BCAJ | Bombay Chartered Accountant Journal

Unabsorbed losses and depreciation – Difference in treatment

Difference between Accounting Standards (AS) and Ind–AS in regard to recognition of Deferred Asset (DTA ) in regard to unabsorbed losses and carry forward depreciation.

There is a difference in the virtual Certainty Principles in AS 22 and Ind AS 12 for recognition of DTA on unabsorbed losses and carry forward depreciation.

Accounting Standard – 22
AS 22 Accounting for Taxes on Income lays down the general criterion of “reasonable certainty” for the recognition of a deferred tax asset (DTA ). However, if an entity has unabsorbed depreciation or carry forward of tax losses, it needed to satisfy a much higher threshold of “virtual certainty supported by convincing evidence” to recognise DTA . Virtual certainty refers to the extent of certainty, which, for all practical purposes, can be considered certain. Virtual certainty cannot be based merely on forecasts of performance such as business plans. Virtual certainty is not a matter of perception and is to be supported by convincing evidence. Evidence is a matter of fact. To be convincing, the evidence should be available at the reporting date in a concrete form, for example, a profitable binding export order, cancellation of which will result in payment of heavy damages by the defaulting party. On the other hand, a projection of the future profits made by an enterprise based on the future capital expenditures or future restructuring etc., submitted even to an outside agency, e.g., to a credit agency for obtaining loans and accepted by that agency cannot, in isolation, be considered as convincing evidence. Even subsequent opinions from the Expert Advisory Committee have emphasised the need for profitable binding orders for recognition of DTA .

Apparently, the “virtual certainty” criteria laid down in AS 22 for the recognition of DTA was difficult to implement because it required the existence of profitable binding orders. In many industries, the requirement for orders does not exist, and hence, it was difficult to demonstrate virtual certainty in those cases, despite the existence of other convincing evidence.

Ind AS – 12
The requirement in Ind AS 12 is somewhat relaxed when compared to the requirements in AS 22. Under Ind AS 12, when an entity has a history of recent losses, the entity recognises a deferred tax asset arising from unused tax losses or tax credits only to the extent that the entity has sufficient taxable temporary differences or there is convincing other evidence that sufficient taxable profit will be available against which the unused tax losses or unused tax credits can be utilised by the entity. An entity considers the following criteria in assessing the probability that taxable profit will be available against which the unused tax losses or unused tax credits can be utilised:

a) whether the entity has sufficient taxable temporary differences relating to the same taxation authority and the same taxable entity, which will result in taxable amounts against which the unused tax losses or unused tax credits can be utilised before they expire;
b) whether it is probable that the entity will have taxable profits before the unused tax losses or unused tax credits expire;
c) whether the unused tax losses result from identifiable causes which are unlikely to recur; and
d) whether tax planning opportunities are available to the entity that will create taxable profit in the period in which the unused tax losses or unused tax credits can be utilised.

A deferred tax asset shall be recognised for the carryforward of unused tax losses and unused tax credits to the extent that it is probable that future taxable profit will be available against which the unused tax losses and unused tax credits can be utilised. To the extent that it is not probable that taxable profit will be available against which the unused tax losses or unused tax credits can be utilised, the deferred tax asset is not recognised.

Differences
Whilst the requirement in Ind AS 12 are somewhat relaxed; it does not necessarily mean that it has become absolutely easy to recognise DTA on unabsorbed losses and carry forward depreciation. Nonetheless, there could be many situations where a DTA can be recognised under Ind AS 12 but not under AS 22. For example, in the scenarios below, DTA is not recognised under AS 22, but may be recognised under Ind AS 12.

a) A newly set-up entity (New Co.) incurred significant losses in the first three years of operations due to reasons such as advertising and initial setup related costs, significant borrowing costs and lower level of activity in the first two years of operations. Over the years, there has been a significant increase in the operations of New Co. and its advertisement cost has stabilised to a normal level. Further, it has raised new capital during the year and repaid its major borrowing. The cumulative effect of all the events is that the New Co. has started earning profits from the fourth year. It is expected to make substantial profits in the next three years that may absorb the entire accumulated tax loss of the entity. However, the nature of the business is such that it does not have any binding orders.

b) A battery manufacturer (Battery Co.), who had incurred tax losses in the past, enters into an exclusive sales agreement with a car manufacturer (Car Co.). According to the agreement, all the cars manufactured by Car Co. will only use batteries manufactured by Battery Co. Though Car Co. has not guaranteed any minimum off-take, there is significant demand for its cars in the market.

c) An oil exploration company may have discovered proven oil reserves, whose extraction will result in significant profits based on current and forward prices of oil.

The virtual certainty principle has a fatal flaw; since nothing in this world is virtually certain. Even profitable binding orders could be cancelled without receiving any penalty or the buyer/seller could end up getting bankrupt. The principle of convincing evidence under Ind-AS12 is not only fair, but is also practical to apply, compared to the “virtual certainty” principle under AS 22. The standard setters should immediately revise AS 22 and bring it in line with Ind-AS 12.

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Presentation of Excise Duty under Ind AS

Query
Paragraph 8 of IAS 18 “Revenue” states as follows:
“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. Therefore, they are excluded
from revenue. Similarly, in an agency relationship, the gross inflows of
economic benefits include amounts collected on behalf of the principal
and which do not result in increases in equity for the entity. The
amounts collected on behalf of the principal are not revenue. Instead,
revenue is the amount of commission.”

Paragraph 47 of Ind AS 115
“Revenue from Contracts with Customers” states, “An entity shall
consider the terms of the contract and its customary business practices
to determine the transaction price. The transaction price is the amount
of consideration to which an entity expects to be entitled in exchange
for transferring promised goods or services to a customer, excluding
amounts collected on behalf of third parties (for example, some sales
taxes). The consideration promised in a contract with a customer may
include fixed amounts, variable amounts, or both.”

IAS 18 and
its replacement IFRS 15 (Ind AS 115) have established a principle that
is very broad and may not be conclusive in determining the presentation
of certain indirect taxes. For example, both the standards may result in
requiring sales tax to be presented as a tax collected from the
customer on behalf of the government; however, the presentation of
excise duty may not be abundantly clear.

The current Indian GAAP AS 9 ‘Revenue Recognition’ states as follows with respect to presentation of excise duty.

The
amount of revenue from sales transactions (turnover) should be
disclosed in the following manner on the face of the statement of profit
or loss:

Turnover (Gross) XX

Less: Excise Duty XX

Turnover (Net) XX

The
amount of excise duty to be deducted from the turnover should be the
total excise duty for the year except the excise duty related to the
difference between the closing stock and opening stock. The excise duty
related to the difference between the closing stock and opening stock
should be recognised separately in the statement of profit or loss, with
an explanatory note in the notes to accounts to explain the nature of
the two amounts of excise duty.

AS 9 is very prescriptive and
does not establish a clear principle for requiring a net presentation of
excise duty. Besides it contains a fatal flaw. On the one hand, it
requires a net presentation, which may mean that excise duty is
collected from the customer on behalf of the government. On the other
hand, it requires excise duty to be included in the cost of inventory,
which may mean that excise duty is paid by the manufacturer as part of
its cost of producing the inventory. Both these principles are
absolutely contradictory to each other. Therefore, AS 9 may not be very
helpful in determining the presentation of excise duty under Ind AS.

Arguments supporting a gross presentation of excise duty under Ind AS
Excise
duty is a duty on manufacture or production of excisable goods in
India. The law in India provides that a duty of excise on excisable
goods which are produced or manufactured in India shall be levied and collected at the time of removal of goods from factory premises or from approved place of storage. The taxable event is the manufacture or production of an excisable article and the duty is levied and collected at a later stage for administrative convenience. The levy of excise duty is not restricted only to excisable goods manufactured and intended for sale. It is also leviable on excisable goods manufactured or produced in a factory for internal consumption. Although the duty is usually paid only when the goods leave the warehouse, this is described as merely a practical expedient. The duty becomes payable once the goods are manufactured and is payable even if the goods are not sold (eg., are scrapped or utilised for own use). Further, scrapping of inventory post manufacture nullifies the whole transaction and any credit availed on inputs needs to be reversed. Thus the manufacturer is not acting as an agent for the tax authority.

The excise duty recovered should be included as part of revenues. The excise duty is a tax on manufacture and the risk of financial loss relating to non-recovery of this duty is with the manufacturer. This duty is similar to any other cost of production and is payable by the manufacturer irrespective of whether it ultimately recovers it from another party or even if it does not sell the goods ultimately. Therefore, the Company is not necessarily recovering these taxes on behalf of the government. In other words, the Company is not acting as an agent for the tax authority but is acting as principal for the whole amount.

Excise duty may be levied on different basis for different industries. These may be linked to the transaction value or Maximum Retail Price (MRP) or based on a specific valuation or a volume-based determination. In the case of sales tax or VAT , levy is on the basis of the sales price charged to customer. Therefore it appears that excise duty is more a cost of production rather than a levy on sales.

Arguments supporting a net presentation of excise duty under Ind AS

The excise duty should be reduced from revenues. From a manufacturer perspective, excise duty is a regulatory levy which is ultimately borne by the consumers. It does not add any value to the goods sold and hence, including it in revenue will not reflect the real revenue of the manufacturer.

IAS18.8 specifically states that 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. The excise duty collected from the customer (as evidenced in the excise invoice) is only a recovery of excise duty paid by the company and therefore does not result in an increase in equity. The excise duty is also similar to a value added tax and accordingly not to be included within revenues. In spirit, the excise duty mechanism is not substantially different from the way sales tax operates, and hence excise duty should be presented in the same manner as sales tax. In other words, revenue is presented net of excise duty.

Amount of excise duty forming part of the sale price of the goods is required to be indicated separately in all documents relating to assessment of duty, e.g., excise invoice used for clearance of excisable goods. It is, however, open to a manufacturer to recover excise duty separately or not to make a separate recovery but charge a consolidated sale price inclusive of excise duty. The incidence of excise duty is deemed to be passed on to the buyer, unless contrary is proved by the payer of excise duty. The buyer can subsequently claim a credit for the amount of excise duty paid (or deemed to be paid) as part of the purchase price. Further, the excise duty paid as a result of purchase of inputs for production/manufacture (as was included in the price of purchases), is available as a duty credit which is set off against the duty payable on production. As a result, effectively, there are no excise duty costs borne by the entities from purchase or production/sale of the goods and costs are borne by the ultimate consumers. In other words, the mechanism relating to excise duty is not materially different from sales tax, and hence the same principles should apply.

The excise duty rates are prescribed by the law and full amount paid is included in the invoice value to be recovered from customers. Further the obligation to make the payment arises only at the time of dispatch to customers. The duty is levied based on invoice value and is required to be separately stated on the invoice itself creating a constructive obligation to transfer the impact of any change in rates to the customers. The above analysis seems to indicate that while legally manufacturers/producers could have the primary obligation to pay the duty; the collection mechanism indicates that they are acting as collection agents.

In case a certain product is exempt from excise (not dutiable) at the time of manufacture, but subsequently is made dutiable on the date of removal for sale, such goods will continue to not be chargeable to excise – considering the status on date of manufacture. However, if a certain rate of duty is applicable at the time of manufacture (say 8%), but changes by the date of removal (say 12%), the rate prevailing at the time of removal (12%) will apply. This provides a mixed indicator of whether excise duty is a cost of manufacture or a duty on sales. Sales tax is usually calculated as a percentage of price charged to the customer. Therefore, if there is a change in the tax rate between manufacture and sale, the price charged to the customer (inclusive of tax) will need to be adjusted for the new tax rate.

In case of sales return, credit is allowed for the excise duty originally paid. Similarly excise duty is refunded if goods that left the factory are returned back to the factory. This operates similar to sales tax. For example, sales returns usually within a period of 6 months are considered for adjustment in sales tax liability.

-Assessment under US GAAP

In the absence of specific guidance under IAS 18/ other IFRS, reference has been made to other GAAP (US GAAP EITF Issue 99-19 Reporting Revenue Gross as a Principal versus Net as an Agent). Under the EITF 99- 19, the various indicators supporting the gross and net presentation are summarised below-

Whether an entity is acting as a principal or agent in collecting excise taxes on behalf of the authorities is a matter of judgment, and no one factor may support a
conclusion on its own, and the relative strength of each indicator may be considered

a. Whether the entity is exposed to financial risks in respect of the excise Duty.

i. General inventory risk

Gross presentation-Excise is levied once goods leave an entity’s warehouse (i.e. even where goods are used for internal consumption and irrespective whether they are sold or not). Thus, an entity would bear the risk of the excise duty where goods may not be sold.

Net presentation- Excise duty may be recovered in cases where goods are damaged, obsolete, or not sellable and thus in this case, the inventory risk for
excise duty would not lie with the entity.

ii. Credit risk
Gross presentation- An entity is required to pay excise on the goods, irrespective of whether they are sold or not. While the amounts can be recovered from the customers on sale, the credit risk will lie with the entity if receivables are not collected.

Net presentation- No matters to support.

b. Whether the entity has the discretion to determine the price of the goods charged to the customer (in respect of the excise duty)

Gross presentation- An entity is required to disclose the amount of excise duty forming part of the sale price of the goods is required to be indicated separately in all documents relating to assessment of duty, e.g., excise invoice used for clearance of excisable goods. It is, however, open to a manufacturer to recover excise duty

separately or not to make a separate recovery but charge a consolidated sale price inclusive of excise duty. Further, an entity would have the final authority in determining the final selling price of the product and may decide to recover a part or the whole excise duty from its customers.

Also, excise is determined as a percentage of the production cost rather than the sales cost.

Net presentation – If excise increases/decreases would mandate (by law) the price of the goods to increase/decrease, the discretion to determining price in respect of
excise may not lie with the entity.

-Guidance Note on Accounting Treatment for Excise Duty

The relevant extracts are given in the table below. Excise duty is a duty on manufacture or production of excisable goods in India. Section 3 of the Central Excise Act, 1944, deals with charge of Excise Duty. This Section provides that a duty of excise on excisable goods which are produced or manufactured in India shall be levied and collected in such manner as may be prescribed. This prescription is contained in the Central Excise Rules, 1944 which provide that excise duty shall be collected at the time of removal of goods from factory premises or from approved place of storage (Rule 49). Rate of duty and tariff valuation to be applied is the one in force on that date, i.e., the date of removal (Rule 9A) and not the date of manufacture. This difference in the point of time between taxable event, viz., manufacture and that of its collection has been examined and discussed in a number of judgements. For instance, the Supreme Court in the case of Wallace Flour Mills Co. Ltd. vs. CCE [1989 (44) ELT 598] summed up the legal position as under:

“It is well settled by the scheme of the Act as clarified by several decisions that even though the taxable event is the manufacture or production of an excisable article, the duty can be levied and collected at a later stage for administrative convenience. The Scheme of the said Act read with the relevant rules framed under the Act particularly Rule 9A of the said rules, reveals that the taxable event is the fact of manufacture of production of an excisable article, the payment of duty is related to the date of removal of such article from the factory.”

Supreme Court in another case, viz., CCE vs. Vazir Sultan Tobacco Co. [1996 (83) ELT 3] held as under:

“We are of the opinion that Section 3 cannot be read as shifting the levy from the stage of manufacture or production of goods to the stage of removal. The levy is and remains upon the manufacture or production alone. Only the collection part of it is shifted to the stage of removal.”

The levy of excise duty is not restricted only to excisable goods manufactured and intended for sale. It is also leviable on excisable goods manufactured or produced in a factory for internal consumption. Such intermediate products may be used in manufacture of final products or for repairs within the factory or for use as capital goods within the factory. Excisable goods so used for captive consumption may be eligible for exemption under specific notifications issued from time to time. Finished excisable goods cleared from the place of removal may also be eligible for whole or partial duty exemption in terms of notifications issued from time to time. Such exemption, subject to specified limits, if any, may relate to a manufacturer, e.g., a small scale industrial unit. Exemption may be goods specific, e.g., handicrafts are currently wholly exempt from duty. The exemption may also be end-use specific, e.g., goods for use by defence services. Excisable goods can be removed for export out of India either whoIly without payment of duty or under bond or on payment of duty under claim for rebate of duty paid.

Excisable goods, after completion of their manufacturing process, are required to be kept in a storeroom or other identified place of storage in a factory till the time of their clearance. Each such storeroom or storage place is required to be declared to the Excise Authorities and approved by them. Such storeroom or storage place is generally referred to as a Bonded Storeroom. Dutiable goods are also allowed, subject to approval of Excise Authorities, to be removed without payment of duty, to a Bonded Warehouse outside factory. In such cases, excise duty is collected at the time of clearance of goods from such Bonded Warehouses.

In considering the appropriate treatment of excise duty for the purpose of determination of cost for inventory valuation, it is necessary to consider whether excise duty should be considered differently from other expenses. Admittedly, excise duty is an indirect tax but it cannot, for that reason alone, be treated differently from other expenses. Excise duty arises as a consequence of manufacture of excisable goods irrespective of the manner of use/disposal of goods thereafter, e.g., sale, destruction and captive consumption. It does not cease to be a levy merely because the same may be remitted by appropriate authority in case of destruction or exempted in case goods are used for further manufacture of excisable goods in the factory. Tax (other than a tax on income or sale) payable by a manufacturer is as much a cost of manufacture as any other expenditure incurred by him and it does not cease to be an expenditure merely because it is an exaction or a levy or because it is avoidable. In fact, in a wider context, any expenditure is an imposition which a manufacturer would like to minimise.

Excise duty contributes to the value of the product. A”duty paid” product has a higher value than a product on which duty remains to be paid and no sale or further utilisation of excisable goods can take place unless the duty is paid. It is, therefore, a necessary expense which must be incurred if the goods are to be put in the location and condition in which they can be sold or further used in the manufacturing process.

Excise duty cannot, therefore, be treated differently from other expenses for the purpose of determination of cost for inventory valuation. To do so would be contrary to the basic objective of carrying forward the cost related to inventories until these are sold or consumed. As stated above, liability to excise duty arises even on excisable goods manufactured and used in further manufacturing process. In such a case, excise duty paid (if the same is not exempted) on the intermediary product becomes a manufacturing expense. Excise duty paid on such intermediary products must, therefore, be included in the valuation of work-in-process or finished goods manufactured by the subsequent processing of such products.

Since the point of time at which duty is collected is not necessarily the point of time at which the liability to pay the duty arises, situations will often arise when duty remains to be collected on goods which have been manufactured. The most common of these situations arises when the goods are stored under bond, i.e., in a bonded Store Room, and the duty is paid when the goods are removed from such bonded Store Room.

Divergent views exist as to whether provision should be made in the accounts for the liability in respect of goods which are not cleared or which are lying in bond at the balance sheet date.

The arguments in favour of the creation of liability are briefly summarised under:

a) The liability for excise duty arises at the point of time at which the manufacture is completed and it is only its collection which is deferred; and

b) failure to provide for the liability will result in the balance sheet not showing a true and fair view of the state of affairs of the enterprise. The arguments against the creation of the liability, briefly summarised, are as under:

a) Though the liability for excise duty arises at the point of time at which the manufacture is completed, it gets quantified only when goods are cleared from the factory or the bonded warehouse;

b) the actual liability for excise duty may get modified by the time the goods are cleared from the factory or bonded warehouse;
c) where goods are damaged or destroyed before clearance, excise duty may be waived by the competent authority and therefore the duty may never be paid; and

d) failure to provide for the liability does not affect the profits or losses.

Since the liability for excise duty arises when the manufacture of the goods is completed, it is necessary to create a provision for liability of unpaid excise duty on stocks lying in the factory or bonded warehouse. It is true that the recovery of the duty is deferred till the goods are removed from the factory or the bonded warehouse and the exact quantification will, therefore, be at the time of removal and that estimate of duty made on balance sheet date may change on account of subsequent events, e.g., change in the rate of duty and exports under bond. But, this is true of many other items also, e.g., provision for gratuity and this cannot be an argument for not making a provision for existing liability on estimated basis.

The estimate of such liability can be made at the rates in force on the balance sheet date. For this purpose, other factors affecting liability should also be onsidered, e.g., exemptions being availed by the enterprise, pattern of sales — export, domestic etc. Thus, if a small scale undertaking is availing the benefit of exemption allowed in a particular financial year and declares that it wishes to avail such exemption during next financial year also, excise duty liability should be calculated after taking into consideration the availability of exemption under the relevant notification. Similarly, if an enterprise is captively consuming all its production of a specific product and has been availing of exemption from payment of duty on that product, no provision for excise duty may be required in respect of non-duty paid stock of that product lying in factory or bonded warehouse.

– Summary of Recommendations
a) Excise duty should be considered as a manufacturing expense and like other manufacturing expenses be considered as an element of cost for inventory valuation.
b) Where excise duty is paid on excisable goods and such goods are subsequently utilised in the manufacturing process, the duty paid on such goods, if the same is not recoverable from taxing authorities, becomes a manufacturing cost and must be included in the valuation of workin- progress or finished goods arising from the subsequent processing of such goods.
c) Where the liability for excise duty has been incurred but its collection is deferred, provision for the unpaid liability should be made.
d) Excise duty cannot be treated as a period cost. The Guidance Note requires excise duty to be treated as a cost of production. If a principal vs. agent analysis is done, the Guidance Note position would effectively translate into treating the manufacturer as the principal rather than an agent who pays excise duty on behalf of the customer. However, the Guidance Note deals with accounting of excise duty. It does not deal with presentation of excise duty in the financial statements. Asstated earlier, AS 9 requires a net presentation of excise duty. The net presentation of excise duty is contradictory to the principle under AS 9 and the Guidance Note to treat excise duty as the manufacturer’s cost.

Conclusion
Overall, it appears that there is an argument both for a gross presentation and a net presentation. Therefore at this stage, either gross presentation or net presentation under Ind AS would be acceptable. It may be more appropriate for the ICAI to come out with a clear guidance so that there can be consistency in the presentation of excise duty.

shailesh.kwebmaker

Tax Consequences of Interest Payments on Perpetual Debt

A debt which does not contain a contractual obligation to pay to the holder of the instrument both the principal and interest amount is known as perpetual debt. That does not mean that the issuer will not redeem the debt or pay interest on it. Generally, the instrument will contain an economic compulsion so that the issuer will be compelled to redeem the debt and pay interest, such as step up of interest rates on the instrument, liquidation of the issuer company, dividend blocker, etc. In accordance with Ind AS 32, such a debt is not a liability but is classified as an equity instrument. The interest paid on such a debt is treated as a distribution to equity holders.

Interestingly, from the Income-tax Act perspective, certain tax advisors argue that perpetual bonds are issued as bonds and hence result in a debtor-creditor relationship. Merely classifying them as ‘equity’ in the financial statements and showing interest payments in a manner similar to dividend to equity holders should not deprive the company of claiming these interest payments for tax deduction. This article assumes that interest payments on perpetual bonds are deductible under the Income-tax Act.

Query
Under Ind AS 12 Income Taxes, should the tax deduction on interest payments be recognised in profit or loss, or directly in equity of the issuer company?

View 1
Paragraph 35 of Ind AS 32 Financial Instruments: Presentation requires that distributions to holders of an equity instrument and transaction costs of equity transactions should be recognised directly in equity. Consequently, the interest payments on, and the costs of issuing, financial instruments themselves are recognised directly in equity. Paragraph 57 of Ind AS 12 requires that presentation of income tax consequences should be consistent with the presentation of the transactions and events themselves that give rise to those income tax consequences.

View 2
Paragraph 52B of Ind AS 12 provides more guidance on the presentation of the income tax consequences of dividends, which requires those income tax consequences to be recognised in profit or loss.

The following example deals with the measurement of current and deferred tax assets and liabilities for an entity in a jurisdiction where income taxes are payable at a higher rate on undistributed profits (50%) with an amount being refundable when profits are distributed. The tax rate on distributed profits is 35%. At the end of the reporting period, 31st December 20X1, the entity does not recognise a liability for dividends proposed or declared after the reporting period. As a result, no dividends are recognised in the year 20X1. Taxable income for 20X1 is Rs. 100,000. The net taxable temporary difference for the year 20X1 is Rs.40,000.

The entity recognises a current tax liability and a current income tax expense of Rs.50,000. No asset is recognised for the amount potentially recoverable as a result of future dividends. The entity also recognises a deferred tax liability and deferred tax expense of Rs.20,000 (Rs. 40,000 at 50%) representing the income taxes that the entity will pay when it recovers or settles the carrying amounts of its assets and liabilities based on the tax rate applicable to undistributed profits.

Subsequently, on 15th March 20X2, the entity recognises dividends of Rs.10,000 from previous operating profits as a liability. On 15th March 20X2, the entity recognises the recovery of income taxes of Rs.1,500 (15% of the dividends recognised as a liability) as a current tax asset and as a reduction of current income tax expense for 20X2.

Author’s View

View 1 is the preferred view. With respect to income tax consequences of interest payments on financial instruments that are classified as equity, it is important to understand whether those income tax consequences are linked to past transactions or events that were recognised in profit or loss. This is because, in accordance with paragraph 52B of Ind AS 12, the rationale for the accounting requirement in example above is because income tax consequences of dividends are more directly linked to past transactions or events than to distributions to owners.

Income tax consequences arising from interest payments on financial instruments that are classified as equity would not be linked to past transactions or events that were recognised in profit or loss, because:

(a) these interest payments that trigger a tax deduction could be made, irrespective of the existence of retained earnings; and
(b) income tax consequences arising from these interest payments cannot be associated with anything other than the interest payments themselves, because it is these interest payments that create a tax deduction.

Consequently, View 2 is not preferred. However, a plain technical reading of Ind AS 12 does allow the recognition of the tax credit in the P&L account. Without the amendment of Ind AS 12, View 2 should also be acceptable. The view selected should be applied consistently.

shailesh.kwebmaker

IND AS – TOO MANY UNANSWERED QUESTIONS

The first phase for Ind AS implementation will soon roll out with quarterly reporting from the first quarter of financial year 2016-17 along with comparative numbers for 2015-16. Despite being so close to the deadline, there are quite a few areas where there is lack of clarity or/and lack of legislation. This article discusses these issues at a very broad level.

Roadmap
One of the key issues with the roadmap is the alignment of implementation dates between NBFC companies and non-NBFC companies. This issue will apply to a consolidated group that has an NBFC company and a non-NBFC company. When a NBFC is below a non- NBFC company, there are several approaches on how the regulators may deal with the issue:

1. Allow the NBFC’s statutory accounts prepared under Indian GAAP to be consolidated without converting to Ind AS

2. The NBFC company prepares separate statutory financial statements under Indian GAAP, but will have to prepare Ind AS numbers for consolidation purposes

3. The NBFC is allowed early conversion to Ind AS, and hence for standalone statutory financial statements as well as consolidation purposes it applies Ind AS

4. The implementation dates for non-NBFC companies are postponed, to align them with the dates when NBFC have to apply Ind AS

When the NBFC is on the top of the structure, the problem is more serious. In this case, the non NBFC companies below the NBFC company may have prepared their financial statements as per Ind AS. For purposes of consolidation by the NBFC the non-NBFC companies beneath will have to continue preparing their accounts under Indian GAAP as well. This problem can be avoided if the NBFC company is exempted from preparing consolidated financial statements, till such time the NBFC is required to prepare Ind AS financial statements.

As can be seen each of the above approaches have their own merits/demerits. The regulators will have to take an appropriate decision after consultations with the affected groups.

The other major challenge with the roadmap is the mandatory application of Ind AS 115 Revenue from Contracts with Customers and Ind AS 109 Financial Instruments. Though the rest of the world will apply these standards much later, Indian companies will have to apply them immediately on Ind AS transition without any fall back to their predecessor standards.

A TRG (Transition Resource Group) has been set up by IASB and FASB to specifically deal with implementation and interpretation issues around IFRS 15 (Ind AS 115). Due to significant implementation issues, the IASB and FAS B are deferring the applicability of IFRS 15 by one year. India is probably the only country that applies Ind AS 115 mandatorily. It is unfortunate that India has to apply Ind AS 115 when the rest of world is still debating on several issues under Ind AS 115. In the authors opinion IAS 18 Revenue/IAS 11 Construction Contracts should apply with a choice to an early adoption Ind AS 115.

In a group that amongst other companies also has an NBFC and a foreign listing; the following situation may develop with respect to Ind AS 109:

1. The NBFC prepares its stand alone accounts under Indian GAAP

2. For India consolidation purposes the NBFC applies Ind AS 109

3. For its global listing purposes the NBFC does not use the option to early apply IFRS 9, but instead applies IAS 39.

NACAS and the ICAI will have to apply their minds on the subject and immediately come out with proper amendments after consulting the affected groups.

Minimum Alternate Tax
MAT is an unfinished legislation vis-a-vis Ind AS. Consider the following:

1. An infrastructure company has to recognise construction revenue upfront, as it is deemed to have exchanged its construction services for an intangible asset, viz., right to collect toll revenue from the public. This will result in recognition of margin and therefore will expose infrastructure companies to a potential MAT liability. This may further impair the ease of doing business in India for infrastructure companies.

2. There is no clarity on what line in the P&L, MAT will apply. This is important under Ind AS because the P&L comprises of two integral parts. The first part is the P&L before comprehensive income. The second part includes other comprehensive income, for example, gain on fair valuation of equity shares, when that option is used.

3. The first time adoption of Ind AS will result in a large number of adjustments which will be recognised in retained earnings. There is no clarity on whether and how MAT will apply to these items.

SEBI regulations
SEBI will have to provide appropriate format under clause 41 for reporting quarterly numbers under Ind AS. In the case of five year restatement for IPO purposes, it should be ideally reduced to three years and those numbers need not be restated to Ind AS, if the roadmap did not apply to the company for the earlier years.

Companies Act
Section 52 of the Companies Act prohibits a specified class of companies from using securities premium account for specified purposes, for example, applying the securities premium to adjust redemption premium on debentures or bonds. It was presumed that when Ind AS is rolled out, the specified class of companies will be notified to be companies that have applied Ind AS. There is no notification yet, from the Ministry of Corporate Affairs.

There is neither clarity nor a change in legislation with respect to distributable profits. Consider an Infrastructure company that recognises huge revenue and margins upfront, thought the cash is received in the form of toll revenue over the next several years. A prudent policy would be not to distribute the accounting profits that will realise over several future years. However, in the absence of legislation this may be difficult to enforce. It is not clear how the first time adoption changes and other comprehensive income (some of which are recycled and others are not recycled to the P&L), will impact distributable profits.

Conclusion
There is very little time, and the government and NACAS should act swiftly to provide the necessary clarifications and make appropriate changes to the legislations. This is imperative for the smooth implementation of Ind AS.

levitra

shailesh.kwebmaker

GUIDANCE NOTE ON ACCOUNTING FOR DERIVATIVE CONTRACTS

The recently issued ‘Guidance Note on Accounting for Derivative Contracts’ (GN) under Indian GAAP amongst other things will apply to forward contracts or derivatives that hedge a highly probable forecasted transaction or firm commitment. It will also apply to derivatives entered into for hedging both foreign currency and interest rate risk such as a cross currency interest rate swap which are outside the scope of AS-11.

The GN however does not cover items that are within the scope of other standards, for example, investments which are in the scope of AS-13 and forward exchange contracts to hedge existing items in the balance sheet which are in the scope of AS-11.

The GN is not meant to be exhaustive, for example, it does not cover accounting of embedded derivatives.

The GN contains the following broad requirements:

i. All derivative contracts should be recognised on the balance sheet and measured at fair value.

ii. If any entity decides not to use hedge accounting as described in this GN, it should account for its derivatives at fair value with changes in fair value being recognised in the statement of profit and loss.

iii. If an entity decides to apply hedge accounting as described in this GN, it should be able to clearly identify its risk management objective, the risk that it is hedging, how it will measure the derivative instrument if its risk management objective is being met and document this adequately at the inception of the hedge relationship and on an ongoing basis.

iv. An entity may decide to use hedge accounting for certain derivative contracts and for derivatives not included as part of Hedge Accounting, it will apply the principles at (i) and (ii) above.

v. Adequate disclosures of accounting policies, risk management objectives and hedging activities should be made in its financial statements.

In case a derivative contract is not classified as a hedging instrument because it does not meet the required criteria or an entity decides against such designation, it will be measured at fair value and changes in fair value will be recognised immediately in the statement of profit and loss.

Transitional provisions in the GN
The transitional provisions in the GN requires any cumulative impact (net of taxes) to be recognised in reserves as a transition adjustment and disclosed separately. The GN becomes applicable for accounting periods beginning on or after 1st April, 2016; its earlier application is encouraged.

Query
In March 2008, the ICAI issued an announcement that in case of derivatives, if an entity does not follow AS 30, keeping in view the principle of prudence as enunciated in Accounting Standard (AS) 1, Disclosure of Accounting Policies, the entity is required to provide for losses in respect of all outstanding derivative contracts at the balance sheet date by marking them to market.

Accordingly, Company Aggrieved Ltd. (CAL), accounting policy is to recognise mark to market losses on derivative, and ignore mark to market gains. As per its accounting policy this exercise is carried out on an itemised basis (and not on a portfolio basis).

Assume CAL is a private company with a low net worth and therefore is not covered under Ind AS, nor does it want to apply it voluntarily. On 1st April, 2016, CAL expects a huge unrecognised mark to market gain, which under the GN it is required to be recognised in reserves. CAL falls in the normal income tax bracket, and is not covered under MAT. For certain reasons, CAL wants to recognise the unrecognised mark to market profits at 31st March, 2016 in the P&L. It feels aggrieved that it is not allowed to do so under the GN.

Can CAL recognise in the year ended 31st March 2016 P&L, the unrecognised mark to market gains?

Author’s Response
Yes. The transitional provisions in the GN are conflicting with the requirement of notified accounting standard AS 5 Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies. As per AS 5, any changes in accounting policies, other than those that are caused on account of a new accounting standard is recognised in the P&L. The changes in accounting policies caused as a result of a new accounting standard are recognised as per the requirement contained in that new accounting standard. The new accounting standard may require the change in accounting policy to be recognised in the reserves.

In the instant case, the change in accounting policy is not caused as a result of a new accounting standard but due to a new Guidance Note. The changes in accounting policy due to the GN should therefore be necessarily recognised in the P&L. This will be the technically right thing to do. However, given that the GN has been issued under the authority of the ICAI, it appears that entities will have an option of either following the principle of AS 5 or to follow the requirements of the GN. In other words, the unrecognised mark to market gains can either be recognised in the 31st March 2016 P&L or alternatively is adjusted in the reserve at 1st April 2016.

levitra

shailesh.kwebmaker

SA 250: Consideration of Laws and Regulations in an Audit of Financial Statements

Laws and regulations form the substratum of any economy to ensure the
forbearance of any acts, deeds or inaction by the regulated which may be
detrimental to the interest of the economy or part thereof. Compliance
with laws and regulations by corporates is imperative, both on the
frontiers of survival and continuance. In present times, given the
multifold increase in the complexity of applicable laws and regulations,
enterprises are finding it extremely difficult to keep pace with the
plethora of changes in regulatory landscape and effective implementation
and compliance.

SA 250 Consideration of Laws and Regulations in
an Audit of Financial Statements requires auditors to ensure compliance
with the applicable framework of laws and regulations by the audited.
However, as is time and again proclaimed, auditors are watchdogs and not
bloodhounds. The responsibilities advocated by this Standard are a
direct function of ‘ifs and buts’. The auditor is not responsible for
preventing non-compliance and cannot be expected to deter non-compliance
with all laws and regulations that apply to an enterprise.

Specific
attention must be paid to the fact that compliance or non-compliance
with all laws and regulations applicable to an enterprise does not find
an immediate reflection in the financial statements. For example, while
the contribution made by an employer to Employees’ Provident Fund is
reflected in the financial statements, but say for instance,
non-compliance with the requirements of filing of returns for effluent
disposal with the Pollution Control board by a chemical manufacturing
company need not necessarily find a mention in the financial statements.

SA 250 draws a thin line between those laws and regulations
which have and which do not have a direct effect on the determination of
material amounts and disclosures in the financial statements.
Accordingly, depending on which category these laws fall under, the
auditor’s responsibilities stand differentiated. For the former, the
auditor’s responsibility is to obtain sufficient appropriate evidence
about compliance with the provisions of those laws and regulations. For
the latter category, the auditor’s responsibility is limited to
undertaking specified audit procedures to help identify non-compliance
with those laws and regulations that have a material effect on the
financial statements. However, when the line between the black and white
is grey, the auditor is supposed to exercise his professional judgment
while determining the umbrella the law falls under.

Just like
every other SA, SA 250 cannot be applied in complete isolation. As
required by SA 200, professional skepticism needs to be maintained in
the backdrop of applicable laws and regulations applicable on the
entity. While adhering to SA 250, the auditor has to also bear in mind
SA 315, which requires the auditor to obtain a general understanding of
legal and regulatory framework applicable to the industry where the
entity operates. At times, when the outcome of non-compliance is severe,
questions get raised on the validity of the growing concern assumption,
in which case, the auditor would need to consider the requirements of
SA 570. The auditor can seek written representations from the management
in terms of SA 580 about management’s knowledge of identified or
suspected non-compliance with applicable laws. However, receipt of
written representations must not affect the nature and extent of other
evidence to be obtained by the auditor in this regard.

Further,
audit procedures applied to form an opinion on the financial statements
may bring instances of noncompliance or suspected non-compliance with
laws and regulations to the auditor’s attention. Such audit procedures
may include reading of minutes, inquiring of the entity’s management and
in-house legal counsel or external legal counsel concerning litigation,
claims and assessments; and performing substantive tests of details of
classes of transactions, account balances or disclosures – for e.g.,
scrutiny of payments made to government authorities towards
fines/penalties, scrutiny of legal and professional expenses to
understand whether unusual payments have been made for
legal/retainership fees as also to seek evidence of legal cases pending
against the company etc.

The next obvious question which arises
is – What is the auditor supposed to do in case of identified or
suspected non-compliance? Firstly, the auditor must have a discussion
with the management or where appropriate, with those charged with
governance, and if sufficient information is not obtained, the auditor
may evaluate the need of obtaining legal advice. If satisfactory
information is still not obtained, the auditor shall consider its effect
on the audit opinion.

A non-compliance with applicable law or
regulation does not merely impact the financial statements.
Noncompliance can also impact the level of reliance that the auditor
places on the integrity of the management or employees. It can also
cause the auditor to reassess the possibility of material misstatements
in other areas, as also the faith the auditor places in the management’s
Written Representations.

However, if the auditor suspects that
the management is involved in non-compliance, the auditor can escalate
the issue to those charged with governance and also consider the impact
of such non-compliance on the audit opinion. If the auditor concludes
that the non-compliance has a material effect on the financial
statements, and has not been adequately reflected in the financial
statements, the auditor may express a qualified or adverse opinion on
the financial statements. This standard also provides for the scenario
that if the auditor has identified or suspects noncompliance with laws
and regulations, the auditor shall determine whether he has a
responsibility to report the same to parties outside the entity, for
instance – regulatory and enforcement authorities.

Let us now examine certain case studies.

Case Study I
ABC
Limited (‘ABC’) is engaged in the manufacturing of pharmaceutical
products, having operations in many countries across the globe. During
the year, a manufacturing unit of ABC, which accounted for over 60% of
the company’s production, received notices from the Food and Drug
Administration Authority of the United States of America and regulators
in other countries, stating that pursuant to the inspection of the
manufacturing processes at the said unit, violations of Good Medical
Practices (GMP) were observed. Several prohibitions were imposed on the
functioning of the said unit, including a prohibition to sell the
products manufactured by the unit to US regulated markets. ABC decided
to voluntarily shut down its operations in this unit on a temporary
basis to examine ‘what went wrong’. ABC however is in dialogue with
regulatory authorities to assuage the restrictions. What would be the
auditor’s responsibility in such a scenario?

Analysis

The auditor must discuss with the management the severity of the case, and the company’s current standing in this regard. The auditor has also to bear in mind that the plant accounted for over 60% of the company’s production and also the fact that other markets may also raise questions on the acceptability of products manufactured in this plant. The auditor would also need to consider whether there is a need for reduction in the carrying value of inventories, whether any provisions are required for fines/penalties, accounting for possible sales returns and if such provisions are required to be made, then the basis used by the management for arriving at such estimates. Further, in such cases, there are inherent uncertainties regarding the future actions of the regulators, the impact of which may not be ascertainable and therefore, the actual amounts incurred may eventually differ from the estimates made. If the auditor concludes that this is a significant matter, he should also consider highlighting the same as a Matter of Emphasis (MOE) in the audit report.

Case Study II

PQR Limited (‘PQR’) is a company engaged in production of steel. During the year, the company and some of its competitors received notices from Competition Commission of India (CCI) for alleged cartelization by certain steel manufacturing companies. CCI imposed a penalty of Rs. 100 Crores on PQR against which PQR has filed an appeal before Competition Appellate Tribunal. The Company has not made any provision in this regard. What would be the auditor’s responsibility in this case?

Analysis

The auditor must assess the facts and circumstances, and must have a detailed discussion with the management on the Company’s standing in the case. The auditor, if he deems necessary, must also take an independent legal opinion to deduce whether the company has a fit case or whether there is a need for making provision on a best estimate basis of the likely penalty that may be levied. The auditor should also have a joint discussion with the company’s legal counsel in this regard. Depending on the significance of the matter, the auditors may consider including a ‘Matter of Emphasis’ in the audit opinion.

Case Study III

LMN Limited is a public listed company engaged in the manufacture of automobiles. During the year ended 31 March 20X0, LMN has incurred loss of Rs.120 crore. LMN has paid to its Managing director Mr.DEF (‘DEF’) (who is also the promoter shareholder holding 51% of the paid up capital of LMN) managerial remuneration exceeding the limits set out by the Companies Act, 2013.

As LMN has incurred losses for the year, LMN was required to obtain approval from the shareholders as well as the Central Government for payment of remuneration to DEF as the same exceeded the limits set out in the Companies Act, 2013. LMN management contends that seeking approval of the shareholders was only a compliance formality as the Managing Director himself holds more than 51% of the paid up capital of LMN. What are the duties of the auditor in this regard?

Analysis

Since LMN Limited had no profits for the year, it was required to comply with the requirements of Schedule V to the Companies Act, 2013 which sets out the limits for maximum managerial remuneration payable to managerial personnel for public listed entities in the event of a loss or inadequate profits. The auditor would need to explain the management the legal position and advise the client to seek approvals of the shareholders and the Central Government or alternatively recover the remuneration paid in excess of the prescribed limits from DEF. In the event DEF chooses not to return the excess payment, the auditor would need to qualify the audit opinion for non-compliance with the requirements of the Companies Act, 2013.

Case Study IV

STU Limited (‘STU’) is engaged in the business of providing mobile telecommunication services. As per TRAI (Telecom Regulatory Authority of India) regulations, a prescribed percentage of Adjusted Gross Revenue (AGR) earned by a telecom operator is payable to the department of telecommunications as license fees. STU has been paying license fees on revenue earned from providing telecom services to its customers. According to TRAI, license fees are also payable on non-telecom revenues like profit on sale of fixed assets, rent, dividend and treasury income. TRAI has accordingly raised a demand of Rs.500 crore as license fees payable on non-telecom revenue earned by STU from inception till date. The definition of AGR is currently being challenged by all telecom operators including STU. The telecom operators have contested this interpretation of TRAI and have filed a petition before the appellate tribunal seeking injunction against TRAI demands. What would be the auditor’s responsibilities in such a case?

Analysis

The issue of payment of license fees on non-telecom revenue seems to be a pan-industry issue as against being specific to STU. The company has contested the demand raised by TRAI. However, the auditor would need to discuss with the Company’s legal counsel the basis of demands raised by TRAI and their tenability. The auditor may consider requesting STU to obtain a formal legal opinion in this regard. It would also help if the auditor were to understand as how this issue has been dealt with by STU’s competitors. Based on this evaluation, the auditor would need to assess whether a provision is warranted or a disclosure as contingent liability would be sufficient compliance.

Case Study V

HIJ Pharma Limited (HIJ) is a pharmaceutical company engaged in the manufacture of life saving drugs. HIJ is required to adhere to pricing norms as prescribed under Drug Price Control Order (DPCO). During the year ended 31 March 20X1, it was observed that some of the drugs were sold at prices much higher than those prescribed under the DPCO. Under DPCO, companies are liable to deposit the overcharged amount to the Credit of Drug Prices Equalization Account, which was not actioned by HIJ. HIJ received demand for payment of Rs.400 crores to the credit of the Drug Prices Equalisation Account under Drugs (Price Control) Order for few of its products, which was contested by HIJ. Based on its best estimate, HIJ made a provision of Rs.100 crore in its books of accounts towards the potential liability related to principal and interest amount demanded under the aforesaid order and believed that the possibility of any liability that may arise on account of penalty on this demand is remote. What are the Auditor’s duties in this regard?

Analysis

The management believes that the company would not be liable for any penalties. The auditor must ensure that adequate provisions are made in books to the extent of overcharged amount and interest thereon. Considering the provisions of AS 29 – Provisions, Contingent Liabilities and Contingent Assets – the auditor must also evaluate whether any need arises for disclosure as Contingent Liability of the amount of penalties leviable by DPCO.

Concluding remarks

The auditor’s responsibilities for reporting compliance with applicable laws and regulations have increased manifold with the increasingly changing regulatory landscape in India. Though the auditor’s professional duty to maintain confidentiality of client information precludes reporting of an identified or suspected non-compliance with laws and regulations to any third party, given the legal framework in India, the confidentiality consideration is overridden by statute, the law or courts of law. For instance, under the present legal and regulatory framework for financial institutions in India, the auditor has a statutory duty to report the occurrence, or suspected occurrence of non-compliance with laws and regulations to the supervisory authorities. The auditor therefore needs to perform his duty with due care and exercise adequate professional skepticism while providing assurance on compliance with applicable laws and regulations.

shailesh.kwebmaker

Income Computation and Disclos URE Standards (ICDS) – No Tax Neutrality

Background
The Indian Accounting Standards (Ind AS), the
Indian version of International Financial Reporting Standards, will have
significant impact on financial statements for many entities. Ind AS’s
are meant to primarily serve the needs of investors and hence are not
suitable for the purposes of tax computation. A clear need was felt for
tax accounting standards that would guide the computation of taxable
income.

The Central Government (CG) constituted a Committee in
December 2010, to draft Income Computation and Disclosure Standards
(ICDS). Section 145 of the Indian Income tax Act bestows the power to
the CG to notify ICDS to be followed by specified class of taxpayers or
in respect of specified class of income.

In August 2012, the
Committee provided drafts of 14 standards which were released for public
comments by the CG. After revisions, the CG has notified 10 ICDS
effective from the current tax year itself (viz. tax year 2015- 16) for
compliance by all taxpayers following mercantile system of accounting
for the purposes of computation of income chargeable to income tax under
the head “Profits and gains of business or profession” or “Income from
other sources”.

Earlier, the CG had notified two standards in
1996 viz., (a.) Accounting Standard I, relating to disclosure of
accounting policies. (b.) Accounting Standard II, relating to disclosure
of prior period and extraordinary items and changes in accounting
policies. They now stand superseded. These standards were largely
comparable to the current AS corresponding to AS 1 & AS 5.

ICDS
are meant for the normal tax computation. Thus, as things stand now,
ICDS has no impact on minimum alternate tax (MAT ) for corporate
taxpayers which will continue to be based on “book profit” determined
under current AS or Ind AS, as the case may be.

ICDS shall apply
to all taxpayers, whether corporate or otherwise. Further, there is no
income or turnover criterion for applicability of ICDS. An entity need
not maintain books of accounts to compute income under ICDS. However, if
the differences between ICDS and Ind AS/current AS as the case may be,
are several, an entity may need to evolve a more sophisticated system of
tracking them as against doing it manually on an excel spreadsheet. It
is possible that the current tax audit requirements will be enhanced to
require auditors to report on the correctness of tax computation under
ICDS. Non-compliance of ICDS gives power to the Tax Authority to assess
income on “best judgement” basis and also levy penalty on additions to
returned income.

List of ICDS
Following is the list of 10 ICDS notified w.e.f. April 1,2015:
1. ICDS I relating to accounting policies
2. ICDS II relating to valuation of inventories
3. ICDS III relating to construction contracts
4. ICDS IV relating to revenue recognition
5. ICDS V relating to tangible fixed assets
6. ICDS VI relating to the effects of changes in foreign exchange rates
7. ICDS VII relating to government grants
8. ICDS VIII relating to securities
9. ICDS IX relating to borrowing costs
10. ICDS X relating to provisions, contingent liabilities and contingent assets

KEY differences between icds and current as A few key differences between ICDS and current AS are given below:

ICDS I prohibits recognition of expected losses or markto- market losses unless permitted by any other ICDS.

During
the early stages of a contract, where the outcome of the construction
contract cannot be estimated reliably, contract revenue is recognised
only to the extent of costs incurred. This requirement is contained both
in AS 7 and ICDS III. However, unlike AS 7, ICDS III states that the
early stage of a contract shall not extend beyond 25 % of the stage of
completion.

AS 7 requires a provision to be made for the
expected losses on onerous construction contract immediately on signing
the contract. Under ICDS III, losses incurred on a contract shall be
allowed only in proportion to the stage of completion. Future or
anticipated losses shall not be allowed, unless such losses are actually
incurred.

Under AS 9, revenue from service transactions is
recognised by following “percentage completion method” or “completed
contract method”. Under ICDS IV, only percentage of completion method is
permitted.

Under AS 11, all mark-to-market gains or losses on
forward exchange or similar contracts entered into for trading or
speculation contracts shall be recognised in P&L. In contrast, ICDS
VI requires gains or losses to be recognised in income computation only
on settlement.

Under AS 11, exchange differences on a
non-integral foreign operation are not recognised in the P&L, but
accumulated in a foreign currency translation reserve. Such a foreign
currency translation reserve is recycled to the P&L when the
non-integral operation is disposed. Under ICDS VI, exchange differences
on non-integral foreign operations shall also be included in the
computation of income.

