delivered), rental in lieu of unoccupied premises, etc]. In such
cases, the contract consideration should be split into separately
identifiable components including one for the construction and delivery
of real estate units. For example, a real estate company in addition to
the consideration on the flat, charges for property maintenance services
for a period of two years, after occupancy. Such revenue is accounted
for separately and over the two year period of providing the maintenance
services. The consideration received or receivable for the contract
should be allocated to each component on the basis of the fair market
value of each component. Such a split-up may or may not be available in
the agreements, and even when available may or may not be at fair value.
When the fair market value of all the components is greater than the
total consideration on the contract, the Guidance Note does not specify
how the discount is allocated to the various components. Under the
proposed revenue recognition standard Ind AS 115, the allocation is done
on a proportion of the relative market value.

Requirement under Ind AS 11

The above guidance is generally not inconsistent with the requirements of Ind AS.

Illustration : Guidance Note vs Ind AS

Example under Guidance Note Relevant Details of a project are as below:

Total saleable area 20,000 Square Feet
Land cost Rs. 300.00 lakh
Estimated construction costs Rs. 300.00 lakh
Estimated project costs Rs. 600.00 lakh
Work Completed till the reporting date (includes land cost of Rs. 300 lakh and construction cost of Rs. 60
lakh) – Scenario 1		 Rs. 360.00 lakh
Work Completed till the reporting date (includes land cost of Rs. 300 lakh and construction cost of Rs. 90
lakh) – Scenario 2		 Rs. 390.00 lakh
Total Area sold till reporting date. 5,000 Square Feet
Total sale consideration as per agreements of sale executed Rs. 200.00 lakh
Amount realised till the end of reporting period Rs. 50.00 lakh
Percentage of work completed
Scenario 1 60% of the total project cost
(including land cost or 20% of construction
cost)
Scenario 1 65% of the total project cost
(including land cost or 30% of construction
cost)
Application of requirements

Scenario 1

At
the end of the reporting period the enterprise will not be able to
recognise any revenue as reasonable level of construction, which is 25%
of the total construction cost, has not been achieved, though 10% of the
agreement amount has been realised. Scenario 2 Apparently, the company
meets all the criteria for revenue recognition from the project. It
therefore recognised revenue arising from the contract using the POCM.
However, revenue recognised should not exceed estimated total revenue
from legally binding contracts. The revenue recognition and profits will
be as under:

Revenue Recognised
(65% of Rs. 200 lakh as per the agreement
of sale)		 Rs. 130.00 lakh
Proportionate cost of revenue
(5000 /20000 x 390)		 Rs. 97.50 lakh
Income from the Project Rs. 32.50 lakh
Work in progress to be carried forward
(Rs. 390 lakh – Rs. 97.50 lakh)		 Rs. 292.50 lakh
Example under Ind AS 11

Analysis of Scenario 1

  • It is questionable
    whether the 25% threshold under
    the Guidance Note for revenue recognition will apply under Ind AS. The
    real estate entity may conclude that the 20% threshold is reasonable and
    thereby start recognising revenue.
  • Even if the real estate
    entity believes that the threshold of revenue recognition has not been
    reached, revenue will have to be recognised. The recognition of revenue
    is restricted to the extent of costs incurred, which are probable of
    recovery. Analysis of Scenario 2
  • Some may argue that under
    Ind AS 11 the cost of land does not represent “contract activity” or
    “work performed” and therefore is not to be considered in determining
    the stage of completion. Therefore percentage completion is not 65% but
    is 30%.

Rs in lakhs
Revenue recognised 30% if Rs 200 lakh 60
Proportionate cost of revenue 30% of (5000/20000 x 600) 45
Profit to be recognised 15
Work in progress (390 – 45) 345

Overall Conclusion

The ICAI should address all the above issues and preferably
come out with a Revised Guidance Note to deal with
Real Estate Accounting under Ind AS.

Section A: Disclosure as per section 186(4) of the Companies Act , 2013

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Section A: Disclosure as per section 186(4) of the Companies Act , 2013

Compilers’ Note
Section 186(4) of the Companies Act, 2013 requires disclosure in the financial statements regarding “full particulars of the loans given, investment made or guarantee given or security provided and the purpose for which the loan or guarantee or security is proposed to be utilised by the recipient of the loan or guarantee or security”. This disclosure is in addition to the disclosures required for ‘loans and advances’ as per Schedule III to the Companies Act, 2013 as well as related disclosures required as per the notified accounting standards.

The disclosures u/s. 186(4) apply to all companies – including private limited companies.

Given below are some illustrative disclosures given by companies for the above.

Hindalco Industries Ltd . (31-3-2015)
From Notes to Financial Statements
Fixed Assets

53. (a) D etails of Loans given, Investments made and Guarantees given covered u/s. 186(4) of the Companies Act, 2013:
(i) D etails of Investments made given as part of Note No. 14 (Non-Current Investments) and Note No. 17 (Current Investments).

(ii) Loans and Corporate Guarantees given below: (Rs. Crore)

Gillette India Ltd. (30-6-2015)
From Notes to Financial Statements

1. Disclosure required under 186(4) of the Companies Act, 2013 for loans given:

Above intercorporate loans have been given for general business purposes for meeting their working capital requirements.

Reliance Industries Ltd . (31-3-2015)
From Notes to Financial Statements

37. Details of loans given, investments made and guarantee given covered u/s 186(4) of THE COMPANIES ACT, 2013 Loans given and Investments made are given under the respective heads.

Sobha Ltd . (31-3-2015) From Notes to Financial Statements Disclosure required u/s.186(4) of the Companies Act 2013: For details of loans, advances and guarantees given and securities provided to related parties refer note 26. Note: Note 26 gives disclosures regarding names of related parties and transaction details. The same are not reproduced here.

Tata Global Beverages Ltd .
(31-3-2015)
From Directors’ Report
Particulars of Loans, Guarantees or Investments by the Company

Details of Loans, Guarantees and Investments covered under the provisions of Section 186 of the Companies Act, 2013 are provided in Annexure 3 attached to this report.

Annexure 3
Particulars of investment made and guarantee/loan given during the year

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