Under AS 12, government grants in the
nature of promoter’s contribution are equated to capital and hence are
included in capital reserves in the balance sheet. Under ICDS VII,
government grants should either be treated as revenue receipt or should
be reduced from the cost of fixed assets based on the purpose for which
such grant or subsidy is given.

Under AS 12, recognition of
government grants shall be postponed even beyond the actual date of
receipt when it is probable that conditions attached to the grant may
not be fulfilled and the grant may have to be refunded to the
government. Under ICDS VII, recognition of Government grants shall not
be postponed beyond the date of actual receipt.

Under AS 16, in
the case of borrowings in foreign currency, borrowing costs include
exchange differences to the extent they are treated as an adjustment to
the interest cost. Under ICDS IX, borrowing cost will not include
exchange differences arising from foreign currency borrowings.

AS
16 requires the fulfilment of the criterion “substantial period of
time” for treating an asset as qualifying asset for the purposes of
capitalisation of borrowing costs. ICDS IX retains substantial period
condition (i.e. 12 months) only for qualifying assets in the nature of
inventory but not for fixed assets and intangible assets. Therefore,
ICDS requires capitalisation of borrowing costs for tangible and
intangible assets even when they are completed in a short period.

Under
ICDS IX, capitalisation of specific borrowing cost shall commence from
the date of borrowing. Under AS 16, borrowing cost is capitalised from
the date of borrowing provided the construction of the asset has
started.

Unlike AS 16, income on temporary investments of
borrowed funds cannot be reduced from borrowing costs eligible for
capitalisation in ICDS IX.

Unlike AS 16, requirement to suspend
capitalisation of borrowing costs during interruption of active
construction of asset is removed in ICDS IX.

Under ICDS X, a
contingent asset is recognized when the realisation of related income is
“reasonably certain”. Under AS 29, the criterion is “virtual
certainty”.

Impact of ICDS
The notification of ICDS was imperative to ensure smooth implementation
of Ind AS, and therefore should have maintained a tax neutral position.
Unfortunately, ICDS are not tax neutral vis-à-vis the current Indian
GAAP and tax practices currently followed and may give rise to
litigation. For example, based on AS 7 Construction Contracts, the
current practice is to recognise any expected loss on a construction
contract as expense immediately. In contrast, ICDS will require expected
losses to be provided for using the percentage of completion method.

ICDS
I lays out the “accrual concept” as a fundamental accounting
assumption. The prohibition on recognising expected or mark-to-market
losses appears to be inconsistent with the accrual concept. Though
mark-tomarket losses are not allowed to be recognised, there is no
express prohibition on recognising mark-to-market gains. The ICDS
therefore appears to be one-sided, determined to maximie tax collection,
rather than routed in sound accounting principles. Matters such as
these are likely to create litigious situations despite the Supreme
Court decision in the Woodword Governor case where the status of ICDS is
upheld.

The preamble of the ICDS states that where there is
conflict between the provisions of the Income-tax Act, 1961 and ICDS,
the provisions of the Act shall prevail to that extent. Consider that a
company has claimed markto- market losses on derivatives as deductible
expenditure u/s. 37(1) of the Income-tax Act. Can the company argue that
this is a deductible expenditure under the Incometax Act (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?

Under ICDS, exchange differences arising on the
settlement or on conversion of monetary items shall be recognised as
income or as expense. Consider that a company uses foreign currency loan
for procuring fixed asset locally. Now under ICDS, the exchange
difference on the foreign currency loan will be recognised in the
P&L A/c. Now consider the following decision in Sutlej Cotton Mills
Ltd. vs. CIT (116 ITR 1) (SC) “The Law may, therefore, now be taken to
be well settled that where profit or loss arises to an assessee on
account of appreciation or depreciation in the value of foreign currency
held by it, on conversion into another currency, such profit or loss
would ordinarily be trading profit or loss if the foreign currency is
held by the assessee on revenue account or as a trading asset or as part
of circulating capital embarked in the business. But, if on the other
hand, the foreign currency is held as a capital asset or as fixed
capital, such profit or loss would be of capital nature”. As per this
decision the exchange difference in our fact pattern will be
capitalised. However, under ICDS it will be recognised in the P&L
A/c. It is not absolutely clear whether the court decision or ICDS will
prevail in the given instance.

All ICDS (except ICDS VIII
relating to Securities) contain transitional provisions. These
transitional provisions are designed to avoid double jeopardy. For
example, if foreseeable loss on a contract is already recognised on a
contract at 31st March 2015, those losses will not be allowed as a
deduction again on a go forward basis using the percentage of completion
method. On the other hand, if only a portion of the loss was
recognised, the remaining foreseeable loss can be recognised using the
percentage of completion method. The detailed mechanism of how this will
work is not clear from the ICDS.

The transitional provisions
are not always absolutely clear. In the case of non-integral foreign
operations, e.g. non-integral foreign branches, ICDS requires
recognition of gains and losses in the P&L (tax computation), rather
than accumulating them in a foreign currency translation reserve. It is
not absolutely clear from the transitional provision whether the
opening accumulated foreign currency translation reserve, which could be
a gain or loss, will be ignored or recognised in the first transition
year 2015-16. Since the amounts involved will be huge, particularly for
many banks, the interpretation of this transitional provision will have a
huge impact for those who have not already considered the same in their
tax computation in the past years.

Some of the transitional
provisions are also expected to have a material 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. Under the transitional provision, it
will recognise all such claims in the first transition year 2015-16. If
the amounts involved are material, the tax outflow will be material in
the year 2015- 16. 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.

Overall,
the CG through CBDT will have to play a highly pro-active role to
provide clarity and minimise the potential areas of litigation. An
amendment of the Incometax Act would have been more appropriate rather
than a notification of the ICDS because the impact is expected to be
very high and all pervasive.

shailesh.kwebmaker

Supplier’ Cred it – Whet her de bt or trade payable ?

Arrangements with respect to payment to suppliers
could vary substantially and may not always be straight-forward. To ease
working capital pressure, companies enter into structured transactions
that involve the supplier and bank/s. These are commonly referred to as
supply-chain finance, supplier finance, reverse factoring and structured
payable transactions. Broadly, the arrangement allows a company to pay
its supplier invoices when due (under the extended terms negotiated with
a supplier) and gives the supplier the option to accelerate collection
through a factoring arrangement. Under the factoring arrangement, the
supplier sells its receivables (i.e., invoices) from the company to the
bank at a discount. The company is then legally obligated to pay the
bank in full (i.e., the amount specified in the original invoice) since
the bank is now the legal owner of the receivables. Such an arrangement
may better enable a supplier to monetize the receivable that has
extended payment terms.

Can a company (buyer of goods and services) continue
to classify the liability related to the supplier’s invoice as a trade
payable or whether it must reclassify the liability as bank debt?

In
evaluating a structured payable arrangement, companies should determine
the classification based on the substance and individual facts and
circumstances, including the following:

What are the roles, responsibilities and relationships of each party (i.e., the company, bank and supplier)?

Is
the company relieved of its original obligation to the supplier and is
now obligated to the bank? However, being obligated to a bank instead of
the supplier does not necessarily mean that the liability is a debt.
One needs to further assess whether the liability to the bank entails a
financing element or it is merely a payment of the liability to the bank
instead of to the supplier.

Have any discounts or rebates been
received by the company that would not have otherwise been received
without the bank’s involvement?

Has the bank extended the date on which payment is due from the company beyond the invoice’s original due date?

The
terms of the structured payable arrangement must be carefully
considered to determine whether the arrangement changes the roles,
responsibilities and relationships of the parties. To continue
classifying the liability as a trade payable, the company must remain
liable to the supplier under the original terms of the invoice, and the
bank must have assumed only the rights to the receivable it purchased.
If the terms of the company’s obligation change as a result of the
structured payable arrangement, that may be an indication that the
economic substance of the liability is more akin to a financing
arrangement.

Under normal circumstances, a factoring arrangement
between a company’s supplier and a bank does not benefit the company.
That’s why it is important to understand whether the company receives
any benefit as a result of the structured payable arrangement. For
example, a bank may purchase a supplier’s receivables in a factoring
arrangement at 95% of its face amount. However, rather than collect the
full amount payable from the company, the bank may require the company
to pay only 98% of that amount. In this case, the company has received a
benefit that it would not have received without the bank’s involvement,
indicating that the liability may be more akin to a financing
arrangement.

If a structured payable arrangement with a bank
allows a company to remit payment to the bank on a date later than the
original due date of the invoice, that may also indicate that the
company has received a benefit that it would not have received without
the bank’s involvement, suggesting the liability may more be more akin
to a financing arrangement.

The analysis should focus on whether
the terms of the payable change as a result of the involvement of the
bank. If the payment terms do not change (i.e., the company must pay the
bank on the original terms of the invoice) the characteristics of the
payable may not have changed and would not reflect a financing. If the
terms of the payable have changed as a result of the bank’s involvement,
the characteristics of the liability have changed and it may no longer
be appropriate to classify the liability as a trade payable.

Other factors that may be considered include:

Is
the supplier’s participation in the structured payable arrangement
optional? If not, the company should evaluate whether the substance of
the transaction is more reflective of a financing.

Do the terms
of the structured payable arrangement preclude the company from
negotiating returns of damaged goods to the supplier?

Is the
company obligated to maintain cash balances or are there credit
facilities or other borrowing arrangements with the bank outside of the
structured payable arrangement that the bank can draw upon in the event
of noncollection of the invoice from the company?

Some
structured payable arrangements require that, as a condition for the
bank to accept an invoice from a supplier (i.e., the receivable) for
factoring, a company must separately promise the bank that it will pay
the invoice regardless of any disputes that might arise over goods that
are damaged or don’t conform with agreed-upon specifications. In the
event of a dispute, a company that agrees to such a condition would need
to seek recourse through other means, such as adjustments on future
purchases. This provision is typical among structured payable
arrangements since it provides greater certainty of payment to the bank.
However, this provision may indicate that the economic substance of the
trade payable has been altered to reflect that of a financing. It is important to consider the substance of any such condition in the context of the company’s normal practices.
For a company that buys enough 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.

In
some factoring arrangements, the bank may require that the company
maintain collateral or other credit facilities with the bank. These
requirements aren’t typical in factoring arrangements and may indicate
that the economic substance of the liability has changed to be more akin
to a financing arrangement. For the liability to be considered a trade
payable, the bank generally can collect the amount owed by the company
only through its rights as owner of the receivable it purchased from the
supplier. As can be seen from the above discussion, whether supplychain
finance should be presented as debts or trade payable is a matter of
significant judgement and would depend on the facts and circumstances of
each case.

Below are four simple examples, and the author’s opinion on whether those result in debt or trade payable classification.

1.
The company issues a promissory note to the supplier, agreeing in
writing to pay the supplier a fixed sum at a fixed future date or on
demand by the bank (discounting bank).

2. The company accepts a
bill of exchange and its banker simultaneously issues a bank guarantee
in favour of the supplier, making the bank liable to pay the supplier if
the company fails to honour its commitment on the due date. The bank
guarantee is not invoked at the reporting date. No interest is charged
to the company, and there is no impact on its credit limits.

3. The company buys goods from a supplier and needs to pay for them immediately. as it does not have the cash, it arranges for a 90 day LC in favour of the supplier. the supplier discounts the LC and receives payment immediately. the discounting charges/interest for 90 days is borne by the company. the credit limit of the company is utilised.

4. The company has entered into a separate credit limit with the bank wherein the bank will make payment to selected suppliers on company’s behalf. as per the arrangement, the supplier will invoice the company with a credit period between 180 to 240 days. This is not a normal credit period which is also appropriately reflected in the pricing of the product. The bank will make payment to the supplier after deducting discounting charges. At the due date, the company will make the full payment to the bank. The bank has no recourse against the supplier.

It may be noted that to take a proper view more detailed facts will be required, including the exact arrangement terms and the legal requirements/interpretations. on the basis of the limited information and above discussion it appears that the first two examples represent traditional factoring arrangement, the arrangement would result in the classification as “trade payables.” In the last two examples, the classification would be more likely a “debt”.

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Notification of the Companies (Indian Accounting Standards) Rules, 2015 and applicability of Indian Accounting Standards (IND AS)

On July 10,2014, the FM, while presenting the budget
for 2014-15 in para 128 has announced that: “There is an urgent need to
converge the current Indian Accounting Standards with International
Financial Reporting Standards (IFRS). I propose for adoption of the new
Indian Accounting Standards (Ind. AS) by the Indian Companies from the
financial year 2015-16 voluntarily and from the financial year 2016-17
on a mandatory basis…………”

Pursuance to above announcement, the
Ministry of Corporate Affairs announced a revised roadmap for
implementation of the new set of Indian Accounting Standards (Ind – AS)
converged with IFRS on 16th February 2015. The revised roadmap does not
cover banking and insurance companies and NBFC’s. The important
provisions of the the Companies (Indian Accounting Standards) Rules,
2015 are discussed below and these Rules are effective from 1st April
2015

– Voluntary Compliance of these Rules by companies– F.Y.2015-2016
Any company can voluntarily comply with IND AS for its financial statements for the mentioned f inancial year

– First Phase – Mandatory from F. Y. 2016/17

a.
Companies whose equity or debt securities are listed or are in the
process of being listed on any recognized stock exchange in India or
outside India and with a net worth of Rs. 500 crores or more and;
b. Companies other than those covered above having a net worth of Rs.500 crores or more;
c. the holding, subsidiary, joint venture or associate companies of the aforementioned companies; –

Second Phase: – Mandatory from F. Y. 2017/18 a.
a.
Companies whose equity or debt securities are listed on a recognized
stock exchange in India or outside India and whose net-worth is less
than Rs.500 crores;
b. Unlisted companies whose net worth is more than Rs.250 crores but less than Rs.500 crores;
c. the holding, subsidiary, joint venture or associate companies of the aforementioned companies;

Exemption:
However,
companies that are listed or in the process of being listed on SME
Exchange are exempt referred to in Chapter XB or on the Institutional
Trading Platform without initial public offering in accordance with the
provisions of Chapter XC of the Securities and Exchange Board of India
(Issue of Capital and Disclosure Requirements) Regulations, 2009.

On
February 16, 2015 the following Companies (Indian Accounting Standards)
Rules, 2015 have been notified by the Ministry of Corporate Affairs

Overview of the impact of the Indian Accounting Standard

–
Objective of the Standards: The objective of IFRS is move from a rule
based method of accounting to principle based method of accounting.
Hence during the initial period there is bound to be significant
volatility in the financial statements.
– Benefits: The Key benefits for Indian Companies with the applicability of Ind – AS include:

i) Improved access to Global Markets:
Majority
of the Stock Exchange globally require financial information as per
IFRS. The need to prepare multiple financial statements for different
requirements is eliminated.

ii) Lower cost of capital:
Convergence
with IFRS means the Indian companies need not prepare two sets of
Financial Statements comply with the requirements abroad and this would
lead to lower cost of administration and minimise the risk premium. Thus
pricing could be comparable and companies can approach any market for
capital.

iii) Benchmarking with Global Peers:
Preparing
accounts as per IFRS will give better understanding of performance in
relation to the Global benchmarks. Targets and milestones will be set
based on the global business environment.

iv) True Value of
acquisition: I n Indian GAAP except for few exceptions net assets
acquired are recorded at its carrying value instead of fair value. Hence
its true value is not reflected. IFRS overcomes this flaw as it
mandates accounting of business combinations at fair value.

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Is internal audit function relevant in a financial statement audit?

In a financial statement audit, amongst the various factors that an external auditor considers in his risk assessment and in determining the nature, timing, and extent of auditing procedures to be performed, one of the very relevant factors is the existence and operation of a competent and effective internal audit function. Internal audit is an appraisal activity which may be constituted as a function within a company or may be outsourced to an external service provider.

The internal audit function is most likely to be relevant for the external auditor if the responsibility assigned to the internal auditor is related to the entity’s financial reporting and other internal control related processes on which the external audit will rely while conducting his audit. Certain internal audit activities may not be relevant to an audit of the entity’s financial statements, for example, the internal auditors’ procedures to evaluate the efficiency of certain management decision-making processes are ordinarily not relevant to a financial statement audit.

While determining whether the work of the internal auditor is relevant and adequate for the purpose of the audit, the external auditor has to evaluate parameters set out in the table below:

The external auditor would need to consider the materiality of the account balances or classes of transactions which were covered by internal audit, the risk of material misstatement of the assertions related thereto and the degree of subjectivity involved in the evaluation of the audit evidence gathered in support of the assertions. As the materiality of the financial statement amounts increases and either the risk of material misstatement or the degree of subjectivity increases, the need for the auditor to perform his or her own tests of the assertions increases. Where an auditor elects to use the work of internal audit, audit documentation prepared by him should include the auditor’s evaluation of internal audit, the nature and extent of the work used and the basis for that decision, the audit procedures performed by the auditor to evaluate the adequacy of the work used, and an overall evaluation of the evidence obtained. The nature and extent of the procedures the auditor would perform when making this evaluation is a matter of judgment. Ordinarily, an external auditor should not use the work of internal audit when performing procedures related to controls that have a higher risk of failure (e.g., internal controls intended to address assertions where a significant judgment or a risk of fraud has been identified).

Unlike in situations of branch audits or audits of subsidiaries for the purpose of consolidation where an external auditor has the latitude of using and relying on the work of other independent auditors, he does not have the same autonomy as far as using the work of internal auditors is concerned. The external auditor remains solely responsible for the audit opinion issued on the financial statements audited by him. At the same time, it is not obligatory for the auditor to rely on the work performed by internal audit.

We will consider two case studies to understand the above concepts:

Case Study 1 – Relevance of Internal Audit function to the External Auditor

Background

LMN Private limited is a company which is engaged in the business of travel and tourism. The management has constituted an in-house internal audit function. The scope of internal audit as decided by the management includes the following:

1) Monitoring the controls over bookings from customers and recording of revenue in the ERP system.
2) Review of the monthly, quarterly and yearly financial statements prepared by the company and. verifying that these comply with the financial reporting framework
3) Verifying the process of pre-departure formalities necessary to be completed like insurance and visa application to ensure compliance with the processes set out in the procedure manual of the company.
4) R eview of contracts entered into with the vendors who provide services to the company including hotels and coordinators for transfers. Ensure that the standard operating procedures for vendor selection as set by the management have been followed.
5) Verifying the process of background verification of the employees joining the company.

PMR and Associates (PMR) have been appointed as the statutory auditors of the company. Which of the above would be relevant and adequate to the work conducted by PMR?

Analysis
As per SA 610 ‘Using the work of the internal auditors’, the external auditor may use the work performed by the internal auditor if he considers it relevant to his audit. Some procedures performed by the internal auditor may impact the nature or timing or extent of the work performed curtailing his planned work for a particular area during the course of audit. In the given scenarios, factors that could be considered in evaluating the relevance of the scope of internal audit function have been explained below.

1) T he work performed by the internal audit function could be used by the external auditor to understand the process over tour bookings and revenue recognition. If there are significant internal control issues identified by the internal auditor, these could be factored in by the external auditor to modify the procedures that he would perform to test revenue. The external auditor may examine some of the controls or transactions that the internal auditors examined or examine similar controls or transactions not actually examined by the internal auditors. In reaching conclusions about the internal auditors’ work, the auditor should compare the results of his tests with the results of the internal auditors’ work.

2) Though the review of the monthly, quarterly and yearly financial statements by the internal audit team is directly related to the financial reporting process, the external auditor cannot merely rely on the work performed by the internal auditor. His review of the financial statements and assurance of compliance with financial reporting framework remains independent of the review performed by the internal auditor. However, the external auditor should be wary of control lapses in the accounts closing process, if any, which have been identified by the internal auditor and ensure that the risk of possible misstatements emanating therefrom is adequately addressed, for e.g., if the internal auditor has commented about the lack of robustness in the he process for provision for expenses for pending bills, the external auditor would need to more skeptical in verifying the completeness of provisions for expenses. He would need to enlarge the sample size, perform a more robust testing of expense booking/payments in the subsequent period, trend analysis etc.

3) One of the objectives of the internal audit function is to test the orderly conduct of business operations consistent with the processes set by the management. Verifying whether the process of completion of predeparture formalities would ensure compliance to the service standards of the company however this is not likely to have any direct impact on financial reporting, as such, may not be relevant from a financial statement audit perspective.

4) The external auditor can use the observations made in the internal audit reports on vendor contracts entered during the period under audit and evaluate whether these have any impact on reporting on internal controls or financial reporting – for e.g., any onerous terms entailing provision/disclosures etc. the internal audit reports could also possibly highlight non-compliance with standard operating procedures in selection and awarding of vendor contracts. The external auditor would be in a position to evaluate whether such non- compliance is indicative of fraud. Internal audit function can act as a good checkpoint for fraud prevention and reporting.

5) Background verification of employees would prevent the company from hiring fraudulent employees or employees with malicious intent. Though there is no direct implication of this on the financial reporting of the company, the procedures performed by the internal auditor may help the external auditor address the risk of fraud over employee hiring. The auditor based on his assessment of internal audit could use their work in this area to re-engineer the substantive work necessary to be performed by him audit for addressing fraud risk.

Case study 2- Adequacy and use of work performrd by the Internal Auditor

background
ABC limited has appointed M/s. XYZ and Co. (XYZ) as their internal auditors. The statutory auditors of the company – M/s.PQR & associates (PQR) need to evaluate the adequacy of the work performed by XYZ. Consider the following scenarios:

1) XYZ is a reputed firm of chartered accountants with a sizeable client portfolio. the recruitment policy of the firm specifies that only qualified Chartered accountants or students pursuing Chartered accountancy course can be recruited in the internal audit department. The firm follows a policy of training new joiners in accordance with XYZ’s audit manual which helps new joiners understand the audit methodology to be followed while conducting internal audits. XYZ also ensures that the team composition on any client comprises of at least one experienced member with relevant industry knowledge. The work performed by the internal audit team goes through various levels of reviews by partners and managers before the final reports are issued to the clients. As far as relationship with ABC limited is concerned, XYZ occupies an independent status and reports directly to the board of directors of ABC Limited. XYZ presents its observations in the monthly operations meeting of the company and the line managers of the company are responsible to take corrective action within an agreed timeline. XYZ organises meetings with the external auditors – PQR on a monthly basis to discuss their findings and also to assess the requirements of the external auditors if any, when planning their scope for the year. Determine whether the work performed by the internal auditor can be considered as adequate for the purpose of the audit by the external auditor

2) Assume that for the year ended 31st march 20X0, XYZ has performed a comprehensive review of revenue cycle of ABC Limited. There were no adverse findings. in view of the background information given in (1) above, mr. Khanna, audit manager – PQR decided not to perform any work on revenue as this area was extensively covered by XYZ. Mr. Khanna elected to rely on the work already performed by XYZ and was contemplating requesting XYZ to provide them with a copy of their report as well as work papers for his audit file documentation.

Analysis
1) In the given scenario, the internal audit function comprises of a highly prestigious firm with set procedures and hierarchy of reviews. The internal audit division has qualified accountants and trainees. New recruits are provided adequate training. It is also ensured that at all times there is at least once experienced member in the engagement team due to which the entire team gets the requisite guidance. The internal auditor enjoys an independent position with ABC Limited. Internal audit reports directly to the board which is indicative of minimal interference by operating management. Management takes cognizance of internal audit findings and has in place a mechanism to address these in a time bound manner. Internal auditors communicate the observations emanating from their audits with the external auditors. Internal auditors take cognizance of the requirements and expectations of the external auditors from the internal auditors. These are indicators of effective implementation of internal audit function within the organisation. In such an environment, the external auditors – PQR may be able to conclude that the internal audit function is effective and may undertake to modify the extent of testing for that they would undertake on those account captions which have been subjected to internal audit.

2) (a) It would not be appropriate for mr. Khanna to conclude that no work should be performed on the revenue cycle. Given that revenue is presumed to have fraud risk, the auditor should not entirely rely on the work of internal audit when performing procedures related to controls that are intended to address assertions which are susceptible to fraud risk. Mr. Khanna would need to devise his own testing plan, he may consider modifying the testing approach in terms of controls testing and substantive procedures. Given the existence of a robust internal audit system, he may elect to test fewer key controls, rationalize the sample size, undertake substantive procedures which are less time consuming etc.

(b) In the indian context, the Code of ethics provides that a chartered accountant in practice would be deemed to be guilty of professional misconduct if he discloses information acquired in the course of his professional engagement to any person other than his client. As such, XYZ would not be in a position to share their work papers with PQR without prior consent from the Company.

(c) Even considering a scenario where PQR provides access to XYZ access to its work papers (after prior approval from the company), it would be incumbent upon PQR to test or re-perform the work performed by XYZ by obtaining evidence directly from the management of the Company supporting the samples verified by XYZ as opposed to reviewing the documentation provided by XYZ. PQR may exercise its judgment as to whether all samples tested by XYZ should be tested again by PQR or whether PQR should select an entirely new sample. Mere reliance on the documentation provided is not sufficient.

Closing Remarks
Using the work of an internal auditor could assist the external auditor in performing a more efficient and effective audit. However, the external auditor would continue to be solely responsible for the audit opinion.

The Companies act, 2013 has re-emphasied the importance of a robust internal financial control environment by casting specific responsibility on the Board of directors of a company to establish internal financial controls and ensuring that these are adequate and they operate effectively. internal audit will play a very significant role in providing a comfort to the Board in this regard. Statutory auditors are also required to comment in their report, whether the company has an adequate internal financial controls system in place and the operating effectiveness of such controls. The statutory auditors too would need to take cognisance of the work performed by internal auditors on testing of controls. This will entail increased cohesiveness between internal and external auditors however, the external auditor would continue to be responsible for his opinion on the design and operative effectiveness of internal controls.

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GAPs in GAAP Contingent Consideration From Seller’s Perspective

Buyers and sellers of businesses in recent times are coming up with innovative deal structures that use contingent consideration and other instruments that allow the buyer and seller to share the economic risks for a period of time. When buyers and sellers cannot agree on the value of a business, contingent consideration arrangements are a common way to close the deal. In these arrangements, part of the purchase price is contingent on future events or conditions. Contingent consideration arrangements often depend on the acquiree meeting certain financial targets, such as revenues, Earnings Before Interest and Taxes (EBIT) or net income. It may also depend on other events, such as achieving a technical milestone (e.g., drug or patent approval).

Question

How does a seller of a business account for the contingent consideration?

Analysis
There is no direct guidance on accounting for contingent consideration under Indian GAAP from a seller’s perspective. Guidance is available under AS 14 Accounting for Amalgamations with respect to contingent consideration for the purposes of acquisition accounting. The provision relating to AS 14 Accounting for Amalgamations is set out below.

AS 14 Accounting for Amalgamations

15. Many amalgamations recognise that adjustments may have to be made to the consideration in the light of one or more future events. When the additional payment is probable and can reasonably be estimated at the date of amalgamation, it is included in the calculation of the consideration. In all other cases, the adjustment is recognised as soon as the amount is determinable.

It may also be worthwhile to consider guidance in AS 9 Revenue Recognition though AS 9 applies to goods and services and not to sale of a business.

AS 9 Revenue Recognition

9.1 Recognition of revenue requires that revenue is measurable and that at the time of sale or the rendering of the service it would not be unreasonable to expect ultimate collection.

9.4 An essential criterion for the recognition of revenue is that the consideration receivable for the sale of goods, the rendering of services or from the use by others of enterprise resources is reasonably determinable. When such consideration is not determinable within reasonable limits, the recognition of revenue is 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.

The guidance in AS 29 Provisions, Contingent Liabilities and Contingent Assets can also be applied by analogy.

AS 29 Provisions, Contingent Liabilities and Contingent Assets
Definition of a contingent asset: A contingent asset is a possible asset that arises from past events the existence of which will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the enterprise.

32. Contingent assets are not recognised in financial statements since this may result in the recognition of income that may never be realised. However, when the realisation of income is virtually certain, then the related asset is not a contingent asset and its recognition is appropriate.

Author’s point of view

All the three standards viz., AS-9, AS-14 and AS-29 seem to uphold the concept of probability in recognition of revenue or gain. A careful analysis of AS-29 definition of contingent asset also indicates that if recovery is probable then it is an asset and not a contingent asset. Contingent asset is a possible asset and not a probable asset. Therefore recognition of contingent asset requires the use of virtual certainty principles.

Whether a seller of a business should recognise gain from contingent consideration will depend upon the nature of the contingent consideration itself. Where contingent consideration is based on normal revenue targets which are easily achievable, it may be highly probable that it would be received. In such circumstances contingent consideration should be recognised by the seller. If it appears that the set targets are unachievable, then it may not be appropriate to recognise contingent consideration. Rather they should be treated as contingent asset.

At other times, it may so happen that the contingent consideration is determined at each level of performance. As a result it is highly probable that a minimum amount of consideration is always received. Any excess of expected consideration over the minimum amount recognised is only possible and hence a contingent asset not to be recognised in the financial statements. For example, a seller will receive a contingent consideration of Rs. 1 million, if the following year performance is equal to previous year, and another half a million if the performance improves by 40%. In this case, the seller recognises one million consideration if it is probable that performance will be atleast as good as the previous year. However, the extra half a million will not be recognized if it is not probable (though possible) that it will be received. The said amount is a contingent asset and hence not to be recognised under AS 29. The standard also prohibits the disclosure of contingent assets.

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NEGATIVE REVENUE

Many of the current business models are highly disruptive, and also throw up interesting accounting challenges from time to time. One of those challenges is with respect to accounting for consideration paid to a customer and the accounting of negative revenue.

Query
Pay Gate runs a website which provides a market place for vendors to sell their merchandise to different buyers. The buyers can open a wallet on Pay Gate by paying cash or using a debit/credit card and then use that wallet to buy goods through that website from vendors. Pay Gate earns a commission from the vendor for every sale made. Pay Gate is desperately seeking to expand in the market and hence provides a sizable cash back incentive to buyers. The commission earned from vendors is much lower than the cash back incentive to buyers. Consequently the overall revenue earned by Pay Gate is negative. How is such revenue presented?

Author’s Response
Many such interesting issues have emerged since the issuance of IFRS 15 Revenue from Contracts with Customers. These issues have gained urgency in India because it makes IFRS 15 (Ind AS 115) mandatory with immediate effect. These issues and the following discussions would be also relevant for Indian GAAP purposes. The Joint Transition Resource Group for Revenue Recognition (TRG) discussed a number of implementation issues on IFRS 15, including the one raised in the query above.

Under IFRS 15, an entity is required to determine if a consideration that it pays a customer is for a distinct good or service. Consider a manufacturer sells to its customer (eg Retailer) certain goods and earns revenue. It also pays the Retailer a fee for prominent display of those goods. Because the payment to the Retailer is not for a distinct good or service, the manufacturer will reduce the fee paid from the revenue it earns from the Retailer.

In the above example, if the Manufacturer paid to the Customer (who is also an advertiser) for carrying a huge advertisement on an advertising space it owns outside the retail outlet, this would be treated as a distinct service received from the customer. Consequently, revenue would be presented gross and the fee paid to the customer (advertiser) would be treated as an advertising expenditure. IFRS 15 also has another interesting concept, where the customer’s customer is also treated as the customer of the entity. Consider the manufacturer sells to its customer (the Retailer) certain goods, and those goods carry some cash coupons which the final buyer (Retailer’s customer) redeems with the manufacturer. Because under IFRS 15, a customer’s customer is the customer of the entity, revenue would be presented net of the cash coupon amount.

TRG members did not agree on whether the new standards are clear as to whether the requirements will also apply to all payments made to any customer of an entity’s customer outside the distribution chain. For example, in an arrangement with a principal, an agent and an end-customer, TRG members agreed it was not clear whether the agent’s fee would have to be reduced for any consideration that the agent may pay to the end-customer (i.e., its customer’s (the principle’s) customer). Some agents may also conclude that they have two customers –the principal and the endcustomer- in such arrangements. TRG members agreed that agent will need to evaluate their facts and circumstances to determine whether payments made to an end-customer will be treated as a reduction of revenue or a marketing expense. TRG member observed that there is currently diversity in practice on this issue and that it may continue under the new standards, absent further application guidance.

On negative revenue, TRG members felt that if negative revenue is determined on an overall customer relationship basis, one view is that entities should present negative revenue as performance obligations are satisfied. An alternative view is that entities should reduce cumulative customer revenue to zero and reclassified the remaining negative revenue as expenses in the period such determination is made.

If
negative revenue is determined based on a specific contract, potential
views are (a) entities should present negative revenue as performance
obligation are satisfied or (b) entities should reclassify negative
revenue as expenses in the period determined. The latter would not
result in negative revenue on a specific customer contract. If
determined on a specific contract basis, there would likely be far fewer
instance of negative revenue given payments to a customer won’t be
linked to a specific revenue contract in many, if not most, cases.

Overall,
in the query raised above, the author believes that multiple views are
possible at this juncture, absent further application guidance:

1.
Disclose revenue as a negative number, on the basis that consideration
received from a customer should be reduced by a payment made to a
customer or a customers’ customer for goods and services that is not
distinct.

2. Disclose revenue at the gross amount and the
consideration paid to the buyers in the fact pattern be treated as a
marketing expense incurred for acquiring eye balls.

3. Disclose
revenue at a zero sum, and present the excess of cash back incentive
paid to buyers over revenue as a marketing expense. This is done on the
basis that revenue is a reward and should not be a negative number.

The author recommends that the ICAI interact with the TRG group and ensure that an amicable view is reached.

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Audit Documentation – a relevant defense or mere record keeping

Robert H. Montgomery in his book, ‘Montgomery’s Auditing (1912)’ had
said, “The skills of an accountant can always be ascertained by an
inspection of his working papers.” More than a century has passed, but
this statement has not lost its relevance. On the contrary, over the
years, given the quantum of litigation that the auditors have had to
face the world over, these words have become all the more significant.
‘Work not documented is work not done’ is a maxim that is sworn by most
reviewers from regulatory or audit oversight bodies particularly in
jurisdictions overseas.

SA 230 on Audit Documentation provides
guidance on the nature of documentation that needs to be maintained
which would provide sufficient and appropriate record of the basis on
which audit was concluded and the audit opinion issued. Audit
documentation also serves as an evidence that the audit was planned and
performed in accordance with Standards on Auditing and the applicable
legal and regulatory framework. Audit documentation should be such that
an experienced auditor, having no previous familiarity with the audit,
can independently review and reach similar conclusions as those reached
by the present auditor.

During the course of his audit, the
auditor usually encounters issues where an expert’s opinion has to be
called for, or a reservation is expressed by either the management or
the auditor on the treatment of a particular transaction or a position.
It is imperative for the auditor to design the audit procedures in a
manner that by performing such procedures, all the material and relevant
factors having an impact on the true and fair opinion are brought to
light. While it is imperative that the position taken is based on sound
judgment and in compliance with the applicable accounting/regulatory
framework, it is equally important that such judgment is well
articulated in the audit documentation. The first defense for an auditor
is his documentation which should be robust enough to prove that audit
was conducted in adherence to the standards.

The form and
content of audit documentation should be designed to meet the
circumstances of the particular audit. The extent of documentation is
influenced by various factors such as:

a. Nature of the audit
b. Audit procedures intended to be performed
c. Audit evidence to be collected
d. Significance of such evidences
e. Audit methodology and tools used

Documentation
obtained during the course of audit can be segregated into those
forming part of the PAF (Permanent Audit File) and CAF (Current Audit
File). A PAF contains those documents, the use of which is not
restricted to one time period, and extends to subsequent audits as well.
E.g. Engagement letters, Communication with previous auditor,
Memorandum of Association, Articles of Association, Organization
structure, List of directors/partners/ trustees/ bankers/lawyers, etc.
On the other hand, a CAF contains those documents relevant for the
period of audit.

Typically, audit documentation would cover the following –
– Client evaluation and acceptance
– Risk Assessment
– Audit planning discussions
– Audit programs
–
Working papers relating to all significant areas documenting the
approach, risks and controls to the relevant area tested, substantive
and analytical procedures performed and the conclusions reached
– Evidence supporting the use and reliance on the work of experts, internal audit etc.
– Evidence of review by partner and manager
– Evidence of communication with those charged with governance
– Management representations

Audit
documentation may be in the form of physical papers or in electronic
form. In past years, audit documentation was maintained in physical
paper files complete with links and notations necessary for independent
understanding and review of work performed. The working papers are the
property of the auditors and the auditor is not bound to provide access
to these work papers to the client.

Over the last few years,
audit documentation has witnessed radical refinement in the manner in
which it is maintained. It has taken form of electronic files which are
prepared using software specifically designed for documentation
purposes. Such software coupled with advancements in telecommunications
has enabled teams working across multiple locations/geographies to
remotely access the same electronic audit documentation file and
document the work performed for their respective client location. Such
software also results in significant economies on a year-on-year basis,
as the base documentation relating to IT systems, processes, audit
programs needs to be done only once at the time of set up of the
electronic audit file. These software enable the electronic audit file
to be ‘rolled forward’ for the next accounting period. As such, the base
documentation relating to knowledge of the client, the industry, IT
systems, processes, flow charts, audit programs etc. gets pre-populated
in the next year’s audit file and the team would then need to update
these for current changes. Such documentation software has features such
as restrictive access rights to the audit file, enabling audit trail by
way of sign off of completion of the work performed by the team member
and its review by manager/partner, enabling reminders to owners of the
file for pending documentation, compulsory archiving of files post
expiry of the mandatory close-out period and many more. Electronic
documentation has revolutionised the manner in which audit work is
documented and has resulted in huge savings in terms of avoiding of
documentation that is repetitive, easy access to and reference of work
done in the past, ease in acquainting of new team members with the
client’s background, reduction in storage costs (for physical files) and
many other benefits. Physical files are maintained only for filing
certain essential documents such as engagement letters, confirmations,
representation letters, original signed copies of the financial
statements etc. The auditor would however need to establish an adequate
IT infrastructure to support electronic documentation of work done.

A
pertinent question that an auditor usually faces is whether he is
required to document all the evidences procured during the course of his
audit. It actually depends on the significance as well as the
materiality of the financial statement caption and the inherent risk of
material misstatement related thereto. The regulatory compliances and
disclosures may also impact the level of documentation. For instance,
the level of documentation required for testing of rental deposits
accepted by a real estate company may not be as detailed as that
required for a borrowing made by the same company. The compliance and
disclosure requirements for borrowings are more onerous and detailed as
compared to rental deposit, as such the level of documentation that
would support auditor’s verification would also get influenced by such
factors.

The administrative process of completion of the
assembly of the final audit file after the date of the auditor’s report
does not construe as performance of new audit procedures or the drawing
of new conclusions. Changes may, however, be made to the audit
documentation during the final assembly process if they are
administrative in nature. Examples of such changes include:

i. Deleting or discarding superseded documentation.
ii. Sorting, collating and cross referencing working papers.
iii. Signing off on completion checklists relating to the file assembly process.
iv. Documenting audit evidence that the auditor has obtained, discussed, and agreed with the relevant members of the engagement team before the date of the auditor’s report.

However, the auditor is expected to complete the administrative process of assembling the final audit file on a timely basis after the date of the auditor’s report. The Standard on Quality Control (SQC) 1 requires firms to establish policies and procedures for the timely completion of the assembly of audit files. An appropriate time limit within which to complete the assembly of the final audit file is ordinarily not more than 60 days after the date of the auditor’s report. The retention period for audit engagements, as per SQC 1, ordinarily is no shorter than seven years from the date of the auditor’s report, or, if later, the date of the group auditor’s report.

If, in exceptional circumstances, the auditor performs new or additional audit procedures or draws new conclusions after the date of the auditor’s report, the auditor is required to document:

– the circumstances encountered;
– the new or additional audit procedures performed, audit evidence obtained, and conclusions reached, and their effect on the auditor’s report; and
– When and by whom the resulting changes to audit documentation were made and reviewed.

Examples of exceptional circumstances include facts which become known to the auditor after the date of the auditor’s report but which existed at that date and which, if known at that date, might have caused the financial statements to be amended or the auditor to modify the opinion in the auditor’s report.

We will now consider some case studies on audit documentation.

Case Study i
Documentation after completion of audit -Key considerations
The audit team, post completion of audit, receives a confirmation from the sole debtor of the company confirming NIL balance whereas the balance appearing in the financial statements was Rs. 80 million which is material to the financial statements. In the absence of the confirmation, alternate audit procedures were performed to obtain evidence on the accuracy of the balance and the same was documented sufficiently and appropriately.

Is there a need to take into consideration the confirmation received post finalisation of the audit and how would that be documented?

Analysis and conclusion
As per SA 230, this situation is an example of an exceptional circumstance. This situation reflect facts which become known to the auditor after the date of the auditor’s report but which existed as at that date and which, if known on that date, might have caused the financial statements to be amended or the auditor to modify his audit opinion. The resulting changes to the audit documentation would need to be reviewed and the engagement partner would need to assume final responsibility for the changes.

In this case, the auditor is required to document:
–    the circumstances encountered;
–    the new or additional audit procedures performed, audit evidence obtained, and conclusions reached, and their effect on the auditor’s report; and
–    When and by whom the resulting changes to audit documentation were made and reviewed.

The above situation will also need to be evaluated in terms of the requirements of the Guidance note on revision of the audit reports as well as SA 560 Subsequent events issued by the Council of the institute of Chartered accountants of india, which states that a revision of the audit report may be warranted in several instances involving reasons such as apparent mistakes, incorrect information about facts, subsequent discovery of facts existing at the date of the audit report, etc.

Case Study ii
Revision in work papers
The audit team, during the finalisation of the audit of a client in the pharmaceutical industry, had several revisions in the financial statements. Consequently, the related working papers also underwent numerous changes. the audit manager is of the opinion that the old papers can be destroyed wherever there were revisions and it is enough to preserve the final version. However, the audit team is of the opinion that all revisions need to be filed for traceability. Which opinion is right ?

Analysis and conclusion
As per para A22 of SA 230, “the completion of the assembly of the final audit file after the date of the auditor’s report is an administrative process that does not involve the performance of new audit procedures or the drawing of new conclusions. Changes may, however, be made to the audit documentation during the final assembly process if they are administrative in nature. Examples of such changes include: deleting or discarding superseded documentation.”

Hence, old papers which have been revised may be deleted or discarded.

Closing Remarks
An auditor simply cannot get away with documentation or its importance. in fact, audit documentation commences even before the auditor accepts an audit engagement. Given the empowerment to statutory authorities for re-opening of financial statements as provided by the Companies Act, 2013 coupled with increased regulatory supervision on the functioning of the audit profession, auditors would need to ensure that timely, adequate and robust documentation is maintained to support the basis on which audit opinion has been issued. this will be all the more accentuated where areas of judgment and estimation uncertainty is involved. oral explanations by the auditor on his own do not represent adequate support for the work performed by him but these may be used to clarify or explain audit documentation. On the other hand, too much documentation can be inefficient and may impact the profitability/recovery rates for the auditor. So for most of the firms, the challenge would be to maintain the right balance. SA 230 sets out the guiding principles in this regard and compliance with SA 230 would result in sufficiency and appropriateness of audit documentation.

shailesh.kwebmaker

Previous GAAP on first-time adoption of Ind AS

IFRS 1 First-time Adoption of International Financial Reporting Standards and its equivalent Ind AS 101 First-time Adoption of Indian Accounting Standards prescribe several exemptions and exceptions in preparing an opening balance sheet on transition from previous GAAP to IFRS and Ind AS respectively. Without these exemptions and exceptions it would be extremely difficult for companies to transition, as that would entail going back in eternity to prepare opening balance sheet/ financial statements as per IFRS or Ind AS.

Ind AS 101 is modelled on the same lines as IFRS 1; however, there are some critical differences. One of them is with respect to previous GAAP, from which one would transition to IFRS or Ind AS. IFRS 1defines 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, which are publicly available, for example, 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, companies preparing their financial statements in accordance with section 133 of Companies Act, 2013, will consider those financial statements as previous GAAP financial statements.

The Securities and Exchange Board of India (SEBI) had on 9th November, 2009 issued a press release permitting listed entities having subsidiaries to voluntarily submit the consolidated financial statements as per IASB IFRS. Further, SEBI issued a circular, dated 5th April, 2010, wherein the Listing Agreement was modified to this effect from 31st March, 2010. Consequent to this, many companies voluntarily prepared and published audited consolidated IASB IFRS financial statements. However, Companies Act, 2013 requires all Indian companies to prepare consolidated financial statements under Indian GAAP, with a one year moratorium (see box below).

Companies (Accounts) Rules, 2014

Rule 6
Manner of consolidation of accounts.- The consolidation of financial statements of the company shall be made in accordance with the provisions of Schedule III of the Act and the applicable accounting standards:

Provided that in case of a company covered under subsection (3) of section 129 which is not required to prepare consolidated financial statements under the Accounting Standards, it shall be sufficient if the company complies with provisions on consolidated financial statements provided in Schedule III of the Act.

Companies (Accounts) Amendment Rules, 2015

In the Companies (Accounts) Rules, 2014,-

(ii) in rule 6, after the third proviso, the following proviso shall be inserted, namely:-

“Provided also that nothing in this rule shall apply in respect of consolidation of financial statement by a company having subsidiary or subsidiaries incorporated outside India only for the financial year commencing on or after 1st April, 2014.”

Consequently, before transiting to Ind AS, most Indian companies will have consolidated financial statements prepared under Indian GAAP. The only exception seem possible is where a company early adopts Ind AS from the financial year beginning 1st April 2015. Therefore, in most cases, both from a separate and consolidated financial statement Indian GAAP will be the previous GAAP for transition to Ind-AS.

The SEBI’s initiative to allow IASB IFRS financial statements was seen by many as a step in the right direction. The option to voluntarily prepare IASB IFRS consolidated financial statements was not only used by companies who were Foreign Private Issuers (FPI) but also other companies that did not have any global listing. Companies that published voluntarily consolidated IASB IFRS financial statements and their investors were able to compare the performance with the global peers. This put the best Indian companies on a very strong footing.

One had hoped that this option would be continued, and companies would be allowed voluntarily to use IASB IFRS for their financial statements instead of Ind AS (that has numerous carve outs from IASB IFRS). However, this option did not come through. Worse still, one hoped that there would be a provision to transition from IASB IFRS to Ind AS. However, that too did not come through. Consequently, all Indian companies will have to mandatorily transition from Indian GAAP (which is their previous GAAP for statutory reporting in India) to Ind AS.

Consider an example. A company transiting from Indian GAAP to Ind-AS, has as options, to retain the book value of fixed assets recorded under previous GAAP (Indian GAAP) or record them at fair value under Ind AS. If the option to use IASB IFRS financial statements as previous GAAP was allowed, companies could have used the book value recorded in IASB IFRS financial statements. This would have reduced the differences between their IASB IFRS financial statements and Ind AS financial statements. Probably these companies would have ended up in a situation where there would be no difference between IASB IFRS and Ind AS financial statements.

However, given that previous GAAP has to be Indian GAAP, these companies may have to deal with a permanent set of differences between Ind AS and IASB IFRS financial statements.

The idea behind having a uniform GAAP (Indian GAAP) for transitioning to Ind AS was probably rooted in the thinking of achieving consistency. However, this thinking is akin to missing the wood for the trees. By wanting to achieve local consistency, the standard setters are giving up on global consistency. Secondly, this is also putting a lot of companies to unnecessary hardship. Lastly, given the numerous options and exemptions within Ind AS on first time adoption, consistency can never be achieved.

Therefore, there is a strong argument to make appropriate amendments to the standards and allow companies to continue with IASB IFRS option or in the least to allow the IASB IFRS financial statements as previous GAAP financial statements.

levitra

shailesh.kwebmaker

To Consolidate or not to Consolidate

Introduction
Section 129(3) of the Companies Act, 2013, requires a company having one or more subsidiaries, to prepare consolidated financial statements (CFS), in addition to separate financial statements. The second proviso to this section states that the Central Government may provide for the consolidation of accounts of companies in such manner as may be prescribed.

Rule 6 in the Companies Accounts Rules deal with manner of consolidation of accounts. The rule states that “The consolidation of financial statements of the company shall be made in accordance with the provisions of Schedule III of the Act and the applicable accounting standards.”

The MCA has recently amended the Company Accounts Rules whereby a new proviso has been added in the Rule 6. The proviso states that “Provided also that nothing in this rule shall apply in respect of consolidation of financial statement by a company having subsidiary or subsidiaries incorporated outside India only for the financial year commencing on or after 1st April 2014.”

Question 1
Whether the above proviso exempts companies from preparing CFS or the exemption relates only to manner of preparing CFS?

Author’s View
The exemption relates only to the manner of preparing CFS and not the preparation of CFS itself. To support this view, the following two arguments can be made:

• The requirement to prepare CFS is arising from the Companies Act 2013. Rule 6 deals only with the manner of preparing CFS, i.e., preparation of CFS as per notified AS and Schedule III. Hence, the exemption relates only to the manner of preparation of CFS. Thus, a company covered under the above proviso can prepare CFS as per any acceptable framework, say, IFRS, instead of CFS as per notified accounting standards/Schedule III. A company covered under the proviso can also prepare CFS as per any other GAAP (other than Ind AS where the dates are those prescribed by the roadmap) say, US GAAP for filing with the Registrar of Companies (ROC). But if the company also needs to comply with the listing agreement requirements, they permit either Indian GAAP or IASB IFRS.

• Hence, for a listed company, in order to meet both ROC requirements and listing requirements, the option is either Indian GAAP or IASB IFRS (for one year). However, a company cannot avoid preparing CFS.

• Presently, there are few companies who are currently preparing IASB IFRS CFS as per the option given in the listing agreement. If these companies are required to prepare Indian GAAP CFS for year ended March 2015, they will have to transit from IASB IFRS to Indian GAAP for March 2015. In March 2016, these companies will move to Ind AS (i.e., IFRS converged standards) once Ind AS become voluntarily applicable for financial years beginning on or after 1st April 2015. It is understood that the MCA has added this proviso in the rules to avoid this flip flop.

Question 2
Whether the exemption discussed above is available for companies which have overseas subsidiaries only or a company having both Indian and foreign subsidiaries can also use this exemption?

Author’s View
The proviso is based on companies having one or more overseas subsidiaries. It does not matter whether a company has Indian subsidiary or not. In other words, this proviso can be used both by companies having (a) only foreign subsidiary/ies and (b) companies having both Indian and foreign subsidiary/ies.

Question 3
Whether the exemption is available only for one year or it will be available going forward also?

Author’s View
The proviso uses the words “only for the financial year commencing on or after 1st April 2014.” Hence, this exemption is available only for one year, for example financial year ending 31st March 2015 or 31st December 2015.

Question 4
Section 129(3) of the 2013 Act requires that a company having one or more subsidiaries will, in addition to separate financial statements (SFS), prepare CFS. Hence, all companies, including non-listed and private companies, having subsidiaries need to prepare CFS. Whether the comparative numbers need to be given in the first set of CFS presented by an existing group?

Author’s View
Schedule III states that except for the first financial statements prepared by a company after incorporation, presentation of comparative amounts is mandatory. In contrast, transitional provisions to AS 21 exempt presentation of comparative numbers in the first set of CFS prepared even by an existing group.

One view is that there is no conflict between transitional provisions of AS 21 and Schedule III. AS 21 gives one exemption that is not allowed under the Schedule III. Hence, presentation of comparative numbers is mandatory in the first set of CFS prepared by an existing company. This interpretation is taken on the basis that when there are two legislations; one of which imposes a more stringent requirement, the stringent requirement would apply.

The other view is that Schedule III is clear that in case of any conflict between Accounting Standards and Schedule III, Accounting Standards will prevail over the Schedule III. Hence, exemption given under AS 21 can be availed by an existing group which prepares CFS for the first time. In other words, an existing Group preparing CFS for the first time need not give comparative information in their first CFS prepared under AS 21.

Both the views appear acceptable.

Question 5
Consider that a non-listed company is preparing CFS in accordance with AS 21 for the first time. It has acquired one or more subsidiaries several years back. Is the company required to go back at the date of acquisition of investment for calculating goodwill/ capital reserve on acquisition?

Authors view
Goodwill/ capital reserve arising on acquisition of subsidiary should be calculated with reference to the date of acquisition of investment in subsidiary. Thus, determining goodwill for an acquisition that took place many years ago may be very challenging. The transitional provisions to AS 21 exempt a company, which is preparing CFS for the first time, from presenting comparative information. There is no exemption from the requirement to determine goodwill/ capital reserve. Hence, any goodwill/ capital reserve arising on acquisition should be determined at the acquisition date.

Let us assume that a company has acquired a subsidiary more than 10 years back, which should have resulted in goodwill arising on the acquisition. Under Indian GAAP, a company is allowed to amortise goodwill over its useful life, say, 5 to 10 years. Alternatively, the company may only test the goodwill for impairment. In this case, the company may argue that in the past, it has amortised goodwill over its useful life, say, 5 to 10 years. Consequent to amortisation, the net carrying value of goodwill on the date of first preparation of CFS is zero. The corresponding impact of goodwill amortisation has gone into profit or loss of the earlier periods and impacts the cumulative retained earnings at the date of first preparation of CFS. The application of this view obviates the need to go back in history for computing goodwill arising on acquisition. However, it impacts the amount of retained earnings and net worth on the transition date. If a company does not wish to have such impact and desires to disclose goodwill amount, it needs to go back in the history for calculating goodwill/ capital reserve arising on acquisition.

In the case of acquisitions made in recent history, say, in past 3-4 years, it may not be possible to take a view that the goodwill is fully amortised. In this case, the company will need to go back in history to determine goodwill arising on acquisition. The amount of goodwill reflected in the first CFS will depend on the company’s policy for goodwill amortisation with respect to past years.

To ensure that goodwill is not carried at amount higher than its recoverable amount, the company will have to test if goodwill is impaired at the transition date in accordance with AS 28 Impairment of Assets.

shailesh.kwebmaker

Audit materiality – a precision cast in stone or a subjective variable measure?

Material information means information that
matters, whether it is important or is essential. In accounting
parlance, it relates to information that should be recognised, measured
or disclosed in accordance with the requirements of a financial
reporting framework. In measuring or disclosing accounting information,
emphasis is on the needs of known or perceived users of the financial
statements.

In auditing, materiality refers to the largest
threshold of uncorrected errors, misstatements, or erroneous disclosures
or omissions that could exist in the financial statements and yet are
not misleading. Misstatements including omissions, are material if they,
individually or in aggregate, could reasonably be expected to influence
the economic decisions of users of the financial statements. The users
are considered as a group of users of the financial statements rather
than as individual users.

SA 320 – ‘Materiality in Planning and
Performing an Audit’ provides guiding principles to auditors on
consideration of materiality in audit of financial statements.

The
determination of materiality is a matter of professional judgment. In
determining the materiality of an item, the auditor considers not only
the item’s nature and amount relative to the financial statements, but
also the needs of the users of such financial statements. Materiality
has a pervasive effect in a financial statement audit. Materiality also
has significant implications for audit efficiency. In current times,
given the scale and volume of operations of enterprises, complexities in
business and supporting IT systems, plethora of regulatory compliances
etc., it is imperative for an auditor to be meticulous in determining
materiality for addressing the risk of material misstatements in an
effective and efficient manner.

Materiality is one of the most
important considerations in planning the audit approach-identifying
significant accounts/disclosures and determining the extent, nature and
timing of audit procedures. While determining materiality at the
planning stage, it may not be possible for the auditor to anticipate all
of the factors that will ultimately influence the materiality judgment
in the evaluation of audit results at the completion of the audit. These
factors must be considered as and when they arise, and therefore
materiality needs to be evaluated throughout the course of the audit and
revised if deemed appropriate.

In planning an audit, the
auditor would ordinarily assess materiality at the overall financial
statement level, because the auditor’s opinion extends to the financial
statements taken as a whole. However, in certain circumstances, for an
entity, it is possible that misstatement of a particular significant
account balance or disclosure could impact or influence the decisions of
the users of the financial statements for that entity. In such cases,
the auditor would need to determine materiality for that account or
disclosure at an amount which is less than the materiality for the
financial statements as a whole. For instance, in enterprises where
financial statements include large provisions with a high degree of
estimation uncertainty, the existence of such provisions may influence
user’s assessment of materiality for such provisions, for example
provisions for insurance claims in an insurance company, oil rig
decommissioning costs in the case of an oil company etc.

In
computing materiality for the financial statements as a whole, the
auditor needs to evaluate an appropriate benchmark to be used. The
benchmark could be profit (loss) before tax from continuing operations,
total assets, or total revenues. Materiality is determined based on the
amount of the benchmark selected. Some of the factors which need to be
considered while determining the amount/percentage of the benchmark are:

Debt arrangements – whether limited debt or publicly traded debt, existence of loan covenants sensitive to operating results.

Business
environment – whether entity operates in a stable or volatile business
environment, business operates in a regulated or non-regulated industry,
business sustainability, complexity of business operations/processes,
product portfolio, few or many external users of the entity’s financial
statements etc

As one can envisage, evaluation of the factors
stated above requires judgment and there can be no scientific formula to
arrive at the percentage to be applied to the benchmark to determine
materiality. SA 320 does not specify a range of percentages that could
be applied to the benchmark as this is left to the auditor’s judgment,
ideally the one selected by the auditor should be the benchmark that
most represents the needs of the users of the financial statements. The
commonly applied ranges are given below:

It
is pertinent to note that materiality is not a mere quantitative
measure. A misstatement that is quantitatively immaterial may be
qualitatively material. Qualitative factors often require subjective
judgment and evaluation in light of other information that may not be
readily available to the auditor.

While selecting account
balances for testing, one cannot assume on a generic basis that account
balances which fall below the materiality determined for the financial
statements as a whole should be scoped out from audit. The auditor
should be wary of the risk that accounts with seemingly immaterial
balances may contain understatements that when aggregated would exceed
the overall materiality, i.e., aggregation risk. To address the
aggregation risk, auditors usually discount (hair-cut) the overall
materiality by 25% or more. Such an adjustment is not a mere calculation
but is driven by factors such as:

Weak or strong Internal control environment at the entity.
Entity with a history of material weaknesses and/or a number of control deficiencies.
High turnover of senior management.
Entity with a history of large or numerous misstatements in previous audits.
Entity with more complex accounting issues and significant estimates.
Entity that operates in a number of locations etc.

Let
us consider some case studies to understand practical application of
the concept of audit materiality from a quantitative measurement
viewpoint.

Case study I – Size and nature

Background
XYZ
Ltd. is a company engaged in the business of dairy products with its
head office in Mumbai. The Company caters to customers in Pune, Mumbai,
Ahmedabad and Surat through its factories in Mumbai and Ahmedabad.

The
turnover and net profit after tax of the company for FY 20X0-X1 (April
20X0-March 20X1) was Rs. 1,456 million and Rs. 305 million respectively.
The net assets of the Company as at 31st March 20X1 aggregated Rs.
13,570 million.

During the financial year 20X0-X1,
1. ZED Ltd., a distributor for Surat region who owed the Company Rs. 0.6 million was declared bankrupt.

2.
HUD Products Ltd., a supplier to whom the Company had paid Rs. 45
million as an advance for future supplies as per the terms of
arrangement had been facing cash crunch and has discontinued its
operations from June 20X0. The Company has not received any supplies
since April 20X1.

3. T he company has decided to curtail its
operations in Ahmedabad which has traditionally been a major source of
revenue for the Company in the past however on account of increase in
competition the Company is unable to sustain its market share. The
Company already commenced the process of dismantling one of the plants
in the month of March 20X1.

As an auditor which of the above events will be material for the Company?

Analysis

As per SA 320, judgments about materiality are made in the light of surrounding circumstances, and are affected by the size or nature of a misstatement, or a combination of both.

In the above scenarios, the default of Rs. 0.6 million by ZED Ltd. is immaterial for a Company with a huge turnover of Rs. 1,456 million. Thus, based on the size of the Company. the auditor would consider the said transaction as not material to be reported.

On the contrary, amount of advance given to HUD Products Ltd. of Rs. 45 million, which is considered doubtful of recoverability would be material to the financial statements as omission of the same could influence the decisions of the users of financial statements. Also, delay in supplies would affect the production schedule of the Company which would also impact sales adversely. Therefore this event would be considered as material.

Similarly, the Company’s decision of curtailing its Ahmedabad’s operations should be disclosed in the financial statements as it is by its nature material to understanding the entity’s scope of operations in the future.

Case study II – Selection of benchmark

Background

TED Private Limited (TED) is in the business of providing courier services. TED is located in Mumbai. It has a subsidiary LED Private Limited (LED), located in Delhi. TED was established in 2001 and its subsidiary was established in 2012. TED is a well established company in the market and is profit making since the year 2005. However, LED being recently established has lower profits and in fact profit has been volatile in nature during the past three years. The financial position for TED and LED given below:

XET & Associates (‘XET’) were appointed as auditors for the year 2014 for TED and its subsidiary LED. Ram Bhave, Audit Manager at XET selected profit before tax as the benchmark for the purpose of calculating the materiality of TED. Since LED had earned higher profit in 2014 as compared to the previous year, Ram selected profit before tax as an appropriate benchmark for the subsidiary as well. In the light of SA 320, evaluate:

a) Whether Ram did the right selection of the benchmark for the purpose of determining audit materiality for both the entities?

b) Also evaluate whether the materiality for LED will be the same if LED was financed solely by debt rather than equity?

c) Would the situation be different in case LED received revenue from TED on a markup of 10% on its expenses?

Analysis (a)

According to SA 320, determining materiality involves the exercise of professional judgment. Factors that may affect the identification of an appropriate benchmark include the following:

Whether there are items on which would be subject to specific focus by the users of the financial statements of the entity in question?

The nature of the entity, the stage at which the entity is in its life cycle, and the industry and economic environment in which the entity operates.

The entity’s ownership structure and the way it is financed.

The relative volatility of the benchmark.

Profit before tax from continuing operations is often used for profit-oriented entity. However when profit before tax from continuing operations is volatile, other benchmarks may be more appropriate, such as total revenue or gross profit.

In the above case, based on financial position for past three years, it is evident that TED is a profit-oriented company and accordingly the profit before tax is an appropriate benchmark taken by the auditor for the purpose of calculating the materiality.

Analysis (b)

Ram selected profit before tax as benchmark for calculating materiality for LED however the company has yet to fully establish its operations and accordingly the profit before tax is volatile in nature. In such a case, based on the relative volatility, Ram must select gross measures like total revenue as the benchmark for calculating the materiality.

Analysis (c)

In case if LED is financed solely by debt, users may lay more emphasis on assets and claims (such as charges/ mortgages/encumbrances or like) on them rather than on the entity’s earnings. In this situation, Ram could consider either net assets or total assets as the benchmark for calculating the materiality.

Analysis (d)

If LED were to earn revenue from TED at a constant markup of 10% on its aggregate expenditure, it would not be appropriate to take profit before tax or revenue as the benchmark as revenue and profits would fluctuate every year in proportion to the expense and may not be considered as the right measure to reflect the financial performance of the entity. In such a scenario, Ram may choose to use total expenses or net assets or total assets as benchmark for purpose of determining materiality.

The above case studies elucidate the quantitative aspects of materiality. In the next article, we shall discuss case studies revolving around other aspects of SA 320 such as qualitative factors, normalisation, materiality at account balance and revision of materiality.

Closing remarks

Materiality is one of the factors that affects the auditor’s judgment about the sufficiency of audit evidence. One may generalise that lower the materiality level, the greater would be the quantum of evidence needed. At the same time, auditing standards do not establish an absolute level or a percentage or a mathematical formula which is universally applicable. The elements an auditor uses to determine the benchmark are based on his experience and on numerous other factors some of which were elucidated in this article. As a judgmental concept, however, materiality is susceptible to subjectivity.

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Ind -AS Carve Out – Recognition of bargain purchase gain and common control transactions

Recognition of bargain purchase gain
IFRS
3 requires bargain purchase gain arising on business combination to be
recognised in profit or loss. However, a careful analysis is required to
determine whether a gain truly exists. Ind-AS 103 (draft) requires the
same to be recognised in other comprehensive income (OCI) and
accumulated in equity as capital reserve. However, if there is no clear
evidence for the underlying reason for classification of the business
combination as a bargain purchase, then the gain should be recognised
directly in the equity as capital reserve. Ind-AS’s are still in draft
stage and a final version may be available even before this article is
published.

Technical perspective
Arguments against this carve out are as follows:

(a)
An economic gain is inherent in a bargain purchase. At the acquisition
date, the acquirer is better off by the amount by which the fair value
of the acquired business exceeds the fair value of the consideration
paid. In concept, the acquirer should recognise this gain in its profit
or loss.

(b) We appreciate that appearance of a bargain
purchase, particularly, without any evidence of the underlying reasons,
will raise concerns about the existence of measurement errors. IFRS 3
have addressed these concerns by requiring the acquirer to review
procedures used to measure the amounts to be recognised at the
acquisition date. Moreover, concerns regarding measurement
errors/potential abuse may not be sufficient reason to reject
technically correct accounting treatment.

(c) The application of
Ind-AS carve-out implies that whilst an entity recognises bargain
purchase gain directly in OCI, it will recognise depreciation,
amortisation or impairment of assets acquired in profit or loss for the
subsequent periods based on the fair valuation of the assets taken over.
This creates a mismatch between items recognised in profit or loss and
those recognized in OCI. Also, it may adversely impact divided paying
capacity of companies.

To avoid such mismatches and to protect
their future profit or loss/distributable reserves, certain entities may
attempt to notionally reduce the fair value of the assets acquired and
avoid bargain purchase gain scenario. The ICAI has made this carve-out
to avoid potential abuse; however, it may actually end up doing the
reverse.

(d) Concerns about abuse resulting from gain
recognition may be exaggerated. Our experience and interactions with
financial analysts and other users suggest that they give little weight,
if any, to one-time or unusual gains, such as those resulting from a
bargain purchase transaction. In addition, we believe that entities
would have a disincentive to overstate assets acquired or understate
liabilities assumed in a business combination because that generally
results in higher post-combination expenses, i.e., when the assets are
used or become impaired or liabilities are re-measured or settled.

We
believe that Ind-AS 103 should require bargain purchase gain arising on
business combination to be recognised in profit or loss both for
acquisition of subsidiaries and associates. In any case, we do not
believe that this is a major issue, and making a carve-out for this
matter seems unwarranted.

Accounting for common control transactions
IFRS
3 excludes from its scope business combinations of entities under
common control and provides no further guidance on how common control
transactions are accounted for. Based on prevailing practices, an entity
may account for such combination by applying either the acquisition
method (in accordance with IFRS 3) or the pooling of interests method.
The selected accounting policy is applied consistently. However, where
an entity selects the acquisition method of accounting, the transaction
must have substance from the perspective of the reporting entity.

Ind-AS
103 requires business combinations under common control to be
mandatorily accounted using the pooling method. The application of this
method requires 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
harmonize the accounting policies.
(iii) The financial information
in the financial statements in respect of prior periods have to be
restated as if the combination had occurred from the beginning of the
earliest period presented in the financial statements, irrespective of
the actual date of the combination.
(iv) Ind-AS 103 originally
hosted on the MCA website required that excess of the amount recorded as
share capital issued plus any additional consideration in form of cash
or other assets given by the transferee entity over the amount of share
capital of the transferor company is recognised as goodwill.

However,
an exposure draft of amendment to Ind-AS 103 proposes that any
difference between the consideration paid and share capital of the
transferor should be transferred to separate component of equity, viz.,
“Common Control Transaction Capital Reserve.” Ind-AS’s are still in
draft stage and a final version may be available even before this
article is published.

Though there is no IFRS standard that
deals with common control transactions, global practice is to account
them using the pooling method; and in case where the common control
transaction has substance acquisition accounting is permitted.

Technical perspective
IFRS
does not deal with the pooling method. However, it was dealt with in
the erstwhile IAS 22 Business Combinations. Both US and UK GAAP also
provide guidance on the pooling method. Interestingly, neither of these
standards nor AS 14 Accounting for Amalgamations under Indian GAAP allow
any new goodwill to be recognized in the pooling method. Any excess
consideration paid to the erstwhile shareholders of the transferee is a
transaction between the shareholders and reflected directly in the
equity. Thus, goodwill accounting required by original Ind- AS 103 was
contrary to the basic principle of the pooling method. Hence, we agree
that the change proposed in the ED reflects better application of the
pooling method. Despite the proposed correction, we have the following
concerns on accounting for common control business combination
prescribed in Ind-AS 103.

(a) I n our view, it is not
appropriate to mandate the pooling method for all common control
business combinations. In practice, many groups enter into these
transactions as part of their IPO plans. Post IPO, there will be
significant non-controlling interest in the combined entity. In such
cases, companies typically prefer applying the acquisition method to the
common control business combination. However, it may not be possible
under Ind-AS 103.

(b) T he pooling method as discussed in Ind-AS
103 is applicable only to accounting for common control business
combinations. It is not applicable to accounting for transfer between
common control entities of assets/ liabilities not constituting
business.

(c) Whilst Ind-AS 103 requires common control business
combinations to be accounted for using the pooling method, it is not
clear whether the same principles also apply to acquisition of an
associate/ joint venture from an entity under common control.

Our preferred view is that at this juncture, the ICAI should not address common control business combination accounting in Ind-AS 103. Rather, there is sufficient global precedence to rely upon. however, this approach is not suitable for the long term. it may be noted that the IASB is developing a separate IFRS for common control transactions. the ICAI should work with the IASB on the proposed IFRS to address India specific concerns. Alternatively, the ICAI should develop a temporary
standard, but ensure that the same is in line with current global practice.

shailesh.kwebmaker

Growing concerns with financial statement

The past few decades have seen frauds related to financial statements increase dramatically, both in terms of numbers and the size of the losses. This has resulted in turmoil in the capital markets, loss in shareholder value, and in some cases, companies filing for bankruptcy. Fraudulent financial statements affect shareholders, lenders, creditors, and employees. Although the regulators (under the Sarbanes-Oxley Act, 2002 and new Companies Act, 2013) have done significantly to improve corporate governance standards in an effort to deter fraud; financial statement fraud continues to remain a serious concern for investors and other capital markets stakeholders.

According to the ACFE’s “Report to the Nations on Occupational Fraud and Abuse, 2014”, it is estimated that only 9 % of cases involved financial statement fraud, but those cases had the highest financial impact, representing a median loss of $ 1 million.

What is financial statement fraud?
Financial statement fraud is deliberate misrepresentation, misstatement or omission of financial statement data for the purpose of misleading the reviewer and creating a false impression of an organisation’s financial strength.

The key causes of this increasing problem could be executive incentives such as stock option benefits, bonuses or justification for increased salaries; stock market expectations which provided rewards for shortterm behaviour; greed by investment banks, commercial banks and investors etc.

Such frauds can take different forms, but there are several methods commonly used by perpetrators. These include creating fictitious revenues, timing differences, concealed liabilities or expenses, improper disclosure, related party transactions, and improper asset valuations. From an accounting perspective, revenues, profits, or assets are typically overstated, while losses, expenses, or liabilities are understated in the books of accounts.

Some common approaches to project a false but improved appearance of financials include:

Overstatement or falsification of revenues is the most common fraud, wherein the perpetrator creates fictitious revenue or customers, records future sales in the current period, reports increased revenue without equally rising cash flow or records sales that never occurred.

Understatement of expenses or liabilities by shrinking the company’s debt on paper. This makes the company appear more profitable, while the fraudster records expenses as assets or even fails to record them at all. Additional ways to manipulate financial statements include leaving special purpose entities or subsidiaries off a parent company’s books or failing to report certain obligations as liabilities.

Improper asset valuation exaggerates company assets to deceive investors or to siphon funds for personal gains. It can involve improperly valuing inventory, investments, fixed assets or accounts receivable. It may also involve creating fictitious receivables, not writing down obsolete inventory on the company’s balance sheet, manipulating the estimates of an asset’s useful life and overstating the residual value.

Related party transactions; fraudulent transactions with the parent company and its subsidiaries and the ability to influence the policies of the other parties.

Warning bells
Red flags around financial statements are indicators of a possible fraud scenario and these warning signs should be addressed immediately. While they may not ascertain the actual occurrence of a fraud, they show that the company may be prone to fraudulent activities. Red flags are never sure signs but indicate that the organisation should ask for reasonable answers.

Warning signs related to financial statement fraud can be categorised into four broad categories:

(i) Tone at the top: aggressive style of management and over ambitious targets by the top management may lead to fraudulent activities at various levels. Concentration of powers in the hands of one or two individuals or an autocratic style of leadership also may lead to fraudulent activities.
(ii) Processes drawback: Lack of supervision and monitoring, lack of segregation of duties and excessive use of journal entries may motivate fraudsters as it opens up multiple avenues to manipulate the books of accounts.
(iii) Systems limitations: lack of system controls, manual (legacy) and disintegrated systems are easy to penetrate and could be manipulated by fraudsters.
(iv) Attitude of employees: Employees with mediocre calibre, ignorant mind-set, little responsibility and no willingness to question the management can create problems in preparing the financial statements.

There are certain indicators that organisations can analyse to proactively identify fraud risks.

Revenue
• A spike in the revenue during the month/ quarter/ year closing without any collections.
• Sales made to fake agents or customers or to small proprietary or partnership firms.
• Increase in debts being substantially higher than revenue growth.

Expenses
• Preference given to a single vendor after receiving quotations from other vendors or contract given to vendors that are relatively unknown in the industry or are fictitious. In case of machinery, purchasing it from agents rather than other OEMs.
• Significant variation in the volume/ value of provision for expenses.
• Large unexplained JV or partnership.
• Consistent advances paid to certain parties whereas some creditors payments are delayed.

Cash and bank balances
• High cash withdrawals or deposits without necessary approvals.
• Large payments issued to certain contractors or vendors.
• Absence of physical bank statements.
• Transfer of large round amounts within different bank accounts.

Accounting records
• Large number of journal entries passed in books of accounts.
• Low end accounting software without audit trail mechanism.
• Large number of backdated entries.

If enough warning signs are in place, the next step will be to perform procedures that will help assess the actual occurrence of fraud. Exposing a fraudulent financial statement can be challenging–irrespective of the company size. Maryam Hussain, an investigator at EY, in her book titled “Corporate Fraud: the Human Factor”, states that every instance of fraud and corruption leaves a trail which is visible but often unseen until it is too late. Perpetrators typically take special care to conceal their wrongdoings in an elaborate fashion.

Sometimes the fraud is buried in a series of complex transactions; other times it can be found in a single transaction recorded in the accounting records. Detection can be accomplished with appropriate forensic procedures that include analysis of financial records, public documents, background checks, interviews with suspects and laboratory analysis of physical and electronic evidence.

Although listed above are common schemes used to commit financial statement fraud, it is imperative to be aware that it is not an exhaustive list. There are many ways to commit fraudulent or unethical activities. No matter what method is used, the fraudster typically tends to either overstate revenues, profits, or assets or understate losses, expenses, or liabilities.

Financial statement fraud is expensive, seemingly common in and typically involves one or more senior executives in the company. To conclude, the impact of such a fraud can be devastating to the organisation’s reputation among stakeholders and business ecosystem as a whole.

levitra

shailesh.kwebmaker

Audit materiality – a precision cast in stone or a subjective variable measure….continued

In the previous article, we attempted to understand
the concept of materiality as elucidated in SA 320 ‘Materiality in
Planning and Performing an Audit’, and discussed case studies around the
practical application of this concept from a quantitative measurement
viewpoint. In the present article, we will dwell on the qualitative
aspects. We will discuss aspects such as setting of materiality for
specific financial statement captions at amounts lesser than the
materiality level determined for the financial statements taken as a
whole, and consider circumstances when adjustments to materiality
benchmark and revision of materiality is necessary. We will also try to
understand the practical application of these concepts through case
studies.

Evaluating qualitative factors
Evaluating
qualitative factors often requires subjective judgment. While
establishing the overall strategy for the audit, the auditor should
consider whether there are particular significant accounts or
disclosures in the financial statements for which misstatements of
lesser amounts than materiality for the financial statements as a whole
could reasonably be expected to influence the economic decisions of
users taken on the basis of the financial statements. Any such amounts
determined represent lower materiality levels to be considered in
relation to the particular items in the financial statements. For
instance, the magnitude of a misstatement that the auditor considers
material when caused by an illegal act or irregularity may be far lower
than the magnitude of a misstatement caused by an error.

Some of the factors to be considered are:

Whether
accounting standards, laws, or regulations affect users’ expectations
regarding the measurement or disclosure of certain items (for example,
related party transactions and the remuneration of management and those
charged with governance)?

The key disclosures in relation to the
industry or the environment in which the entity operates (for example,
research and development costs for a pharmaceutical company).

Whether
attention is focused on the financial performance of a particular
subsidiary or division that is separately disclosed in the consolidated
financial statements (for example, for a newly acquired business)?

Normalisation
There
may be particular circumstances that cause the materiality benchmark
amount to be at an unusual level for the current period — either
unusually high or unusually low. If so, it may be appropriate and
necessary to normalise the benchmark amount for the current period.
However, if the entity has recurring charges or credits, then
normalising for those items is inappropriate.

Examples of charges that may result in an exceptional decrease in profit before tax from continuing operations may include:
Unusual restructuring charges

Impairment of fixed assets or long-term investments not in the ordinary course of business

Changes in accounting methods/estimates

Examples of credits that may result in an exceptional increase in profit before tax from continuing operations may include:

One-time gains arising from the settlement of legal matters

One-time
gains arising from the sale of a component of a business (where the
ongoing business model of the entity is not focused on acquisitions and
disposals of components).

Use of another benchmark or
normalising the benchmark may also be appropriate if profit before tax
from continuing operations is nominal (i.e., small and close to zero) in
the current period. However, if an entity has a past history of low
earnings from continuing operations in relation to large revenues and
expects to continue generating income at such levels, this may represent
the normal operating results for the entity, and consequently,
normalisation of profit before tax from continuing operations in such
cases may not be appropriate.

Audit documentation needs to
explicitly substantiate as to why the identified benchmark is required
to be normalised and the corroborative factors that caused the
normalisation. It may not be sufficient if the documentation merely
states that the factor causing the normalisation is considered unusual
or exceptional without stating the basis on which such a conclusion was
reached.

Revision in materiality
At times,
particularly where an interim audit is performed before the year-end,
the auditor may need to set materiality for planning purposes based on
the entity’s annualised interim financial statements or financial
statements of one or more prior annual periods. While setting
materiality in such cases, the auditor needs to be cognisant of:

observations
emanating from the audit of the previous period i.e., control
deficiencies previously communicated to those charged with governance,

the effects of major changes in the entity’s circumstances (for example, a significant merger),

the effectiveness of the entity’s internal control,

any
public information about the entity relevant to the evaluation of the
likelihood of material financial statement misstatements,

relevant changes in the economy as a whole or the industry in which the entity operates.

Because
it is not feasible for the auditor to anticipate all situations that
may ultimately influence judgments about materiality in evaluating the
audit findings at the completion of the audit, the auditor’s judgment
about materiality for planning purposes may differ from the judgment
about materiality used while evaluating the audit findings at audit
completion. For example, while performing the audit, the auditor may
become aware of additional quantitative or qualitative factors that were
not initially considered but that could be important to users of the
financial statements and that should be considered in making judgments
about materiality when evaluating audit findings.

If the auditor
concludes that a lower materiality level than that initially determined
is appropriate, the auditor should reconsider the related levels of
tolerable misstatement and appropriateness of the nature, timing, and
extent of further audit procedures. The auditor should consider whether
the overall audit strategy and audit plan needs to be revised if the
nature of identified misstatements and the circumstances of their
occurrence are indicative that other misstatements may exist that, when
aggregated with identified misstatements, could be material. The auditor
should not assume that a misstatement is an isolated occurrence.

If
the aggregate of the misstatements (known and likely) that the auditor
has identified during the course of his audit approaches the set
materiality, it would be prudent for the auditor to evaluate the risk
that the possibly unidentified misstatements together with the
identified misstatements may exceed the materiality level. If in the
auditor’s judgment, such a risk is perceptible, then the nature and
extent of further audit procedures would need to be reconsidered.

Let us consider some case studies to understand the practical application of the above concepts.

Case Study I – Materiality at account balance and qualitative factors

Background

CAB Private Limited (‘CAB’ or ‘the Company’) is a trader of fans and has three streams of revenue. Revenue from sale of high speed ceiling fans comprises 60% of the total revenue, revenue from sale of automatic fans comprises 30% of the total revenue and the balance 10% represents revenue from table fans. High speed ceiling fans are sold entirely to XYZ Private Limited, a company in which one of the directors of CAB has a majority stake. M/s. ABC & Associates are the auditors of the Company and Mr. A is the audit in-charge on the job. The Company is profit making and accordingly Mr. A selected profit before tax as the benchmark for the purpose of materiality. The materiality for the purpose of audit of the financial statements for the year ending 31st March 20X1 as ascertained in the planning stage was set at Rs. 80 million.

The table below sets out the position of sales and debtor balances as on 31 March 20X1:

Account
description

Amount
in Rs.

Revenue from high speed ceiling fans

600 million

Revenue from automatic fans

300 million

Revenue from table fans

100 million

Account
description

Amount in Rs.

Outstanding
for

more
than 90 days

Debtors –
high speed

250 million

Rs. 60
million

ceiling fans

Debtors – automatic fans

150
million

Rs.

5 million

Debtors – table fans

80
million

Rs.

5 million

As per Company policy, debtors outstanding for more than 90 days are fully provided for. However, for the year ended 31st March 20X0, management has not made any provision for debtors. In light of the concept of materiality evaluate the following:

I) Considering the fact that there are no other unadjusted misstatements in the financial statements, as an auditor, is the above misstatement material for reporting purposes?

What will be the situation in case where the outstanding debtors for more than 90 days is nil for Debtors – high speed ceiling fans, Rs. 35 million under Debtors – automatic fans and Rs. 50 million for Debtors under table fan category?

The Company received share application money from its parent company located overseas in the month of May 20X0 aggregating to $ 1.66 million (Rs. 100 million) against which shares aggregating to $ 1.42 million (Rs. 85 million) were allotted. No allotment or refund has been done for the balance amount till date. For the shares allotted, the Company did not file

Form FC-GPR with the Reserve Bank of India within prescribed timelines. Non-compliance with the above provisions would be reckoned as a contravention under FEMA Act and could attract penal provisions. Let us evaluate what would be the implications of this situation.

Analysis I

As per SA 320, one or more particular class of transactions, account balances or disclosures may exist for which misstatements of lesser amounts than materiality for the financial statements as a whole could reasonably be expected to influence the economic decisions of users. In such a case, the auditor may consider the account balance or transaction or disclosure as material.

It is pertinent to note that more than 50% of the debtor balance is due from a related party. Further, 60% of the aggregate sales are to related party. Accordingly in the above case even though the aggregate misstatement of Rs. 70 million is below materiality, i.e., Rs. 80 million, Mr. A could consider having a lower threshold as far as debts due from related party are concerned rather than applying the benchmark selected for the financial statements as a whole.

Analysis II

In the second situation though the account balances individually are below materiality but on aggregate level the total misstatement exceeds the materiality of Rs. 80 million and accordingly, Mr. A needs to consider the said misstatement as material and perform necessary procedures.

Analysis III

As per the Circular No. RBI/2007-08/213 dated 14th December 2007 issued by the Central Government under Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000, the Company is either required to allot shares within 180 days from the date of receipt of the application money or intimate Reserve Bank of India (‘RBI’) if 180 days have elapsed as on the date of notification.

In the above situation, the Company is in violation of FEMA regulations and accordingly although the un-allotted amount (Rs. 15 million) is below materiality (Rs. 80 million), the auditor will have to consider the same as material information for disclosing the same to the users of the financial statements and consider reporting the same in his report.

Case Study II – Normalisation

Background

FAT Private Limited (‘FAT’ or ‘the Company’) is a gem manufacturing company. The said Company has shut two of its plants in the current year. The financial position for FAT is given below:

Rs. in Millions

Financial
statement caption

Amount

Total Assets

500

Total Revenue

1,200

Net Assets

150

Profit before tax

400

This is a first year audit by MTS and Associates and the audit engagement partner has determined that the most appropriate benchmark to use in determining materiality is profit before tax from continuing operations. As shown above, the estimated profit before tax from continuing operations for the period is Rs. 400 million. This amount is net of Rs. 80 million restructuring charge for the closure of entity’s plant. In the light of the concept of materiality, evaluate the following:

I. Whether the auditor should consider profit before tax of Rs. 400 million for the purpose of materiality?

Now consider a situation where FAT has two divisions where total revenue and profit before tax for Division
A is Rs. 800 million and Rs. 30 million and that for Division B is Rs. 1,200 million and Rs. 400 million respectively. The profit before tax from the Division A has historically been low as compared to Division B.

Since the profit from Division A is very low, the auditors have decided not to consider the same for the purpose of materiality. Evaluate if the approach is appropriate?

Analysis

As per SA 320, when the materiality for the financial statements as a whole is determined for a particular entity based on a percentage of profit before tax from continuing operations, circumstances that give rise to an exceptional decrease or increase in such profit may lead the auditor to conclude that the materiality for the financial statements as a whole is more appropriately determined using a normalised profit before tax from continuing operations figure based on past results.

In the current scenario, the current-period profit before tax from continuing operation includes a significant amount that is on account of an unusual transaction and is not a recurring expenditure. Accordingly the audit team needs to normalise the benchmark amount by excluding the restructuring charge from the current-period profit before tax from continuing operations.

In situation II, although the profits from Division A are low as compared with the profits from Division B, it is not exceptional in nature. The profits have been historically low from Division A and accordingly if the Company expects that the same will be continued, the auditor should consider the profit of Division A for the purpose of calculating the benchmark for materiality.

Case Study III – Revision in materiality

Financial
position

20X1

20X0

Rs. Millions

Total Assets

400

250

Total Revenue

1200

1000

Net Assets

Profit before tax

(0.2)

GFT and Associates are the auditors of Small Ltd. (‘the Company’). The following is the financial position of the Company:

Based on financial position given above, the auditor decided to use revenue as the benchmark for the purpose of calculating materiality for 20X1. During the course of audit while performing cut off procedures, the audit team realized that the Company had recognized excess revenue of Rs. 200 million. This amount was substantial comprising approximately 16.66% of the total revenue. Should the audit team revise the materiality?

What would be the answer had there been an under-recognition of revenue by Rs. 200 million, should the auditor revise the materiality?

Analysis

As per SA 320, the auditor shall revise materiality for the financial statements as a whole in the event of becoming aware of information during the audit that would have caused the auditor to have determined a different amount (or amounts) initially. In the given scenario, as the revenue amount has been revised significantly the auditor would need to revise the materiality amount. As a higher materiality figure was earlier used to scope account balances/transactions for scrutiny, the likelihood of the risk of misstatements remaining undetected may not have been adequately addressed.

On the contrary, in a situation where the revenue recognised was lower by Rs. 200 million and accordingly the materiality calculated was also lower, the auditor may use his professional judgment to evaluate whether it is necessary to revise the materiality.

Concluding remarks

In conclusion, auditors need to make materiality judgments on every audit which is a difficult process as it requires both qualitative and quantitative aspects to be evaluated. Additionally there is no formal or scientific method to compute materiality. Materiality judgments are crucial for conduct of a successful audit as poor judgments can result in an inappropriate audit opinion or may result in the audit being inefficient or ineffective.

shailesh.kwebmaker

Accounting for cost of test runs

BACKGROUND
The accounting for cost of test runs raises some very interesting questions both under Indian GAAP and IFRS. Paragraph 16 of IAS 16 states that the cost of an item of plant and equipment includes any costs directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in the manner intended by management. Paragraph 17 enumerates examples of directly attributable cost and includes cost of testing whether the asset is functioning properly, after deducting the net proceeds from selling any items produced while bringing the asset to that location and condition; such as samples produced when testing equipment. However, it does not clearly state what the treatment should be when the net proceeds are greater than the cost of testing. Now consider the following two scenarios.

Scenario 1
The cost of test run is Rs. 100. The samples produced are sold at Rs. 80. Theoretically, two answers are possible. The first answer is to capitalise Rs. 100 and consider Rs. 80 as revenue (P&L). The second answer is to capitalise net, i.e., Rs 20. Nothing is taken to P&L.

Scenario 2
The cost of test run is Rs 100. The samples produced are sold at Rs. 130. Theoretically, the following three possibilities exist.

1. Capitalise Rs.100. Take Rs. 130 to revenue (P&L)
2. Capitalise a negative amount of Rs. 30. Nothing is taken to P&L.
3. Capitalise zero amount. Take Rs. 30 to revenue (P&L).

Interpretation under IFRS
This matter was discussed in the IFRS Interpretation committee. They felt that the way paragraph 17 is written, it is only the costs of testing that are permitted to be included in the cost of the plant and equipment. These costs are reduced by the net proceeds from selling items produced during testing. It is self-evident that if the net proceeds exceed the cost of testing, then those excess net proceeds cannot be included in the cost of the asset. Those excess net proceeds must therefore be included in the P&L.

IFRS Interpretation Committee also relied upon paragraph 21 of IAS 16, which indicates that proceeds and related costs arising from an operation, which is not necessary to bring the item to the location and condition necessary for it to be capable of operating in the manner intended by management, should be recognised in P&L and cannot be capitalised. Paragraph 21 is reproduced below.

“Some operations occur in connection with the construction or development of an item of property, plant and equipment, but are not necessary to bring the item to the location and condition necessary for it to be capable of operating in the manner intended by management. These incidental operations may occur before or during the construction or development activities. For example, income may be earned through using a building site as a car park until construction starts. Because incidental operations are not necessary to bring an item to the location and condition necessary for it to be capable of operating in the manner intended by management, the income and related expenses of incidental operations are recognised in profit or loss and included in their respective classifications of income and expense.”

Based on the above discussion, in Scenario 1, a net amount of Rs. 20 is capitalised. In Scenario 2, zero amount is capitalised, and Rs. 30 is taken to revenue (P&L).

Interpretation under Indian GAAP
The following guidance is available in Indian GAAP. It may be noted that the below mentioned Guidance Note on Treatment of Expenditure During Construction Period is withdrawn, but nonetheless relevant for our assessment, since it does not conflict with any accounting standard with respect to the principle that is being debated.

Paragraph 9.1 of AS 10 Accounting for Fixed Assets

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.

Paragraph 9.3 of AS 10 Accounting for Fixed Assets

The expenditure incurred on start-up and commissioning of the project, including the expenditure incurred on test runs and experimental production, is usually capitalised as an indirect element of the construction cost.

Paragraph 8.1 of Guidance Note on Treatment of Expenditure During Construction Period

It is possible that a new project may earn some income from miscellaneous sources during its construction or preproduction period. Such income may be earned by way of interest from the temporary investment of surplus funds prior to their utilisation for capital or other expenditure or from sale of products manufactured during the period of test runs and experimental production. Such items of income should be disclosed separately either in the profit and loss account, where this account is prepared during construction period, or in the account/statement prepared in lieu of the profit and loss account, i.e., Development Account/Incidental Expenditure During Construction Period Account/Statement on Incidental Expenditure During Construction. The treatment of such incomes for arriving at the amount of expenditure to be capitalised/deferred, has been dealt with in para 15.2.

Paragraph 11.4 of Guidance Note on Treatment of Expenditure During Construction Period

During the period of test runs and experimental production it is quite possible that some income will be earned through the sale of the merchandise produced or manufactured during this period. The sale revenue should be set off against the indirect expenditure incurred during the period of test runs as suggested in para 15.2.

Paragraph 15.2 of Guidance Note on Treatment of Expenditure During Construction Period

From the total of the aforesaid items of indirect expenditure (one of the aforesaid items included expenditure relating to expenditure on test runs) would be deducted the income, if any, earned during the period of construction, provided it can be identified with the project.

Paragraph 14.5 of Guidance Note on Treatment of Expenditure During Construction Period

Income during the construction or pre-production period should be shown separately in the financial statements (see paragraph 8.1 of this Note).

Conclusion
Based upon the above guidance, it is clear in Scenario 1, that a net amount of Rs. 20 is capitalised and nothing is taken to the P&L. However, in the case of Scenario 2, when the corresponding income is greater than the cost of trial run, neither the guidance note nor the standard are absolutely clear on what should be done. However, the author believes that based on similar arguments produced above in the context of IFRS interpretation, a net amount of zero is capitalised and Rs. 30 is taken to revenue (P&L).

levitra

shailesh.kwebmaker

An auditor’s expert – a mere specialist or a Man Friday?

Where an enterprise involves an expert to provide information necessary for the preparation of the financial statements, the auditor would need to decide whether he has the requisite knowledge and experience to evaluate on his own, the work performed by the expert or whether he needs to engage an ‘auditor’s expert’ so as to decrease the risk that material misstatement will not be detected.

In the previous article, we explained aspects that an auditor would need to consider where he himself chooses to evaluate the work of the expert rather than employing an ‘auditor’s expert’. We will now focus on audit considerations where an auditor elects to engage his own expert. SA 620 provides the requisite guidance in this regard.

An auditor’s expert refers to a person or organisation possessing expertise in a field other than accounting or auditing, employed or engaged by the auditor to assist him to obtain sufficient appropriate audit evidence for the purpose of the audit. SA 620 accentuates the need for the auditor to evaluate the expert’s objectivity and to establish a proper understanding with the expert of the expert’s responsibilities for the purposes of the audit.

An auditor’s expert could be an internal expert or an external expert. An auditor’s internal expert may be a partner or staff of the auditor’s firm or of a network firm. The internal expert could therefore be subject to quality control policies and procedures of the auditor’s firm. The auditor would be in a better position to exercise oversight over the functioning of the expert where he engages an internal expert.

Whereas an auditor’s external expert is not a member of the engagement team and may not be subject to quality control policies and procedures instituted by the audit firm. Where the auditor engages an external expert, he would need to exercise greater diligence in evaluating the objectivity of the external expert. Some of the factors that the auditor should be cognisant of while engaging an external expert are:

i. Enquire from the client of any interest or relationship that the client has with the auditor’s external expert that may affect the expert’s objectivity.

ii. Discuss with the expert whether he has any other interest in the client other than the present engagement for which he is being engaged by the auditor. Interests and relationships that may be relevant to discuss with the auditor’s expert include financial interests, business and personal relationships and provision of other services.

iii. Discuss whether there are any safeguards to prevent his objectivity from being impaired. Such safeguards could be in terms of code of conduct/independence requirements as prescribed by the professional body of which the expert is a member.

iv. The auditor should consider obtaining a written representation from the auditor’s external expert about any interests or relationships with the entity of which that expert is aware.

Other aspects that the auditor needs to consider while engaging internal or external experts are:

i. Whether the work of the auditor’s expert relates to a significant matter that involves subjective and complex judgments.
ii. Whether the auditor’s expert is performing procedures that are integral to the audit, rather than being consulted to provide advice on an individual matter.
iii. The competence, capabilities and objectivity of the auditor’s expert.
iv. Obtaining an understanding of the auditor’s expert’s field of expertise.
v. The nature, scope and objectives of the auditor’s expert’s work are agreed between the auditor and the auditor’s expert, regardless of whether the expert is an auditor’s external expert or an auditor’s internal expert.
vi. Whether the auditor’s expert will have access to sensitive or confidential entity information.

Application of SA 620 in practice
• Engagement of auditor’s internal expert
Due to complexities involved in various matters, which in turn leads to specialisation, many firms have separate departments which offer direct tax, indirect tax, transfer pricing and other advisory services. These departments employ professionals other than qualified accountants as well like lawyers, engineers, management graduates, corporate finance professionals etc., for rendering tax and advisory services.

It is a usual practice for auditors to refer client’s matters involving direct and indirect taxes having implications on financial reporting to tax specialists within their firm. These specialists need not necessarily be qualified accountants (could be tax lawyers). An illustrative list of factors that need to be borne in mind are:

a) Such specialists would be subject to relevant ethical requirements including those pertaining to independence.

b) Where an auditor engages such internal experts, it is important that such experts understand the interrelationship of their expertise with the audit process.

c) The fact that the auditor would be involving an internal expert from a different service line should be clearly articulated and agreed to in the terms of engagement agreed with the client.

d) T here should be a clear agreement between the auditor and the internal expert covering aspects such as, who would test the source data, consent of the expert to discuss his findings or conclusions with the client, whether the auditor would get access to and could retain the work papers of the expert and the manner and form of the report/findings that would be communicated by the expert.

For example, the auditor may seek assistance from an internal tax expert to evaluate the likelihood of pending cases involving tax demands raised by tax authorities being decided against the client. In such cases, there needs to be a clear agreement as to whether the internal expert would evaluate only the likelihood of the demands fructifying in favour or against the client or would the tax expert also comment on the adequacy of the tax provisions carried in the books. Likewise, in order to obtain comfort on the adequacy of tax expense/provision, the auditor may seek clearance from his internal tax expert on whether the transactions with related parties are at the arms’ from a transfer pricing perspective.

Similarly, the auditor may seek clearance from indirect tax experts on disputed indirect tax cases involving service tax, customs duty, excise etc. from the perspective of recording a provision or disclosure as contingent liability or otherwise.

A vital factor that the auditor should be cognisant of is whether the tax specialist (auditor’s internal expert) is rendering tax advisory services to the client. In such cases, the auditor needs to assure himself that the position advocated by the tax specialist in respect of tax matters that the audit team has requested for evaluation is not in any manner influenced by the existing relationship that the tax specialist has with the client. The auditor should be mindful of whether the quantum of fees billed by the tax specialist would in any manner impair the objectivity of the tax specialist in providing his clearance.

Another area where an auditor may seek assistance from an internal expert is testing of automated IT controls surrounding an accounting system to the extent that such controls have a bearing on financial reporting. Where clients deploy sophisticated IT systems to process large amounts of data for financial reporting, it may not be possible for the auditor to perform substantive testing manually. Take for instance, testing of revenue for a telecom client involving millions of subscribers or testing of interest on deposits accepted by bank having thousands of deposit accounts. In such cases, the Company would need to deploy high end ERP systems to initiate, record, process and report transactions. Given the IT environment in these enterprises, one would need to engage IT experts to test the general IT controls and application controls. The auditor may engage his internal expert having expertise in information technology to assist him in testing the controls. This would entail sharing of sensitive client data with the internal expert. Here again, the auditor would need to ensure that adequate safeguards are in place to maintain confidentiality of client information that is shared with the IT expert. Further, the auditor would need to verify the origin of the data, obtain an understanding of the internal controls over the data and review the data for completeness and internal consistency.

Another practical example of involvement of auditor’s internal expert relates to the involvement of specialists in corporate finance/financial risk management for testing the valuation of complex derivatives, business purchase, brand valuation etc. In these cases, management would have obtained the valuation of the derivatives/business purchase from a management expert and the auditors would need to obtain assurance that the valuation is appropriate. Given the highly technical nature of the valuation, an auditor may engage an internal expert to evaluate the underlying assumptions and methods for arriving at the valuation.

Engagement of auditor’s external expert

Typically, general insurers need to make an estimate on the ultimate cost of claims to know the full cost of paying claims in order to set future premium rates. Further, they also need to set up reserves in their accounts to ensure that they have sufficient assets to cover their liabilities. Such reserves are in the form of Incurred But Not Reported (IBNR) and Incurred But Not Enough Reported (IBNER).

Assuming a year end of 31st March, IBNR claim reserve is required in respect of claims that have occurred before 31st March, but the claim has not yet been reported to the insurer whereas IBNER is required in respect of claims that have been reported, but not yet closed.

In other words, IBNR is the liability for future payments on losses which have already occurred but have not yet been reported in the insurer’s records whereas IBNER refers to expected future development on claims already reported (i.e., claims which have not yet been recorded in full to its ultimate loss value).

Reserve for IBNR/IBNER is recorded by management based on actuarial valuation carried out by a management appointed actuary. In such determination, the appointed actuary follows the guidance issued by the professional body governing the actuarial profession in concurrence with the directions issued in this regard by the statutory authority regulating insurance business. The quantum of such reserves would be material to the financial statements of the insurance company.

In India, auditors usually include in their report a comment to the effect that they have placed reliance on the management appointed actuary for valuation of liabilities for IBNR and IBNER claims.

Auditors in certain jurisdictions overseas may appoint their own actuary(external expert)to assess the appropriateness of management’s judgments and assumptions used in the calculation of the reserves for reported claims. The actuary would review the methodology and assumptions used for calculating the reserve and comment whether they are in line with the related regulations and also comment on the reasonableness.

The auditors would nevertheless need to have discussions with the client and the actuaries and would need to perform the following with the assistance of its own expert:

Determine the client’s overall methodology for generating the reserves for reported claims including changes compared to the previous period.

Assess whether the auditor appointed actuary has adequately reviewed the appropriateness of managements judgments and assumptions used in the calculation of the reserves.

Assess whether the overall reasonableness of the reserves for reported claims is appropriate given the consideration of historical evidence of the reasonableness of the previous periods level of the reserves for reported claims.

Perform reconciliation of net earned premium, net claims paid together with net claims outstanding as appearing in the financial statements and the actuarial data inputs used by the actuary for the IBNR/IBNER computation.

Closing remarks

The decision of auditors of whether to employ their own experts or otherwise, should be taken only after very careful consideration of the risk of material misstatement in the relevant area of the financial statements and scrutiny of the status and the work of the management’s expert. Any decision in this regard should be influenced by the knowledge that, ultimately, the audit opinion is the sole responsibility of the auditor, and that this responsibility is not reduced by reliance on the work of a management’s expert or an auditor’s expert.

In terms of requirements of Indian GAAS, the auditor is not permitted to refer to the work of the auditor’s expert in the audit report containing an unmodified opinion, unless required by law or regulation. Further, even if any local law were to permit inclusion of such reference in the audit report, SA 620 mandates the auditor to state that such reference does not in any manner reduce his responsibility for the opinion issued.

shailesh.kwebmaker

Ind-AS Carve Outs

Synopsis
You may be aware that adoption of the converged Indian Accounting Standards (Ind-AS) has been prescribed under the Union Budget 2014-2015, voluntarily from the fiscal year 2015-16 and mandatorily from the year 2016-17. The Ind-AS are formed in alignment with the principles of IFRS as issued by the International Accounting Standards Board (IASB). In this article, the learned author points out an illustration of the Ind-AS 40 ‘Investment Property’, wherein some differences between Ind-AS and IFRS have been noted. The author explains therein, the necessity to keep the carve-outs to the bare minimum while finalising the Ind-AS, to ensure that there is global acceptability for financial statements that are prepared using these standards once thay are issued.

The Honourable Finance Minister during the Union Budget 2014-15 announced that Ind-AS would be applicable voluntarily from the year 2015-16 and mandatorily from the year 2016-17. To meet the roadmap, swift measures need to be taken. One key step is the notification of the final Ind-AS on a priority basis. This will help companies in timely preparation for Ind-AS adoption. The author is confident that the ASB and the ICAI will meet our expectations and ensure that the final Ind-AS are notified promptly.

A major part of the world is now reporting under the IFRS as issued by the International Accounting Standards Board (IASB). The last of the developed countries to adopt the IFRS was Japan. Earlier, China too has adopted the IFRS, but retained only one difference between Chinese GAAP and the IFRS. As of now, there are only two significant countries that do not use the IFRS. One is the USA. However, the USA allows the IFRS for foreign private filers. It is also being hoped that the US may ultimately allow US companies to voluntarily adopt the IFRS in future. Besides, for a long time, the US and the IASB have been working together on numerous standards, which has resulted in the US slowly inching towards the US GAAP that is closer to the IFRS. The other significant exception to the IFRS adoption is India.

The IASB is an independent standard setting body comprising of 14 full-time members from different parts of the world. The IASB is also responsible for approving interpretations of IFRS. IFRS’s are developed through an international consultation process, the “due process,” which involves interested individuals and organisations from around the world. The development of an the IFRS is carried out during the IASB meetings, when the IASB considers the comments received on the Exposure Draft. Finally, after the due process is completed, all outstanding issues are resolved, and the IASB members have balloted in favour of publication, the IFRS is issued. This is a very time consuming process, but results in technically solid IFRS’s being issued. It takes into consideration the needs and realities of different countries, and tries to balance them. At times, some of these needs and realities could be conflicting, and it would be impossible to keep all countries happy all the time. Nonetheless, the bottom line remains that the standards should be technically robust, one that would reflect the substance of the underlying business and transactions in a fair and transparent manner.

Most countries that have adopted the IFRS, have adopted them as they are, i.e., without indigenising them to their local GAAP. There were many reasons for taking this approach. Foremost, their local GAAP was developed to meet some regulatory and other objectives such as taxes or capital adequacy or protecting creditors. They did not often reflect the true and fair picture and hence were not typically driven towards meeting the needs of the investors. This had to change and investor needed to be given precedence if capital formation and growth objectives were important for that country.

Most countries that did adopt the IFRS as it is, did so because it enhanced the credibility of the financial statements which resulted in low cost of capital. As major groups have companies all over the world, using one accounting language helped them in preparing consolidated financial statements seamlessly. Using one accounting language across their different companies in the world also meant that their management information systems and IT was consistent across the globe. This made their lives much more predictable, consistent and easier. Today most stock exchanges in the developed world either

require or allow the IFRS. Also, investors around the globe understand the IFRS and are very comfortable with it. Any country that departs from the IFRS will not receive any of the above benefits. For example, in countries such as Singapore and Hong Kong, local standards are largely aligned to IFRS, but there are very few differences. This does not allow Singapore/Hong Kong entities to demonstrate compliance with IASB IFRS.

The Credit Lyonnais Securities Asia (CLSA) and the Asian Corporate Governance Association (AGCA) recently released their seventh joint report on corporate governance in Asia. Among other matters, the report ranks 11 Asian markets on macro Corporate Governance (CG) quality. A perusal of the report extracts indicate that amongst the 11 Asian countries, India has got the lowest rating on accounting and auditing matters as it has not implemented IFRS. Due to the same reason, India’s rating has also declined vis-à-vis previous periods. The chart given above depicts this.

The adoption of Ind-AS will resolve these issues and bring India at par with the world at large that has adopted IFRS. To achieve full benefit, it is imperative that Ind- AS’s are notified without any major difference from IASB IFRS. If India were to implement the IFRS with too many differences, it would be akin to moving from one Indian GAAP to another Indian GAAP. It would not be possible for Indian companies to state that they are compliant with the IFRS, and hence, those financial statements will be treated as local GAAP financial statements. More importantly if an Indian company wants to prepare IASB IFRS financial statements in the future, it will have to convert again from Ind-AS to IASB IFRS.

At the same time, it is appreciated that accounting is an art, and not a precise science. Primarily, financial statements should reflect and capture the underlying substance of transactions. The accounting standards are drafted to ensure that underlying transactions are properly accounted for and also aggregated and reflected transparently in the financial statements. But as already pointed out, this is not a precise science, and people may have different views on how to achieve this objective. Also at times, countries depart from the basic objective of true and fair display, to help companies in difficulty and pursue other unrelated objectives. Hence, a country may desire to have a few carve-outs in exceptional circumstances from IASB IFRS. To illustrate, it is believed that in the Indian scenario, classification of loan liability as current merely based on breach of minor debt covenant, say, few days delay in submission of monthly stock statement to bank, does not reflect the expected behaviour of the lender (who may ultimately condone the violation) and may create undue hardship for Indian corporates.

On the other hand, the proposed removal of the fair valuation option under Ind-AS 40 with respect to investment property, does not appear to be reasonable as can be seen from the arguments in the table below. This is not typically a carve-out, but certainly removes one option provided in the IFRS.

Ind-AS 40 Investment Property

Background

IAS 40 allows entities 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.

Ind-AS 40 hosted on the MCA website 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. It is understood that the ICAI may now be proposing to retain fair valuation model for subsequent measurement of investment property. However, all changes in the fair value will be recognised in the OCI, instead of profit or loss. It is expected that the proposed fair valuation model may be similar to revaluation model under Ind-AS 16 Property, Plant and Equipment.

Technical perspective

Before issuing the IAS 40, the IASB had specifically considered whether there was a need for issuing separate IFRS for investment property accounting or should it be covered under the IAS 16 Property, Plant and Equipment. After detailed evaluation and consultation with stakeholders, the IASB decided that characteristics of investment property differ sufficiently from those of the owner-occupied property. Hence, there is a need for a separate IFRS. In particular, the IASB was of the view that information about fair value of investment property, and about changes in its fair value, is highly relevant to the users of financial statements.

An investment property generates cash flows largely in-dependently of other assets held by an entity. The generation of independent cash flows through rental or capi-tal appreciation distinguishes investment property from owner-occupied property. This distinction makes a fair value model (as against revaluation model) more appropriate for investment property.

The ICAI proposal for allowing fair valuation for investment property is unclear. Particularly, it is unclear whether a company will need to depreciate investment property. Since a company is not recognising fair value gain/ loss in P&L and on the lines of revaluation model in Ind-AS 16, it appears that companies may need to charge depreciation on investment property in profit or loss for the period. This means that while a company will charge depreciation on investment property to profit or loss; it will recognise fair value change directly in OCI. This may give highly distorted results.

In case of investment property companies, investors and other stakeholders measure performance based on rental income plus changes in the fair value. Under the ICAI proposal, no single statement will reflect such performance of an investment property company. A major global accounting firm had conducted a survey in India “IFRS convergence: an investor’s perspective.” Among the survey participants, 67% were in favour of allowing fair value model for investment property as an option to the cost model.

The author would therefore strongly support retaining the fair valuation option under IAS 40. India is at the threshold of introducing new structures such as REIT to provide a boost to the infrastructure and real estate sector. Fair valuation would be the most appropriate basis for investors to enter or exit out of these funds. Hence, retaining the fair valuation model under IAS 40 is imperative.

IASB IFRS may not necessarily provide the best answers in all cases, and there may be a few instances where the standards could have been much better. Nonetheless, the author believes that the standard setters and regulators will have to consider the benefit of these carve outs with the benefits lost as a result of departing from IASB IFRS. Ultimately, it is not about one-upmanship but aligning with the world. In my view, full adoption of IASB IFRS is a goal worth pursuing. At the same time the standards setters and regulators should engage with the IASB in resolving the Indian specific pain points amicably. As an alternative approach, the author suggests that companies should be allowed an option to adopt IASB IFRS, instead of Ind-AS, if they wish to.

In the long-run, the standard setters and regulators should work closely with the IASB so that any differences that arise are resolved more promptly. A mutually respectable relationship can be built with the IASB, where the IASB and the world can gain from India’s participation in the standard setting process and simultaneously India can also benefit from the process in improving its financial reporting framework.

shailesh.kwebmaker

Auditing outsourced services – Auditors’ predicament

Cost optimisation – the genesis of outsourcing
Many enterprises operate more efficiently and profitably by outsourcing certain functions to other organisations that have the personnel, expertise or infrastructure to accomplish these tasks. The past several years have seen rapid growth in outsourcing of various business functions to service organisations. This growth has been fueled by a number of factors, including economic recession, pressure to improve operational costs, an increasingly virtual workforce and lack of internal resources to support a process or function. Traditionally the term ‘outsourcing services’ would elicit reference to services such as book keeping, payroll processing, clearing house services, mortgage services and medical claims processing amongst others. However, with advancement of information technology, the outsourcing space has witnessed emergence of a plethora services such as Software as a Service (SaaS), Application Service Providers (ASP), Cloud Computing, Credit Card Processing platforms, Internet Service Providers (ISP), Data Centers, Tax processing etc.

How is an outsourced function relevant to audit?
In some cases the outsourced work generates information that is included in the outsourcer’s financial statements. Consider the example of a claims processor (third party administrator (TPA)) who processes claims for an insurance company. When the claims processing function is outsourced to a TPA, health plan customers are instructed to submit their claims directly to the TPA, which processes the claims based on rules established by the insurance company, such as rules related to eligibility and the amount to be paid against each claim. The claims processor provides the insurers with data, such as the cost of claims processed during a period, and this information flows through to the insurance company’s financial statements i.e., the expense claims and the related liability. Even though this information is generated by the claims processor, the insurance company is responsible for the accuracy of that information because the same is included in its financial statements.

For the auditors of the insurance company, the responsibility for auditing the information generated by the claims processor is the same as it would have been for auditing other financial statement information generated by the insurance company itself. The auditors must find a way to obtain evidence that supports the assertions in the insurers’ financial statements that include or are affected by the information generated by the claims processor. Under auditing parlance, the claim processor is termed as a ‘service organisation’, the insurance company would be a ‘user organisation’ whereas the auditor of the user organisation would be called as ‘user auditor’.

Auditors’ Responsibilities under SA 402
SA 402 – ‘Audit Considerations Relating to an Entity Using a Service Organisation’ expands on the factors that an auditor needs to bear in mind while auditing the financial statements of an entity that outsources functions that affect its financial statements. Services provided by a service organisation are relevant to the audit of a user entity’s financial statements when those services, and the controls over them, are part of the user entity’s information system, including related business processes, relevant to financial reporting.

In some cases, management of a user entity is able to monitor the quality of the data it receives from a service organisation by establishing controls to prevent, or detect and correct, misstatements in its financial statements resulting from errors in the data received from a service organisation. This would be the case if the user entity initiates and records the transactions it submits to the service organisation for processing. A good example of such services are payroll processing services.

In other cases, the user entity relies on the service organisation to initiate, execute and record the transactions. Consider for example where a user entity that grants an investment manager the authority to purchase and sell investments on its behalf based on written guidelines provided by the user entity.

Even though such controls are located and operating at the service organisation, they are relevant to the user entity’s internal control over financial reporting because they are designed to prevent, or detect and correct, errors in the information provided to user entities. The question is whether the auditor of a user organisation is required to test these controls and if yes, what approach would enable the user auditor to obtain sufficient information that such controls are designed and are operating effectively. Testing of controls at a service organisation.

SA 402 requires that where a user entity establishes controls over the services provided by a service organisation, the user auditor should test those controls which impact financial reporting to evaluate whether the same are operating effectively. Where the user auditor is satisfied that such controls at the user entity are operating effectively, he is not required to test controls established by the service organisation in relation to the services outsourced by the user entity. This may usually be the case where the process is less complex and the transaction volume is not substantial, for e.g., payroll processing for a small/medium sized enterprise.

Where the services provided by a service organisation involve highly automated processing, a user entity may not be able to implement effective controls over the transactions processed by the service organisation and may need to rely on the controls at the service organisation. From the user auditor’s perspective, he may be unable to obtain sufficient evidence by performing substantive procedures alone at the user entity. In such cases, the user auditor shall obtain an understanding through one or more of the following procedures:

a) O btaining a Type 1 or Type 2 report, if available

b) Contacting the service organisation, through the user entity, to obtain specific information

c) Visiting the service organisation and performing procedures that will provide the necessary information about the relevant controls at the service organisation; or

d) U sing another auditor to perform procedures that will provide the necessary information about the relevant controls at the service organisation.

A Type I report is a report by the service auditor on the design of the controls whereas a Type II report is a report on the design and operating effectiveness of controls at the service organisation.

The following case study highlights the procedures that a user auditor would perform to obtain sufficient evidence for risk assessment in relation to the services performed by a service organisation.

Case Study

World Wanderers Private Limited (WWPL) a wholly owned Indian subsidiary of World Wanderers Inc. USA (WWI) is an online travel company offering outbound and inbound travel services. WWI commenced operations in India in June 20X0. In order to rationalise the operating costs, the parent company, WWI outsourced the accounting for accounts payable function for all its subsidiaries including WWPL to Rapidex Accounting Services (RAS), an outsourcing firm based out of Philippines. The processing of accounts payable for WWPL happened at RAS whereas the general ledger was maintained by WWPL in India. WWI and all its subsidiaries used a globally renowned ERP system called ‘Apex’. Access to the Apex accounts payable module was provided by WWI to RAS. RAS used Apex for its other clients as well.

Under the accounts payable process, raising of purchase orders in Apex and approval of receipt of goods and services against these purchase orders was performed by authorised staff of WWPL. RAS accounts payable team was responsible for invoice and payment processing, reconciliations, journal posting in Apex and vendor helpdesk services. WWPL maintained a documentation imaging database called OMNI to which the designated accounts personnel from RAS accounts were given access. Scanned images of the invoices duly authorized by WWPL would be uploaded on OMNI. WWPL would provide a list of scanned images of specimen signatures of WWPL staff who were authorised to approve invoices. A designated team leader (TL) authorised by RAS would need to match the signatures on the invoices with the specimen provided and where these matched, the invoices were to be processed in Apex. A quality check was performed by RAS QC team on a test check basis.

Apex generated details of payments to be released to vendors based on due date which were compared by RAS accounts payable team with the payment authorisation received from personnel of WWPL. The request was then uploaded on the bank’s website by RAS Team Leader and payments released after sign off by WWPL. The contractual terms agreed by WWI with RAS included the requirement of RAS furnishing a Type 2 report on a calendar year basis for all the subsidiaries by an independent firm of IT auditors.

RAS engaged a service auditor ABC & Co. (‘ABC’) a firm based in Philippines to provide his opinion on the design and effectiveness of controls over the accounts payable function. The period of coverage was from 1st January 20X0 to 31st December 20X0. The significant controls tested by ABC inter alia included the following critical controls:

a. Controls provide reasonable assurance that invoices posted by RAS are authorised and accurate.

b. Controls provide reasonable assurance that only authorised payments are processed accurately by RAS.

c. Controls provide reasonable assurance that RAS IT resources used to provide services to WWPL are restricted to authorised personnel only.

ABC provided a Type 2 report stating that all controls related to accounts payable process were designed and operated effectively, other than the following controls:

• For 3 out of 25 samples, the verification of the payments uploaded on bank website by RAS was done using the ID of a resigned Team Leader of RAS.

• For 1 out of 25 samples, the verification of payment uploaded on the bank website was done using an ID which could not be associated with any of the Team Leaders of RAS assigned to WWPL.

• For 2 out of 25 samples, the evidence for verification by the TL on the bank website was not available.

ABC & Co. qualified their opinion on the above count.

WWPL had also outsourced its tax planning and processing function to XYZ & Co. (‘XYZ’), an Indian firm of chartered accountants. XYZ was responsible for filing of all statutory returns such as Service tax returns, withholding tax returns, and income-tax returns as well as providing assistance in tax assessments.

The accounting period for WWPL ended on 31st March 20X1. M/s.PQR & Associates (‘PQR’) were appointed as auditors of WWPL.

Let us now examine what procedures would PQR would need to perform to ensure compliance with the requirements of SA 402:

1. PQR may need to enquire whether WWPL has maintained independent detailed records or documentation of invoices processed and payments made by RAS on its behalf. It could be possible that no independent records could be maintained by WWPL on account of costs and operational efficiency.

2. Auditors generally have broad rights of access established by legislation. PQR would need to obtain an understanding of the legislation applicable in Philippines to determine whether appropriate access rights can be obtained to RAS systems. PQR could consider requesting WWPL to incorporate rights of access in the contractual arrangements between the WWPL and RAS. PQR may need to consider Inspecting records and documents held by RAS.

3. PQR may need to obtain evidence as to the adequacy of controls operated by RAS over the completeness and integrity of WWPL’s accounts payable data for which RAS is responsible.

4. If independent records of accounts payable are being maintained by WWPL, PQR could consider obtaining confirmations of balances and transactions from RAS for corroborating WWPL’s records. This may constitute reliable evidence confirming existence of transactions and balances.

5. Given the significant volume of payments, performing substantive procedures or testing of operating effectiveness of controls at WWPL by PQR would not be sufficient. It would be imperative that the design and operative effectiveness of controls over processing of invoices as well as payments which occurred at RAS were tested by PQR.

6. As ABC is a firm based out of Philippines and assuming that ABC is not registered with ICAI, PQR would need to evaluate the professional competence of ABC, its independence from WWPL and the adequacy of the standards under which ABC has issued the Type 2 Report. PQR may need to make enquiries about ABC to ABC’s professional organization and enquire whether ABC is subject to regulatory oversight.

7. (a) If PQR is satisfied as to the professional competence of ABC, PQR could use ABC to perform procedures on the WWPL on its behalf such as testing of controls at RAS (other than those covered by the Type 2 Report) or substantive testing on WWPL financial statement transactions and balances maintained by RAS.

(b) Alternatively, PQR could use another auditor to perform test of controls or substantive procedures at RAS on its behalf. The results of such procedures performed could be used by PQR to support its audit opinion. In such a case, it would be essential for ABC and PQR to agree to the form of and access to audit documentation.

8. As far as reliance on Type 2 Report is concerned, the controls tested by ABC and the results thereof would need to be evaluated by PQR to determine whether these support PQR’s risk assessment. In the present case it is pertinent to note that:

(a) The period covered by the Type 2 report is until 31st December 20X0 whereas the period under audit ended on 31st March 20X1. PQR would need to discuss with WWPL or where permissible with RAS whether there were any significant changes to the relevant controls at WWPL outside of the period covered by ABC’s Type 2 report. PQR could consider extending tests of controls over the remaining period or testing WWPL’s monitoring of controls. PQR may also review current documentation of such controls as provided by RAS

(b) PQR would need to evaluate the scope of work performed by ABC, i.e., the controls tested, the appropriateness of the sample sizes and whether there were significant changes to the relevant controls beyond the period covered by the Type 2 Report.

(c) The service was designed with the assumption that WWPL user will have controls in place for authorizing invoices before they are sent to RAS for processing. Other control to consider would be whether an updated list of signatories authorized to approve invoices was sent by WWPL to RAS. PQR would need to consider whether such complementary controls at WWPL were relevant to the service provided to WWPL.

(d) Merely because ABC had issued a qualified opinion does not imply that ABC’s report will not be useful for the audit of WWPL’s financial statements in assessing the risks of material misstatement. Subject to considerations explained in paragraph 7(a) above, the exceptions giving rise to the qualified opinion in ABC’s report should be considered in PQR’s assessment of the testing of controls performed by ABC.

(e) The exceptions pertained to inconsistency in the login IDs used by RAS team to process transactions on Apex. PQR would need to evaluate how these exceptions impacted the overall control environment around accounts payable processing, any remedial was taken post 31 December 20X0 and whether alternative checks were available to prevent or detect and correct errors in misstatement.

(f) The involvement of ABC or another auditor does not alter PQR’s responsibility to obtain sufficient appropriate audit evidence as a basis for forming his opinion. PQR would not be in a position to make a reference to ABC’s report as a basis for PQR’s opinion on WWPL’s financial statements. However, if PQR were to modify its opinion based on ABC’s opinion, then PQR could refer to the ABC’s report in its own audit opinion with prior consent of ABC.

9. As regards tax processing services performed by XYZ, a report on controls at XYZ may not be available and visiting XYZ may be the most effective procedure for PQR to gain an understanding of controls XYZ as there is likely to be direct interaction of WWPL’s management with XYZ.

The above is an illustrative inventory of procedures that SA 402 mandates auditors to perform. The procedures may be customised to meet the requirements of an actual scenario.

CONCLUDING REMARKS
Increasingly, enterprises are outsourcing their business functions to achieve cost efficiencies. The rise of cloud computing has played a key role in the number of businesses that outsource functions to service organisations. Cloud computing providers offer user entities access to applications, data storage, and numerous other computing functions on a pay-as-you- go basis. Controls at a service organisation that are related not only to user entities’ internal control over financial reporting but also to other critical aspects such as data privacy of customers and other stakeholders have gained prominence. User entity would continue to remain responsible for such data though the same resides with the service organisation.

SA 402 provides useful guidance to auditors to understand the nature and significance of services provided by service organisations and to design and perform procedures to respond to risk of material misstatements related thereto.

shailesh.kwebmaker

Gaps in GAAP— Component accounting under Schedule II

Schedule II to the Companies Act, 2013 is
applicable from 1 April 2014. Notes to Schedule II, among other matters,
state as below:

“Useful life specified in Part C of the
Schedule is for whole of the asset. Where cost of a part of the asset is
significant to total cost of the asset and useful life of that part is
different from the useful life of the remaining asset, useful life of
that significant part shall be determined separately.”

An illustrative example is given below.

Some key issues are discussed in this article.

How does a company go about conducting this exercise?
Schedule
II requires separate depreciation only for parts of an item of tangible
fixed asset having (i) significant cost, and (ii) different useful
lives from remaining parts of the asset. In many cases, such
determination may be straight forward. For example, an IT company, which
has only computers as fixed assets, may be able to determine with
little analysis that there are no significant components requiring
separate depreciation. Similarly, for an airline company, it may be
clear that engine has different useful life vis-à-vis remainder of the
aircraft. In many other cases, identification of components requiring
separate depreciation may involve complex analysis.

The company
first splits the fixed asset into various identifiable parts to the
extent possible. The identified parts are then grouped together if they
have the same or similar useful life. There is no need to identify and
depreciate insignificant parts as separate components; rather, they can
be combined together in the remainder of the asset or with the principal
asset.

Identification of significant parts is a matter of
judgment and decided on case-to-case basis. Identification of separate
parts of an asset and determination of their useful life is not merely
an accounting exercise; rather, it involves technical expertise. Hence,
it may be necessary to involve technical experts to determine the parts
of an asset.

How does one judge materiality in the context of identification of components?
A
company needs to identify only material/significant components
separately for depreciation. Materiality is a matter of management/audit
judgment and needs to be decided on the facts of each case. Normally, a
component having original cost equal to or less than 5% of the original
cost of complete asset may not be material. However, a component having
original cost equal to 25% of the original cost of complete asset may
be material. In addition, a company also needs to consider impact on
retained earnings, current year profit or loss and future profit or loss
(say, when part will be replaced) to decide materiality. If a component
may have material impact from either perspective, the said component
will be material and require separate identification.

In many
cases, identification of material components may involve complex
judgment, particularly, for assessing impact on future P&L. Also
what may not be material in a particular period could become material in
later years, and vice versa.

Auditors will have to modify
their audit opinion for a company that does not follow component
accounting, the impact of which is likely to be material in the context
of the overall results or financial position of that company.
In the case of a company that has a manufacturing facility and is asset
intensive, component accounting is likely to be material, not only
because of depreciation impact, but also the way replacement costs are
accounted for.

How is depreciation computed for components vis-avis the requirements of Schedule II?

Each
significant component of the asset having useful life, which is
different from the useful life of the remaining asset, is depreciated
separately. Though component accounting is mandatory, its application should be restricted only to material items.
If the useful life of the component is lower than the useful life of
the principal asset as per Schedule II, such lower useful should be
used. On the other hand, if the useful life of the component is higher
than the useful life of the principal asset as per Schedule II, the
company has a choice of using either the higher or lower useful life.
However, higher useful life for a component can be used only when
management intends to use the component even after expiry of useful life
for the principal asset.

To illustrate, assume that the useful
life of an asset as envisaged under the Schedule II is 10 years. The
management has also estimated that the useful life of the principal
asset is 10 years. If a component of the asset has useful life of 8
years, AS 6 requires the company to depreciate the component using eight
year life only. However, if the component has 12 year life, the company
has an option to either depreciate the component using either 10 year
life as prescribed in the Schedule II or over its estimated useful life
of 12 years, with appropriate justification. However, in this case 12
years life for the component can be used only when management intends to
use the component even after expiry of useful life for the principal
asset.

How are replacement costs accounted for?
The
application of component accounting will cause significant change in
measurement of depreciation and accounting for replacement costs.
Currently, companies need to expense replacement costs in the year of
incurrence. Under component accounting, companies will capitalize these
costs as a separate component of the asset, with consequent expensing of
net carrying value of the replaced component. If it is not practicable
for a company to determine carrying amount of the replaced component, it
may use the cost of the replacement as an indication of what the cost
of the replaced part was at the time it was acquired or constructed.

Even
under the component accounting, a company does not recognise in the
carrying amount of an item of fixed asset the costs of the day-to-day
servicing of the item. These costs are expensed in the statement of
profit and loss as incurred.

How are major inspection/overhaul expenses accounted for when component accounting is applied?

Under
Indian GAAP, no specific guidance is available on component accounting,
particularly, major inspection/ overhaul accounting. In the absence of
guidance, the following two options are likely. A company can select
either of two options for accounting of major inspection/ overhaul. The
option selected should be applied consistently.

Option 1
Though
AS 10 Accounting for Fixed Assets or any other pronouncement under
Indian GAAP does not comprehensively deal with component accounting,
Ind-AS 16 Property, Plant and Equipment contains comprehensive guidance
on the matter. Under component accounting as envisaged in Ind-AS 16,
major inspection/overhaul is treated as a separate part of the asset,
regardless of whether any physical parts of the asset are replaced.
Hence, one option is to apply Ind-AS 16 guidance by analogy. The
application of this approach is explained below.

When a company
purchases a new asset, it is received after major inspected/ overhaul by
the manufacturer. Hence, major inspection/ overhaul is identified
separately even at the time of purchase of new asset. The cost of such
major inspection/ overhaul is depreciated separately over the period
till next major inspection/overhaul.

Upon next major inspection/overhaul, the costs of new major inspection/ overhaul are added to the asset’s cost and any amount remaining from the previous inspection/ overhaul is derecognized. There is no issue in application of this principle, if the company has identified major inspection/ overhaul at the time of original purchase. However, sometimes, it may so happen that the cost of the previous inspection/overhaul was not identified (and considered a separate part) when the asset was originally acquired or constructed (this may not necessarily be an error but a change in an estimate). This process of recognition and derecognition should take place even in such cases.

If the element relating to the inspection/overhaul had previously been identified, it would have been depreciated between that time and the current overhaul. However, if it had not previously been identified, the recognition and derecognition principles still apply. In such a case, the company uses estimated cost of a future similar inspection/overhaul to be used as an indication of the cost of the existing inspection/overhaul component to be derecognized after considering the depreciation impact.

OPTION 2
It may be argued that under AS 10 approach, all repair expenditure (including major inspection/overhaul) need to be charged to P&L as incurred. Though schedule II mandates component accounting, it does not state that application of component accounting is based on Ind-AS 16 principles. Hence, AS 10 applies for repair expenditure (including major inspection/overhaul).

Under this option, the application of component accounting is restricted only to physical parts. Neither on initial recognition nor subsequently, the compa- ny identifies major inspection/overhaul as separate component. Rather, any expense on major inspection/ overhaul is charged to P&L as incurred.

What are the presentation/disclosure requirements when component accounting is followed?
Component accounting is relevant for purposes such as depreciation and accounting for replacement cost. Companies are not required to disclose components separate- ly in the financial statements or notes thereto. Rather, the company discloses the asset with all its components as one line item.

With regard to disclosure of useful life/depreciation rates, Schedule II has prescribed depreciation rates only for principal asset and no separate rates are prescribed for its components. Also, schedule II requires disclosure of justification if a company uses higher/lower life than what is prescribed in Schedule II. To comply with these require- ments, the following principles are used:

(i) A company discloses useful life/depreciation rate used for the principal asset separately. If this life/rate is higher/ lower than life prescribed in schedule II, justification for the difference is disclosed in the financial statements.
(ii) There is no need to disclose useful lives or depreciation rates used for each component (other than principal asset) separately. It will be sufficient compliance, if disclosure is given as a range by presenting the highest and lowest amount. It may not be sufficient to present the average of the useful lives or depreciation rates used in that class of components.

What are the transitional provisions with respect to componentisation?

Component accounting is applicable from 1st April, 2014. It is required to be applied to the entire block of assets existing as at that date. It cannot be restricted to only new assets acquired after 1st April, 2014. Since companies may not have previously identified components separately, they may use estimated cost of a future similar replacements/ inspection/ overhaul as an indication of to determine their current carrying amount.

AS 10 gives companies an option to follow component accounting; it does not mandate the same. In contrast, component accounting is mandatory under the Schedule
II. Considering this, transitional provisions of Schedule II can be used to adjust the impact of component accounting. If a component has zero remaining useful life on the date of Schedule II becoming effective, i.e., 1st April 2014, its carrying amount, after retaining any residual value, will be charged to the opening balance of retained earnings. The consequent impact with respect to deferred taxes should also be adjusted to retained earnings. The carrying amount of other components, i.e., components whose remaining useful life is not nil on 1st April 2014, is depreciated over their remaining useful life.

In the case of listed companies do companies have to comply with component accounting in the quarterly results provided under Clause 41?

Listed companies having 31st March year-end need to apply component accounting for quarter ended 30th June, 2014. It may be possible that certain companies have not completed the process of identifying components by due date for publishing its results for quarter ended 30th June, 2014. In such a case, the auditors should make materiality assessment particularly considering that there is no need to publish balance sheet on a quarterly basis. In many cases, it may be clear that application of component ac- counting may not have impacted results for the quarter materially. If so, the auditor should document its basis for materiality assessment in the work papers. As already indicated elsewhere in this article, for most asset intensive companies, the impact on current or future results or financial position will most likely be material because of depreciation and accounting for replacement costs.

shailesh.kwebmaker

Ind-AS Carve Outs – Straightlining of leases

The issue of straight-lining of leases is very important for many enterprises; particularly entities that obtain assets on long-term operating leases; for example, retail entities, multiplexes, telecom towers, etc. Thus, if a telecom tower was leased for nine years on a non-cancellable basis, paying rent of Rs.1,00,000 in the first year, with a 10% escalation each year, the charge in the P&L each year would be Rs.1,50,883 and not the contractual amount to be paid which is the rent for previous year plus 10% escalation. In determining the lease period for straight-lining the possibility of lease extension is also considered, and hence the impact could be much higher than one would normally anticipate.

In a recent discussion organised by an industry association on IFRS adoption, the author was surprised, when the presenter opined that operating leases should not be straight-lined under IFRS and hence a carve-out was required. The reason provided for the carve-out was that IFRS should be pain free. Interestingly, straight-lining is required under Indian GAAP (and is also clarified by an Expert Advisory Committee opinion). Thus, it was absolutely fine to give pain under the Indian GAAP but not under IFRS!

Financial statements should reflect a true and fair view, based on robust accounting standards. Whether the accounting gives pain or is pain free is not relevant. However, what is an appropriate technical approach can sometimes be very debatable. Straight-lining of leases is one such instance where there are strong arguments in favour of and against straight-lining of leases, which one should consider. Let us discuss what those arguments are.

Arguments for and against straight-lining of leases
The primary reason for straight-lining of leases is contained in paragraph 23 of AS-19 which states that “Lease payments under an operating lease should be recognised as an expense in the statement of profit and loss 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.” In other words, in the above example of telecom towers, the benefit received from the telecom tower over the nine years is absolutely uniform and hence the charge in each of the nine years should be equal. The lessee is expected to derive the same benefit, in physical terms, from the leased asset over the lease term and, accordingly, the scheduled rent increases in the lease rental do not meet the criterion for recognising expense/ income on a basis other than straight-line basis over the lease term.

One view is that the increases in rent in the agreement may only be considered as an adjustment for inflation and hence leases should not be straight-lined. The counter argument is that inflation factor in the agreement may not be representative of the inflation index in the country. Thus, it may so happen that a 10% escalation is built in the rent agreement each year in anticipation of inflation, was not supported by the inflation index, which was expected to be 5%. In reality, it may so happen that in subsequent years rents may fall down drastically, instead of going up. In other words, the cost of operating would be cheaper in future years and hence the assumption that escalations represent future inflation may not be tenable. In India, it may be fair to state that one of the reasons for lease rentals to increase is the inflation factor. Now if the scale up on the rentals in the agreement was based on an inflation index rather than a fixed amount, the scale up would be treated as contingent rentals under AS-19 and accounted for as and when the contingent rentals become due (not on straight-line). However, if the rent increases does not represent an inflation index then straight-lining would be required. This appears to be a fair argument for straightlining leases.

It is understandable that in India people focus on contractual terms and therefore recognising any expense or income that does not represent those contractual terms makes them very uncomfortable. An interesting point would be to look at the standard on depreciation, which permits the straight-line, written down value method and other methods such as unit of production method. A lessee would depreciate an asset obtained on finance lease and capitalised by it using any of the above methods. In other words, the P&L charge would not be based on the contractual terms/payments. Thus, focusing on contractual terms/payments in the case of operating lease would also not be appropriate and would unnecessarily result in structuring possibilities.

Some argue that straight-lining results in recognising future costs. The standard ignores the fact that as time passes, costs go up (or may go down) and so does revenue. The cost of operating in 2007 would always be different from the cost of operating in 2008. The same can be said for the revenue rates; they may go up or down. To try and straight-line the cost (in the case of lessee’s) selectively for leases is a violation of sound accounting principles.

Paragraph 24 of AS-19 states that, “for operating leases, lease payments (excluding costs for services such as insurance and maintenance) are recognised as an expense in the statement of profit and loss on a straight-line basis unless another systematic basis is more representative of the time pattern of the user’s benefit, even if the payments are not on that basis.” This means that if services are provided by lessor to the lessee, for example, maintenance services with a 10% increase each year, those are not required to be straight-lined. Also when a purchaser makes an upfront commitment to purchase goods each year from a seller with a 10% increase over the previous year’s rate, one does not straight-line the cost of purchase over those years. Therefore the point is if straight-lining is not required as a principle in the framework or by other standards, then is it appropriate to apply it selectively in the case of leases?

A point to be noted is that the straight-lining under the standard is an anti-abuse measure arising out of rent-free periods. Thus, if a building is taken on operating lease for three years, with zero rent in the first two years and rent of Rs. 3 lakh for the third year, the standard would require Rs. 1 lakh to be charged each year. This is fair, because in substance there is no such thing as rent-free period. Therefore, some argue that to require straight-lining when there is no indication of deliberate ballooning is unfairly stretching the argument for straight-lining.

The straight-lining of lease rentals would result in a deferred equalisation which may be a liability or an asset. For example, if the operating lease is for two years with rental in year one, of Rs. 100 and rental in year two of Rs. 110; equalisation would result in a deferred liability of Rs. 5 in the first year (which will reverse in the following year). Now the problem with deferred equalisation is that it does not fulfill the definition of an asset or liability under “The Framework For The Preparation And Presentation Of Financial Statements” issued by the Institute of Chartered Accountants of India. Under the framework, asset and liability is defined as follows:

(a) An asset is a resource controlled by the enterprise as a result of past events from which future economic benefits are expected to flow to the enterprise.

(b) A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

It begs the question therefore that if deferred equalisation is not an asset or liability as defined under the Framework, then what is it doing in the balance sheet?

Overall, there appears to be good arguments for and against straight-lining of leases. Ultimately, one has to take a decision.

Overall Conclusion
The adoption of Ind-AS will bring India at par with the world (more than 120 countries) at large that has adopted IFRS. To achieve full benefit, it is imperative that Ind-AS’s are notified without any major difference from IASb IFRS. If India were to implement IFRS with too many differences, it would be akin to moving from one Indian gAAP to another Indian gAAP. This would entail 100% efforts with zero benefits. Moving from Indian GAAP to IASB IFRS would entail 100% efforts but will provide 100% benefits. By adopting IASB IFRS it would become possible for Indian companies to state that they are compliant with IASB IFRS, and hence those financial statements can be used globally.

It is well appreciated that accounting is an art, and not a precise science. Primarily, financial statements should reflect and capture the underlying substance of transactions. The accounting standards are drafted to ensure that underlying transactions are properly accounted for and also aggregated and reflected transparently in the financial statements. But as already pointed out, this is not a precise science, and people may have different views as is evident from the above debate on leases. Sometimes there are no right or wrong answers, and a decision needs to be taken and people need to move ahead.

IASB IFRS is not necessarily the best cut in all cases, and there may be a few instances where the standards could have been better, from another person’s perspective. Nonetheless, the author believes that the standard setters and regulators will have to consider the benefit of these carve outs with the benefits lost as a result of departing from IASB IFRS. ultimately, it is not about one-upmanship but aligning with the world. In my view, full adoption of IASb IFRS is a goal worth pursuing. At the same time the standards setters and regulators should engage with the IASB in resolving the Indian specific issues amicably. As an alternative approach, the author suggests that companies should be allowed an option to adopt IASb IFRS, instead of Ind-AS, if they wish to.

In the long-run, the Indian standard setters and regulators should work closely with the IASB so that any differences that arise are resolved more promptly. A mutually respectable relationship can be built with the IASB, where the IASB and the world can gain from India’s participation in the standard setting process and simultaneously India can also benefit from the process in improving its financial reporting framework.

IASB certainly has a global objective of having one set of uniform IFRS standards across the world. Therefore, if IFRS are adopted in India without any carve-outs it would be a positive development for IASB. But adopting full IFRS or providing an option to do so, would be a far bigger positive development for India.

shailesh.kwebmaker

Role of an auditor in assessing fraud risks

Introduction
Worldwide, companies are striving to survive in adverse economic and competitive market conditions. This survival struggle often results in some of them engaging in unethical business practices such as fraud, espionage and corruption. To help organisations mitigate these risks, regulatory bodies, both international and national, have reformed and implemented several stringent laws and regulations. These include Foreign Corrupt Practices Act (FCPA) in the US, UK Bribery Act in UK and the new Companies Act, 2013 in India.

The Companies Act 2013 – A new era of corporate governance
According to the 13th Global Fraud Survey, 2013 by EY, 34% of India respondents said that they resorted to unethical actions in a business situation, which is the second highest amongst the surveyed nations. The Companies Act, 2013 is set to be a game changer for corporate India, paving the way for an enhanced control environment, greater transparency and higher standards of governance. Section 447, under the Act for the first time provides a definition of fraud and also makes extensive provisions for penalising fraudulent activities.

The Securities and Exchange Board of India (SEBI) has specifically outlined the Clause 49 of the Listing Agreement to adopt leading global practices on corporate governance and to make the corporate governance framework more effective. The enforcement of these norms demands organisations to provide assurance to the board, audit committee on adequacy of internal controls, effective risk management process, anti-fraud controls and effective legal compliance framework. With these changes in place, the role of an auditor has undergone a significant transformation.

Reporting on internal financial controls
Management is still dependent on auditors to provide them assurance on anti-fraud controls which are in place across businesses, together with the ability to detect and deter a potential fraud. Auditors are expected to evaluate accounting systems for weakness, reviewing and monitoring internal controls, determining the degree of fraud risks and interpreting financial data for picking up unusual trends and following up on red flags.

The Companies Act, 2013 has made it mandatory for the auditors to comment on whether the company has adequate internal financial controls system in place and operating effectiveness for such controls. Here, the term, ‘internal financial controls,’ means the policies and procedures adopted by the company for ensuring orderly and efficient conduct of its business, including the prevention and detection of frauds or errors, the accuracy and completeness of the accounting records, and the timely preparation of reliable financial information.

Evaluating fraud risks
An auditor should have the ability to understand how a fraud is committed and how it can be identified. He/ she should also understand the underlying factors that motivate individuals to commit fraud. As per the Companies Act, 2013, the term ‘fraud’ includes any act, omission, concealment of any fact or abuse of the position committed by any person, with intent to deceive, to gain undue advantage from, or to injure the interests of, the company or its shareholders or its creditors or any other person, whether or not there is any wrongful gain or wrongful loss.
• Under the Act, liability and punishment for fraud is extended to every individual who has been a party to it intentionally, including the auditors of the organisations.
• Auditors need to be involved in monitoring the whistleblowing mechanism, which is made mandatory for directors and all employees to report genuine cases of frauds.

Therefore, an auditor is expected to be in a position to identify potentially fraudulent situations during the course of the audit and play a vital role in preventing fraud and other unethical acts. It is essential they remain unbiased and must conduct the audit with a clear mind-set to catch possible material misstatements resulting from a fraud. This should be regardless of their relationship with the organisation or their belief about the management’s honesty or integrity. Objectively, the auditor is always in a better position to detect symptoms that accompany fraud, and usually has continual presence in the organisation. This provides them with a better understanding of the organisation and its internal financial controls.

With the new legislations, the auditor will now need to take responsibility over the adequacy of fraud prevention measures in various business processes. He/she is required to exercise professional scepticism, which requires an ongoing questioning of whether the information and evidence obtained suggests that a material misstatement or fraud has occurred. Sometimes, he/ she may even have to undertake extended audit procedures in areas where potential red flags were noticed. Another key consideration is the inclusion of fraud detection procedure as part of every audit and keeping an eye open for red flags.

Proactive auditing to look for fraud risks
In this new era of auditing, ushered in by the Companies Act 2013, Auditors will have to proactively look for fraud vulnerabilities and fraud risks, by extending the audit procedure to:

Examine and evaluate the adequacy and effectiveness of internal financial controls

• Unusual transactions
• Adjustments in the period-end financial reporting process
• Related party transactions

Make use of data analytics to find unfamiliar items and perform detailed analyses of high risk transactions
Identify relevant fraud risks: Understand the business environment. Review the documentation of previous and suspected frauds, monitoring the reporting through whistle-blowing mechanisms and formulating the ethics programme
Outline existing controls to potential fraud schemes and carry out a gap assessment.

In the standard audit reports that accompany corporate financial statements, the auditor’s responsibility for detecting fraud is not discussed. Indeed, the word fraud isn’t mentioned at all. The auditing profession calls the discrepancy between what investors expect and what auditors do an “expectations gap.”

In recent years, audit firms have attempted to close the gap by educating the public on their role. Even though fraud is not one of the main objectives of auditors, it has been observed in past few years they have been instrumental in detecting or raising a warning sign to the management. It has been an increasing trend that the auditors have come across a fraud or a potential fraud and highlighted the same to the management or investigating agencies. It is with their help that investigators are able to crack the toughest cases by using various forensic tools and techniques such as data analytics, disk imaging, extensive public domain searches etc. Understanding fraud risk and developing the necessary skills for fraud detection is now a necessity for auditors; as stakeholders expect them to be red flag bearers of good corporate governance within the company.

The road ahead
Going forward, the role of the auditor is expected to become much more onerous as the board, management and Independent Directors seek increased comfort on newer areas to comply with the complex regulatory environment and legal duties and responsibilities. Their role is set to evolve into a more extensive, outward, forward looking and continuous activity to help deliver a more sustainable, efficient and effective audit function.

Please note: Views expressed in this article are personal to the author.

levitra

shailesh.kwebmaker

Comments on Exposure Draft – Guidance Note on Accounting for Service Concession Arrangements by Concessionaires

28th August 2014

The Secretary,
Accounting Standards Board,
The Institute of Chartered Accounts of India,
Indraprastha Marg,
ICAI Bhawan, Post Box No. 7100,
New Delhi – 110002

Dear Sir,

Subject: Comments on Exposure Draft – Guidance Note on Accounting for Service Concession Arrangements by Concessionaires

We have pleasure in forwarding herewith Comments of Bombay Chartered Accountants’ Society on Exposure Draft – Guidance Note on Accounting. The Exposure Draft was discussed in detail by our Accounting and Auditing Committee and on the basis of the same we are sending our comments. We hope that our comments will receive due consideration.

Thanking you.

Bombay Chartered Accountants ‘ Society

Nitin Shingala                                                                                         Harish N. Motiwalla
President                                                                                                Chairman
                                                                                                Accounting & Auditing Committee

Comments on Exposure Draft – Guidance Note on Accounting for Service Concession Arrangements by Concessionaires Para 14 Here it is stated as follows:

“The concessionaire should recognize and measure revenue in accordance with Accounting Standard (AS) 7, Construction Contracts, and Accounting Standard (AS) 9, Revenue Recognition, for the construction or upgrade and operating the services it performs, respectively. If the concessionaire performs more than one service under a single contract or arrangement, consideration received or receivable should be allocated by reference to the relative fair values of the services delivered.”

Comment
If the concessionaire performs service and books its income on the basis of its performance, the consideration received or receivable should also be allocated by reference to the relative fair values of the services performed and not delivered.

As such, there may be difference between the services performed and considered as delivered, which would be the billed revenue. However, there is a possibility where the concessionaire would consider certain services being already performed and accordingly would book the same as revenue though, the difference between the income recognized as performed and delivered would be treated as Unbilled Revenue.

In view of the adoption of new IFRS 15 – Revenue Recognition, which replaces IAS 11 – Construction Contracts as well as IAS 18 – Revenue Recognition, when a contract contains more than one distinct performance obligation, an entity allocates the transaction price to each distinct performance obligation on the basis of relative stand alone selling price.

Considering the above scenario, kindly provide guidance as to whether the concessionaire can allocate consideration by reference to the fair values of the services on the basis of the Input Method (on the basis of the cost incurred towards each distinct performance obligation to the overall cost of the contract).

Para 18
Here it is stated as follows:

“AS 10, Accounting for Fixed Assets, requires that ‘when a fixed asset is acquired in exchange for another asset, its cost is usually determined by reference to the fair market value of the consideration given. It may be appropriate to consider also the fair market value of the asset acquired if this is more clearly evident’. Thus, in accordance with AS 10, service concessions arrangement which is compensated by grant of a right to collect fees from users of the public service would require the acquired ‘intangible asset’ to be recorded at a value which represents the fair value of the construction services rendered.”

Comment
As per AS 26 – Intangible Assets, Para 23 states “An intangible asset should be measured initially at cost.” Hence if there is to be capitalization of cost incurred for receiving a right to charge users of the public service by the concessionaire, the same has to be on the basis of the identifiable component of cost incurred which can be categorized for the receipt of such rights. The reference is the Guidance should be through AS 26 which is the standard specifying treatment for intangibles.

The reference to AS 10, it is felt deals with situation of exchange of tangible asset with a tangible asset. In the case of concessionaire, the cost incurred may not be creation of any tangible asset, since the ownership will be with the operator. Hence the determination of fair value on the basis of treating the cost incurred for construction of a certain asset which does not belong to the concessionaire and treating the said cost towards exchange for another asset which is also not a tangible asset, seems to be faulty.

Para 23
Here it is stated as follows:

“………These contractual obligations to maintain or restore infrastructural facilities, except for any upgrade element (see paragraph 14), ……..”

Comment
Reference to “(see paragraph 14)” should be “(see paragraph 15)”.

Para 25 & 26

“Receivable

25 The amount due from or at the direction of the grantor is accounted for as a receivable

26 In case of an annuity, interest element should be segregated and should be recognized in the statement of profit and loss at the rate implicit in the annuity contract.”

Comment
Clarification in cases where the Concessionaires have already recognized financial asset in accordance with 2008 Guidance note in its financial statements.

The 2014 Guidance Note deals only with accounting of Receivable and not financial asset except in cases where the amounts are in nature of Annuity Para 26 of GN provides the segregation of interest.

However since there may be Concessionaires who may have early adopted the 2008 Guidance note (as early adoption was allowed), in cases where such entities have recognized Financial asset in accordance with Para 23 to 25, it will be required to derecognize the same under 2014 GN as no similar provisions have been made. Guidance Note should provide the manner in which such changes will be incorporated in financial statements.

Para 28
Here it is stated as follows:
“The, depreciable amount of the intangible asset recognized according to paragraph 27 should be allocated on a systematic basis over the best estimate of its useful life.”

Comment
Intangible asset has to be amortized over its useful life and hence the word “depreciable amount” should be replaced with “amortizable amount”.

Para 28 & 29
Here it is stated as follows:
“28 the depreciable amount of the intangible asset recognized according to paragraph 27 should be allocated on a systematic basis over the best estimate of its useful life.

29 the amortisation method used should be in accordance with the principles laid down in AS 26.”

Point 16 of Example 2 of Illustration
Here it is stated as follows:
“16 In accordance with AS 26, the intangible asset is amortized over the period in which it is expected to be available for use by the concessionaire, i.e. years 3–10. for the purpose of this example, the depreciable amount of the intangible asset (rs.1, 084) is allocated using the straight-line method. the annual amortization charge is therefore rs.1, 084 divided by 8 years, i.e. Rs.135 per year.”

Comment
Para 28/29 of GN prescribes the method of amortization as per AS 26 (para 73). Point 16 of Example 2 provides the amortization on straight line method over the concession period. However, Schedule II of Companies Act 2013 specifically provides that the amortization will be in
accordance expected revenue for the year as compared to the total revenue during the concession period. to this extent the Gn will have to be amended for the Concessionaires who are covered by the provisions of the Companies act, 2013

Para 33
Here it is stated as follows:
“in those service concession arrangements, where the concession fees or periodic premium payable to the grantor is of the nature of revenue sharing arrangement, i.e., the concessionaire acts as the agent of the grantor as a collector of fees from the users of the public service, the amount of fees collected is adjusted for the concession fees or premium paid to the grantor.”

Comment
If the concessionaire is acting as an agent, guidance and clarity is sought as to whether the fees collected by the concessionaire should be accounted on gross basis or on Net basis.

shailesh.kwebmaker

Is an auditor expected to be omniscient?

Auditors are experts in accounting and auditing matters, but are they expected to possess competencies in fields not usually related to their profession? Quite frequently, auditors are confronted with situations which require expertise that transcends well beyond the realm of accounting and auditing. Consider for instance the following scenarios:

• For an oil exploration company, if the results of exploration and drilling indicate the presence of oil and gas reserves which are considered to be commercially viable, the expenditure incurred on exploration and drilling is capitalised and amortised (depleted) on a ‘unit of production’ basis computed based on proved reserves in the oilfield. How would an auditor estimate the quantum of oil reserves in an oil field?

• In case of a coal mining company, it is necessary to remove overburden and other barren waste materials from the land pit to access ore from which minerals can economically be extracted. Costs incurred for removal of such waste materials during the initial development phase of the mine are generally capitalised. These costs are usually amortised using a proportion of the quantity of ore extracted during a period over the estimated ore reserves. How would one estimate the ore reserve in a mine?

• How would an auditor obtain assurance over the reported liabilities of a company that has made a provision for costs arising as a consequence of an environmental disaster for which the company is culpable?

• How would an auditor obtain sufficient appropriate evidence to support the ‘true and fair’ opinion on the financial statements of a company that owns expensive jewelry, works of art or antiques, either as trading or as investment assets.

The above scenarios present situations where it is imperative to involve an expert to provide necessary information for preparation of the financial statements.

Other areas where experts may be involved are actuarial valuation of liabilities associated with insurance contracts and employee benefit plans, valuation of intangible assets such as brands, patents and trademarks, site clean-up costs, interpretation of contracts, laws and regulations, analysis or valuation of complex derivatives or financial instruments etc.

Depending on the nature, significance and complexity of the matter that requires the involvement of an expert, an auditor may determine whether he has the expertise to evaluate the work of the expert engaged by the management (known as management’s expert), or whether he needs to engage an ‘auditor’s expert’ so as to decrease the risk that material misstatement will not be detected.

An ‘auditor’s expert’ is an individual or organisation possessing expertise in a field other than accounting or auditing, whose work in that field is used by the auditor to assist him in obtaining sufficient appropriate audit evidence. An auditor’s expert may be either an auditor’s internal expert (from within his own firm) or an external expert. It is pertinent to note that an auditor’s expert is engaged by the auditor and not by the client (‘auditee’).

In the present article, we will focus on aspects that an auditor would need to consider where he himself chooses to evaluate the work of the expert rather than employing an ‘auditor’s expert’.

SA 500 Audit Evidence provides guiding principles for auditors where information to be used as evidence has been prepared using the work of a management’s expert.

Having regard to the significance of the expert’s work for audit purposes, the auditor would need to evaluate the competence, capabilities and objectivity of the expert when assessing the risk of material misstatements; obtain an understanding of the work performed by him and evaluate the appropriateness of the expert’s work as audit evidence for the relevant assertion.

Let us understand the application of SA 500 with certain practical real-life scenarios.

1. Actuarial valuation of retirement benefits

Use of actuaries in valuation of retirement benefits/longterm employee benefits is one of the most common practice followed by enterprises world over. While auditors are not expected to re-work the valuation performed by the actuary, an auditor is expected to be cognisant of key factors considered in the valuation and to perform corroborative audit procedures. An illustrative inventory of procedures that need to be performed are as under:

i. Testing the assumptions and methods used by the actuary with empirical data available in public domain as well as historical data of the enterprise. The procedures that could be followed while testing some of these assumptions are listed below –

a. Salary increments – could be tested based on past history of increments given by the enterprise and the general level of increment in the industry in which the enterprise operates.

b. Mortality – could be tested by reference to the mortality tables used by insurance companies

c. Attrition – could be tested based on past history/ experience of employees exiting the enterprise. The workforce could be categorised into various age profiles and a graded attrition rate be applied to each profile.

d. Discount rate – could be tested by reference to yields on government bonds with a maturity that corresponds to the remaining service life considered by the actuary.

e. Expected return on plan assets – could be tested by reviewing the profile of investments comprised in the plan.

f. An analytical review of the various components of the actuarial valuation such as current service costs, return on plan assets, actuarial gains/losses, past service costs etc. in relation to the previous year may also provide directional insights to the auditor.

ii. T esting whether the assumptions and methods are generally accepted by the actuarial profession and are appropriate for financial reporting purposes

iii. Testing whether the source data provided by the enterprise to the actuary was relevant, complete and accurate, for e.g., employee data provided by the enterprise relating to salary, date of joining, leave policy and accumulated leave balances (in case of valuation of compensated absences) etc.

iv. Whether the actuary is a member of any statutory professional body governing the actuarial profession and is subject to ethical/accreditation standards of that body.

v. T he auditor could also consider discussing with the actuary on any aspect relating to the actuarial valuation where clarifications are needed. The personal experience with previous work of the expert could also assist the auditor in evaluating the competence of the actuary.

vi. T he auditor should also be mindful of circumstances that would impair objectivity of the actuary, for e.g. , whether the actuary has any financial interest in the enterprise, whether he provides other services and has any business/personal relationships with the enterprise (other than the engagement for actuarial services).

vii. I t may however be noted that the auditor continues to be responsible for opining on the financial statements which incorporate the retirement benefits liability accounted using the valuation provided by the actuary.

2. Valuation of employee stock option plans

Generally, listed companies in india which issue employee stock options (ESOP) are required to obtain a valuation of the ESOP using an appropriate valuation model for the purpose of determining the fair value of the options for accounting/disclosure purposes. Such valuations are performed by a valuation expert using an appropriate model such as Black Scholes or Binomial models. Usually, in such cases, an auditor does not engage an ‘auditor’s expert’ for evaluating the work performed by the management expert. though the valuation may be performed by the management expert, the auditor can validate the same by independently testing some of the assumptions/data used by the management expert in valuing the options such as –

i.    dividend yield – by reviewing the past dividend history to validate this assumption
ii.    Volatility – by reviewing the fluctuation in the share prices of the Company over the valuation period
iii.    testing the number of options granted, exercised and lapsed during the qualifying period

Even in this case, the auditor continues to be responsible while opining on the financial statements which include the ESOP charge accounted based on the valuation provided by the management’s expert.

3. Estimation of reserves in an oilfield

Enterprises engaged in such industries would have their own internal team of professional engineers and geologists or may seek the services of external experts to deduce the expected reserves in an oil field. Such a team of experts may evaluate data to determine whether oil can be economically produced from the well, whether infrastructure exists to enable the marketing of production to be obtained from the field, findings from prior years, their own knowledge of relevant formations and drilling, completion and production techniques applied by the Company etc.

Some of the significant points of focus for oil reserve valuation by an expert could be –

i. The nature, scope and objectives of the expert’s report – whether the report is prepared solely for the exclusive use of the enterprise and forms the basis for the assessment of impairment of property, plant and equipment.

ii. Whether the expert acknowledges the fact that the auditors use the report for the purposes of the year end audit?

iii. Whether the evaluation of reserves is a routine part of the expert’s business?

iv. Are these experts employed by other oil and gas development and exploration companies to perform such evaluations and thus have established procedures and guidelines that are followed as part of the reserve evaluation process?

v. Whether the expert compares the data provided by the management with public information before incorporating the data in to the model used for computing the reserve. Whether assumptions are reviewed and tested by management to ensure the reliability and consistency of the output with expectations and actual results?

vi. Whether the expert is required to comply with the ethical standards of any governing body and whether the report issued has under any statutory sanction?

vii. Whether the expert has any direct or indirect interest in the enterprise which could impair his objectivity?

viii. Based on the complexity involved, the auditors could consider incorporating a ‘matter of emphasis’ in the audit report clearly expressing his reliance on the technical evaluation done by the expert of the expected oil reserves which has formed basis of providing for amortization of the exploratory and drilling costs of the oil well.

4. Valuation of Artworks

Where an enterprise is engaged in trading of artworks/ antiques, one would need the involvement of a valuation expert to test whether the net realisable value of such items exceeds the cost so as to comply with the requirements of AS 2 – Valuation of inventories.

The valuation of artworks is influenced by factors such as the identity of artist, the art style deployed (such as contemporary, modern etc.), the age of the artwork, the medium used i.e., whether the artwork is on canvas or paper, at what price have the paintings of the artist concerned been sold in the recent past, recognition of the artist by art galleries/auctioneers, demand and supply of the artworks of the concerned artist etc. In addition to the generic audit procedures discussed in the preceding cases, the auditor would need to be aware of these nuances while verifying the valuation performed by the expert.

5. Physical verification of stock pile of minerals

For enterprises that transact in/consume minerals such as natural gypsum (usually found in rock form) or coal, it may not be practical to conduct a physical verification of the entire stock by weighment, where the quantum of stock at the year-end is substantial. In such cases, the enterprise may engage a surveyor to certify the quantum of stock based on volumetric measurement. The auditors in such cases should not merely rely on the report furnished by the surveyor but perform alternative procedures such as an overall reconciliation of quantity of materials purchased, expected material consumption (relative to finished goods produced) and derived closing inventory.

Concluding Remarks
Where enterprises involve experts to provide information necessary for preparation of the financial statements, auditors would need to decide whether they have the requisite knowledge and experience to evaluate the work performed by the experts and not merely rely on their reports. ultimately, the audit opinion is the sole responsibility of the auditor, and that this responsibility is not reduced by reliance on the work performed by the expert.

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Contingent Pricing of Fixed Assets and Intangible Assets

In most cases, fixed assets and intangible assets are purchased at a certain price and the accounting is fairly straight forward. Purchase of an asset on credit gives rise to a financial liability when the asset is delivered. The buyer makes the payment to the seller and relinquishes the financial liability. However, more complex contracts are emerging, where the payments could be contingent upon one or more variables. This is generally referred to as contingent consideration.

Some payments are dependent on the purchasers future activity derived from the underlying asset. For example, a contract for the purchase of a licence may specify that payments are based on a specified percentage of sales derived from that licence. Some payments could depend upon the performance of the asset, for example whether the asset acquired complies with agreed-upon specifications at specific dates in future, such as standard production capacity or a standard performance. Other payments may be dependent on an index or a rate. For example, an operator in a service concession agreement agrees to pay an annual concession fee to the grantor, with the principal amount increasing at the end of each year based on the consumer price index.

The provisions relating to AS 10 Accounting for Fixed Assets, AS 6 Depreciation Accounting and AS 26 Intangible Assets are set out below.

AS 10 Accounting for Fixed Assets
9.1 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:

i. site preparation;
ii. initial delivery and handling costs;
iii. installation cost, such as special foundations for plant; and
iv. professional fees, for example fees of architects and engineers.

The cost of a fixed asset may undergo changes subsequent to its acquisition or construction on account of exchange fluctuations, price adjustments, changes in duties or similar factors.

11.2 When a fixed asset is acquired in exchange for shares or other securities in the enterprise, it is usually recorded at its fair market value, or the fair market value of the securities issued, whichever is more clearly evident.

AS 26 Intangible Assets
25. The cost of an intangible asset comprises its purchase price, including any import duties and other taxes (other than those subsequently recoverable by the enterprise from the taxing authorities), and any directly attributable expenditure on making the asset ready for its intended use. Directly attributable expenditure includes, for example, professional fees for legal services. Any trade discounts and rebates are deducted in arriving at the cost.

26. If an intangible asset is acquired in exchange for shares or other securities of the reporting enterprise, the asset is recorded at its fair value, or the fair value of the securities issued, whichever is more clearly evident.

AS 6 Depreciation Accounting
6. Historical cost of a depreciable asset represents its money outlay or its equivalent in connection with its acquisition, installation and commissioning as well as for additions to or improvement thereof. The historical cost of a depreciable asset may undergo subsequent changes arising as a result of increase or decrease in long-term liability on account of exchange fluctuations, price adjustments, changes in duties or similar factors.

16. Where the historical cost of an asset has undergone a change due to circumstances specified in para 6 above, the depreciation on the revised unamortised depreciable amount is provided prospectively over the residual useful life of the asset.

Author’s point of view
Neither AS-10 Accounting for Fixed Assets nor AS 26 Intangible Assets provides any clear guidance on how to account for such contingent pricing arrangement for acquisition of fixed assets and intangible assets. Theoretically many views are possible.

View 1.1
The fixed asset and the liability can be measured at cost on date of acquisition. The cost would be the amount paid on the date of acquisition. In the case of fixed assets, based on paragraph 9.1 of AS-10, any subsequent change in the liability or consideration is capitalised to the cost of fixed asset. This can be used by analogy for intangible assets as well. AS 6 is also clear that any such changes to the fixed asset cost are depreciated prospectively. This is not clear in the case of intangible assets; however the same analogy may be used.

View 1.2
A variation of View 1.1 is that any change to the cost of the asset is not included in cost of the asset, but the impact is taken to P&L. This view is supportable as paragraph 9.1 of AS-10 includes price adjustments, which is not the same as contingent consideration. In other words paragraph 9.1 does not clearly deal with accounting for contingent consideration and hence it is arguable that the changes to the liability are included in the P&L.

View 2
On the date the fixed asset or intangible asset is purchased, the control is transferred to the buyer and consequently a debit to fixed asset or intangible asset and a credit to liabilities would arise equal to the fair value of the contingent payment. Paragraph 11.2 of AS 10 and paragraph 26 of AS 26 support this view, though those paragraphs apply to consideration by way of shares or securities.

The core issue would then be whether the remeasurement of the liability on account of changes in the consideration should be recognised in the profit or loss or included as an adjustment to the cost of the asset. This is a major issue that is not clear even under International Financial Reporting Standards and is a matter of significant debate in the International Financial Reporting Interpretations Committee (IFRIC).

Paragraph 9.1 requires subsequent changes in cost to be included as cost of fixed assets. However those costs do not include contingent consideration adjustment. Therefore there are supportable arguments that subsequent changes in the remeasurement of liability may be recognised in the profit or loss.

Conclusion
In this article, we have simplified the issue of contingent payments and not taken into consideration the various complex arrangements that may be involved and their impact on accounting. Take for example, the contingent payments based on a quoted index. Under IFRS typically one would make an assessment of whether there is an embedded derivative, and whether that embedded derivative needs to be valued and accounted for separately or not. Indian GAAP does not contain any guidance on this matter. The ICAI should participate in the current discussions of IFRIC on this subject and arrive at an amicable conclusion as this would also be relevant for the purposes of interpretation of Ind-AS.

levitra

shailesh.kwebmaker

Can email addresses constitute an Intangible Asset?

Synopsis
With the growth of E-commerce,
wherein Indian companies and start-ups have been investing heavily on
building their customer databases, the accounting treatment of
purchasing the said databases has gained importance with regards to
Indian GAAP. In this Article, the learned author has expressed and
justified the accounting treatment under different scenarios for
purchase of such database of E-mail ID’s based on facts of the cases put
forth in the following article, by referring to technical definitions
and relevant extracts of Accounting Standard-26 ‘Intangible Assets’.

BACKGROUND
Online
Limited (referred to as the company or Online) is specialised in the
online selling of a range of products. The company’s commercial strategy
relies on purchase of databases of email address containing lists of
people who may be interested in purchasing its products. The lists are
provided by the specialised vendors based on the specifications of
Online. These specifications include:
(i) M inimum amount of data, e.g., email address, first name and last name.
(ii)
Based on the potential to buy its products, Online has defined various
categories of data, e.g., income, employment, education, residential
location, past history, age, etc. The person should fall under one or
more of these prescribed categories.
(iii) D ata check against the
existing lists of Online – The purpose of this check is to avoid
duplication with existing email address lists.

The email addresses meeting these specifications are treated as valid email addresses.

Scenario 1
The
specialised vendors carry out search activities to identify valid email
addresses. The company makes payment to these vendors on cost plus
margin basis. Though the company will monitor the quality of work of the
vendor it would nonetheless have to make the payment, even if they have
not found any valid email address. Also, vendors do not guarantee any
exclusivity and they may provide the same email address lists to other
companies also.

Scenario 2
The specialised vendors
carry out search activities to identify valid email addresses. The
company makes payment to these vendors on performance basis. If vendors
do not provide any valid email address, they will not be entitled to any
payment from the company. Also, vendors need to guarantee exclusivity
and they cannot provide the same lists to the competitors of Online.

ISSUE
Can Online recognise the lists of email addresses as an intangible asset under AS 26 Intangible Assets?

TECHNICAL REFERENCES

1. AS 26 defines the terms intangible assets and assets as below:

“An
intangible asset is an identifiable non-monetary asset, without
physical substance, held for use in the production or supply of goods or
services, for rental to others, or for administrative purposes.

An asset is a resource:

(a) Controlled by an enterprise as a result of past events, and
(b) From which future economic benefits are expected to flow to the enterprise.”

2. A s per paragraph 20 of AS 26, an intangible asset should be recognised if, and only if:
(a) It is probable that the future economic benefits that are attributable to the asset will flow to the enterprise, and
(b) T he cost of the asset can be measured reliably.

3. Paragraphs 11 to 13 of AS 26 explain the requirement concerning “identifiability” as below:

“11.
The definition of an intangible asset requires that an intangible asset
be identifiable. To be identifiable, it is necessary that the
intangible asset is clearly distinguished from goodwill. …

12.
An intangible asset can be clearly distinguished from goodwill if the
asset is separable. An asset is separable if the enterprise could rent,
sell, exchange or distribute the specific future economic benefits
attributable to the asset without also disposing of future economic
benefits that flow from other assets used in the same revenue earning
activity.

13. Separability is not a necessary condition for
identifiability since an enterprise may be able to identify an asset in
some other way. For example, if an intangible asset is acquired with a
group of assets, the transaction may involve the transfer of legal
rights that enable an enterprise to identify the intangible asset. …”

4. Paragraphs 14 and 17 of AS 26 provide as under with regard to “control”:

“14.
A n 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. The
capacity of an enterprise to control the future economic benefits from
an intangible asset would normally stem from legal rights that are
enforceable in a court of law. In the absence of legal rights, it is
more difficult to demonstrate control. However, legal enforceability of a
right is not a necessary condition for control since an enterprise may
be able to control the future economic benefits in some other way.

17.
A n enterprise may have a portfolio of customers or a market share and
expect that, due to its efforts in building customer relationships and
loyalty, the customers will continue to trade with the enterprise.
However, in the absence of legal rights to protect, or other ways to
control, the relationships with customers or the loyalty of the
customers to the enterprise, the enterprise usually has insufficient
control over the economic benefits from customer relationships and
loyalty to consider that such items (portfolio of customers, market
shares, customer relationships, customer loyalty) meet the definition of
intangible assets.”

5. Paragraph 18 of AS 26 explains the requirement concerning “Future Economic Benefits”:

“18.
The future economic benefits flowing from an intangible asset may
include revenue from the sale of products or services, cost savings, or
other benefits resulting from the use of the asset by the enterprise.
For example, the use of intellectual property in a production process
may reduce future production costs rather than increase future
revenues.”

6. Paragraph 24 of AS 26 states that if an intangible
asset is acquired separately, the cost of the intangible asset can
usually be measured reliably.

7. Paragraphs 50 and 51 of AS 26 state as under:

“50.
I nternally generated brands, mastheads, publishing titles, customer
lists and items similar in substance should not be recognised as
intangible assets.

51. T his Standard takes the view that
expenditure on internally generated brands, mastheads, publishing
titles, customer lists and items similar in substance cannot be
distinguished from the cost of developing the business as a whole.
Therefore, such items are not recognised as intangible assets.”

DISCUSSION AND ALTERNA TIVE VIEWS
View 1 – The email address lists cannot be recognised as an intangible asset.

An item without physical substance should meet the following four criteria to be recognised as intangible asset under AS 26:
(a) Identifiability
(b) Future economic benefits
(c) Control
(d) R eliable measurement of cost

In
the present case, the email address lists are acquired separately and
the company has the ability to sell them to a third party. Thus, based
on guidance in paragraph 12 of AS 26, the lists satisfy identifiablity
criterion for recognition as intangible asset. Online will use the email
address lists to generate additional sales. Therefore, future economic
benefits are expected to derive from the use of these lists and the
second criterion is also met.

However, the third criterion, viz., control, for recognition of intangible asset is not met. email addresses are public information and the company cannot effectively restrict their use by other companies. hence, in scenario 1, the control criterion for recognition of intangible asset is not met.

The following additional arguments can be made:

(a) Purchase of email address lists can be analysed as outsourcing. these lists are prepared by the suppliers based on the specifications of the com- pany, which is not different from the situation where the company would have built them in-house. hence, guidance in paragraph 50 and 51 of as 26 should apply which prohibit recognition of internally generated intangible assets of such nature.

(b) These lists can be viewed as marketing tool, such as leaflets or catalogues; their purchase price being similar to a marketing expense. in accordance with paragraph 56(c) of as 26, expenditure on advertising and promotional activities cannot be recognised as an intangible asset.

View 2 – the email address lists can be recognised as an intangible asset.

Based on the analysis in view 1, the first two criteria for recognition of an intangible asset (identifiability and future economic benefits) are met.

Regarding the third criterion, viz., future economic benefits are controlled by the company; it may be argued that the company acquires the ownership of the email address lists prepared by the vendor as well as the exclusivity of their use. it is able to restrict the access of third parties to those benefits. Hence, in scenario 2, the third criterion is also met.

Online can reliably measure the cost of acquiring email address lists. indeed, in accordance with paragraph 24 of as 26, the cost of a separately acquired intangible item can usually be measured reliably, particularly when the consideration is in the form of cash.

The author believes that the company, which sub-contracts the development of intangible assets to other parties (its vendors), must exercise judgment in determining whether it is acquiring an intangible asset or whether it is obtaining goods and services that are being used in the development of a customer relationship by the entity itself. in determining whether a vendor is providing services to develop an internally generated intangible asset, the terms of the supply agreement should be examined to see whether the supplier is bearing a significant proportion of the risks associated with a failure of the project. for example, if the supplier is always compensated irrespective of the project’s outcome, the company on whose behalf the development is undertaken should account for those activities as its own. however, if the vendor bears a significant proportion of the risks associated with a failure of the project, the company is acquiring developed intangible asset, and therefore the requirements relating to separate acquisition of intangible asset should apply.

Under this view, the company will amortise intangible asset over its estimated useful life. the author believes that due to the following key reasons, the asset may have relatively small useful life, say, not more than two years:

(a) the company will use email address lists to generate future sales. once the conversion takes place, the email address lists will lose their relevance for the company and a new customer relationship asset comes into existence which is an internally generated asset.

(b) for email addresses which do not convert into customers over the next 12 to 24 months, it may be reasonable to assume that they may not be interested in buying company products.

Concluding remarks
in scenario 1, the control criterion is not met. Besides the vendor is providing the company a service rather than selling an intangible asset. therefore the author believes that only view 1 should apply in scenario 1. in scenario 2, view 2 is justified. In scenario 2, the exclusivity criterion and consequently the control requirement is met. secondly, since the payment to the vendor is based on performance the company pays for an intangible asset, rather than for services. however, the amortisation period will generally be very short.

shailesh.kwebmaker

Related Party Transactions – A Potential for Abuse?

While auditing related party transactions, an auditor is usually confronted with questions such as:

“Why should auditing related party transactions be any different from like transactions that are entered into with unrelated parties?”

“How does one ensure completeness of identification of all related party relationships and transactions with such parties?”

“How does an auditor deal with situations where the related party is the only source of supply of goods or services for an enterprise?

Related party transactions can be legitimate and value-enhancing for a corporation but they can also serve as a vehicle for illegitimate expropriation of corporate value by management or controlling shareholders. Related party transactions do not merely pose the potential harm of direct expropriation of value from minority investors, but they also reinforce negative perception of the country’s capital markets as a whole, and lead to a general discounting of equity markets.

Generally, related party transactions are not regarded as mechanisms for fraud, and their presence need not indicate fraudulent financial reporting. It is important for the auditor to understand the benign nature of most related party transactions, the differentiating features between benign and fraudulent transactions, and the importance of evaluating a company’s related party transactions in light of its broader corporate governance structure. However, at the same time, the auditor should not discount the fact that, related party relationships may present a greater opportunity for collusion, concealment or manipulation.

Enterprises establish a matrix of related party entities/ structures for tax efficiencies, compliance with regulatory requirements, ring fencing promoter interests, protecting intellectual property rights, providing common services etc. At times, related parties may be the only source of supply of goods and services. It is imperative that management designs, implements and maintains adequate controls over related party relationships and transactions so that these are identified and appropriately accounted for and disclosed in accordance with the reporting framework. In their oversight role, those charged with governance are required to monitor how management discharges its responsibility for such controls.

Standard on Auditing (SA) 550 Revised – Related Parties deals with the auditor’s responsibilities regarding related party relationships and transactions when performing an audit of financial statements.

As per the standard, the objectives of the auditor are:

a) Irrespective of whether the applicable financial reporting framework establishes related party requirements, to obtain an understanding of related party relationships and transactions sufficient to be able:

i. To recognise fraud risk factors, if any, arising from related party relationships and transactions that are relevant to the identification and assessment of the risks of material misstatement due to fraud; and

ii. To conclude whether the financial statements, insofar as they are affected by those relationships and transactions:

– Achieve a true and fair presentation (for fair presentation frameworks); or

– Are not misleading (for compliance frameworks); and

(b) In addition, where the applicable financial reporting framework establishes related party requirements, to obtain sufficient appropriate audit evidence about whether related party relationships and transactions have been appropriately identified, accounted for and disclosed in the financial statements in accordance with the framework.

Now, let us understand the application of SA 550 considering the following two case studies.

Case study I- Fraudulent financial reporting

ABC limited (‘ABC’) was engaged in the business of selling electronic items to retail, individual customers. The Company operates through retail outlets across the country and recognises revenue on sale to the retail customer on transfer of ownership of the goods. During the financial year ended 31st March 20X0, the Company entered into an arrangement with XYZ Limited (‘XYZ’) to sell goods and the Company recognised revenue on delivery of goods at the premises of XYZ. XYZ would in turn sell goods to retail customers. XYZ is an entity in which a whole time director of ABC owns 51% of the share capital. XYZ would fall within the definition of related party as per Accounting Standard 18-Related Parties (AS-18) as a key managerial personnel of ABC is able to exercise significant influence over XYZ. Sales made to XYZ constitute 15% of ABC’s total sales for the year. Initially, the auditor’s procedures were restricted to verification of documents such as delivery challans and sales invoices and ensuring that appropriate disclosures have been made as per the requirements of the AS- 18. Further, management asserted that related party transactions were conducted on terms equivalent to those prevailing in an arm’s length transaction.

The facts that were not discovered by the audit team were as follows:

• The risks of ownership were not transferred from ABC Limited to XYZ Limited on delivery of goods as XYZ was required to pay ABC only on further sale of goods and collection of money from XYZ’s end customers.

• Further, XYZ had an unlimited right to unilaterally return unsold goods back to ABC.

• The prices at which the goods were sold to XYZ were substantially higher prices than those charged to other customers.

• ABC limited also had a retail outlet in close proximity of XYZ Limited.

• The auditor should have obtained sufficient appropriate audit evidence supporting management’s representation that the transactions with XYZ were at arm’s length.

This above facts came to light when the internal auditors identified that XYZ had returned goods in the subsequent financial year and such returns constituted a significant value and volume of sales pertaining to earlier periods.

Analysis with respect to SA 550

Auditors’ Responsibilities

1 Identification and assessment of risk of material misstatement associated with related party transactions

Historically, the Company had not entered into any such transactions with any related/unrelated party as the Company’s ordinary business constituted selling of goods to individual end-customers. The Company already had an outlet in close proximity of XYZ. The sales were undertaken at prices higher than those with normal customers. Hence, this transaction should have been considered as a significant related party transaction giving rise to significant risk of fraud while performing risk assessment procedures.

2. Response to the risk of material misstatement

– The auditor should have then appropriately responded to the identified risk by performing the following procedures:

a. Inspecting the underlying contract with XYZ and evaluating –

i. The business rationale (or lack thereof) of the transaction which may suggest the same has been entered into to engage in fraudulent financial reporting.

ii. Consistency of the terms of transactions with management’s representation

b. Obtaining evidence that the transactions have been appropriately discussed and approved.

c. Where applicable, reading the financial statements of the related party or other relevant financial information, if available, for evidence of accounting of transactions in the accounting records of related party.

d. Confirming the purpose, specific terms or amounts of the transactions with the related parties. (This procedure will be less effective where the auditor judges that the Company is likely to influence the response of the related party)

3. Communication to those charged with governance:
The auditor in the above case would need to promptly communicate to those charged with governance to arrive at a common understanding of the issues involved and the expected resolution. The auditor would also need to communicate the impact on the financial statements and any resultant impact on the auditor’s report.

4. Independent Auditor’s report:
The auditor would need consider the requirement to appropriately modify the main report considering the materiality of amounts involved. Further, the auditor would also have to appropriately modify the reporting relating to paragraph 4(xxi) of the Companies (Auditor’s Report) Order, 2003 (‘CARO’) report.

We would now evaluate another case study which involves a complex structure of related party transactions.

Case Study 2
Mr. P and Mrs. P, well-known fashion designers, incorporated ABC Ltd. in April 20X0 as a 100% export oriented company to be engaged in the business of manufacturing and export of garments. The initial capital contribution was Rs. 5 crore. Given their expertise, the couple were able to attract investment from other individual shareholders of Rs. 45 crore. The shareholding pattern of ABC comprised of promoter shareholding of 51% held by Mr. P and Mrs. P whereas the balance 49% was held by other non-related shareholders. The shareholder agreement with individual shareholders mandated appointment of 3 independent directors. This appointment was made with the objective of protecting the interests of the minority shareholders.

During the year 20X1, ABC Ltd. incorporated XYZ Ltd (‘XYZ’), a subsidiary in the United States of America (US) with 60% shareholding by ABC and the balance 40% held by Mr. P and Mrs. P. ABC entered into an exclusive arrangement with XYZ by virtue of which the entire production of ABC was to be sold to XYZ. The agreement stipulated that given the commitment to buy-out the entire production, the sales consideration to be paid by XYZ to ABC for goods purchased should be just sufficient for ABC to earn a margin of 10% on cost of goods sold. This arrangement was approved by all the directors (including the 3 independent directors) in the board meeting held on 1st April 20X1. The arrangement was also approved in an extra ordinary general meeting held on 15th April
20X1 wherein only Mr. P and Mrs. P were present as shareholders.

XYZ in turn sold the goods purchased from ABC at a margin of 5% to M/s. PQR & Co., a partnership firm formed by Mr. P and Mrs. P in the US. M/s. PQR & Co. sold the goods in the retail market in the US at a margin of 40% of its cost. Against the aggregate purchases of Rs. 30 crore made by XYZ from ABC during the years 20X1-20X4, payments made by XYZ to ABC aggregated to only Rs. 10 crore. The balance payment of Rs. 20 crore could not be made by XYZ pending collection from PQR. The chief accountant at XYZ provided a confirmation to ABC for the year-end balance. PQR & Co. too provided a balance confirmation to XYZ for the amount due. The financial statements of ABC and XYZ have been audited by M/s. DEF & Associates (‘DEF’) since incorporation. Let us examine the factors which the auditors of ABC Ltd. would need to be cognizant of to comply with the requirements of SA 550

1. While assessing the risk of material misstatement, the auditors would need to assess the isk associated with related party transactions as significant risk given the existence of a related party with dominant influence–Mr. P and Mrs. P were significant shareholders in ABC and XYZ.

2. The auditors would need to understand the controls established by ABC and XYZ for identifying, accounting and disclosing related party relationships. DEF were the auditors for both ABC and XYZ. Assuming that Mr. P and Mrs. P would have disclosed their interest in the partnership firm, M/s. PQR & Co. in the notice of disclosure, DEF as auditors would need to ensure that the sales made by XYZ to PQR were disclosed as related party transactions in the financial statements of XYZ.

3. The terms of the contract between ABC and XYZ were authorised by the board as well as by the shareholders by an ordinary resolution. Authorisation and approval alone, however, may not be sufficient in concluding whether risks of material misstatement due to fraud are absent because authorisation and approval could have been ineffective, given that ABC was subject to the dominant influence of a related party.

4. Given that the related party transaction involved a clear conflict of interest, the auditors of ABC would need to consider whether the independent directors had appropriately challenged the business rationale of the contract, for e.g., by seeking advice from external professional advisors.

5. The contract was approved by way of an ordinary resolution passed by Mr. P and Mrs. P in their capacity as shareholders. DEF would need to consider whether the contract should have been approved by members (other than Mr.P and Mrs.P) who were not interested in the contract and whether all facts were made available to these members to enable decision -making.

6. DEF would need to evaluate the business rationale of the contract from the perspective of the related parties, XYZ and PQR to better understand the economic reality of the transaction. The subsidiary XYZ was used as a conduit to transfer goods to PQR at a price far lower than the market price so as to benefit the dominant shareholders. DEF would need to evaluate whether the transactions between the related parties were at arms’ length and complied with the benchmarking norms as per local transfer pricing regulations. Another important aspect was the disparity in the margins earned by PQR on the re-sale of goods to retail customers as against the margin earned by XYZ on
sale of goods to PQR. DEF in their capacity as auditors of PQR would need to be cognizant of this aspect in their risk assessment for related party transactions.

7. In view of the non-collection of the amounts due from PQR, the ability of XYZ to settle the receivable of Rs. 20 crore was significantly impacted. The mere fact that XYZ had provided a confirmation of the balance due to ABC would not be sufficient evidence in support of the recoverability of the amount due. The auditor would need to evaluate the realisability of receivables in the books of ABC.

Concluding remarks

Considering that a large number of frauds in the corporate world involve related parties, governments and standard setting bodies have adopted stronger and proactive standards and laws to provide for guidance and monitoring of companies and auditors for accounting, disclosures and validation requirements of related party transactions.The Companies Act, 2013 has widened the scope of coverage in terms of the definition of related party and the nature of transactions covered and at the same time mandated approval of such transactions by the audit committee/board of directors/shareholders as applicable. The tax laws have also been amended to cover transactions with specified domestic related parties in addition to cross border transactions with overseas affiliates and has made it obligatory on the tax payer to substantiate that such transactions are at arms’ length. With sweeping changes in legislation, the auditor would need to exercise heightened professional skepticism in identification of related party transactions, related risk of material misstatement (including fraud risk) and design adequate procedures to ensure compliance with the financial reporting and legal framework.

shailesh.kwebmaker

GapS in gaap ? Consolidated Financial Statements

Section 129(3) of the 2013 Act requires that a company having one or more subsidiaries will, in addition to Separate Financial Statements (SFS), prepare Consolidated Financial Statements (CFS). Hence, the 2013 Act requires all companies, including non-listed and private companies, having subsidiaries to prepare CFS.

The 2013 Act also provides the following:

(a) CFS will be prepared in the same form and manner as SFS of the parent company.

(b) The Central Government may provide for the consolidation of accounts of companies in such manner as may be prescribed.

(d) An explanation to the section dealing with the preparation of CFS states that “for the purposes of this sub-section, the word subsidiary includes associate company and joint venture.”

While there is no change in section 129(3), Rule 6 under the Companies (Accounts) Rules, 2014 deals with the “Manner of consolidation of accounts.” It states that the consolidation of the financial statements of a company will be done in accordance with the provisions of Schedule III to the 2013 Act and the applicable accounting standards. The proviso to this rule states as below:

“Provided that in case of a company covered under s/s. (3) of section 129 which is not required to prepare consolidated financial statements under the Accounting Standards, it shall be sufficient if the company complies with provisions on consolidated financial statements provided in Schedule III of the Act.”

Given below is an overview of key requirements under the Schedule III concerning CFS:

(a) Where a company is required to prepare CFS, it will, mutatis mutandis, follow the requirements of this Schedule as applicable to a company in the preparation of the balance sheet and statement of profit and loss.

(b) In CFS, the following will be disclosed by way of additional information:

(i) In respect of each subsidiary, associate and joint venture, % of net assets as % of consolidated net assets.

(ii) In respect of each subsidiary, associate and joint venture, % share in profit or loss as % of consolidated profit or loss. Disclosures at (i) and (ii) are further sub-categorised into Indian and foreign subsidiaries, associates and joint ventures.

(iii) For minority interest in all subsidiaries, % of net assets and % share as in profit or loss as % of consolidated net assets and consolidated profit or loss, separately.

(d) A company will disclose the list of subsidiaries, associates or joint ventures which have not been consolidated along with the reasons of nonconsolidation.

Practical issues and perspectives

AS 21 does not mandate a company to present CFS. Rather, it merely states that if a company presents CFS for complying with the requirements of any statute or otherwise, it should prepare and present CFS in accordance with AS 21. Keeping this in view and proviso to the Rule 6, can a company having subsidiary take a view that it need not prepare CFS?

This question is not relevant to listed companies, since the listing agreement requires listed companies with subsidiaries to prepare CFS. This question is therefore relevant from the perspective of a non-listed company.

Some argue that because neither AS 21 nor Schedule III mandates preparation of CFS, the rules have the effect of not requiring a CFS. Instead, a company should present a statement containing information, such as share in profit/ loss and net assets of each subsidiary, associate and joint ventures, as additional information in the Annual Report. In this view, the rules would override the 2013 Act. If it was indeed the intention not to require CFS, then it appears inconsistent with the requirement to present a statement containing information such as share in profit/loss and net assets of each of the component in the group.

Others argue that the requirement to prepare CFS is arising from the 2013 Act and the rules/ accounting standards cannot change that requirement. The proviso given in the rules is to deal with specific exemptions in AS 21 from consolidating certain subsidiaries which operate under severe long-term restrictions or are acquired and held exclusively with a view to its subsequent disposal in the near future. If this was indeed the intention, then the proviso appears to be poorly drafted, because the exemption should not have been for preparing CFS, but from excluding certain subsidiaries in the CFS.

In our view, this is an area where the MCA/ ICAI need to provide guidance/ clarification. Until such guidance/ clarifications are provided, the author’s preferred approach is to read the “proviso” mentioned above in a manner that rules do not override the 2013 Act. Hence, all companies having one or more subsidiary need to prepare CFS.

The subsequent issues are discussed on the assumption that the preferred view, i.e., all companies having one or more subsidiary need to prepare CFS, is finally accepted. If this is not the case, the views on subsequent issues may change.

IFRS exempts non-listed intermediate holding companies from preparing CFS if certain conditions are fulfilled. Is there any such exemption under the 2013 Act read with the rules?

Attention is invited to discussion on the previous issue regarding need to prepare CFS. As mentioned earlier, the preferred view is that all companies having one or more subsidiary need to prepare CFS. Under this view, there is no exemption for non-listed intermediate holding companies from preparing CFS. Hence, it requires all companies having one or more subsidiaries to prepare CFS.

Currently, the listing agreement permits companies to prepare and submit consolidated financial results/ financial statements in compliance with IFRS as issued by the IASB. For a company taking this option, there is no requirement to prepare CFS under Indian GAAP. Will this position continue under the 2013 Act?

Attention is invited to discussion on the earlier issue regarding the requirement to prepare CFS. As mentioned earlier, the preferred view is that CFS is required for all companies having one or more subsidiary. The rules are clear that consolidation of financial statements will be done in accordance with the provisions of Schedule III to the 2013 Act and the applicable accounting standards. Hence, the companies will have to mandatorily prepare Indian GAAP CFS, and may choose either to continue preparing IFRS CFS as additional information or discontinue preparing them.

An explanation to section 129(3) of the 2013 Act states that “for the purpose of this sub-section, the word subsidiary includes associate company and joint venture.” The meaning of this explanation is not clear. Does it mean that a company will need to prepare CFS even if it does not have any subsidiary but has an associate or joint venture?

The following two views seem possible on this matter:

(a) One view is that under the notified AS, the application of equity method/ proportionate consolidation to associate/joint ventures is required only when a company has subsidiaries and prepares CFS. Moreover, the rules clarify that CFS need to be prepared as per applicable accounting standards. Hence, the proponents of this view argue that that a company is not required to prepare CFS if it does not have a subsidiary but has an associate or joint venture.

b)The second view is that the above explanation requires associates/ joint ventures to be treated at par with subsidiary for deciding whether CFS needs to be prepared. Moreover, the 2013 Act decides the need to prepare CFS and the rules are relevant only for the manner of consolidating entities identified as subsidiaries, associates and joint ventures. Hence, CFS is prepared when the company has an associate or joint venture, even though it does not have any subsidiary. The associate and joint venture are accounted for using the equity/proportionate consolidation method in the CFS.

We understand that the MCA/ ICAI may provide an appropriate guidance on this issue in the due course. Until such guidance is provided from the author’s perspective, the second view appears to be more logical reading of the explanation. Hence, the preference is to apply the second view.

Section 129(4) read with Schedule III to the Act suggests that disclosure requirements of Schedule III, mutatis mutandis, apply in the preparation of CFS. In contrast, explanation to paragraph 6 of AS 21 exempts disclosure of statutory information in the CFS. Will this exemption continue under the 2013 Act?

A company will need to give all disclosures required by Schedule III to the 2013 Act, including statutory information, in the CFS. To support this view, it may be argued that AS 21 (explanation to paragraph 6) had given exemption from disclosure of statutory information because the 1956 Companies Act did not require CFS. With the enactment of the 2013 Act, this position is likely to change. Also, the exemption in AS 21 is optional and therefore this should not be seen as a conflict between AS 21 and Schedule III. In other words, the statutory information required by Schedule III for SFS will also apply to CFS.

The disclosures given in the CFS will include information for parent, all subsidiaries (including foreign subsidiaries) and proportionate share for joint ventures. For associates accounted using equity method, disclosures will not apply. This ensures consistency with the manner in which investments in subsidiaries, joint ventures and associates are treated in CFS.

There would be some practical issues in implementing the above requirement. For example,
(a) It is not clear as to how a company will give disclosures such as import, export, earnings and expenditure in foreign currency, for foreign subsidiaries and joint ventures. Let us assume that an Indian company has US subsidiary that buys and sells goods in USD. From CFS perspective, should the purchase/sale in US be treated as import/export of goods? Should such purchase/sale be presented as foreign currency earning/expenditure?

(b) How should a company deal with intra-group foreign currency denominated transactions which may get eliminated on consolidation? Let us assume that there are sale/purchase transactions between the Indian parent and its overseas subsidiaries, which get eliminated on consolidation. Will these transactions require disclosure as export/ import in the CFS?

The ICAI should provide appropriate guidance on these practical issues. Until such guidance is provided by the ICAI, differing views are possible on this this matter. To help resolving this issue, one may argue that the MCA has mandated these disclosures to be included in the financial statements to present information regarding imports/exports made and foreign currency earned/spent by Indian companies. In the absence of specific guidance, the preference is to use the said objective as a guiding principle to decide the disclosures required.
Assume that the 2013 Act requires even non-listed and private groups to prepare CFS. Under this assumption, the following two issues need to be considered:

(a) The date from which the requirement concerning preparation of CFS will apply. Particularly, is it mandatory for non-listed/ private groups to prepare CFS for the year-ended 31st March 2014?
(b) Whether the comparative numbers need to be given in the first set of CFS presented by an existing group?

(a) Based on the General Circular No. 8/2014 dated 4th April 2014, non-listed/private groups need to prepare CFS only for financial year beginning on or after 1st April 2014.
(b) Regarding the second issue, Schedule III states that except for the first financial statements prepared by a company after incorporation, presentation of comparative amounts is mandatory. In contrast, transitional provisions to AS 21 exempt presentation of comparative numbers in the first set of CFS prepared even by an existing group.

One may argue that there is no conflict between transitional provisions of AS and Schedule III. Rather, AS 21 gives an exemption which is not allowed under the Schedule III. Hence, presentation of comparative numbers will be mandatory in the first set of CFS prepared by an existing company.

shailesh.kwebmaker

Gaps in GAAP

Depreciation
Synopsis
In this article, the author has dismissed inconsistencies in the depreciation policy prevailing AS-6 on Depreciation Accounting and as per the Schedule II of the new Companies Act, 2013 with regard to the concepts of “Useful Life” and “Residual Value”. The author has addressed issues like Revenue-based amortisation, component accounting, revaluation of fixed assets, etc. along with the applicability of transitional provisions in different situations.

Background In the 1956 Act, Schedule XIV prescribed depreciation rates for various assets, both under the SLM method and WDV method. The purpose of prescribing minimum rates was to ensure that dividends are declared out of profits determined after providing for minimum depreciation. AS-6 on Depreciation Accounting laid out principles for depreciation for the purposes of financial statements. Under this standard, depreciation under Schedule XIV is counted as minimum. Higher depreciation was required to be provided for, if based on management’s assessment, the useful life of asset was lower than that laid out in Schedule XIV.

Initially, Schedule II of the 2013 Act laid out useful lives for assets, which were to be compulsorily used as minimum rates except by Ind-AS companies. Pursuant to an amendment to Schedule II this requirement was removed. Rather, the provision now reads as under:

“(i) The useful life of an asset shall not be longer than the useful life specified in Part ‘C’ and the residual value of an asset shall not be more than five per cent of the original cost of the asset:

Provided that where a company uses a useful life or residual value of the asset which is different from the above limits, justification for the difference shall be disclosed in its financial statement.”

From the use of word “different”, it seems clear that both higher and lower useful life and residual value are allowed. However, a company needs to disclose in the financial statements justification for using higher/lower life and/ or residual value.

Transitional provisions
With regard to the adjustment of impact arising on the first-time application, the transitional provisions to Schedule II state as below:

“From the date Schedule II comes into effect, the carrying amount of the asset as on that date:
(a) Will be depreciated over the remaining useful life of the asset as per this Schedule,
(b) A fter retaining the residual value, will be recognised in the opening balance of retained earnings where the remaining useful life of an asset is nil.”

Proviso to Schedule II states that if a company uses a useful life or residual value of the asset which is different from limit given in the Schedule II, justification for the difference is disclosed in its financial statements. How is this proviso applied if notified accounting standards, particularly, AS 6 is also to be complied with?

AS 6 states that depreciation rates prescribed under the statute are minimum. If management’s estimate of the useful life of an asset is shorter than that envisaged under the statute, depreciation is computed by applying the higher rate. The interaction of the above proviso and AS 6 is explained with simple examples:

(i) T he management has estimated the useful life of an asset to be 10 years. The life envisaged under the Schedule II is 12 years. In this case, AS 6 requires the company to depreciate the asset using 10 year life only. In addition, Schedule II requires disclosure of justification for using the lower life. The company cannot use 12 year life for depreciation.

(ii) T he management has estimated the useful life of an asset to be 12 years. The life envisaged under the Schedule II is 10 years. In this case, the company has an option to depreciate the asset using either 10 year life prescribed in the Schedule II or the estimated useful life, i.e., 12 years. If the company depreciates the asset over the 12 years, it needs to disclose the justification for using the higher life. The company should apply the option selected consistently.

Similar logic will apply for the residual value.

Whether revenue based amortisation under Schedule II can be applied to intangible assets other than toll roads?

Amended Schedule II reads as follows “For intangible assets, the provisions of the accounting standards applicable for the time being in force shall apply except in case of intangible assets (Toll roads) created under BOT, BOOT or any other form of public private partnership route in case of road projects.” The amendment clearly suggests that revenue-based amortisation applies to toll roads. The same method cannot be used for other intangible assets even if they are created under PPP schemes, such as airport infrastructure.

Is component accounting under Schedule II mandatory? Is it applied retrospectively or prospectively? How are transitional provisions applied in the case of component accounting?

Component accounting requires a company to identify and depreciate significant components with different useful lives separately. For example, in the case of a building, the base structure or elevators or chiller plant may be identified as separate components. The application of component accounting is likely to cause significant change in the measurement of depreciation and accounting for replacement costs. Currently, companies need to expense replacement costs in the year of incurrence. This was causing a volatility. Under component accounting, companies will capitalise these costs as a separate component of the asset, with consequent expensing of net carrying value of the replaced part. Component accounting would comparatively result in a more stable P&L account.

Schedule II clarifies that the useful life is given for whole of the asset. If the cost of a part of the asset is significant to the total cost of the asset and the useful life of that part is different from the useful life of the remaining asset, the useful life of that significant part will be determined separately. This implies that component accounting is mandatory under Schedule II. In contrast, AS 10 gives companies an option to follow the component accounting; it does not mandate the same.

Materiality in the context of component accounting is decided on an asset by asset basis, and how significant the cost of component is, compared to cost of the total asset. This will call for judgement to be exercised. Component accounting is required to be done for the entire block of assets as at 1st April, 2014. It cannot be restricted to only new assets acquired after 1st April 2014.

If a component has zero remaining useful life on the date of Schedule II becoming effective, i.e., 1st April 2014, its carrying amount, after retaining any residual value, will be charged to the opening balance of retained earnings. The carrying amount of other components, i.e., components whose remaining useful life is not nil on 1st April 2014, is depreciated over their remaining useful life.

In case of revaluation of fixed assets, companies are currently allowed to transfer an amount equivalent to the additional depreciation on account of the upward revaluation of fixed assets from the revaluation reserve to P&L. What is the position under Schedule II?

Under Schedule XIV, depreciation was to be provided on the original cost of an asset. Considering this, the ICAI Guidance Note on Treatment of Reserve Created on Revaluation of Fixed Assets allowed an amount equivalent to the additional depreciation on account of the upward revaluation of fixed assets to be transferred from the revaluation reserve to the P&L.

In contrast, schedule II to the 2013 Act requires depreciation to be provided on historical cost or the amount substituted for the historical cost. therefore, in case of revaluation, a company needs to charge depreciation based on the revalued amount. Consequently, the ICAI Guidance note, which allows an amount equivalent to the additional depreciation on account of upward revaluation to be recouped from the revaluation reserve, will not apply.

Schedule II to the 2013 Act is applicable from 1 April 2014. Section 123, which is effective from 1 April 2014, among other matters, states that a company cannot declare dividend for any financial year except out of (i) profit for the year arrived at after providing for depreciation in accordance with Schedule II, or
(ii) … Given this background, is the applicability of Schedule II preponed to financial statements for even earlier periods if they are authorised for issuance post 1st April 2014?

As per MCA announcement, Schedule II is applicable from 1st april 2014.

Schedule II contains depreciation rates in the context of Section 123 dealing with “Declaration and payment of dividend” and companies use the same rate for the preparation of financial statements as well. Additional depreciation may be provided, based on assessment of useful life as per AS 6.

One view is that for declaring any dividend after 1st April 2014, a company needs to determine profit in accordance with Section 123. this is irrespective of the financial year-end of a company. Hence, a company uses Schedule ii principles and rates for charging depreciation in all financial statements finalised on or after 1st April 2014, even if these financial statements relate to earlier periods.

The second view is that based on the General Circular 8/2014, depreciation rates and principles prescribed in Schedule II are relevant only for the financial years commencing on or after 1st april 2014. the language used in the General Circular 8/2014, including reference to depreciation rates in its first paragraph, seems to suggest that second view should be applied. For financial years beginning prior to 1st april 2014, depreciation rates prescribed under the Schedule XiV to the 1956 act will continue to be used.

In the author’s view, based on the clear intent of the regulator, second view is the preferred approach for charging depreciation in the financial statements.

How do the transitional provisions apply in different situations? In situation 1, earlier Schedule XIV and now Schedule II provide a useful life, which is much higher than AS 6 useful life. In situation 2, earlier Schedule XIV and now Schedule II provide a useful life, which is much shorter than AS 6 useful life.

In situation 1, the company follows aS 6 useful life under the 1956 as well as the 2013 Act. In other words, a status quo is maintained and there is no change in depreciation. hence, the transitional provisions become irrelevant. in situation 2, when the company changes from Schedule XiV to Schedule ii useful life, the transitional provisions would apply. for example, let’s assume the useful life of an asset under Schedule XiV, Schedule ii and as 6 is 12, 8 and 16 years respectively. the company changes the useful life from 12 to 8 years and the asset has already completed 8 years of useful life, i.e., its remaining useful life on the transition date is nil. in this case, the transitional provisions would apply and the company will adjust the carrying amount of the asset as on that date, after retaining residual value, in the opening balance of retained earnings. if, on the other hand, the company changes the useful life from 12 years to 16 years, the company will depreciate the carrying amount of the asset as on 1st April 2014 prospectively over the remaining useful life of the asset. this treatment is required both under the transitional provisions to Schedule ii and AS 6.

How are tax effects accounted for adjustments made to retained earnings required by transitional provisions?

Attention is invited to the ICAI announcement titled, “Tax effect of expenses/income adjusted directly against the reserves and/or Securities Premium Account.” the announcement, among other matters, states as below:

“… Any expense charged directly to reserves and/or Securities Premium Account should be net of tax benefits expected to arise from the admissibility of such expenses for tax purposes. Similarly, any income credited directly to a reserve account or a similar account should be net of its tax effect.”

Considering the above, it seems clear that the amount adjusted to reserves should be the net of tax benefit, if any.

shailesh.kwebmaker

Gaps in GaAp – Core Inventories

In a certain manufacturing or a distribution process a certain amount of core inventory is required to run the plant, transport the raw material or finished goods. Examples of core inventories are cushion gas in cavern storage facilities, crude oil used as line fill and minimum levels of some materials in non-ferrous metal refining. The essential features of core inventory are:

(a) Use: are necessary to permit a production facility to start operating and to maintain subsequent production;

(b) Physical form: not physically separable from other inventories and interchangeable with them;

(c) Removal: can be removed only when production facilities are abandoned, decommissioned or overhauled or at a considerable financial charge. Sometimes the quality of what can be removed may not be the same as the original inventory, for example, on decommissioning there could be a lot of sludge or waste material.

The issue could be material for some companies, such as in the case of an oil pipeline company where the pipeline runs into several kilometres. In such cases, the impact of the manner in accounting for the initial fill could be very significant.

Query
Whether core inventories should be classified as inventories or fixed assets? How are they subsequently measured?

View 1: Classification under AS-2 Valuation of Inventories

Inventories are defined in AS-2 as (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services. Core inventories meet that definition of inventories. The rationale for classification as inventories is that core inventories are ordinarily interchangeable with other inventories, and thus, core inventories held at a particular reporting date will be either consumed or sold in the next period.

On the other hand, AS-10 Accounting for Fixed Assets, defines fixed assets as “Fixed asset is an asset held with the intention of being used for the purpose of producing or providing goods or services and is not held for sale in the normal course of business.” Core inventories do not meet this definition because they are held for sale in the normal course business. On the assumption that the unit of account is the smallest unit of the material concerned (ultimately individual atoms), core inventories are classified as inventories because they represent materials that are consumed in the production process

The two different views on subsequent measurement of core inventories are:

(a) Core inventories are measured collectively with other inventories using FIFO or a weightedaverage cost formula. These methods are supported in AS-2.

(b) Core inventories are measured separately from other inventories. The rationale for this accounting treatment is that the accounting transaction does not take place at the time of each inventory’s swap and therefore their value is not stepped up. Support for this may be found in paragraph 14 of AS-2 which states that “The cost of inventories of items that are not ordinarily interchangeable and goods or services produced and segregated for specific projects should be assigned by specific identification of their individual costs.” However, a more appropriate view may well be that measuring core inventory separately is similar to applying the base stock method which is prohibited in AS-2.

A matter of concern is that if core inventories are accounted for as inventories, an entity would in many cases, need to recognise an immediate loss on writing off to net realisable value, if the inventory is not expected to be fully recoverable when the plant is ultimately decommissioned. Either full quantity is not recovered or some recovery may be in the form of sludge. Also, the net realisable value would factor the cost incurred for recovering the inventory. At other times, such as the initial fill in the case of an oil pipeline company, the net realisable value on account of price changes could fluctuate significantly, and create volatility in the P&L A/c.

View 2: Classification under AS-10 Accounting for Fixed Assets

The rationale for classification as fixed asset is that core inventories are not held for sale or for consumption; instead, their intended use is to ensure that a production facility is operating. Even though core inventories are commingled with ordinary inventories, the characteristics and intended use of a particular part of the inventories remain the same at each individual reporting date. Thus these core inventories need to be accounted for separately.

Core inventories should be classified as fixed asset because they are necessary to bring a fixed asset to its required operating condition. Paragraph 9.1 of AS-10 states that “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:

i. site preparation;
ii. initial delivery and handling costs;
iii. installation cost, such as special foundations for plant; and
iv. professional fees, for example fees of architects and engineers.”

If core inventories are carried as inventories, it would not properly reflect the fact that core inventories are necessary to operate another asset over more than one operating cycle. On the assumption that the unit of account is the minimum amount of material as a whole, core inventories are classified as fixed asset because they are neither held for sale nor consumed in the production process.

The classification of core inventories should be based on their intended primary use because:

(a) A part of inventories of the same quantity, characteristics and use for an entity is always in the production facility, whether this part is commingled with other inventories or not. Core inventories need to be accounted for separately from ordinary inventories.

(b) The classification based on the intended primary use, rather than on their physical form, would provide more relevant information for the users of financial statements.

The primary use of core inventories is to be held for use in the production or supply of goods or services (meets the definition of a fixed asset), rather than to be sold or consumed in the production process or in the rendering of services (does not meet the definition of inventories).

The loss of core inventories over-time should be recognised as an expense over the useful life of a fixed asset, based on the following:

(a) economic benefits associated with core inventories are consumed over the entire useful life of the fixed asset.

(b) in the case of a systematic allocation, the costs would match with the associated revenues.

Both the above would meet the spirit of the Conceptual Framework on the basis of which Indian accounting standards are drafted.

Some are of the view that only core inventories that could not be substantially recovered from the production facility form an element of fixed asset cost. Otherwise, they may be carried as inventories. The author believes that assets’ recoverability should not change their classification. The classification of core inventories should not be based on their recoverability, because this guidance is not explicitly stated in Indian GAAP. Instead, the depreciation mechanism described in AS 6 addresses accounting in such cases; i.e., core inventories that can be recovered would be depreciated to the extent of their residual value. However, due to price increases over time in core inventories, the residual value would go up significantly, leading to low or no depreciation.

The historical cost measurement is a common approach for non-current assets. However, if an entity believes that the current cost of core inventories would provide more relevant financial information to the users, a revaluation model in AS-10 may also be applied.

Overall Conclusion
The accounting practice prevalent globally on this matter is mixed. However, the predominant view, globally, is that core inventories are fixed assets. The Expert Advisory Committee (EAC) of the Institute of Chartered Accountants of India, have opined that core inventories should be classified as Inventories under AS-2. However, the author believes that there are enough provisions within Indian GAAP, that lend core inventories to be either classified as fixed assets or inventories. This choice can be eliminated only through appropriate amendment of the scoping paragraphs in the standards rather than through an interpretation by the EAC.

shailesh.kwebmaker

SA 540 Accounting Estimates

Synopsis

An accounting estimate is defined as an approximation of the amount of an item in the absence of a precise means of measurement. There are various items in the Financial Statements that cannot be measured with precision and therefore are required to be estimated. SA 540 describes the auditor’s responsibility with respect to the auditing of accounting estimates and related disclosures made by the management. Read on to know more about SA 540 with respect to the objective of the auditor, procedure to be followed, analysis to be done, approach to be used while auditing accounting estimates with the help of two case studies.

An estimate is made when there is an absence of a precise means to measure. This applies in accounting parlance as well, whereby certain items of financial statements cannot be measured with precision and are therefore required to be estimated based on reliable information and justifiable assumptions available at a point in time.

Accounting estimates (other than fair value accounting estimates)	Fa ir v alue a c c ounting estimates
Allowance for doubtful	Complex financial
accounts	instruments, which are not
Inventory obsolescence	traded in an active and open
Warranty obligations	market
Depreciation method or	Share-based payments
asset useful life	Property or equipment held
Provision against the	for disposal
carrying amount of an	Certain assets or liabilities
investment where there	acquired in a business
exists uncertainty regarding	combination, including
its recoverability	goodwill and intangible
Outcome of long term	assets
contracts	Transactions involving
Costs arising from litigation, settlements and judgments.	the exchange of assets or liabilities between independent parties without
	monetary consideration, for example, a non-monetary exchange of plant facilities in different lines of business.

An accounting estimate is defined as an approximation of the amount of an item in the absence of a precise means of measurement. An illustrative list of financial statement captions where estimates are used is summarised below:

SA 540 describes the auditor’s responsibility with respect to the auditing of accounting estimates, including fair value accounting estimates, and related disclosures made by the management, wherein the objective of the auditor is to obtain sufficient appropriate audit evidence as to whether in the context of the applicable financial reporting framework:

a) accounting estimates, including fair value accounting estimates, in the financial statements, whether recognised or disclosed, are reasonable; and

b) related disclosures in the financial statements are adequate.

In order to evaluate the reasonableness of recognition of accounting estimates, the auditor shall:

a) obtain an understanding of how management identifies those transactions, events and conditions that may give rise to the need for accounting estimates to be recognised or disclosed in the financial statements and

b) understand how the estimates have been made and what data and assumptions have been used to make such estimates

The understanding so obtained will enable the auditor to assess:

a) for recurring estimates, the historical reliability of the entity’s estimates and the appropriateness of changes, if any, in the existing accounting estimates or in the method or assumptions for making them from the prior period;

b) the completeness and accuracy of key data used in making the estimate;

c) evaluation of management’s use of an expert;

d) the reasonableness of management’s significant assumptions, including any indication of management bias and, where relevant, management’s intent to carry out specific courses of action and its ability to do so;

e)   the reasonableness of management’s estimate, including whether the selected measurement basis for the accounting estimate and management’s decision to recognise or not recognise the estimate is in accordance with the require-ments of the applicable financial reporting framework;
f)   subsequent events or other subsequent information, if any, that may affect the estimate;
g)   the consistency of application of judgments or estimates to similar transactions;
h)   business or industry specific factors that may have significant effect on the assumptions

For accounting estimates that give rise to significant risks at the financial statement assertion level, the auditor needs to evaluate how management has considered alternative assumptions and their outcomes on accounting estimates and reasons for their rejection/acceptance. Such examples include estimates pertaining to useful life of tangible assets particularly for entities operating in specialised sectors such as aviation, oil exploration, power generation, infrastructure etc, estimate of useful life of intangible assets such as toll collection rights purchased by a toll operating company, cash flows from a cash generating unit for the purpose of impairment testing, allowances for doubtful debts, inventory obsolescence in technology driven industries, etc.

Sensitivity analysis is one of the methods that can be used to evaluate how an accounting estimate varies with different assumptions. The objective of this evaluation is to obtain sufficient appropriate audit evidence to ensure that management has assessed the effect of estimation uncertainty on accounting estimates. Where management has not considered alternative assumptions or outcomes, the auditor would need to discuss with the man-agement as to how it has addressed the effects of estimation uncertainty and where empirical external evidence is available, evaluate the appropriateness of the estimate considered by the management.

Once the auditor understands the process, there are generally two approaches that the auditor can use:
a) test the process used by management to make the estimate, including testing the reliability of the underlying data, or alternatively
b) develop an independent expectation of the estimate and compare this with the estimate developed by the management.

The choice between these two approaches will depend on the magnitude and complexity of the account balance. An example of the latter ap-proach is the comparison of provision for warranty costs with the estimates made by the management in recent past to determine its reasonableness.

While assessing the methods and assumptions used, the auditor may also need to consider whether management has engaged an expert having specialised knowledge or skills in determining an accounting estimate. Actuarial valuation of employee benefits by an actuary, surveyor’s estimation of the quantum of inventory in certain specialised industries using items such as coal, natural gypsum etc., certification of completion of project work by project engineers to facilitate revenue recognition in construction contracts are some of the elementary examples of involvement of an expert to determine an accounting estimate. The auditor would need to review the appropriateness of estimates made by the expert. For e.g., in case of actuarial valuation of retirement benefits, the auditor would need to evaluate the appropriateness of the estimate of discount rate by reviewing economic reports for interest rates, estimate of salary growth and attrition by reviewing industry reports, estimate of mortality by reviewing annuity/life tables used by insurance companies etc. Similarly for estimation of inventory by surveyors, the auditor would need to assess the estimation methodology used by the surveyor, quantum of inventory holding vis-à-vis consumption pattern, subsequent production of finished goods and other related factors to obtain assurance over the appropriateness of the inventory estimated by the surveyor.

Another pertinent area where estimates are used is for impairment testing for fixed assets. Asset impairment is based either on appraisal of current market value of the asset or based on estimated cash flows from the continuing use of such asset for its remaining useful life. Estimates of future cash flows provided by the management need to be analysed for the reasonableness of the assumptions and consistency with current and predicted future results.

Management may be satisfied that it has adequately addressed the effects of estimation uncertainty in accounting estimates that give rise to significant risks in the preparation of financial statements, however, the auditor may consider this to be inadequate due to non- availability of sufficient appropriate audit evidence or where the auditor believes there exists an indication of management bias in making the estimates. The auditor in such a case may evaluate the reasonableness of the accounting estimate by developing a point estimate or a range. This can be understood with the help of the following example:

Case study 1 (Accounting estimates):

XYZ Ltd (‘XYZ’) is a reputed watch manufacturer and has been in this business for the last 5 years. XYZ commenced its operations during the year ended 31st March 20X0. XYZ formulated a policy of providing free repairs to its customers for a period of 1 year from the date of sale. The sale contract gives the customer, a right to have the watches repaired free of cost for defects that get contracted within a period of one year from the date of purchase of the product. Since inception, XYZ has been providing for warranty costs @ 3% of the value of watches sold during the year.

During the year ended 31st March 20X6, XYZ upgraded its quality testing equipment enabling introduction of certain additional quality checks in the manufacturing process. Management expects that these additional checks would result in more stringent quality clearance of finished products for ultimate sale to customers. Therefore for the year ended 31st March 20X6, management decided to provide for warranty costs at a lower rate of 1% of the value of sales made during the year.

Let us examine the procedures that auditors would need to follow in terms of the requirements of SA 540:

Though the accounting framework does not prescribe a method or model to provide or compute warranty provision, management is required to make a best estimate of the warranty cost based on cumulative experience of the industry, customer base and the likely cost of repairs.

Auditors would need to review the outcome of accounting estimates included in the prior period financial statements and their subsequent re-estimation for the purpose of the current period. Auditors would need to perform a subsequent period testing to deduce actual costs incurred against the provision and effectiveness of controls on accounting of such costs.

Auditors would need to review the trend of actual repair costs incurred over the years and evaluate whether the basis of measurement (as a percentage of sales) needs modification.

Auditor would compare the nature of the earlier warranty claims and how the new machines would take care of these complaints to reduce the warranty costs.

Obtain written representations from management whether they believe significant assumptions used in making accounting estimates are reasonable.

Auditors would need to evaluate whether the management decision to change the estimate basis is indicative of a possible management bias.

Case study 2 (Fair value accounting estimate):

Double Dip Ltd. (DDL) has given 100 options to its employees to receive remuneration in the form of equity settled instruments, for rendering services over a defined vesting period of three years.

The options will vest in three tranches over a period of three years as follows:

Period within which options % of options
will vest to the participant that will vest

End of 12 months from the

date of grant of options

End of 24 months from the

date of grant of options

End of 36 months from the

date of grant of options

DDL measures options granted by reference to the fair value of the instrument at the date of grant. The expense is recognised in the statement of income with a corresponding increase to the share based payment reserve, a component of equity.

The fair value determined at the grant date is ex-pensed over the vesting period of the respective tranches of such grants. The stock compensation expense is determined based on DDL’s estimate of equity instruments that will eventually vest over a period of three years.

The key assumptions used to estimate the fair value of options are given below:

The options were granted on 31st December 20XX and DDL has recognized Rs. 10 crore as fair value cost of options granted.

Analysis

Risk-free interest rate

Expected Life

3 years

Expected volatility

46%

Expected dividend yield

0.02%

Price of the underlying share

in market at the time of

option grant

Rs. 250

Expected forfeiture rate

In the given example, the fair value of options as arrived by the management is an estimate and the same has been derived on the basis of various assumptions considered by the management.

The auditors of the Company would need to verify whether the fair value of the options as estimated by the management is reasonable. For this purpose, various assumptions considered by the management would need to be evaluated and assessed independently i.e., completeness and accuracy of data considered for arriving at business and industry specific factors like risk free interest rate etc.

The auditors would also need to consider estimation uncertainty i.e. possible effects of the various alternatives. In the given case, expected volatility is the factor wherein the auditor would need to assess various assumptions and data used to compute the volatility benchmark and what would be the possible effects on the expected volatility if there is a change in the underlying assumptions as well as the overall effect on the fair value of the options because of change in expected volatility.

The auditor needs to ensure that work done by management to mitigate the risk of estimation uncertainty is sufficient enough to support the appropriateness of the estimate. In the event where work done by management is inadequate, the appropriateness of the estimate would have to be assessed independently by the auditors, if required, through point of estimation or range. The auditor may obtain assurance on the expected volatility, based on an analysis of data of entities in similar industry having issued similar options.

Conclusion

An estimate can be significantly affected by management bias and estimation uncertainty. An estimate is a complex process of arriving to an answer where we do not have precise measure of calculating an item of provision. There are accounting estimates as well as as fair value estimates that requires thorough review by an auditor of the process and assumptions used by the management of arriving the same. As such, significant estimates require the exercise of signifi-cant judgment by the auditor and documentation of those judgments is critical to understanding how conclusions were reached. In some cases, even small changes in inputs can result in large changes in value. Hence, an estimate is an estimate; it is not a precise answer.

shailesh.kwebmaker

Gap in GaAp – Accounting for Demerger

Synopsis

Following the rapid ushering in of the Companies Act, 2013, MCA has also started issuing draft rules. The author highlights the glaring lacunae in the Draft Rules for Accounting for Demerger, which require the accounting to be undertaken in accordance with the current provisions under Income Tax governing demergers, instead of acceptable accounting principles.

This article deals with the issues relating to accounting for demerger, as a result of the draft rules under the Companies Act 2013. The said rules are not yet final.

As per the draft rules, “demerger” in relation to companies means transfer, pursuant to scheme of arrangement by a ‘demerged company’ of its one or more undertakings to any ‘resulting company’ in such a manner as provided in section 2(19AA) of the Income Tax Act, 1961, subject to fulfilling the conditions stipulated in section 2(19AA) of the Income Tax Act and shares have been allotted by the ‘resulting company’ to the shareholders of the ‘demerged company’ against the transfer of assets and liabilities.

As per section 2 (19AA) of the Income-tax Act, “demerger” in relation to companies, means the transfer, pursuant to a scheme of arrangement under the Companies Act, 1956, by a demerged company of its one or more undertakings to any resulting company in such a manner that—

i. all the property of the undertaking, being transferred by the demerged company, immediately before the demerger, becomes the property of the resulting company by virtue of the demerger;

ii. all the liabilities relatable to the undertaking, being transferred by the demerged company, immediately before the demerger, become the liabilities of the resulting company by virtue of the demerger;

iii. the property and the liabilities of the undertaking or undertakings being transferred by the demerged company are transferred at values appearing in its books of account immediately before the demerger;

iv. the resulting company issues, in consideration of the demerger, its shares to the shareholders of the demerged company on a proportionate basis [except where the resulting company itself is a shareholder of the demerged company];

v. the shareholders holding not less than threefourths in value of the shares in the demerged company (other than shares already held therein immediately before the demerger, or by a nominee for, the resulting company or, its subsidiary) become share-holders of the resulting company or companies by virtue of the demerger, otherwise than as a result of the acquisition of the property or assets of the demerged company or any undertaking thereof by the resulting company;

vi. the transfer of the undertaking is on a going concern basis;

vii. the demerger is in accordance with the conditions, if any, notified u/s.s. (5) of section 72A by the Central Government in this behalf.

Explanation 1—For the purposes of this clause, “undertaking” shall include any part of an undertaking, or a unit or division of an undertaking or a business activity taken as a whole, but does not include individual assets or liabilities or any combination thereof not constituting a business activity.

Explanation 2—For the purposes of this clause, the liabilities referred to in sub-clause (ii), shall include—

(a) the liabilities which arise out of the activities or operations of the undertaking;
(b) the specific loans or borrowings (including debentures) raised, incurred and utilised solely for the activities or operations of the undertaking; and
(c) in cases, other than those referred to in clause (a) or clause (b), so much of the amounts of general or multipurpose borrowings, if any, of the demerged company as stand in the same proportion which the value of the assets transferred in a demerger bears to the total value of the assets of such demerged company immediately before the demerger.

Explanation 3—For determining the value of the property referred to in sub-clause (iii), any change in the value of assets consequent to their revaluation shall be ignored.

Explanation 4—For the purposes of this clause, the splitting up or the reconstruction of any authority or a body constituted or established under a Central, State or Provincial Act, or a local authority or a public sector company, into separate authorities or bodies or local authorities or companies, as the case may be, shall be deemed to be a demerger if such split up or reconstruction fulfils such conditions as may be notified in the Official Gazette, by the Central Government.

Accounting for demerger under the draft rules issued under Companies Act 2013

The draft rules recognise that accounting standards issued under the Companies Accounting Standard Rules do not contain any standard for demergers. Till such time an accounting standard is prescribed for the purpose of ‘demerger’, the accounting treatment shall be in accordance with the conditions stipulated in section 2(19AA) of the Income Tax Act, 1961 and

(i) in the books of the ‘demerged company’:-

(a) assets and liabilities shall be transferred at the same value appearing in the books, without considering any revaluation or writing off of assets carried out during the preceding two financial years; and

(b) the difference between the value of assets and liabilities shall be credited to capital reserve or debited to goodwill.

(ii) in the books of ‘resulting company’:-

(a) assets and liabilities of ‘demerged company’ transferred shall be recorded at the same value appearing in the books of the ‘demerged company’ without considering any revaluation or writing off of assets carried out during the preceding two financial years;

(b) shares issued shall be credited to the share capital account; and

(c) the excess or deficit, if any, remaining after recording the aforesaid entries shall be credited to capital reserve or debited to goodwill as the case may be.

Provided that a certificate from a chartered accountant is submitted to the Tribunal to the effect that both ‘demerged company’ and ‘resulting company’ have complied with conditions as above and accounting treatment prescribed in this rule.

Author’s Analysis

First, the draft rules are designed to ensure compliance with section 2(19AA). In the author’s view, accounting treatment should be governed by Indian GAAP, Ind-AS/IFRS or generally acceptable accounting practices; rather than, the provisions of the Income- tax Act. The requirement to record demergers at book values in accordance with section 2(19AA) may not gel well with the requirements of generally acceptable accounting practices. For example, under IFRS/Ind-AS, distribution to shareholders is recorded at fair value, whereas under the draft rules the same is recorded at book value. This anomaly should be rectified through a collaborative effort of the Institute of Chartered Accountants (ICAI), the Ministry of Corporate Affairs (MCA) and the Central Board of Direct Taxes (CBDT). However it appears that this may not be as easy as it appears. Many issues need to be first resolved, such as, the strategy with respect to, implementation of Ind-AS/ IFRS, continuation of Indian GAAP for some entities, implementation of Tax Accounting Standards, implementation of the IFRS SME standard, etc needs to be finalised. Right now, this whole area is a maelstrom and the Government and the ICAI should provide a clear roadmap, before complicating this space any further.

Second, the draft rules and section 2(19AA) of the Income-tax Act assumes a very simple scenario of demerger. In practice, demerger may involve many structuring complexities. The draft rules therefore are very elementary. They focus on the accounting that is required in a narrow situation where the demerger is in accordance with section 2(19AA) of the Income-tax Act.

Third, the draft rules on accounting of demerger is applicable only when the demerger is in accordance with section 2(19AA) of the Income-tax Act. These accounting rules are not applicable when the demerger is not in accordance with section 2(19AA). For example, a company demerging one of its undertaking may be doing so, to unlock value rather than obtaining tax benefits under section 2(19AA). For such demerger, the prescribed draft accounting rules are not applicable. Thus, as an example, the resulting company could account for the assets and liabilities taken over at fair value rather than on the basis of book values as prescribed in the draft rules.Fourth, in the books of the demerged company when the transfer to a resulting company is a net liability, the draft rules require the corresponding credit to be given to capital reserves. This accounting seems appropriate, as it could be argued that the shareholders are taking over the net liability, and hence this is a contribution by the shareholders to the company. When the transfer to a resulting company is a net asset, the draft rules require the corresponding debit to be given to goodwill. This seems completely ridiculous as distribution of net assets to shareholders cannot under any circumstances result in goodwill for the demerged company. Rather it is a distribution by the demerged company of the net assets to the shareholders, and hence the debit should be made to general reserves. This mistake should be corrected in the final rules. Fifth, in the books of the resulting company, the net assets/liabilities taken over are recorded at book values. This is designed to comply with the requirements of section 2(19AA). As already indicated, the accounting in statutory books should not be guided by the requirements of the Income-tax Act. In practice, the resulting company may want to record the said transfer at fair value, to capture the business valuation. Whilst for tax computation purposes, he net assets may be recorded at book values; it is inappropriate for the Income-tax Act to suggest the accounting to be done in statutory books.Lastly, in the resulting company there is no requirement in respect of how share capital is valued. Thus the securities premium, goodwill and capital reserves can be flexibly determined by ascribing a desired value to the share capital. This is certainly not an appropriate approach from an accounting point of view.

In conclusion, the author believes that some immediate correction is required in the draft accounting rules as suggested in this article. In the long term, accounting should be driven by sound accounting practices and not by income-tax requirements. In this regard, ICAI, CBDT and the MCA should collaborate and establish a clear roadmap for the future.

shailesh.kwebmaker

The Going Concern Conundrum – Should One Get Concerned About a Going Concern?

‘Nothing lasts forever’. However, in accounting parlance, one of the fundamental accounting assumptions used by the management for preparation and presentation of financial statements is ‘Going concern’ which assumes that an enterprise will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. Indeed, the assumption of a going concern is critical to the decision and usefulness of financial information under the accrual basis of accounting. Investors and creditors ordinarily invest in or transact with enterprises that they expect to continue its operations in future. It is also the justification for following historical cost basis for accounting its assets and liabilities.

SA 570 lays down the auditor’s responsibility with respect to the management’s use of going concern assumption in the preparation of financial statements.

General purpose financial statements are prepared on a going concern basis, unless the management either intends to liquidate the entity or to cease operations, or has no realistic alternative but to do so. When the use of the going concern assumption is appropriate, assets and liabilities are recorded on the basis that the entity will be able to realise its assets and discharge its liabilities in the normal course of business.

An enterprise may be required by either the reporting framework or by statute to specifically state that the financial statements have been drawn up on a ‘going concern basis’. Eg., in the Indian context, directors are required to specifically assert in the directors’ report that the financial statements of the company are prepared on going concern basis. Where reporting framework does not contain an explicit requirement to assess ‘going concern’, management’s responsibility for the preparation and presentation of the financial statements nevertheless includes such a responsibility. The minimum period over which such assessment is to be made is normally one year (12 months).

The auditor is required to obtain sufficient appropriate audit evidence about the appropriateness of management’s use of the going concern assumption.A Based on this evidence, the auditor should evaluate management’s assessment of the entity’s ability to continue as a going concern. SA 570 envisages two scenarios:

a. Use of going concern assumption is appropriate but a material uncertainty exists

b. Use of going concern assumption is inappropriate

Under scenario (a), the auditor would need to evaluate whether a material uncertainty exists relating to events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern, including evaluating mitigating factors, if any. A material uncertainty exists when the magnitude of its potential impact and the likelihood of its occurrence is such that, in the auditor’s judgment, appropriate disclosure of the nature and the implications of the uncertainty is necessary for a fair presentation of the financial statements. The disclosure would also include a statement to the effect that the entity may be unable to realise its assets and discharge its liabilities in the normal course of business. Where adequate disclosures have been made, the auditor would need to express an unmodified opinion and include an Emphasis of Matter paragraph to highlight the material uncertainty which casts a doubt on the entity’s ability to continue as a going concern. In cases where adequate disclosures have not been made, the audit report would need to be qualified.

Under scenario (b), if the auditor concludes that going concern assumption is inappropriate, the accounts cannot be prepared on a going concern basis. If these are in any case prepared on agoing concern basis, the auditor would need to express an adverse opinion.

A tabular presentation of the approach is given below:

Material uncertainty arises from conditions which cast doubt about the going concern assumption and such conditions could be financial, operational or statutory in nature. We will try to understand some of these conditions with examples.

Financial condition resulting in material uncertainty

Case Study 1
ABC Limited (‘ABC’) is a company incorporated in India and is a wholly owned subsidiary of PQR Investment Ltd (‘PQR’), an investment company based in Mauritius. ABC Limited is engaged in the business of process research and development and analytical services. As at 31st March 20X0, ABC has accumulated losses aggregating to Rs. 600 lakh as against paid-up capital of Rs. 250 lakh. The accumulated losses have exceeded the net worth of the Company. The current assets of the company as at 31st March 20X0 stand at Rs. 120 crore, whereas the current liabilities due for payment over the next one year are Rs. 100 crore, i.e. ABC does not have a net current liability position. Management contends that it has no intentions of discontinuing business operations and believes that the Company will be able to continue to operate as a going concern and meet all its liabilities as they fall due for payment based on support from PQR. Management provided a confirmation to this effect letter from PQR Investment Limited to the auditors as evidence of support. The accounts of ABC were prepared on a going concern basis. Was this basis appropriate per requirements of SA 570?

Analysis
The existence of accumulated losses exceeding the net worth represents a financial condition of material uncertainty. In the instant case, PQR, the parent company provided a confirmation extending financial support to ABC to enable it to continue as a going concern. While SA 570 requires auditor to obtain written confirmation from the parent confirming the support, it also makes it incumbent upon auditors to evaluate the parent company’s ability to provide the requisite financial support. It is pertinent to note that PQR is an investment company. In such a case, the auditors would need to consider additional factors like whether PQR has the necessary wherewithal to provide financial support and if PQR was a mere investment vehicle then evaluating whether the shareholders of PQR have the ability to provide support and if yes, consider obtaining confirmation from the shareholders to that effect. Mere reliance on the confirmation would not suffice. Management would need to make detailed disclosures stating that the accounts have been prepared on going concern on the basis of financial support guaranteed by the parent company would be required to be made in the financial statements. The auditor would need to include in his audit report, a Matter of Emphasis highlighting this condition. Alternatively, where the auditor is satisfied with the appropriateness of the going concern assumption, he would not be required to include a Matter of Emphasis in his audit report.

Case Study 2
XYZ Winds Limited (‘XYZ”) is in the business of manufacturing windmills. XYZ has a paid up capital and reserves of Rs. 200 crore as at 31st March 20X5. XYZ has been incurring losses for the last three years however the Company has a positive net worth as at 31st March 20X5. XYZ had borrowed funds aggregating to Rs. 150 crore by way of foreign currency convertible bonds (FCCBs) on 1st April 20X0 which were due for repayment on 1st January 20X5. In view of continuing losses, XYZ was unable to repay the FCCBs on the due date. The Company also has overdue amounts payable to creditors and certain other lenders as at 31st March 2013. The current liabilities as at 31st March 20X5 amount to Rs. 800 crore whereas current assets stand at Rs. 550 crore. The Company is in negotiations with the FCCB holders and is working on various solutions with them to ensure settlement of their dues. The Company is also taking various steps to reduce costs and improve efficiencies to make its operations profitable. The final outcome of the negotiations is pending as on the date the financial statements are approved by the Board. Does this
situation trigger a
material
uncertainty
leading to the going concern
assumption being challenged?

Analysis
The fixed term borrowings are overdue for pay- ment. The given situation
also represents a net liability or net
current liability position. The Com- pany’s ability to continue as a going concern
is in part dependent on the successful
outcome of the discussions with the FCCB holders as well its ability to
generate/source additional cash flows to
repay its liabilities in the short-term. An assess- ment covering qualitative
and judgmental aspects needs to
be made, an illustrative
inventory of which could include:

• Whether management has a history of success- fully refinancing or renewing the entity’s debt obligations as they come due

• Whether management has made sufficient progress in negotiating with planned funding source(s), if any and whether management has provided evidence to support its assertions rela- tive to progress

• Whether the uncommitted funding amount is significant or insignificant relative to the total funding need

• Ability and willingness of the owners to provide additional capital to fund the liquidity crisis.

If based on additional procedures performed, auditors are satisfied with the appropriateness of the going concern assumption, the auditor would need to include a matter of emphasis in their re- port highlighting the fact that the accounts have been prepared on a going concern basis despite the material uncertainty. Management would need to make enhanced disclosures about the material uncertainty as well as mitigating factors. Where the auditor is not satisfied with the appropriate- ness of the going concern assumption, he would need to issue an adverse opinion.

Case Study 3

Moon Metals Limited (MML) is in the business of manufacturing of hot rolled steel plates. The paid up capital of MML as at 31st March 20X0 is Rs. 2,000 crore as against accumulated losses of Rs. 2,250 crore. Due to the sluggish market conditions in the steel industry, high rates of interest and short tenure of loans taken, MML was unable to repay significant portion of loans from financial institutions/banks as per the repayment schedule. The overdue amount of such loans including over- due interest, as at 31st March 20X0 aggregates to Rs. 1,000 crore. Further, loans aggregating to Rs. 500 crore are due for repayment within one year from the Balance Sheet date. The aggregate loans outstanding as at 31st March 20X0 amount to Rs. 4,000 crore.

In view of the deterioration in the steel market conditions, the management of MML submitted a omprehensive Financial Restructuring Plan (CFRP) in April 20X0 to the Corporate Debt Restructuring Group (CDR) consisting of all the secured lenders of the company. The CFRP, inter alia, provides for conversion of promoter loans into equity, buy- back of certain unsecured loans at a discount, additional equity infusion by promoters, enhanced cash flow projections through cost rationalisation, operational efficiencies, renegotiation of contracts and other cost control measures to improve Com- pany’s operating results; all these factors ultimately resulting in improvement of the company’s net worth. The CFRP is under consideration by the CDR as on the date of approval of the accounts,
i.e. 30th June 20X0.

The liabilities due for repayment amount to ap- proximately Rs. 2,500 crore, which is greater than the currently expected cash flows from business and any committed or contracted sources of funds of the Company. The Company’s ability to repay its loan and related liabilities falling due up to 31st March 20X1 is dependent on the Company being able to successfully implement the actions proposed in the CFRP. What factors need to be reckoned, if the accounts for the year ended 31st March 20X0 were prepared on a going concern basis in the above case?

Analysis

In this case study, the Company has been admit- ted to CDR whereby management has provided commitments in lieu of the CDR restructuring the loans and waiving off existing events of defaults/ penal interest and provision of further finance. In addition to the factors explained in the analysis to Case Study 2 above, the auditors would need to evaluate the following aspects:

• Analysing and determining the reliability of cash flow, sales, profit and other relevant forecasts prepared by the management, the auditor may consider consulting corporate finance experts to validate these assumptions.

• Considering historical evidence of growth and profitability of the entity as well as the industry in which the entity operates

• Considering apparent feasibility of plans to reduce overhead (e.g. existence of labor agree- ment restrictions) or administrative expendi- tures, to postpone maintenance or research and development projects, or to lease rather than purchase assets

• Whether the company’s financial health has de- teriorated significantly or its operations changed significantly since the reporting date

• Assessing the ability and intent of the promot- ers to fulfill the funding commitment, assess- ing whether the commitment is sufficient and enforceable The time horizon over which the evaluation of the mitigating factors in this case would transcend beyond one year.

Depending on the status of approval of the CRPF and consideration of the factors listed above, the auditor would need to perform additional proce- dures to evaluate management’s assessment of going concern. Where in the auditor’s evaluation, the going concern assumption is appropriate, he would need to include a matter of emphasis in the audit report and ensure that detailed disclosures are made in the financial statements. Where the auditor is not satisfied with the appropriateness of the going concern assumption, he would need to issue an adverse opinion.

Operational condition resulting in material uncertainty

An operational condition may arise where an en- terprise is formed for achieving a stated objective and the objective is either achieved or becomes infructuous. For e.g. a project office that was constituted to execute the contract for construc- tion of a power plant for a power generating company would get annulled on completion of the project or where the contract with the power company gets cancelled.

Legal condition resulting in material uncertainty

A going concern issue may also arise where the operation of an enterprise is subject to licensing by statutory authorities and such license is with- drawn or cancelled thereby entailing a cessation to the enterprise’s existence. In the Indian con- text, a recent example of the applicability of the legal condition resulting in material uncertainty of an enterprise to continue as a going concern is the cancellation of telecom licenses of certain operators by the telecom regulatory authorities leading to termination of business operations for those operators.

It is easier to evaluate going concern for enterprises operating in a mature industry experiencing turbulent times. However, for enterprises that operate in nascent or niche environments, this evaluation could pose difficulties. Consider the case of a company which is engaged in drug discovery and whose net worth is completely eroded. For such cases, the auditors would need to apply heightened professional skepticism to conclude appropriateness of going concern assumption, as this would involve evaluating factors such as fu- ture cash flows from development of molecules, success in clinical trials, ability to sell the product at development stage or engage a partner for further development, outsourcing of development of molecules etc.

In the Indian context, companies operating in the aviation industry have been encountering going concern issues. The operating results of these companies continue to be materially affected mostly by extraneous factors such as high aircraft fuel costs, significant depreciation in the value of currency, declining passenger traffic and general economic slowdown. Some of these companies have continued to prepare the financial statements based on their ability to explore various options to raise finance to meet short-term and long-term obligations, promoter commitment to provide op- erational and financial support and amendments to FDI policy which may improve investor sentiment towards the aviation industry.

Concluding remarks

As the world deals with the cascading impacts of the financial crisis, which continue to this day, the global economy has had to find a course through uncharted waters. The growing complexi- ties in companies’ balance sheets due to the global economic crisis and foreign exchange volatility have triggered a debate over one of the basic premises of financial accounting — every company is a ‘going concern’ that will not go out of busi- ness or liquidate in the foreseeable future. Going concern issues have significant ramifications for companies such as market capitalisation, ability to raise resources, employee retention, protection of stakeholders interests, investor confidence and so on. The significance of the going concern concept is also evident in the valuation of the assets of the business as ‘going concern’ also forms one of the basis on which businesses are valued.

Where going concern assumption is no longer appropriate, the financial statements would need to be prepared under the liquidation basis of ac- counting whereby the carrying values of all assets (including fixed assets) are presented at their estimated realisable value and all liabilities are presented at their estimated settlement amounts.

In fact, a going concern assumption being invali- dated post the balance sheet date is considered to be an adjusting event. Accounting Standard 4 requires assets and liabilities should be adjusted for events occurring after the balance sheet date that indicate that the fundamental accounting assumption of going concern is not appropriate. The Companies (Auditor’s Report) Order, 2003 specifically requires the statutory auditor to report whether disposal of a substantial part of the as- sets has affected the going concern of a company. Similarly, the reporting requirement under CARO 2003 with respect to erosion of net worth and incurrence of cash losses is also aimed at assessing the financial health and as a corollary, the going concern of a company.

In practice, evaluating the appropriateness of a going concern assumption can be highly judgmental and SA 570 provides adequate guidance for an auditor to make this assessment.

shailesh.kwebmaker

Gap in Gap-Accounting for Expenditure on Corporate Social Responsibility

In this article we discuss the accounting of CSR expenditure, particularly focusing on the issue relating to constructive and legal obligation under Indian GAAP.

Provisions relating to Companies Act, 2013 on CSR

1. The Companies Act requires that every company with net worth of Rs. 500 crore or more, or turnover of Rs. 1,000 crore or more or a net profit of Rs. 5 crore or more during any financial year will constitute a CSR committee.

2. The CSR committee will consist of three or more directors, out of which at least one director will be an independent director.

3. The CSR committee will:

(a) Formulate and recommend to the board, a CSR policy, which will indicate the activities to be undertaken by the company.

(b) Recommend the amount of expenditure to be incurred on the activities referred to in the CSR policy.

4. The board will ensure that company spends, in every financial year, at least 2% of its average net profits made during the three immediately preceding financial years. For this purpose, the average net profit will be calculated in accordance with the clause 198.

5. The company will give preference to local areas around where it operates, for spending the amount earmarked for CSR activities.

6. The board will approve the CSR policy and disclose its contents in the board report and place it on the company’s website.

7. If a company fails to spend such amount, the board will, in its report specify the reasons for not spending the amount.

8. Schedule VII of the Act sets out the activities, which may be included by companies in their CSR policies. These activities relate to (a) eradicating extreme hunger and poverty (b) promotion of education (c) promoting gender equality and empowering women (d) reducing child mortality and improving maternal health (e) combating HIV, AIDs, malaria and other diseases (f) ensuring environmental sustainability (g) employment enhancing vocational skills (h) social business projects (i) contribution to certain funds and other matters.

Naming and Shaming

The Companies Act does not prescribe any penal provision if a company fails to spend the amount prescribed on CSR activities. The board will need to explain reasons for non-compliance in its report. Thus many believe that there is no legal obligation to incur CSR expenditure. Creating a legal obligation under the Companies Act to incur CSR expenditure, would have created constitutional hurdles for the regulator. Hence the Government has chosen a path of applying moral pressure, by requiring disclosure of CSR expenditure. As there is no legal obligation to incur CSR expenditure, there would be no legal obligation to make good short spends of previous years or prohibition on taking credit in future years for excess amount spent on CSR.

The draft rules clarify that CSR is not charity or mere donations. CSR is the process by which an organisation thinks about and evolves its relationships with stakeholders for the common good, and demonstrates its commitment in this regard by adoption of appropriate business processes and strategies. CSR is a way of conducting business, by which corporate entities contribute to the social good. Socially responsible companies do not limit themselves to using resources to engage in activities that increase only their profits. They use CSR to integrate economic, environmental and social objectives with the company’s operations and growth.

From the draft rules, it is clear that CSR is based on shared values and should be a part of a company’s business strategy. It should not be seen as a discretionary expenditure. Certainly reputed companies can ill afford not to have CSR as part of their business strategy and spend the legislated amount on CSR. Hence, these companies would have, if not a legal obligation, atleast a constructive obligation to incur the CSR expenditure. The same cannot be said of companies that do not care about CSR or have cash flow problems and hence would not pursue CSR.

In a nutshell, as a result of the Companies Act 2013, for companies that meet the threshold, there may or may not be a constructive obligation. It is a company specific analysis that will have to be made.

Accounting of CSR expenditure

Assume, Company A meets one of the thresholds, and hence CSR is applicable to it. There are three scenarios with respect to CSR expenditure.

1. Company A spends 2% (determined in accordance with the Act) each year.

2. Company A spends nothing or less than 2% each year.

3. Company A spends more than 2% in one year, and may or may not take credit for the excess spend in future years

Scenario 1 is fairly straight-forward. Scenario 3 is not dealt with in this article. This article focusses on Scenario 2. How does Company A account for CSR expenditure in Scenario 2?

Author’s Response
To answer this question, one will have to answer three questions. Is there a legal obligation to spend on CSR? If there is no legal obligation, has the company created a constructive obligation for itself? How are constructive obligations accounted for under AS 29 – Provisions, Contingent Liabilities and Contingent Assets?

Based on discussions above, the author believes that there is no legal obligation to incur CSR expenditure. However, companies are advised to seek legal clarity on this matter. The answer to the second question, whether or not there is a constructive obligation, would depend on facts and circumstances of each case.

Paragraph 11 of AS 29 provides some insight on constructive obligation. It states “An obligation is a duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner.”

Whether or not there is a constructive obligation, will be clear from facts and circumstances of each case. Infact the requirement of Companies Act 2013, could throw some light on whether constructive obligation exists in a given fact pattern. As per the Act, the CSR committee will: (a) Formulate and recommend to the board, a CSR policy, which will indicate the activities to be undertaken by the company (b) Recommend the amount of expenditure to be incurred on the activities referred to in the CSR policy (c) Monitor CSR policy from time to time. Further, the board will approve the CSR policy and disclose its contents in the board report and place it on the company’s website. The above disclosures should throw adequate light on whether or not there is constructive obligation in a given fact pattern.

Now the million dollar question. Assuming there is constructive obligation in a given fact pattern, would a company require to make provision for the short or nil spends, on the basis that the short or nil spends will be made good in the future years. The response of the standard setters on this issue has been very confusing.

Constructive obligations should be provided

The requirements in Indian GAAP, suggesting constructive obligations should be provided for are:

(a) AS 29 defines ‘obligating event’ as an event that creates an obligation that results in an enterprise having no realistic alternative in settling that obligation. This definition is capable of being interpreted as requiring a provision based on constructive obligation criteria rather than merely on legal criteria.

(b) Paragraph 11 of AS 29 describes obligation at a constructive level rather than on a legal basis. Paragraph 11 describes obligation as follows: “An obligation is a duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner”.

(c) In the case of refund by retail stores, AS 29 requires a provision based on constructive obligation criteria and not on the basis of a legal obligation. The example contained in AS 29 is reproduced below.

Illustration 4: Refunds Policy

A retail store has a policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. Its policy of making refunds is generally known. Present obligation as a result of a past obligating event – The obligating event is the sale of the product, which gives rise to an obligation because obligations also arise from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner. An outflow of resources embodying economic benefits in settlement – Probable, a proportion of goods are returned for refund (see paragraph 23).

Conclusion – A provision is recognised for the best estimate of the costs of refunds (see paragraphs 11, 14 and 23).

(d)Paragraph 3 of AS 15 Employee Benefits states that “The employee benefits to which this Standard applies include those provided:……(c) by those informal practices that give rise to an obligation. Informal practices give rise to an obligation where the enterprise has no realistic alternative but to pay employee benefits. An example of such an obligation is where a change in the enterprise’s informal practices would cause unacceptable damage to its relationship with employees.” In the Indian context, bonus, increments, etc. are provided for based on constructive obligation rather than on the basis of a legal obligation. This is in accordance with AS-15. Thus the concept of constructive obligation is not an alien concept and is recognized not only in AS-29, but also other Indian standards such as AS-15. (e) AS 25 – ‘Interim Financial Reporting’, requires the constructive obligation criteria to be applied in making provision for bonus in interim periods. As per AS 25, “a bonus is anticipated for interim reporting purposes, if, and only if, (a) the bonus is a legal obligation or an obligation arising from past practice for which the enterprise has no realistic alternative but to make the payments, and (b) a reliable estimate can be made.”

Only legal obligations are provided, constructive obligations are not provided The requirements in Indian GAAP, suggesting constructive obligations should not be provided for are:

1. The view that constructive obligation should not be provided for is clearly confirmed in two EAC opinions. In a recent opinion published in The Chartered Accountant of July 2013, the EAC opined “Since as per Department of Public Enterprises Guidelines, there is no such obligation on the enterprise, provision should not be recognised. Accordingly, the Committee is of the view that the requirement in the DPE Guidelines for creation of a CSR budget can be met through creation of a reserve as an appropriation of profits rather than creating a provision as per AS 29. On the basis of the above, the Committee is of the view that in the extant case, it is not appropriate to recognise a provision in respect of unspent expenditure on CSR activities. However, a CSR reserve may be created as an appropriation of profits.”

Another opinion is contained in Volume 28, Query no 26. In this query EAC opined “A published environmental policy of the company by itself does not create a legal or contractual obligation. From the Facts of the Case and copies of documents furnished by the querist, it is not clear as to whether there is any legal or contractual bligation for afforestation, compensatory afforestation, soil conservation and reforestation towards forest land. In case there is any legal or contractual obligation, compensatory afforestation, felling of existing trees or even acquisition of land could be the obligating event depending on the provisions of law or the terms of the contract.”

2. AS 29 has rejected the concept of constructive obligation in regard to provision for restructuring costs (e.g. voluntary retirement cost), which is required to be provided for based on a legal obligation rather than when there is an announcement of a formal and detail plan of restructuring.

3. The draft Ind-AS ED corresponding to IAS 37 Provisions, Contingent Liabilities, and Contingent Assets, identifies constructive obligation as a difference between Ind-AS and AS-29.
This is reproduced below.

Major Differences between the Draft of AS 29 (Revised 20xx), Provisions, Contingent Liabilities and Contingent Assets, and Existing AS 29 (issued 2003)

1. Unlike the existing AS 29, the Exposure Draft of AS 29(Revised 20XX) requires creation of provisions in respect of constructive obligations also. [However, the existing standard requires creation of provision arising out of normal business practices, custom and a desire to maintain good business relations or to act in an equitable manner]. This has resulted in some consequential changes also. For example, definition of provision and obligating event have been revised in the Exposure Draft of AS 29 (Revised 20XX), while the terms ‘legal obligation’ and ‘constructive obligation’ have been inserted and defined in the Exposure Draft of AS 29(Revised 20XX). Similarly, the portion of existing AS 29 pertaining to restructuring provisions has been revised in the Exposure Draft of AS 29 (Revised 20XX).

Conclusion

Apparently, there are internal inconsistencies in AS 29. While some requirements of AS 29 require creation of provision toward constructive obligation; other aspects may be read as if the same may not be required. Overall, it appears that the ICAI does not favour creation of a provision with respect to constructive obligation. This is particularly clear from the two EAC opinions. However, it is unclear, how the EAC opinions can override some of the requirement under AS-29 which require a provision to be created for constructive obligation. This creates a huge anomaly; one that can be resolved only by suitably amending AS-29 to bring it completely in line with the intentions of the standard setters. The author does concede that at this stage, it may not be advisable to amend Indian GAAP. Rather it would be advisable to take swift steps to adopt IFRS/Ind-AS, and leave the past behind.

shailesh.kwebmaker

AUDITOR’S REPORTING TO THE AUDIT COMITES — A GLOBAL PERSPECTIVE

Synopsis

Effective External Audit, a key pillar for having a good governance structure, is not only a statutory requirement but is also intended to be an unbiased review of the financial statements and the underlying transactions by an independent audit professional to protect the interests of all the stakeholders. In this process, communication by the auditors with those in charge of governance such as audit committees is very crucial. Regulators in various countries are seriously exploring the possibility of introducing a framework for extracting additional information from the auditors. Read on to know more about the items which are typically reported by the auditors to the audit committees based on the practices prevailing in several countries and the emerging trends in this area.

Introduction
Effective External Audit is one of the key pillars for having a good governance structure in any organisational set up especially in the corporate form. The audit process is not only a statutory requirement but is also intended to be an impartial/ unbiased review of the financial statements and the underlying transactions by an independent audit professional, which protects the interests of all the stakeholders. In this process, communication by the auditors with those in charge of governance such as audit committees is very crucial and helps in better understanding of the financial statements and the accounting aspects. Above all, it brings in enormous transparency in sharing the critical information relating to the entity with those who are legally and morally responsible for ensuring good governance. Further, these communications with the audit committee also provide auditors with an exclusive forum separate from the management to discuss matters about the audit and the company’s financial reporting process.

Currently, in addition to the standard audit report on the financial statements and the existing requirement of reporting to those in charge of governance, the regulators in various countries are seriously exploring the possibility of introducing a framework for extracting additional information from the auditors such as Auditors’ Discussion & Analysis on the financial statements similar to that of the Management Discussions & Analysis and enhancing the audit scope/reporting requirements to provide a more detailed and professional analysis to all the readers of the financial statements.

In this context, considering the ever increasing appetite for obtaining more information from the auditor, and the legal/regulatory environment, the auditing standards in general provide for reporting on various matters to those in charge of governance. This article summarises some of the items which are typically reported by the auditors to the audit committees based on the practices prevailing in several countries and the emerging trends in this area.

Reporting Framework in India and in Other Countries

Indian Standard on Auditing SA 260 -“Communication with Those Charged with Governance” deals with the reporting requirements for auditors to those in charge of governance. The SA 260 does not contain any material modifications vis-a-vis ISA 260, which is the equivalent International Auditing Standard. This standard aims at creating a platform to promote effective two-way communication between the auditor and those charged with governance and provides an overall framework for the auditor’s communication with those charged with governance and identifies some specific matters to be communicated to them. However, nothing in this SA precludes the auditor from communicating any other matters to those charged with governance.

Although the auditor is responsible for communicating matters required by this SA, the management also has a responsibility to communicate matters of governance interest to those charged with governance. Communication by the auditor does not relieve the management of this responsibility. Similarly, communication by the management with those charged with governance of matters that the auditor is required to communicate does not relieve the auditor of his responsibility to also communicate to them.

The requirement in India is similar to the reporting requirement in several other geographies where the standard establishes a framework for the auditor to communicate certain matters related to the conduct of an audit to those who have responsibility for oversight of the financial reporting process. For example, in the United States, AU Section 380 – “Communication with Audit Committees” deals with such a reporting requirement for the auditors. Recently, the Public Company Accounting Oversight Board (PCAOB), the auditing regulator in the USA, approved Auditing Standard 16 on communications with the audit committees, which substantially enhances the reporting obligations on the part of the auditors. In Australia, the auditing standard ASA 260 deals with the communication relating to those charged with governance which is very similar to the international reporting framework. The Financial Reporting Council in the UK has recently issued FRC 260, International Standard on Auditing (UK and Ireland) relating to communication with those charged with governance, which puts onerous responsibilities on the external auditors. Singapore Standard on Auditing (SSA 260) is also in line with the reporting requirements of other countries.

Whilst the basic audit committee reporting requirements on the part of the auditors remain the same in many jurisdictions, there is also an emerging trend of mandating auditors to provide more specific information on various aspects relating to the audit process and the financial statements duly considering the country specific requirements and the expectations of the stakeholders.

Matters considered for Reporting The matters which are typically included in the communications to the audit committee can be broadly classified in to two categories, namely;

• Regular Reportable Matters
• Emerging Additional Reporting Requirements

This classification is based on the general practice/ applicability in various jurisdictions and the contents could vary depending on the need/other requirements.

Regular Reportable Matters

The list of items which are included in the regular list of items to be reported would include the following:

• The Auditor’s Responsibility under Generally Accepted Auditing Standards

• Significant Accounting Policies

• Management Judgments and Accounting Estimates

• Composition of the Engagement Team

• A statement that the Engagement Team and others in the firm as appropriate, the firm and, when applicable, network firms have complied with relevant ethical requirements regarding independence

• Planned Scope of Audit

• Overview of the Audit Strategy, Timing of the Audit, and Significant Risks

• Consideration of Fraud in a Financial Statements Audit

• Significant Issues Discussed with the Management prior to retention

• The form, timing, and expected general content of communications

• Disagreements with the Management

• Consultation with other accountants

• Difficulties encountered in performing the audit

• Communication about Control Deficiencies in an audit of Financial Statements

• Financial Statement Presentation

• Alternative Accounting Treatments.

• Significant Audit Adjustments

• Significant Findings from the Audit

• All written representations requested from the Management (where the Management is separate from those charged with governance)

Emerging Additional Reporting Requirements

Items which are increasingly required to be reported in communications by the auditors to the audit commit-tee depending on the various regulatory/other requirements/practices are listed below;

• All relationships and other matters between the firm, network firms and the entity which, in the auditor’s professional judgment, may reasonably be thought to bear on the firm’s independence.

• The related safeguards that have been applied to eliminate identified threats to independence or reduce them to an acceptable level.
• The total fees charged by the audit firm (including network firms) for audit and non-audit services for the period covered by the financial report audit.

• Assessment of the adequacy of the communication process, between the auditor and those charged with governance for the purposes of the audit.

•   Illegal Acts
•   Going-Concern Matters
•   Material Written Communications between the audi-tor and the Management.
•   Significant unusual transactions
•   Departure from the Auditor’s Standard Report
•   Matters that have arisen during the audit which are significant to the oversight of the financial reporting process
•   Difficult or contentious matters on which the auditor was consulted
•   Specific matters relating to the group audits to be communicated by the parent company auditors

•   Auditor’s Judgments about the quality of the entity’s accounting principles and practices
•   Auditor’s opinion on other information in any other document which contains the Audited Financial Statements
•   New accounting pronouncements and their impact on the entity

Background for the Enhanced Expectations for Additional Reporting Requirements

The emerging regulatory framework is tilted towards enhancing the relevance, timeliness, and quality of the communications between the auditor and the audit committee relative to the annual audit and related in-terim period reviews and fosters constructive dialogue between the auditor and the audit committee about significant audit and financial statement matters. The underlying reasons for enhancing the reporting requirements to the audit committee by the auditors which are emerging in several jurisdictions are explained below.

The audit committee has an important role to play in the relationship between the executive management and the external auditors. The audit committee should always make the external auditor aware of any issues which are of concern to it. Similarly, the external auditor should inform the audit committee of any concerns he has so as to ensure that the financial oversight process is complete and comprehensive. This is absolutely essential since the extent of importance provided to the audit process and the oversight provided by the audit committee is on the rise worldwide. For example, in Belgium, the statute explicitly requires that the audit committee monitors the statutory audit of the annual consolidated accounts, including the follow up of questions raised by the statutory auditor. The French Stock Exchange Authority requires the audit committees to discuss with their statutory auditors specifically and formally, any difficulties they have faced during the course of their audit.

Facing more scrutiny from regulators and investors, audit committees are continuing to challenge their roles and responsibilities. A primary responsibility of the audit committee is to oversee the integrity of the company’s accounting and reporting practices and financial statements. As financial reporting becomes more complex, the audit committee needs to make sure that the financial statements are understandable and transparent. To perform their oversight responsibilities, audit committee members need to understand what information they need, how to analyse it and what questions to ask to gain insights and make informed decisions. In view of the above, the audit committees are expecting enhanced support from the external audi-tors and candid and open communication between the external auditor and the audit committee is imperative in this regard.

The expectations from different stakeholders relating to the compliance aspects of various laws and regulations are also another reason for the enhanced reporting requirements. In some of the jurisdictions, the auditor is now required to inquire if the audit committee is aware of any matters relevant to the audit, including but not limited to violations or possible violations of laws or regulations. Further, the auditor should also assure himself that the audit committee or others with equivalent authority and responsibility is adequately informed with respect to illegal acts that come to the auditor’s attention.

Need for proactive action, understanding the nuances relating to the audit process, managing the subjective assessments, fixing the specific responsibilities have changed the entire dimension of the oversight function. This has also resulted in mandating the auditors to provide information on various significant aspects of the audit such as the planned use of other auditors to audit certain components or subsidiaries, the basis for the auditor’s determination that they can serve as the principal auditor, consultations on difficult or contentious matters outside the engagement team, specialised skill and knowledge to complete the audit, any concerns regarding the management’s anticipated application of accounting pronouncements that are not yet effective.

Audit is no longer an exercise of just ticking the numbers and confirming the mathematical accuracy of the figures provided by the management. It has changed its dimension quite drastically in the recent past and the audit process now requires thorough understanding of the business, external and the internal environments, regulatory framework in which the entity operates business and other risks, internal control framework, computer environment and much more. Currently, there is an expectation to have industry specialists in the audit field so as to bring lot more value to the audit process by demonstrating the immense industry experience. In this background, an auditor is now required to ensure that the audit committee is informed about the methods used to account for significant unusual transaction and the auditor would also be required to communicate about additional aspects of such significant unusual transactions, including the his understanding of the business rationale for them and not just the company’s methods of accounting for them.

Conclusion

Regulators worldwide believe that effective communication between the auditor and the audit committee allows the audit committee to be well-informed about accounting and disclosure matters, including the auditor’s evaluation of matters that are significant to the financial statements and to be better able to carry out its oversight role. Further, the auditor also benefits from a meaningful exchange of information regarding significant risks of material misstatement in the financial statements and other matters that may affect the integrity of the company’s financial reports.

In today’s world, the varying expectations of the stakeholders impose an onerous responsibility on the part of the audit committee and the auditors to discharge their duties properly. One should always remember that the roles of the auditors and the audit committees are critical to the efficiency and integrity of the capital markets and for protecting the interests of the various stakeholders. Considering enhanced regula-tory and legal environment and the investor activism, seamless and timely communication between the au-ditor and the audit committee is absolutely essential. This would pave the way for transparent and focused discussions and would also help in taking well informed decisions and having an effective financial oversight.

In a dynamic environment, the roles and the responsibilities keep changing and the audit profession is not an exception to this ground level reality. Hence, the audit community should rise to the occasion and use this tool of communicating with the audit committee purposefully for not only discharging their professional/ regulatory responsibilities but also for demonstrating their professional expertise and the value created by the services rendered. This would enhance the image of the profession and make the audit process more valuable and reliable.

shailesh.kwebmaker

Rehabilitation & Resettlement: Future Subsistence Cost

Synopsis:

Land acquisition now has become a crucial driver for development activities undertaken by Government and Private Sector. Central Government has proposed a combined bill on land acquisition and rehabilitation and resettlement which shall now also cover private sector. Hence it is all the more important to analyze various nuances involved in such kind of transactions. There are three types of cost involved in acquisition of land Direct compensation, future subsistence cost for displacement of livelihood of the families and community development and welfare activities in general. The author describes accounting, recognition , measurement treatment and taxation impact on such kind of costs.

Introduction

With the growing need to grow, various industrialists in developing nations like India step forward to invest in new manufacturing facilities. One of the key requisite for this activity is Land, on which the upcoming industries will be set up. Land acquisition is a crucial driver for various infrastructures projects and economic developmental activities undertaken by the Government as well as by Private sector.

Land acquisition refers to the compulsory acquisition of land by the government from the owner of land. In India it is governed under Land Acquisition Act, 1894. Land may be acquired for defence and national security; roads, railways, highways, and ports built by public as well as private sector enterprises; planned development; residential purposes for the poor and landless, etc. This Act did not include any rehabilitation or resettlement scheme or address any Social impact on such acquisition by Government. In 2003, the Central Government formulated the National Rehabilitation and Resettlement Policy, which was last updated in 2007. It provides for minimum rehabilitation and resettlement expenditure that has to be incurred by the Government machinery, though State Governments can provide for additional rehabilitation avenues. In order to facilitate the process of acquisition, many private enterprises have adopted to acquire the land through Government under the provisions of the Act.

Central Government has proposed a combined bill on Land Acquisition and Rehabilitation and Resettlement in the Parliament. The proposed bill requires all Private land acquisitions also to provide rehabilitation and resettlement to displaced people if the area of acquisition is over a certain limit.

As per the existing and proposed guidelines, there are three types of costs incurred while acquiring land:

a. Direct Compensation for the fair value of the piece of land;
b. Future subsistence cost for displacement of the livelihood of the families; and
c. Community development and welfare activities in general.

To take a practical view, following are the objectives and various cost components that are part of Jharkhand Rehabilitation and Resettlement policy – 2008:

Objectives of the Policy
1. to minimise displacement and to promote, as far as possible, non-displacing or least displacing alternatives;

2. to ensure adequate rehabilitation package and expeditious implementation of the rehabilitation process with the active participation of the affected families;

3. to ensure that special care is taken for protecting the rights of the weaker sections of society, especially members of the Scheduled Tribe and Scheduled Castes with concern and sensitivity;

4. to provide a better standard of living, making concerted efforts for providing sustainable income to the affected families;

5. to integrate rehabilitation concerns into the development planning and implementation process; and

6. where displacement is on account of land acquisition, to facilitate harmonious relationship between the requiring body and affected families through mutual cooperation.

Direct Compensation – Family specific

i. Piece of land for constructing house, free of cost

ii. Construct a permanent establishment for the displaced land owner

iii. One time financial assistance in case of the family wishes to relocate.

Future Subsistence – Family specific

i. Allowance for displacement of cattle and Employment to individuals from those family

ii. Employment to family members.

iii. If employment is not given or accepted by land owner, then regular income for sustaining life of the individual for a period of 25 to 30 years depending upon State Governments i.e. Bhatta.

iv. Percentage share in net profits of the company

Community/Infrastructure Development – General

i. Expenses on village infrastructure development such as roads, water and sewerage systems, drainage systems, education, skill development, etc.

ii. Construction of Residential colonies.

Recognition and measurement With respect to compensation cost, there is no ambiguity as it represents direct cost of acquisition based on fair market value of the piece of land.

It is Rehabilitation and Resettlement (R&R) expenditure where various practices have been observed in its recognition and measurement. Some attribute a nexus to acquisition of land and capitalise the entire expected outflow on this account. While some account the R&R cost as revenue expenditure, as and when incurred.

Accounting Policy excerpt from NTPC Limited Consolidated Financial Statements 2009

“Based on the opinions of the Expert Advisory Committee (EAC) of the Institute of Chartered Accountants of India (ICAI) received during the year, in respect of land in possession of the company, provision of Rs. 3,197 million has been made towards expenditure on resettlement & rehabilitation activities including the amount payable to the project affected persons (PAPs) towards land for land option, resettlement grant or other grants, providing community facilities and compensatory afforestation, greenbelt development & loss of environmental value etc. based on the Rehabilitation Action Plan (RAP) of the Company or as per the agreement with/demand letters/directions of the local authorities and the same is included in the cost of land”.

Accounting Policy excerpt from NTPC Limited Consolidated Financial Statements 2012

“Fixed assets: Deposits, payments/liabilities made provisionally towards compensation, rehabilitation and other expenses relatable to land in possession are treated as cost of land.”

Accounting Policy excerpt from Coal India Limited Annual Report 2012

“Land: Value of Land includes cost of acquisition and Cash rehabilitation expenses and resettlement cost incurred for concerned displaced persons. Other expenditure incurred on acquisition of land viz. compensation in lieu of employment, etc are, however, treated as revenue expenditure.”

Looking at the compensation structure in acquisition of land, it seems to be similar to acquisition of Spectrum, which requires initial license fee and regular revenue share to the government with minimum committed every year.

In fact, the analogy also holds good in case of acquisitions of definite life assets such as Mine, Coal or an Oil Block. In these cases, since the assets are not in ready to use condition at the first instance. Government allots them at nominal value with limit on its capital exploration expenditure, as seen in case of Oil& Gas exploration. Once the asset is ready to use, there is a regular fee/royalty/revenue share based on production on an annual basis till the useful resource is depleted.

This analogy is drawn on following counts:

i. Both, the assets, ie Spectrum in specific, as well as Land, have indefinite useful life.

ii. The compensation for both types of asset acquisition is split into 3 categories

iii)immediate compensation at the time of acquisition to secure right to use the asset and
– sustaining expenditure, in case of spectrum, it is on usage of spectrum over its life and in case of land it is R&R expenditure i.e. subsistence cost for every subsequent year’s livelihood.

– The utilisation of natural resource also requires certain rehabilitation expenditure such as mine rehabilitation, maintenance of flaura & fauna of the place and other environmental obligations on sustaining basis.

Let us understand the facets of concerns and issues involved in measurement and recognition for accounting of various components of such rehabilitation and resettlement cost.

Recognition and Measurement:

From the accounting perspective, the following two issues arise with regard to the R&R expenditure:

i) The timing of the creation of the provision for R&R expenditure; and
ii) The corresponding debit in respect of the provision, i.e., whether the same should be capitalised or recognised as an expense in the statement of profit and loss.

There is no specific literature for the given case except from the Technical guide on Accounting for Special Economic Zones (SEZs) Development Activities.

It states that “in accordance with the above principles of recognition of provision as enunciated in AS 29, the provision for R & R expenditure should be created and accounted for as follows:

(i) In respect of the R&R expenditure which arises on the acquisition of land as the lump-sum or annuity payment to be made by a Developer to the land seller, provision should be created at the time of the acquisition of the land itself. This is because the Developer has present obligation in this regard at the time of the acquisition of the land itself and the other two criteria for recognition are normally met at that point of time. The amount in respect of the provision should be capitalised as a part of the cost of the land. Similarly, provision should be created at the time of acquisition of land in respect of the other R&R expenditure with regard to which the Developer has a present obligation which cannot be avoided by the Developer by a future action.

Such expenditure should also be capitalised as part of the cost of land.

(ii) Where a provision is not related to any asset, to be recognised as the asset of the Developer, for example, R&R incurred with respect to those assets which will not be recognised by the Developer because he would not be the owner of these assets as these will be transferred to the local area administrators, for example, village panchayats, the same should be recognised in the statement of profit and loss when the provision in this regard is made.

(iii)The R&R expenses, which are revenue in nature, e.g., revenue expenditure in respect of Education and Health Programmes, should be recognised in the statement of profit and loss for the period in which the criteria for making the provision in this regard are met.

The Acquirer has present obligation in this regard at the time of the acquisition of the land itself, there is high probability of outflow of resources to settle the obligation and a reliable estimate can be made at that point of time. These are essentially the three criteria with regard to the timing of the creation of the provision, Accounting Standard (AS) 29, Provisions, Contingent Liabilities and Contingent Assets.”

The Technical guide as referred above, requires all direct and indirect expenditure i.e. Compensation as well as subsistence cost, to be capitalised with the Cost of Land. For Community related expenditure, it however suggests to recognise a separate asset if the expenditure is incurred for creation of a capital asset ie roads, hospitals, buildings, etc and charge to income statement if the expenditure is for health programs and other such Corporate social responsibility measures, as and when incurred.

It is to note that all the three types of expenditure (ie direct compensation of fair value, subsistence cost and community development) is incurred only for acquiring the Land and hence there is direct nexus of such expenditure with the asset in balance sheet. It is within the direct framework of AS 10 Fixed assets to capitalise direct compensation cost to Cost of land, however, capitalising future subsistence expenditure to cost of Land seems to be little unreasonable.

Expert advisory Opinion:

Provision towards resettlement and rehabilitation schemes (Compendium of Opinions — Vol. XXVIII)

The querist had sought an opinion on recognition and measurement of expenditure incurred/to be incurred while acquiring land of project purposes.

The Committee opined as follows:

(a)In respect of the estimated amount payable to the land oustees in respect of ‘Land for Land’, re-habilitation/ resettlement grants, subsistence grant/ self-resettlement grant, a provision, on the basis of best estimate of the expenditure required to settle the obligation, should be made on the acquisition of land from the project affected persons.

(b) In respect of infrastructural measures, a provision on the basis of best estimate of the expenditure re-quired to settle the obligation, should be made on the acquisition of land from the project affected persons.

The recognition criteria for provision is dependent on an Obligating event. The committee has considered the acquisition of Land as the obligating event for recognising a provision for future subsistence cost as well as Community development/Infrastructure related cost.

Looking at the larger picture, following aspect may be evaluated for considering the substance, while applying the recognition and measurement principles for R&R expenditure:

In a growing economy which has natural resources and tribal population residing in interior rural India, setting up a manufacturing plant requires following five major partners:

1.    Businessmen, i.e., Promoter with equity and vi-sion;
2.    Banks to support the additional capital;
3.    Government to allow use of the country’s re-sources (some having definite and some indefi-nite life)
4.    People who own a perpetual/indefinite life asset, i.e., Land; and last but not the least
5.    Environment/nature itself.

Establishment of any project in backward rural areas is possible only if it benefits all. Government Policy plays a crucial role in combining and serving the interest of all parties and executing the project.

While Promoters with equity investment earn profits from an ongoing business, Lenders earn their share of profit in terms of fixed service cost since they part their money only for short period.

Government initially recovers a fair value of the natural resource but since some of them have in-definite life, it also charges on-going basis, a share in its profits as in case of spectrum usage in Telecom i.e. Revenue Share, Revenue share in Oil & Gas and Royalty in case of mines.

Similar to Government, people who have been living and earning their livelihood also possess and own an asset with indefinite life. In order to obtain their consent, a similar policy is followed wherein they initially get the fair value of their asset and continue to earn the share of business profits for their balance life.

Their contribution to the business is more than Lenders as they have a right to share the profits in a fixed form like “Bhatta” or Share in profits till plant operation, in perpetuity as per the regulations promulgated by the State Governments. This partnership with people promises a regular income to the owner of land which is similar to the revenue share in case of Spectrum Usage, Revenue share and Royalty.

In the above presented partnership, the cost of acquisition as well as future expenditure obligations is known, but then there is no need to create a provision/capitalisation on Day 1 for the Promoter for his future share of profits, for the lender/banker for its committed interest service, Government for its future estimated royalties based on estimated business cashflows, then why should there be a provision and capitalization (in land) of future subsistence cost in case of displaced landowners !!.

Excerpts from AS 29: Provisions, Contingent Liabili-ties and Contingent assets

14. A provision should be recognised when:

(a) an enterprise has a present obligation as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and

Analysing the above requirement of the standard, all the components of R&R costs arise on account of signing an agreement with the land owners for acquiring their land and hence at any subsequent reporting date, an enterprise has obligation on account of the past event i.e. signing the land acquisition contract. However, some of the expenses are arguably not the present obligation but are future obligations.

It is probable that the obligation will lead to out-flow of resources but reliable estimate may not be done for cases that require sharing of future profits. The future estimates are though available with the Company as they are shared with various analysts, it may not be completely reliable, though contrary view exists.

Further, the future obligations under Indian GAAP are recorded at its full value instead of using dis-counted approach. In any case, if such costs are considered as part of capital costs, the actual share in profit for every year will lead to adjustment to the cost of land, which the entity will have to keep a tab till the life of asset. It is more cumbersome under IFRS, which requires use of present value principles for making a provision.

As we have broadly categorised various expenditure components of R&R cost into Compensation, Future subsistence and Community Development.

The first category that includes viz..cost of piece of land for constructing house, free of cost, construct a permanent establishment for the displaced land owner, one time financial assistance in case of the family wishes to relocate, satisfy all the three criteria for provision under AS 29 and also has a direct established nexus for acquisition of land. Thus a provision is made and amount is capitalised with the cost of Land in case of payments to landowners.

Commitments for schools, hospitals, etc. be owned by the Company but for the benefit of people are recognised as fixed assets as and when constructed, CSR activities are expensed as and when incurred. Unfinished work forms part of Commitments disclosure in Balance Sheet.

It is the cost that is in the nature of future subsis-tence that needs to be recognised and measured with its substance rather than form.

Taxation impact

Any cost capitalised as part of land is a capital cost. There is no depreciation benefit available to the Company, though the cost of land increases and the company can avail higher cost at the time of sale of such land. However, it is to note that the Company has not acquired the land for disposal, hence the cost incurred on land is essentially a sunk cost which yields no tax benefit.

Considering the tax perspective, the company sharing percentage profit every year with land owners, will not be allowed to consider as a revenue expenditure if the Company had to provide for and capitalise the entire future profits along with the cost of land.

No depreciation benefit and no direct allowable ex-pense benefit is available in income tax computation for such cost. Thus entities will have to carefully determine its accounting policy.

Points of relevance

a.    The Land is for a specific usage as per the policy of the State Government.
b.    It can be observed that the Future subsistence costs are in the nature of Corporate Social Responsibility (CSR) which are incurred by the Company and moreso governed by Statute.
c.    Some costs are not compensation for land but for future subsistence of displaced people till the plant is in operation and have direct nexus with Operations of the plant. For example, if the company is shut down, there will be no employment, if there is not profit, there is no share of profit.
d.    Some are in the nature of regular taxes levied by stature such as property taxes. In case of R&R these are regular income to land owners in the form of Bhatta.
e.    If the landowner agrees for employment, the amount of salary is charged to the income statement, but if he agrees for fixed income without employment, then it gets linked towards cost of land and not for future right to use on annual basis like property taxes.
f.    Payments made on account of future subsistence, if capitalised with the cost of land, then it may not be allowed as expenditure in income statement which is not the case with “Revenue share” and “Royalty”.
g.    Acquiring the land is in substance similar to a Purchase order issued by a company for future subsistence cost. Thus the obligating event is de-ferred to respective future period for provisioning.

Views that emerge
Immediate cost that is compensating the landowners immediate needs to be capitalised with cost of land.

Subsistence allowance which is committed by the Company at the time of acquisition of land is a binding commitment towards land owners. The Obligating event ie acquisition of land only gives rise to a commitment for future and should be viewed as a period cost charged to operations. Especially for clauses such as share of profits, where even determination of profit may not be a reliable estimate, though alternate view exists.

Similar to telecom and hydrocarbon businesses, land acquisition also is regulated for specific usage and regular subsistence cost based on earning. Hence recognising the future subsistence cost component in substance to be considered as part of income state-ment, as one of the charges for the usage of asset. This would to be more in line with comparative asset acquisitions (ie Spectrum, Mine, Oil & Gas) followed by enterprises and also justifies its core substance. Unrecognised commitment can be disclosed as off-balance sheet item under ‘Contractual Commitments’.

shailesh.kwebmaker

Auditing Opening Balances – How Far Should an Auditor Go?

Synopsis

When you study SA-510 ‘Initial Engagements Opening Balances’as an auditing standard, the critical points that you, as an auditor need to stress upon, is the verification of opening balances. In the given article, the authors stress on the important areas that an auditor should carefully verify, viz. unaudited prior period balances, reliance on the financial statements audited by the previous auditor.

• For an initial audit engagement, where prior period balances were unaudited, should the auditor be held responsible for opening balances which he never audited?
• Why can’t the auditor rely on work performed by the predecessor auditor where the balances of the prior period were audited by the predecessor auditor?
• Can the auditor request for a review of the work papers of his predecessor?
• Should the auditee be made to undergo ‘fatigue’ once again in assisting the incoming auditor reestablishing the veracity of balances which were already audited by the predecessor auditor in the prior period?

One could easily reach these suppositions on a plain reading of SA 510 Initial Audit engagements – Opening balances. These conjectures gain more relevance in current times, particularly with the requirement of auditor rotation seeming to be a reality as envisaged in the Companies Act, 2013.

SA 510 lays down the guiding principles for performing audit procedures on opening balances where financial statements for the prior period were either not audited or were audited by a predecessor auditor. SA 510 underlines the nature and extent of audit procedures necessary to obtain sufficient appropriate audit evidence regarding opening balances which depend on such matters as follows:

a. the accounting policies followed by the entity;
b. the nature of the account balances, classes of transactions and disclosures and the risks of material misstatement in the current period’s financial statements;
c. the significance of the opening balance relative to the current period’s financial statements; and
d. whether the prior period’s financial statements were audited and, if so, whether the predecessor auditor’s opinion was modified.

SA 510 requires the auditor to obtain sufficient appropriate evidence about whether:

1. Opening balances contain misstatements that materially affect the current period’s financial statements.
2. Accounting policies reflected in the opening balances have been consistently applied in the current period’s financial statements
3. Changes in accounting policies have been properly accounted for, adequately presented, and disclosed in accordance with the applicable financial reporting framework.

Procedures to address these requirements could include:

• Determining whether prior period closing balances are brought forward correctly to the current period or when appropriate, any adjustments have been any adjustments have been disclosed as prior period items in the current year’s Statement of Profit and Loss;
• Determining whether opening balances reflect appropriate application of accounting policies
• Evaluating whether current period audit procedures provide evidence about opening balances
• Performing specific audit procedures to obtain evidence regarding opening balances.

We will try to understand the above requirements with the help of a case study.

Case Study
ABC Limited (‘ABC’) was incorporated on 1 April, 20X0 with an initial paid-up capital of Rs. 15 crores for undertaking the business of production and trading of welding equipments.

ABC took a long-term loan of Rs. 20 crores on 1st June, 20X0 from Universal Bank repayable after 3 years. The loan was taken to fund the setting up of plant for manufacturing welding equipments. The completion of plant set up and commencement of commercial operations was achieved within three months, i.e., by 31st August, 20X0. ABC management was of the view that the project was a qualifying asset and interest on borrowed funds was eligible to be capitalised to the cost of the asset. Interest of Rs. 1 crore for the period 1st June, 20X0 until 31st March, 20X1 payable on the loan from bank was capitalised to the cost of assets as follows:

For depreciating plant and machinery and furniture and fixtures, management adopted the straight line method of depreciation and the estimated useful life was considered as 10 years and 5 years respectively.

Purchases of tools and components were made from local vendors and finished welding equipments are sold through a dealer network. Inventory of raw materials as at 31st March, 20X1 was valued on ‘FIFO’ basis whereas finished goods were valued at cost or net realisable value whichever is lower.

During the year, ABC spent Rs. 5 crore on advertising and launch expenses of its brand – ‘BestWeld’. ABC management capitalised the entire amount of Rs. 5 crore as cost of brand development as an ‘intangible asset under development’. ABC has plans to spend a further amount of Rs. 8 crore during 20X2 towards advertising its brand – BestWeld in the print and other media as well in trade fairs.

The state of affairs of ABC as at 31st March, 20X1 is summarised below.

Statement of Profit and Loss for the year ended 31st March, 20X1

Balance Sheet as at 31st March, 20X1

The statement on accounting policies in the audited financial statements articulates the accounting policies for capitalisation of interest on borrowed funds, accounting for costs of brand development, depreciation and valuation of inventories.

The accounts for the year ended 31st March 20X1 were audited by M/s. PQR & Co., (‘PQR’) a proprietor audit firm and an unqualified opinion was issued thereon. PQR were reappointed as auditors for the year ending 31st March, 20X2 in the annual general meeting of ABC held in September, 20X1.

In the month of February, 20X2, PQR expressed their unwillingness to continue as auditors on account of ill health of the proprietor and tendered their resignation. ABC appointed M/s. XYZ & Associates (‘XYZ’) as their auditors in March, 20X2. XYZ attended the physical count of inventories which was conducted by the management of ABC on 31st March, 20X2. XYZ plans to commence the audit of ABC in the month of May, 20X2.

I. What audit procedures should XYZ perform to comply with the requirements of SA 510?

II. Continuing with the case study, how would the audit approach be different had the fact pattern around inventory been the following?

III. Can XYZ request for a review of the workpapers of PQR?

IV. Would the solution be different if the prior period financial statements were unaudited?

We will evaluate procedures the incoming auditor, XYZ needs to perform to comply with the requirements of SA 510.

Analysis – I

1. As the financial statements for the year ended 31st March, 20X1 were audited by PQR, the present auditors, XYZ could obtain comfort over opening balances by perusing the audited financial statements and could also seek and peruse other relevant documents such as supporting schedules to the audited financial statements for year ended 31st March, 20X1.

2. XYZ would need to trace whether the prior period’s closing balances have been correctly brought forward to the current period. While in a smaller and less complex accounting set-up, this could be relatively straightforward, tracing the opening balances in a multi-locational ERP set-up could pose a challenge entailing involvement of IT experts.

3. Accounting policies – SA 510 requires the incoming auditor to evaluate whether the opening balances reflect the application of appropriate accounting policies. The following points of focus in this case study need consideration:

a. Ordinarily, XYZ could place reliance on the closing balances as contained in the financial statements audited by PQR. However, in the present case, while performing audit procedures on the financial statement captions such as tangible fixed assets and intangible assets under development for the current year, XYZ would need to evaluate the possibility of misstatement of the opening balances, in view of the accounting policies followed for these captions. ABC has capitalised cost of brand development as intangible asset. Cost of internally generated brands is specifically prohibited from being recognised as ‘intangible assets’ under AS 26 – Intangible Assets. Similarly, given
that the plant was set up within a period of four months, it cannot be classified as a ‘qualifying asset’ for capitalisation of the interest costs on related borrowings under AS 16 – Borrowing Costs.

b. In the instant case, the accounting policy followed for the capitalisation of borrowing costs and brand development costs is inconsistent with the requirements of Indian GAAP. As such, the opening balances of fixed assets and intangible assets under development contain a misstatement which affects the financial statements for the year

ended 31st March, 20X2. The amount of interest capitalised to tangible fixed assets (net of the amount written off as depreciation in 20X1) and brand development cost would need to be charged off to the statement of profit and loss for the year ended 31st March, 20X2. ABC would also need to make necessary disclosures in the notes explaining the prior period charge and XYZ would need to ensure that these disclosures are appropriate.

c. It may be noted that the restatement of
the prior period financial statements does
not exist in the Indian scenario, hence the
adjustments to opening balances would need
to be disclosed as ‘prior period items’ in the
current year’s statement of profit and loss.

d. Where the management refuses to make
adjustments as stated above, XYZ would
need to consider issuing a qualified or an
adverse opinion even though the predecessor
auditor had issued an unqualified opinion
for the prior period.

4. For current assets and liabilities, XYZ would need
to obtain some evidence about the opening balances
as part of the audit for the year ended 31st
March, 20X2 to get comfort on assertions such
as existence, rights and obligations, completeness
and valuation. For
e.g., for debtors, XYZ
would need to obtain evidence around collection
of opening debtors. Similarly, for creditors,
evidence around payments to creditors during
20X2 would need to be examined.

5. Inventories – Physical verification procedures
performed on inventories by XYZ as at 31st
March, 20X2 would provide limited assurance on
the opening inventory as at 31st March, 20X1.
Given that appointment of XYZ was made in
latter part of the year 20X2, it may be difficult
to perform a rollback of quantities physically
verified as on 31st March, 20X2 and reconciling
the same to the quantities as at 31st March,
20X1. In such cases, XYZ could consider the procedures
around valuation of opening inventory,
verification of management papers on physical
verification of inventory and cut-off.

6. For non-current assets such as plant and machinery,
furniture and fixtures, audit evidence
relating to these captions obtained during the
course of audit for the year ended 31st March,
20X2 could provide assurance on underlying
opening balances. The title deeds/agreement
for sale could be examined to obtain comfort
over opening balance for land.

7. For long-term debt, review of loan agreement,
charge documents and trail of receipt of funds
could provide evidence of the existence of
the loan as at 31st March, 20X1. The source
and application of loan amounts would also
be reviewed for the purpose of reporting in
the Companies Auditor’s Report Order, 2003
(CARO).

8. XYZ would need to ensure that the accounting
policies which are appropriate for opening balances
are consistently applied to the current
period financial statements, so in the instant
case, the policy on depreciation and inventory
valuation which was followed for the year ended
31st March, 20X1 should be consistently applied
for the year ended 31st March, 20X2 as well.

9. XYZ may consider stating in an Other Matter
paragraph in the auditor’s report that the corresponding
figures (for the year ended 31st
March, 20X1) were audited by another auditor
whose report expressed an unqualified opinion
on those statements. Such a statement does
not, however, relieve XYZ of the requirement
to obtain sufficient appropriate audit evidence
that the opening balances do not contain misstatements
that materially affect the financial
statements for the year ended 31st March, 20X2.

Analysis – II

1. XYZ was appointed as auditors of ABC in March,
20X2 and thus, did not observe the counting
of the physical inventories at the beginning of
the year. XYZ was also unable to obtain assurance
by alternative means concerning inventory
quantities held at 31st March, 20X1 in view of
the database issue. Since opening inventories
enter into the determination of the results of
operations and cash flows from operating activities,
in the absence of adequate alternative
audit procedures, XYZ would need to consider
whether to issue a qualified/modified opinion
for the year ended 31st March, 20X2.

Analysis – III

1. In India, the Code of Ethics prohibits a
Chartered Accountant in practice from
disclosing information acquired in the course
of his professional engagement to any

person other than his client. As such, an auditor
cannot provide access to his working papers
to another auditor. Therefore, keeping in view
the requirements of Code of Ethics, XYZ may
not be able to review working papers of PQR.

2. It may be noted that the draft revised Code of
Ethics finalised by the Ethical Standards Board
(ESB) of the ICAI in January, 2014 proposes that
disclosure of client information by a member
would be appropriate where such disclosure is
required by law and is authorised by the client
or where disclosure is required for compliance
with technical standards.

Analysis – IV

1. The fact that previous period’s figures were unaudited
does not absolve XYZ from its responsibility
of obtaining evidence on opening balances.
XYZ should consider including under an Other
Matter paragraph in the auditor’s report stating
that the corresponding figures are unaudited.

Concluding remarks

Compliance of SA 510 would enable an auditor
to satisfy himself that the opening balances do
not contain misstatements that materially affect
the current period’s financial statements and appropriate
and consistent accounting policies are
followed in both the prior and current periods.
This would also increase the credibility of the financial
statements by ensuring comparability even
though the auditors may have changed during the
year. As is the practice internationally, review of
work papers of predecessor auditor by successor
auditor is a proposition worth considering, more
so in light of audit rotation requirements stipulated
in the Companies Act, 2013. Such disclosure
of client information could be subject to the adequate
safeguards in terms of prior consent with
the client, hold harmless agreements
etc. This is
a subject matter which may gain more traction
in coming times.

shailesh.kwebmaker

Practical insights into accounting for certain revenue arrangements

The revenue recognition principles as discussed under Ind AS provide elaborate guidance on various types of arrangements that may be applicable to select class of companies or to most companies in general. In this article, we focus on the guidance provided under appendix B (Customer Loyalty Programmes) and C (Transfer of Assets from Customers) to Ind AS 18 on Revenue, sharing our perspectives on the accounting for the said arrangements.

Customer loyalty programmes
Customer loyalty programmes, comprising loyalty points or ‘award credits’, are offered by a diverse range of businesses, such as supermarkets, retailers, airlines, telecommunication operators, credit card providers and hotels. Award credits may be linked to individual purchases or groups of purchases, or to continued custom over a specified period. The customer can redeem the award credits for free or discounted goods or services.

The structure of loyalty programmes offered by sellers varies, but in general they can be classified into one of the following schemes:

Award credits earned can be redeemed only for goods and services provided by the issuing entity.
Award credits earned can be redeemed for goods and services provided either by the issuing entity or by other entities that participate in the loyalty programme.

For a programme to be accounted as a customer loyalty programme, it needs to contain two essential features:

the entity (seller) grants award credits to a customer as part of a sales transaction; and
subject to meeting any other conditions, the customer can redeem the award credits for free or discounted goods or services in the future.

For instance, a customer receives a complimentary product with every fifth product bought from the entity (seller). As the customer purchases each of the first five products, they are earning the right to receive a free good in the future, i.e., each sales transaction earns the customer credits that go towards free goods in the future.

However, it may be noted that not all types of programmes that provide free or discounted goods are accounted as customer loyalty programmes. For instance, say a purchase of membership of a club entitles a member to purchase certain goods or services at a discounted price. In such case, the substance of such membership needs to be evaluated closely. It may seem that the purchase of membership may not be a separate transaction and the amount received by the club may be against purchase of those discounts themselves.

Accounting for customer loyalty programmes
Deferral of revenue
Under Ind AS, the award credits (i.e., air miles, credit card points, etc.) under customer loyalty programmes are not recognised as sales promotion or any other expense. Instead, they are recognised as a separate component within a multiple element revenue arrangement. As such, the revenue under the sales arrangement is allocated to one or more elements, including the award credit. At the inception of the arrangement, the revenue attributable to the award credit is deferred and is recognised as and when the award credits are redeemed by the customer. The revenue attributed to the award credits takes into account the expected levels of redemption.

Allocation of revenue to award credits
Ind AS requires that the consideration received or receivable from the customer is allocated between the current sales transaction and the award credits by reference to fair values. The Ind ASs do not prescribe a particular allocation method. However, the following two methods provided under IFRS may also be applied under Ind ASs:

relative fair values; or
fair value of the award credits (residual or fair value method).

Using relative fair values, the total consideration is allocated to the different components based on the ratio of the fair values of the components relative to each other. For instance, assume a transaction comprises two components, X and Y. If the fair value of component X is 100 and of component Y is 50, then two-thirds of the total consideration would be allocated to component X. If the total consideration is 120, then revenue of 80 would be allocated to component X and 40 to Y.

Using the residual method, the undelivered components are measured at fair value, and the remainder of the consideration is allocated to the delivered component. For example, assume a transaction consists of two components, X and Y; at the reporting date only component X has been delivered. If the fair value of component Y is 50 and the total consideration is 120, then revenue of 70 would be allocated to component X and 50 to Y.

In estimating fair value, the entity (seller) takes into account:

the amount of the discounts or incentives that would otherwise be offered to customers who have not earned award credits from an initial sale; and
the proportion of award credits expected not to be redeemed, i.e., expected forfeitures.

Other estimation techniques may be available. For example, if an entity (seller) pays a third party to supply the awards, then the fair value of the award credit could be estimated by reference to the amount that the entity pays plus a reasonable profit margin. However, judgment is required to select and apply the estimation technique that is most appropriate in the circumstances.

Accounting for revenue related to award credit The revenue attributable to the award credit (that was deferred at inception) shall be recognised as such in the income statement as and when the awards are redeemed.

Any subsequent change in the estimates of awards expected to be redeemed are trued up for differences between the number of awards expected to be redeemed and the actual number of awards redeemed; the amount of revenue deferred at the time of the original sale is not recalculated.

Steps involved in accounting for customer loyalty programmes
Having discussed the principles of revenue recognition relating to the customer loyalty programmes, the following are the broad steps involved in accounting for the same:
1. Understand the various customer loyalty programmes in effect.

2. Identify the deliverables in the different programmes. Along with the principal goods, the deliverables could be supply of own goods free of cost or at a discounted price in future, supply of promotional gifts based on the level of purchases made by the customer, gift coupons which can be redeemed as a discount on future purchases, award credits, etc.

3. Identify the fair value of the goods sold and the award credit. The fair value of the award credit to be determined based on expected level of redemption, after considering the market price of the award and the amount of the discounts or incentives that would otherwise be offered to customers who have not earned award credits from an initial sale.

4. The appropriate method of allocation of consideration to award credit needs to be chosen. There are mainly two methods to allocate values to the components of a multiple deliverable arrangement: — Relative fair value method — Fair value of the undelivered component.

5. Once the value of the deliverables has been assigned as above, the management then needs to recognise revenue for the delivered goods at its fair value allocated as above and defer revenue equivalent to the allocated fair value of the award credit.

6. Once the fair value allocation is determined as above, the consideration allocated to sale of goods is not subsequently re-assessed based on change in estimates of forfeiture rate. The change in estimates of forfeiture rate only affects the pattern of recognition of revenue relating to the award credits.

7. For the undelivered item (i.e., the award credit) the revenue would have to be deferred till the date of actual redemption. On redemption, the revenue attributable to the award credits is recognised.

Let us understand the above principles with the help of an example:

Company X runs a loyalty scheme rewarding a customer’s spend at its stores. Under this scheme, customers are granted 10 loyalty points (or award credits) for every 100 spent in X’s store. Customers can redeem their points for a discount in the price of a new product in X’s stores. The loyalty points are valid for five years and 50 points entitle a customer to a discount of 50 on the retail price of the product in X’s store.

During 2011, X has sales of 500,000 and grants 50,000 loyalty points to its customers. Based on the expectation that only 40,000 loyalty points will be redeemed, management estimates the fair value of each loyalty point granted to be 0.80. During 2011, 15,000 points were redeemed in exchange for new products, and at the end of the reporting period management still expected a total of 40,000 points to be redeemed, i.e., a further 25,000 points will be redeemed.

X records the following entries in 2011 in relation to the loyalty points granted in 2011:

Particulars

Debit

Credit

Bank

Dr.

500,000

To Revenue

460,000

To Deferred Revenue

40,000

(50,000*0.8)

(Being revenue recognised in relation to sale of goods and deferred
revenue for loyalty points)

At the end of the reporting period, the balance of the deferred revenue is 25,000 [(25,000/40,000) x 40,000]. Therefore, the difference in the deferred revenue balance is recognised as revenue for the year.

Particulars

Debit

Credit

Deferred revenue

Dr.

15,000

To Revenue

15,000

(Being revenue recognised in relation to 15,000 loyalty points
redeemed in 2011)

During 2012, 17,500 points are redeemed, and at the end of the year management expects a total of 42,500 points to be redeemed, i.e., an increase of 2,500 over the original estimate. The fair value of each award credit does not change, but the redemption rate is revised based on the new total expected redemptions. At the end of the year, the balance of deferred revenue for 10,000 loyalty points (i.e., 42,500 — 15,000 — 17,500) is 9,412 [(10,000/42,500) x 40,000]. X records the following entry in 2012 in relation to the loyalty points granted in 2011:

Particulars

Debit

Credit

Deferred revenue

Dr.

15,588

(25,000 – 9,412)

To Revenue

15,588

(Being revenue
recognised in relation to loyalty points redeemed in 2012)

Alternatively, on a cumulative basis 30,588 has been released, which can be calculated as (32,500/ 42,500) x 40,000.

Transfer of assets from customers
Ind AS 18 provides guidance on transfers of property, plant and equipment (or cash to acquire it) for entities that receive such assets from their customers in return for a network connection and/or an ongoing supply of goods or services. As such, the principles contained hereunder do not apply to gratuitous transfers of assets i.e., transfer of assets without consideration. Further, the guidance also cannot be applied to transfers that are in the nature of government grants or those covered under the service concession arrangements.

Concept of control
When the Company receives an item of property, plant and equipment from the customer, it will have to assess if the transferred item meets the definition of the asset from the Company’s perspective. An asset is defined as “an asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity”.

It is important to note that in determining whether an asset exists, the right of ownership is not essential. Therefore, if the customer continues to control the transferred item, the asset definition would not be met despite a transfer of ownership. Hence, the Company must analyse if it has obtained the control of the transferred asset to recognise the same in its books.

Control would imply right to utilise the transferred asset the way Company deems fit. For example, the Company can exchange that asset 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.

As part of the arrangement for transfer of asset from the customer, the arrangement may require that the Company must use the transferred item of property, plant and equipment to provide one or more service to the customer. However, if the Company has the ability to decide how the transferred item of property, plant and equipment is operated and maintained and when it is replaced, it can be concluded that the Company controls the transferred item of property, plant and equipment.

If based on the above principles, it is concluded that the company has obtained control over the asset transferred by the customer, the company shall recognise (debit) the transferred asset as its own asset (though it may not have the ownership). The corresponding impact of the transfer shall be recognised as either revenue or deferred revenue, depending upon the obligations assumed by the company in lieu of the transferred asset.

Timing of revenue recognition
In determining the timing of revenue recognition, the entity (recipient) considers:

what performance obligations it has as a result of receiving the customer contribution;

whether these performance obligations should be separated for revenue recognition purposes; and

when revenue related to each separately identifiable performance obligation should be recognised.

Comprehensive guidance on how to determine the entity’s performance obligations is not provided under the appendix C. In practice it may be difficult to determine whether the entity only has to connect the customer to a network, or it has to provide ongoing access to a supply of goods and services, or both.

All relevant facts and circumstances should be evaluated when determining whether additional performance obligations arise from the transfer including:

whether or not the customer providing the contribution is charged the same fee for the supply of goods or services as is charged to other customers that are not required to make such customer contributions;

whether customers have the ability to change the supplier of goods or services at their discretion; and

whether a successor customer needs to pay a connection fee when the customer that made the customer contribution discontinues the service, and if so, the amount of such connection fee relative to the fair value of the asset contributed.

In our view, in determining whether a rate charged to a customer includes a discount, the entity should compare rates for ongoing services charged to customers that make a contribution with the rates charged to customers that do not.

If it is determined that some or all of the revenue arising from the customer contribution relates to the ongoing supply of goods or services, then the revenue is recognised as those services are delivered. Typically, such revenue is recognised over the term specified in the agreement with the customer. If, however, no such term is specified, then the period of revenue recognition is limited to the useful life of the transferred asset.

Instead of property, plant and equipment, an entity may receive cash that must be used to construct or acquire an item of property, plant and equipment in order to connect the customer to a network and/or provide the customer with ongoing access to a supply of goods or services. The accounting for such cash contributions depends on whether the item of property, plant and equipment to be acquired or constructed is recognised as an asset of the entity on acquisition/completion.

If the asset is not recognised by the entity, then the cash contribution is accounted for as proceeds for providing the asset to the customer under Ind AS 11 or Ind AS 18, as applicable.

If the asset is recognised by the entity, then the asset is recognised and measured as it is constructed or acquired in accordance with Ind AS 16; the cash contribution is recognised as revenue following the guidance as stated above.

Steps involved in accounting for transfer of assets from customers
Having discussed the principles of revenue recognition relating to the transfer of assets from customers, the following are the broad steps involved in accounting for the same:
(1) Analyse all the relevant agreements to identify arrangements covered within this guidance.

(2) Assess whether the control over the transferred asset is obtain by the company. If the control is transferred to the company, the asset will be recognised in the Company’s balance sheet.

(3) Determine the obligations assumed by Company in lieu of the transfer of control over the transferred asset.

(4) If the above-mentioned obligations are in the nature of ongoing services, then revenue attributable to those obligations is deferred and recognised as the underlying services are rendered and obligations fulfilled.

(5) To the extent the above-mentioned obligations are fulfilled at the inception of the contract, recognise appropriate revenue upfront.

(6) Depreciate the acquired asset over its useful life.

Let us understand the above principles with the help of an example:

Company X has entered into an agreement with Company Y to outsource some of its manufacturing process. As part of the arrangement, Company X will transfer the ownership of its machinery to Company Y.

Based on a report submitted by independent valuer, the fair value of assets transferred is Rs. 90,000. Initially, Company Y must use the equipment to provide the service required by the outsourcing agreement. Company Y is responsible for maintaining the equipment and replacing it when it decides to do so. The useful life of the equipment is 3 years. The outsourcing agreement requires service to be provided for 3 years for a fixed price of Rs.10,000 per year which is lower than the price that Company Y would have charged if the equipment had not been transferred. In such case the fixed price would have been Rs.40,000 per annum.

Pursuant to a detailed analysis, Company Y determines that the control over the equipment is transferred in its favour. Hence, Company Y would have to initially recognise the asset at its fair value in accordance with Ind AS 16. Further, Company Y would also have to recognise the revenue over the period of the services performed i.e., over 3 years.

Company Y shall recognise the following journal entries to recognise the transactions under the arrangement:

Particulars

Yr
1

Yr
2

Yr
3

Asset

Dr.

90,000

15,000

To Deferred

90,000

15,000

Revenue (Being transfer of

assets from customer)

Bank

Dr.

10,000

Deferred Revenue

Dr.

30,000

To Revenue

40,000

(Being revenue recognised

under the arrangement)

Depreciation

Dr.

30,000

To acc. depreciation

30,000

(Being assets transferred

from customer depreciated

over its useful life)

Summary
Overall, the implementation of the above guidance on customer loyalty programmes and transfer of assets from customers will require significant judgment in several respects while preparing the entity’s financial statements.

shailesh.kwebmaker

Consolidated Financial Statements presented in accordance with International Financial Reporting Standards (IFRS) (as permitted by SEBI)

Glenmark Pharmaceuticals Ltd. (31-3-2011)

Notes to Consolidated Financial Statements

As permitted by Securities Exchange Board of India (‘SEBI’) Circular CIR/CFD/DIL/1/2010, dated 5th April, 2010 (hereinafter referred to as ‘SEBI Circular’), the Group has voluntarily chosen to present its consolidated financial statements in accordance with International Financial Reporting Standards after taking benefit of the additional exemptions provided vide the SEBI Circular (hereinafter referred to as ‘IFRS’). Accordingly, the Group has :

prepared and presented the financial statements for the year ended 31st March, 2011 in accordance with IFRS instead of the accounting standards specified in section 211(3C) of the Companies Act, 1956 (‘Indian GAAP’);

elected to provide the figures for the comparative period as per Indian GAAP as permitted by the SEBI Circular and not as per IFRS as required by International Financial Reporting Standard 1, ‘First-time adoption of International Financial Reporting Standards’ and International Accounting Standard 1, ‘Presentation of Financial Statements’. However, as the classification of the individual line items is not consistent and comparable between the two periods, the figures for the comparative period are not presented alongside that of the current year. Accordingly, these consolidated financial statements should be read along with the consolidated financial statements for the year ended 31st March 2010 presented in the Annual Report for the year ended 31st March 2010;

not presented reconciliations between the equity and comprehensive income as per IFRS and Indian GAAP for the comparative period, as the Group has not prepared financial information in accordance with IFRS for the comparative period as indicated above; and

not presented a reconciliation of significant differences between the figures as disclosed as per IFRS for the year ended 31st March 2011 and the figures as they would have been if Indian GAAP was adopted for the year ended 31st March 2011 as required by the SEBI Circular as the Group has not prepared consolidated financial statements in accordance with Indian GAAP for this period.

These are the Group’s first financial statements prepared in accordance with IFRS (see Note EE for explanation of the transition to IFRS).

Note EE — Transition to International Financial Reporting Standards

The transition from Indian GAAP to IFRS has been made in accordance with the principles laid down in IFRS 1, First-time Adoption of International Financial Reporting Standards. As elaborated in Note A-2.2, the Group has voluntarily elected to use IFRS as permitted by the SEBI Circular along with the additional exemptions provided therein. Accordingly, the Group has transitioned to IFRS with 1st April 2010 being the date of transition.

1. First-time adoption exemptions applied

Upon transition, IFRS 1 permits certain exemptions from full retrospective application. The Group has applied the mandatory exceptions and certain optional exemptions, as set out below.

Mandatory exceptions adopted by the Group

(i) Financial assets and liabilities that had been de-recognised before 1st April 2010 under Indian GAAP have not been recognised under IFRS.

(ii) The Group has used estimates under IFRS that are consistent with those applied under Indian GAAP (with adjustment for accounting policy differences), unless there is objective evidence those estimates were in error.

Optional exemptions applied by the Group

(i) The Group has elected not to apply IFRS 3R Business Combinations retrospectively to business combinations that occurred before the date of transition 1st April 2010.

(ii) The Group has elected to use fair value as deemed cost at the date of transition for some items of property, plant and equipment (see Note H).

(iii) The Group has elected to use facts and circumstances existing at the date of transition to determine whether an arrangement contain a lease. No such assessment was done under Indian GAAP.

(iv) The Group has elected to designate some financial assets as available for sale at the date of transition. The Group has not taken the exemption to designate some financial instruments at fair value through profit or loss.

(v) The Group has elected to recognise all cumulative actuarial gains and losses for its defined benefit plans at the date of transition. Further, the Group has elected to use the exemption not to disclose defined benefit plan surplus/deficit and experience adjustment before the date of transition.

The following reconciliation and explanatory notes thereto describe the effect of the transition on the IFRS opening statement of financial position as at 1st April 2010. All explanations should be read in conjunction with the IFRS accounting policies of Glenmark Group as disclosed in Note A-3.

The reconciliation of the Group’s equity reported under Indian GAAP to its equity under IFRS as at 1st April 2010 may be summarised as follows:

Notes to the reconciliation

2. Foreign currency convertible bonds (FCCBs)

The Company had outstanding ‘zero coupon’ FCCBs as on 1st April 2010. Under Indian GAAP, the Company had chosen to adjust these premium payable on redemption to the additional paid-in capital. As per IAS 32, FCCBs issued by the Company are treated as a liability with an embedded derivative for the call option for conversion to equity shares. Finance costs for the period and the related liability has been computed using the effective interest rate method. The liability is re-measured at amortised cost at each reporting period. Further, the embedded derivative is fair value at the date of transition. Accordingly, the adjustments have been made to retained earnings.

3. Share-based compensation

According to IFRS 2 — Share-based Payments, the Group has recognised share-based payments on fair value and has made an adjustment in the opening statement of financial position by charging such cost to retained earnings.

Under Indian GAAP the Group had an option to account for these options at intrinsic value and therefore no such cost was required to be recognised in the Income statement.

4. Fixed Assets (Including Intangible assets)

(a) Intangible assets

Derecognition of intangible assets

On transition to IFRS, the Group undertook a detailed evaluation of its portfolio of product development assets and intangibles under development, which were previously classifieds intangibles and capital work-in-progress under Indian GAAP. Based on such evaluation, the Group determined that certain products/projects had been de- prioritised and that no future economic benefits were expected to flow to the Group from these products or products being developed under such projects. Accordingly such products/projects did not qualify to be carried forward as intangible assets and accordingly have been derecognised. The Group also determined that the de-prioritisation and the conditions considered for this evaluation excited prior to the date of opening statement of financial position and accordingly, theses intangible assets have been derecognised in the preparation of the opening statement of financial position with a corresponding adjustment to retained earnings as this adjustment relates to earlier periods. (Also refer note 1 on Intangible Assets.)

Reclassification of intangible assets
On transition to IFRS, the Group has reclassified certain assets into intangible assets. These assets were previously classified as fixed tangible assets and their classification has been rectified on preparation of the opening statement of financial position. (Also refer Note H on ‘Property, Plan and Equipment’.)

(b) Property, plant and equipment

Election to use of fair value as deemed cost

At the date of transition, the Group elected to measure some items of assets within property, plant and equipment at fair value as deemed cost. The items of assets fair valued include freehold land, factory and other buildings, plant and machinery and equipments. Depreciation under IFRS is based on this deemed cost. (Also refer Note H on ‘Property, Plant and Equipment’.)

Depreciation

Further, depreciation under Indian GAAP was computed by assigning a life to each item of property, plant and equipment. However, under IFRS, the Group has identified the cost/deemed cost of each significant part item of property, plant and equipment and assigned an estimate of useful life to each such significant part. Accordingly, the depreciation has been recomputed.

5. Non-controlling interest

Under Indian GAAP, financial statements are prepared as per the requirements of Schedule VI of The Companies Act, 1956. Under Schedule VI, non-controlling interest is not included in the total stockholders’ equity and is disclosed separately on the face of the statement of financial position.

On transition to IFRS, the Group has included the non-controlling interest in the statement of equity under the total stockholders’ equity. Further, the non-controlling interest under IFRS has been calculated using the minority’s share of the net assets of the subsidiary.

6. Proposed dividend

In preparation of the financial statements in accordance with Indian GAAP, the Company provided for proposed dividend and tax thereon to comply with the Schedule VI requirements of the Companies Act, 1956. On transition to IFRS, proposed dividend is recognised based on the recognition principles of IAS 37 — ‘Provisions, Contingent Liabilities and Contingent Assets. Considering that the dividend has been proposed after the date of statement of financial position and becomes payable only after approval by the shareholders, there is no present obligation to pay this dividend as at the date of statement of financial position. Accordingly, the liability for proposed dividend and tax thereon has been reversed.

7. Deferred tax

Deferred tax assets and liabilities under Indian GAAP were recorded only on timing differences. However, on transition to IFRS, deferred tax assets and liabilities are recorded on temporary differences. Further, on transition to IFRS, the carrying values of assets and liabilities have undergone a change as a result of the adjustments indicated above, and accordingly, the deferred tax position has been recomputed after considering the new carrying amounts.

8. Presentation differences

In the preparation of these IFRS financial statements, the Group has made several presentation differences between Indian GAAP and IFRS. These differences have no impact on reported profit or total equity. Accordingly, some assets and liabilities have been re-classified into another line item under IFRS at the date of transition. Further, in these financial statements, some line items are described differently (renamed) under IFRS compares to Indian GAAP, although the assets and liabilities included in these line items are unaffected.

From Auditors’ Report on International Financial Reporting Standards

3. We report that the consolidated financial statements have been prepared by Glenmark Group’s management in accordance with the requirements of International Accounting Standard 27, ‘Consolidated and Separate Financial Statements’ forming part of International Financial Reporting Standards (‘IFRS’) as permitted by SEBI Circular CIR/ CFD/DIL/1/2010, dated 5th April 2010 (‘SEBI Circular’).

4. As described in Note A-2.2 to the consolidated financial statements, in the preparation of its first financial statements in accordance with International Financial Reporting Standards, Glenmark Group has not presented any financial information for the comparative period as required by SEBI Circular.

5. As described in Note A-2.2 to the consolidated financial statements, Glenmark Group has not presented a reconciliation of significant differences between the figures as disclosed as per IFRS and the figures as they would have been if the notified Indian Accounting Standards were adopted, as required by SEBI Circular.

6. Based on our audit and consideration of report of other auditors on financial statements and on the other financial information of the components, and to the best of our information and according to the explanations given to us, we are of the opinion that, subject to the omission of the disclosures described in paragraphs 4 and 5 above, subject to the omission of the disclosers described in para 4 and 5 above, the attached consolidated financial statements give a true and fair view in conformity with International Financial Reporting Standards as permitted vide SEBI circular:

shailesh.kwebmaker

GAPS IN GAP — Acounting for eviction costs by lesors

Issue What is the accounting treatment, from a lessor’s perspective, for costs incurred by the lessor to evict tenants? Are these costs capitalised or expensed as incurred?

Scenario 1
A lessor makes compensation payments to evict the tenants in an investment property with the intention to refurbish/renovate the property.

Scenario 2
A lessor makes a compensation payment to evict a tenant in a multi-tenanted investment property with the intention to re-let the vacated space to a new tenant. The lessor has signed an agreement with the new tenant to occupy the space that the existing tenant is occupying. Under the agreement, the new tenant will pay a significantly higher rent than the existing tenant.

Scenario 3
The same fact pattern as Scenario 2, except that the lessor has not yet found a new tenant when it evicts the existing tenant.

Relevant literature
Under Indian GAAP the following accounting literature is relevant for concluding on this fact pattern.

Paragraph 20 & 21 of AS-10 Accounting for Fixed Assets

Paragraph 20 : The cost of a fixed asset should comprise its purchase price and any attributable cost of bringing the asset to its working condition for its intended use.

Paragraph 21 : The cost of a self-constructed fixed asset should comprise those costs that relate directly to the specific asset and those that are attributable to the construction activity in general and can be allocated to the specific asset.

Paragraph 31 & 42 of AS-19 Leases Paragraph 31 : Initial direct costs, such as commissions and legal fees, are often incurred by lessors in negotiating and arranging a lease. For finance leases, these initial direct costs are incurred to produce finance income and are either recognised immediately in the statement of profit and loss or allocated against the finance income over the lease term.

Paragraph 42 : Initial direct costs incurred specifically to earn revenues from an operating lease are either deferred and allocated to income over the lease term in proportion to the recognition of rent income, or are recognised as an expense in the statement of profit and loss in the period in which they are incurred.

Author’s view Scenario 1 View A — Expense the eviction costs as incurred

The eviction costs are costs of terminating the existing lease. Therefore, they should be expensed as incurred.

View B — Capitalise the eviction costs It is necessary for the lessor to make eviction payments to the existing tenants in order to refurbish the property. The eviction costs are directly attributable to the property and meet the definition of construction costs of the property and are costs required to bring the asset to “the condition necessary for it to be capable of operating in the manner intended by management”. Therefore, the costs should be capitalised.

Considering paragraph 20 & 21 of AS-10, the author believes that View B is more appropriate.

Scenario 2
View A — Expense the eviction cost as incurred

The eviction cost is a cost of terminating the existing lease, and does not represent a cost of the underlying investment property. Therefore, it should be expensed as incurred.

View B — Eviction costs are initial direct costs and hence can be either capitalised or expensed

Since the lessor has signed an agreement with a new tenant, it must evict the existing tenant in order to allow the new tenant to move into the property. The eviction cost is an initial direct cost incurred by the lessor to arrange the new lease.

For a lessor, paragraph 31 in the case of a finance lease and paragraph 42 in the case of an operating lease, allows either expensing or amortisation of the eviction cost. For finance leases, these eviction costs are incurred to produce finance income and are either recognised immediately in the statement of profit and loss or allocated against the finance income over the lease term. In case of operating lease, eviction costs are either deferred and allocated to income over the lease term in proportion to the recognition of rent income or expensed as incurred.

Hence, for scenario 2, the author believes that the eviction costs are initial direct costs and could be either expensed or capitalised (View B). Nonetheless, some may argue that initial direct costs include expenses such as legal fees and commission (as per paragraph 31) and not eviction costs. Hence they may favour View A, which requires compulsorily expensing as those costs are incurred.

Scenario 3
In the absence of a secured new lease contract the eviction of existing tenants and the costs incurred thereon would not constitute initial direct costs of entering into a new lease arrangement. Consequently, the author believes that such costs should not be capitalised. Nonetheless, some may still argue that under the Framework for the Preparation and Presentation of Financial Statements “An asset is a resource controlled by the enterprise as a result of past events from which future economic benefits are expected to flow to the enterprise.” Therefore, based on the asset definition in the framework, some may argue, it is possible to capitalise and amortise such eviction costs.

Considering that these issues are highly debatable the ICAI may consider providing guidance.

levitra

shailesh.kwebmaker

Infosys Limited (quarter ended 30th June 2011)

Income taxes

The provision for taxation includes tax liabilities in India on the Company’s global income as reduced by exempt incomes and any tax liabilities arising overseas on income sourced from those countries. Infosys’ operations are conducted through Software Technology Parks (‘STPs’) and Special Economic Zones (‘SEZs’). Income from STPs are tax exempt for the earlier of 10 years commencing from the fiscal year in which the unit commences software development, or 31st March, 2011. The tax holiday for all of our STP units has expired as of 31st March, 2011. Income from SEZs is fully tax exempt for the first five years, 50% exempt for the next five years and 50% exempt for another five years subject to fulfilling certain conditions. For Fiscal 2008 and 2009, the Company had calculated its tax liability under Minimum Alternate Tax (MAT). The MAT credit can be carried forward and set-off against the future tax payable. In fiscal 2010, the Company calculated its tax liability under normal provisions of the Income-tax Act and utilised the brought forward MAT Credit.

The Company is contesting the demands and the Management, including its tax advisors, believes that its position will likely be upheld in the appellate process. No tax expense has been accrued in the financial statements for the tax demand raised. The Management believes that the ultimate outcome of this proceeding will not have a material adverse effect on the Company’s financial position and results of operations.

As of the Balance Sheet date, the Company’s net foreign currency exposures that are not hedged by a derivative instrument or otherwise is Rs.1,024 crore (Rs.1,196 crore as at March 31, 2011).

The foreign exchange forward and option contracts mature between 1 to 12 months. The table below analyses the derivative financial instruments into relevant maturity groupings based on the remaining period as of the balance sheet date :

The Company recognised a gain on derivative financial instruments of Rs.37 crore and a loss on derivative financial instruments of Rs.69 crore during the quarter ended June 30, 2011 and June 30, 2010, respectively, which is included in other income.

2.22 Quantitative details

The Company is primarily engaged in the development and maintenance of computer software. The production and sale of such software cannot be expressed in any generic unit. Hence, it is not possible to give the quantitative details of sales and certain information as required under paragraphs 5(viii)(c) of general instructions for preparation of the statement of profit and loss as per revised Schedule VI to the Companies Act, 1956.

2.25 Dividends remitted in foreign currencies
The Company remits the equivalent of the dividends payable to equity shareholders and holders of ADS. For ADS holders the dividend is remitted in Indian rupees to the depository bank, which is the registered shareholder on record for all owners of the Company’s ADSs. The depositary bank purchases the foreign currencies and remits dividends to the ADS holders.

The particulars of dividends remitted are as follows :

Not reproduced.

2.28 Segment reporting
The Company’s operation predominantly relates to providing end-to-end business solutions, thereby enabling clients to enhance business performance, delivered to customers globally operating in various industry segments. Effective this quarter, the company reorganised its business to increase its client focus. Consequent to the internal reorganisation there were changes effected in the reportable segments based on the ‘management approach’, as laid down in AS-17, Segment reporting. The Chief Executive Officer evaluates the company’s performance and allocates resources based on an analysis of various performance indicators by industry classes and geographic segmentation of customers. Accordingly, segment information has been presented both along industry classes and geographic segmentation of customers. Accordingly, segment information has been presented both along industry classes and geographic segmentation of customers, industry being the primary segment. The accounting principles used in the preparation of the financial statements are consistently applied to record revenue and expenditure in individual segments, and are as set out in the significant accounting policies.

Industry segments for the company are primarily financial services and insurance (FSI) comprising enterprises providing banking, finance and insurance services, manufacturing enterprises (MFG), enterprises in the energy, utilities and telecommunication services (ECS) and retail, logistics, consumer product group, life sciences and health care enterprises (RCL). Geographic segmentation is based on business sourced from that geographic region and delivered from both on-site and offshore. North America comprises the United States of America, Canada and Mexico, Europe includes continental Europe (both the east and the west), Ireland and the United Kingdom, and the Rest of the World comprising al both places except those mentioned above and India. Consequent to the above change in the composition of reportable segments, the prior year comparatives have been restated.

Revenue and identifiable operating expenses in relation to segments are categorised based on items that are individually identifiable to that segment. Allocated expenses of segments include expenses incurred for rendering services from the company’s offshore software development centers Certain expenses such as depreciation, which form a significant component of total expenses, are not specifically allocable to specific segments as the underlying assets are used interchangeably. Management believes that it is not practical to provide segment disclosures relating to those costs and expense, and accordingly theses expenses are separately disclosed as ‘unallocated’ and adjusted against the total income of the company.

Fixed assets used in the Company’s business or liabilities contracted have not been identified to any of the reportable segments, as the fixed assets and services are used interchangeably between segments. Accordingly, no disclosure relating to total segment assets and liabilities are made. Geographical information on revenue and industry revenue information is collated based on individual customer invoiced or in relation to which the revenue is otherwise recognised.

Industry segments
Not reproduced.

Geographic segments
Not reproduced.

2.29 Gratuity plan
The following table set out the status of the Gratuity Plan as required under AS-15 :
Not reproduced.

2.30 Provident fund
The Guidance on Implementing AS-15, Employee Benefits (revised 2005) issued by Accounting Standards Board (ASB) states that benefits involving employer established provident funds, which require interest shortfalls to be recompensed are to be considered as defined benefit plans. Pending the issuance of the final guidance note from the Actuarial Society of India, the Company’s actuary has expressed an inability to reliably measure provident fund liabilities. Accordingly the Company is unable to exhibit the related information.

The Company contributed Rs.51 crore towards provident fund during the quarter ended 30th June, 2011 (Rs.43 crore during the quarter ended 30th June, 2010).

2.31 Superannuation

The Company contributed Rs.15 crore to be superannuation trust during the quarter ended 30th June, 2011 (Rs.14 crore during the quarter ended 30th June, 2010).

2.32 Reconciliation of basic and diluted shares used in computing earnings per share

2.33 Restricted deposits

Deposits with financial institutions as at June 30, 2011 include Rs.351 crore (Rs.431 crore and Rs.344 crore as at 30th June, 2010 and 31st March, 2011, respectively) deposited with Life Insurance Corporation of India to settle employee-related obligations as and when they arise during the normal course of business. This amount is considered as restricted cash and is hence not considered ‘cash and cash equivalents’.

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GAPS in GAAP — Accounting for an operating lease that containS contingent rentals

Issue
How does a lessee and a lessor account for a rent-free period in an operating lease with rental amounts that are entirely contingent (e.g., a percentage of sales)?

Fact pattern
A lessee enters into a new lease agreement for retail property with a lessor. The lease agreement has a term of 5 years with no renewal or purchase option. No rents are due for the first year (the ‘rent-free’ period). For years 2 through 5, the rent is set at 18% of the lessee’s annual sales, with no minimum rent payable. The rental rate will not be revised during the lease term, i.e., there are no market resets or other adjustments during the lease term. (The lease agreement actually states that rent is set at 18% of annual sales, and the lessor has agreed to forego the first year’s rent as an incentive to the lessee to enter into the lease.)

Analysis
Paragraph 3 of AS-19 defines contingent rent as that portion of the lease payments that is not fixed in amount but is based on a factor other than just the passage of time (e.g., percentage of sales, amount of usage, price indices, market rates of interest, etc.).

Contingent rents are not included in the definition of minimum lease payments, and hence do not determine whether a lease is a finance lease or operating lease. In the case of an operating lease, with regards to the lessee, paragraph 25(c) requires disclosure of lease payments recognised in the statement of profit or loss for the period, with separate amounts for minimum lease payments and contingent rents. Similarly, with regards to the lessor, paragraph 46(c) requires disclosure of total contingent rents recognised as income in the statement of profit and loss for the period. In other words, in the case of an operating lease, the disclosure requirements both for the lessor and the lessee seem to suggest that the accounting of contingent rent should be in the period to which they relate to.

Further, AS-19 requires straightlining of operating lease income/expense. The relevant paragraphs are reproduced below:

23. Lease payments under an operating lease should be recognised as an expense in the statement of profit and loss on a straightline basis over the lease term, unless another systematic basis is more representative of the time pattern of the user’s benefit.

40. Lease income from operating leases should be recognised in the statement of profit and loss on a straight-line basis over the lease term, unless another systematic basis is more representative of the time pattern in which benefit derived from the use of the leased asset is diminished.

View 1 — All payments under the lease are considered contingent rent

The lessee and lessor record the actual rent amounts as expenses and income when they are incurred. In the fact pattern above, the lessee does not record any rent expense in year 1. For years 2 through 5, the lessee recognises rent expense, calculated as 18% of its annual sales, as amounts are incurred (i.e., as sales occur). Consistent with the amounts of rent recorded by the lessee, the lessor does not record any rent income in year 1; for years 2 through 5, the lessor recognises rental income, calculated as 18% of the lessee’s annual sales, as earned.

Reasons for View 1
AS-19 is not explicit in the treatment of contingent elements of operating lease rentals, and whether straightlining would be required.

Paragraph 3 of AS-19 excludes contingent rents from the determination of minimum lease payments for ascertaining rental income in finance leases. Notwithstanding that AS-19 uses different terminology to describe the determination of rental income for finance leases (‘minimum lease payments’) and operating leases (‘lease income’), it is inappropriate to purport that contingent rents cannot be determined for ascertaining total finance lease revenue but that they could be determined for ascertaining total operating lease revenue. Accordingly, lease payments or receipts under operating leases exclude contingent amounts.

A similar issue was also discussed by IFRIC in the context of similar IFRS standard. In its May 2006 meeting, the IFRIC considered a request for clarification of the requirements of IAS 17 with respect to contingent rentals. In particular, the IFRIC was asked to consider whether an estimate of contingent rentals payable/receivable under an operating lease should be included in the total lease payments/lease income to be recognised on a straight-line basis over the lease term. The IFRIC noted that although the standard is unclear on this issue, a consistent application is being adopted; that is, current practice is to exclude contingent rentals from the amount to be recognised on a straight-line basis over the lease term. Accordingly, the IFRIC decided not to add the issue to its agenda.

In practice, contingent rent payments or receipts made in connection with operating leases are recognised in the period in which they are incurred. Since no rent is paid in year 1 of the lease, no expense/income is recorded in the first year. Importantly, no amount of rent is due or receivable based upon sales in year 1 and such rents only accrue upon the future sales after year 1 (i.e., sales in years 2 through 5). In years 2 through 5, the contingent amounts are recognised as expense/income when they are incurred.

View 2 — The rent-free period is taken into consideration to determine lease expense/income

The rent-free period is taken into consideration to determine the rent expense and income for each period. In the fact pattern above, the lessee amortises the rent-free benefit (determined either based on expected sales for year 1 or actual sales for year 1) over the term of the lease on a straight-line basis.

Assume that sales in the first year are approximately Rs.1,945,000. Using the contingent rental rate applicable for years 2 through 5, the incentive related to the rent-free period is calculated as Rs. 350,000 (Rs.1,945,000 x 18%). Since the term of the lease is 5 years, the annualised benefit for the lessee is Rs.70,000. The lessee accrues rent payable of Rs.280,000 (total incentive of Rs.350,000 less amortisation of year 1 benefit of Rs.70,000) in year 1 and recognises that amount as rent expense in year 1. The accrued amount is amortised as a reduction of rental expense (i.e., the amounts due based on the sales in each year) over the remaining years.

Similarly, the lessor recognises lease income and a receivable of Rs.280,000 in year 1 and amortises the accrued amount as a reduction of rental income (i.e., the amounts receivable based on the sales in each year) over the remaining years.

Reasons for View 2
Accounting for the rent-free period in the above manner is consistent with the requirement of paragraph 23 and 40 of AS-19. The rent-free period, is an integral part of the net consideration agreed for the property and it should be recognised on a systematic basis over the term of the lease, even though the rent receipts or payments in the lease are all contingent on performance.

Even though the IFRS Interpretations Committee concluded in its May 2006 meeting that current practice was to exclude contingent amounts from operating lease receipts or payments, it noted that IAS 17 is ‘unclear’ as to whether an estimate of contingent rent under an operating lease should be included in the total lease consideration to be recognised on a straight-line basis over the lease term.

Applying paragraphs 23 and 40 of AS -19, the view reflects the notion that if there was no rent-free period, the parties to the lease agreement would have revised the annual rent payable to be based on a lower percentage of a performance indicator (i.e., in the fact pattern above, less than 18% of sales). The recognition of the rent-free benefit or cost over the lease term results in a pattern of expense or income recognition that is similar to a lease that has no rent-free period.

Accordingly, the benefit of such an incentive should be quantified, and recognised over the lease term on a straight-line basis (unless another systematic basis is more appropriate).

Author’s view

The author favour’s View 1, because it is rather improbable that the intention of the standard was to require straightlining of lease rentals that were contingent in nature. Straightlining requires knowing in advance the rentals for all the years covered by the operating lease arrangement. In an arrangement that is fully contingent, and there are no fixed or minimum or guaranteed payments, straightlining may not be appropriate.

View 2 may be possible under Ind-AS and IFRS. For example, in IFRS for operating leases, paragraph 5 of SIC 15 Operating Leases — Incentives states that: “All incentives for the agreement of a new…. operating lease shall be recognised as an integral part of the net consideration for the use of the leased asset, irrespective of the incentive’s nature or form or the timing of payments.”

The incentives in the paragraph above include a rent-free period, as reflected in paragraph 1 of SIC 15: “In negotiating a new or renewed operating lease, a lessor may provide incentives for the lessee to enter into the agreement. Examples of such incentives are…..

Alternatively, initial periods of the lease term may be agreed to be rent-free or at a reduced rent.”

Under SIC 15, the lessee and the lessor recognise the aggregate benefits of incentives in the following manner: “The lessee shall recognise the aggregate benefit of incentives as a reduction of rental expense over the lease term, on a straight-line basis, unless another systematic basis is representative of the time pattern of the lessee’s benefit from the use of the leased asset.” (SIC 15.5).

“The lessor shall recognise the aggregate cost of incentives as a reduction of rental income over the lease term, on a straight-line basis, unless another systematic basis is representative of the time pattern over which the benefit of the leased asset is diminished.” (SIC 15.4).

It may be noted that Ind-AS also contains similar requirements.

ICAI may consider addressing this issue both under Indian GAAP and Ind-AS.

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Gaps in GaAp – Presentation of Changes in Accounting Policies in Interim Periods

Synopsis

In this article, the author has touched upon a case of prevailing inconsistencies in the Indian GAAP and the listing agreement. The question raised here is whether changes in accounting policies should be disclosed by way of restatement of results of the earlier periods, while presenting quarterly financial results prepared as per the listing agreement requirements. This question has been analysed by taking into account AS-5, AS-25 and Clause 41 of the Listing Agreement. Read on for the analysis made by the author and a brief comparison with IFRS.

Question

How are changes in accounting policies (other than those required on adoption of new accounting standards) presented in the quarterly financial results prepared as per the listing agreement requirements? Is the impact of change in accounting policy on earlier periods disclosed as a one line item in the current interim period or reflected by restating the financial results of the prior interim periods? Response Let us first consider the requirements of various standards.

AS 5 – Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies

Paragraph 32

Any change in an accounting policy which has a material effect should be disclosed. The impact of, and the adjustments resulting from, such change, if material, should be shown in the financial statements of the period in which such change is made, to reflect the effect of such change.

Paragraph 33

A change in accounting policy consequent upon the adoption of an Accounting Standard should be accounted for in accordance with the specific transitional provisions, if any, contained in that Accounting Standard.

AS 25 Interim Financial Reporting

Paragraph 2

A statute governing an enterprise or a regulator may require an enterprise to prepare and present certain information at an interim date which may be different in form and/or content as required by this Standard. In such a case, the recognition and measurement principles as laid down in this Standard are applied in respect of such information, unless otherwise specified in the statute or by the regulator.

Paragraph 16

An enterprise should include the following information, as a minimum, in the notes to its interim financial statements, if material and if not disclosed elsewhere in the interim financial report:

(a) a statement that the same accounting policies are followed in the interim financial statements as those followed in the most recent annual financial statements or, if those policies have been changed, a description of the nature and effect of the change……..

Paragraph 42

A change in accounting policy, other than one for which the transition is specified by an Accounting Standard, should be reflected by restating the financial statements of prior interim periods of the current financial year.

Paragraph 43

One objective of the preceding principle is to ensure that a single accounting policy is applied to a particular class of transactions throughout an entire financial year. The effect of the principle in paragraph 42 is to require that within the current financial year any change in accounting policy be applied retrospectively to the beginning of the financial year.

Stock Exchange Listing Agreement Clause 41

Clause 41 IV (i)

Discussion Paper on “Revision of Clause – 41 of Equity Listing Agreement”

Paragraph 4.13

Disclosure of impact of change in accounting policy: If there are any changes in the accounting policies during the year, the impact of the same on the prior quarters of the year, included in the current quarter results, shall be disclosed separately by way of a note to the financial results of the current quarter, without restating the previously published figures.

IV h

Changes in accounting policies, if any, shall be disclosed in accordance with Accounting Standard 5 (AS 5 – Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies) notified under the Company (Accounting Standards) Rules, 2006 (as amended) / issued by the Institute of Chartered Accountants of India (ICAI), as applicable. If there are any changes in the accounting policies during the year, the impact of the same on the prior quarters of the year, included in the current quarter results, should be disclosed separately by way of a note to the financial results of the current quarter without restating the previously published figures. Where the impact is not quantifiable a statement to that effect shall be made.

Executive Summary

1. AS-5 requires the cumulative effect of changes in accounting policies to be disclosed in the current period. The current period could be a financial year or an interim period.

2. AS-25 requires changes in accounting policies to be reflected by restating the financial statements of prior interim periods of the current financial year. Interestingly, AS-25 allows restatement of only prior interim periods of the current financial year. In other words, interim periods of previous financial year are not restated. Therefore under AS-25 results are comparable only with respect to current financial year but not with respect to previous financial years.

3. The appropriate standard for quarterly accounts is AS-25 and not AS-5. However, AS-25 clearly states that regulations will have an overriding effect.

4. The listing agreement and the discussion paper on clause 41 clearly articulate that changes in accounting policies in interim periods are reflected in the current interim period. Comparative interim periods are not restated.

5. In the author’s opinion, clause 41, which is the regulation, will have to be followed. In other words, the cumulative effect of changes in accounting policies is reflected in current interim periods. Comparative interim periods are not restated.

Author’s suggestion

The International Financial Reporting Standards (IFRS) require comparative interim periods to be restated when accounting policies are changed. However unlike AS-25, they require even previous financial year’s interim period to be restated. Even in annual financial statements, IFRS requires previous year results to be restated to give effect to change in accounting policy. This ensures complete comparability.

Restatement of previous period financial statements is a better presentation of changes in accounting policies as it provides comparable numbers based on the new accounting policy. In India, we need to align AS-5, AS-25 and the listing agreement to enforce this comparability in line with IFRS (IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors & IAS 34 Interim Financial Reporting).

levitra

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Redefining the framework for taxation under Ind AS

In the recent past, the corporate sector has seen the much needed refinement of the accounting and tax frameworks, with Notification of several new accounting standards and pronouncements under Indian GAAP, Notification of 35 accounting standards (Ind AS) that are converged with IFRS, and discussions around introduction of the Direct Tax Code (DTC) and the Goods and Services Tax (GST).

While the changes in the accounting and tax frameworks will have a substantial impact on the Indian industry, there was a need for more clarity on the tax implications of the accounting adjustments pursuant to adoption of Ind AS. Further, one of the common criticisms for implementation of Ind AS has been that the differences in recognition and measurement principles between Ind AS and the tax frameworks would potentially lead to additional efforts of maintaining different accounting records — one for accounting purposes and the other for tax purposes.

Background to accounting standards for tax purposes

For the purpose of enabling more clarity on accounting treatment for certain transactions for tax purposes and to standardise the alternative accounting options as contained in the financial accounting standards, the Income-tax Act, 1961 (the Act) permits the Central Government to notify accounting standards that shall be mandatorily applied by the assessees for determining accounting income for income-tax purposes.

Since the introduction of these provisions, two accounting standards relating to disclosure of accounting policies and disclosure of prior period and extraordinary items and changes in accounting policies have been notified.

In 2003, a committee on formulation of accounting standards under the Act submitted its report, recommending that the accounting standards issued by the Institute of Chartered Accountants of India (ICAI) be notified under the Act. The recommendation acknowledged that it would be impractical for the assessee to maintain two sets of books of accounts (i.e., for financial reporting as well as for tax purposes) in case the accounting standards for tax purposes differed significantly from financial accounting standards.

However, the said recommendation could not be effected at that time as new financial accounting standards were evolving and some of the existing standards were under revision. Further, the tax authorities believed that the Notification of the accounting standards issued by ICAI under the Act would require extensive revision to the Act in order to avoid complexity and litigation.

Accounting standard committee

In December 2010, the Central Board of Direct Taxes (CBDT) constituted an Accounting Standard Committee (the Committee) comprising of officers from the Income-tax Department and other professionals. The terms of reference of this Committee were as follows:

(a) to study the harmonisation of accounting standards issued by the ICAI with the direct tax laws in India, and suggest accounting standards which need to be adopted u/s.145(2) of the Act along with the relevant modifications;

(b) to suggest method for determination of tax base (book profit) for the purpose of Minimum Alternate Tax (MAT) in case of companies migrating to IFRS (Ind AS) in the initial year of adoption and thereafter; and

(c) to suggest appropriate amendments to the Act in view of transition to IFRS (Ind AS) regime. On 17 October 2011, based on the recommendation of the Committee, the Ministry of Finance issued a Discussion Paper on Tax Accounting Standards. This paper discusses the key recommendations of the Committee on point (a) above.

Main recommendations of the Committee

(a) As the accounting standards to be notified under the Act are required to be in conformity with provisions of the Act, the standards notified by ICAI cannot be adopted without modification. Further, the accounting standards notified under the Act should also eliminate the alternative accounting treatment permitted by the ICAI standards in order to ensure uniformity;

(b) The accounting standards notified under the Act may be termed as Tax Accounting Standards (TAS); such TAS shall be applicable only to those assessees who follow mercantile system of accounting (rather than cash system of accounting);

(c) TAS are intended to be in harmony with the provisions of the Act. As such, in case of conflict, the provisions of the Act shall prevail over TAS;

(d) The starting point for computing the taxable income under the Act would be the income computed based on TAS, instead of net profit as per the financial statements;

(e) The assessee need not maintain separate books of accounts based on TAS. Instead, the assessee should prepare a reconciliation of income computed based on financial accounting standards and TAS.

If the recommendations in the Discussion Paper are eventually accepted and incorporated into the Act, income for tax purposes (to which a set of allowances and disallowances would be adjusted to derive taxable income) would be computed based on provisions of TAS, irrespective of the accounting standards followed for the preparation of the financial statements.

This would partially address the issue relating to the impact of transition of Ind AS on taxation, as taxes payable (other than MAT) would be computed based on TAS, irrespective of whether a company follows the currently applicable accounting standards or Ind AS.

Further, though taxpayers will not be required to maintain separate books of account as per TAS, they would need to maintain and present the reconciliation between the profits per the financial statements and per the provisions of TAS.

So far, the Ministry of Finance has also issued the Draft TAS on Construction Contracts and Government Grants for comments and suggestions. Draft of other TAS will also be issued at a later date.

Draft TAS on construction contracts

Though the draft TAS on construction contracts is substantially similar to Accounting Standard 7 (AS-7) on Construction Contracts, the following modifications merit consideration:

Uncertainty relating to ultimate collection

In line with paragraphs 21 and 22 to AS-7, the revenue from the construction contract cannot be recognised unless it is probable that the ultimate collection of the consideration shall be made from the customer. As such, the revenue recognition in such cases is postponed until such collection is probable.

The draft TAS does not seem to have directly incorporated the above principles, thereby leading to an interpretation that contract revenue to be recognised based on percentage of completion method, even if the ultimate collection is not probable. As such, the company needs to recognise revenue even if at inception the collection does not seem probable, and subsequently write off the receivables as bad debts. This modification may lead to higher income for taxation purposes and may lead to higher income taxes in the initial phase of the contract as compared to the current practice.

Provision for loss-making contracts

AS-7 and Ind AS-11 requires that on construction contracts where the total contract costs exceed the total contract revenue, a provision for such loss should be made immediately. The draft TAS has not incorporated the said requirement of recognising a provision for the said loss immediately. As such, while computing income based on provisions of TAS, such provision for expected losses is not permitted for recognition. Consequently, the income computed based on TAS may be higher than that reported in the financial statements. However, one needs to watch the development of TAS equivalent to Ind AS-37 and AS-29 on Provisions, Contingent Liabilities and Contingent Assets closely, as Ind AS-37 and AS-29 require a provision for onerous contracts for an amount equivalent to lower of the expected loss in case of fulfilment and penalties in case of termination.

Method of computing the stage of completion
AS-7 and Ind AS-11 do not require any particular method for the purpose of computing the stage of completion of the construction contract, but prescribes an illustrative list of the following methods:
(a) the proportion that contract costs incurred for work performed up to the reporting date bear to the estimated total contract costs; or
(b) surveys of work performed; or
(c) completion of a physical proportion of the contract work.

As such, for accounting purposes, the company could follow any of the above methods or any other method if that would lead to more reliable computation of stage of completion.

However, the draft TAS seems to have restricted the alternatives to the ones mentioned above and does not provide flexibility to adopt any other method. As such, modification is more in line with the objective of the committee to eliminate the alternate accounting practices permitted under the financial accounting standards.

Even though TAS permits non-recognition of margins during the early stages of a contract, it prohibits such deferral if the stage of completion exceeds twenty-five percent. Varied practices are currently prevailing on the point of time from which margin is recognised by different companies. This will be aligned under TAS to some extent.

Incidental income to be reduced from costs
AS-7 requires the contract costs be reduced by any incidental income that is not included in contract revenue. The draft TAS clarifies that such incidental income cannot be in the nature of interest, dividends or capital gains.

Need for some more clarity on draft TAS on construction contracts

(A) Combining and segmenting contracts
The draft TAS on construction contracts has retained the guidance on combining and segmenting contracts that requires the assessee, based on the substance of the arrangement, to:

(i) combine two or more contracts, or
(ii) split one contract into multiple components.

Based on the current draft, two specific areas within the combining and segmenting contracts that may require more clarity includes allocation of consideration to identified components within an arrangement and whether the said principles on combining and segmenting contracts shall also extend to accounting for arrangements that are not construction contracts, and commonly referred to as linked transactions and multiple element arrangements.

(a) Allocation of consideration to components
In cases where a single contract is required to be split into components, the draft TAS does not clarify a methodology for such allocation of consideration under a single contract into components.

On adoption of Ind AS, the companies generally allocate the consideration to each component based on either residual method (where the fair value of undelivered components is deferred and residual consideration is allocated to delivered components) or relative fair value method (where the consideration is allocated to each component in the ratio of their fair values). This has not been specifically addressed in TAS.

(b) Extension of principles to arrangements that are not construction contracts

The principles of combining and segmenting contracts are sometimes applied in case of arrangements that may not be a construction contract, but the commercial substance may be established by either combining or segmenting the contract(s) and are commonly referred to as linked transactions or multiple element arrangements, respectively. This may be further clarified in the corresponding TAS of AS-9 or Ind AS-18 on revenue recognition.

As a general principle based on current practices, the taxes are usually levied based on contractually agreed prices for the agreed deliverables and there may not be any need for allocation or aggregation of sale consideration for tax purposes.

(B) Discounting of retention money as per Ind AS

As TAS is based on AS-7, the new concepts in Ind AS that may impact accounting for construction contracts (for example, discounting of retention receivables) have not been incorporated into TAS. Accordingly, companies that transit to Ind AS may need to make certain additional adjustments to comply with TAS.

Draft TAS on government grants

Though TAS is based on Accounting Standard 12, Accounting for Government Grants (AS-12), there are some fundamental modifications to AS-12, which require consideration:

TAS does not permit the capital approach for recording government grants. Accordingly, the current practice of recording grants in the nature of promoters’ contribution or grants related to non-depreciable assets, directly in shareholders’ funds as a capital reserve will not be permitted under TAS;

Under TAS, all grants will either be reduced from the cost of the asset; or recorded over a period as income; or recorded as income immediately; depending on the nature of the grant; and

Unlike AS-12, TAS provides that the initial recognition of the grant cannot be postponed beyond the date of actual receipt. AS-12 specifically provides that mere receipt of a grant is not necessarily conclusive evidence that conditions related to the grant will be fulfilled.

Further, as TAS is derived from AS-12, the new concepts in Ind AS that impact accounting for government grants (for example, recognition of non-monetary grants at fair value) have not been incorporated into the TAS. Accordingly, companies that transition to Ind AS may need to make certain additional adjustments to comply with TAS.

Conclusion
The proposal to issue separate TAS will represent a significant change for taxpayers. Taxpayers would need to evaluate the requirements of the draft TAS proposed from time to time, and determine the specific areas of impact.

The recommendations in the current Discussion Paper will partially address one of the key stated bottlenecks for implementation of Ind AS, by requiring computation of taxable income using a uniform basis. It is likely that recommendations by the Committee on points (ii) and (iii) of their terms of reference will further facilitate the adoption of Ind AS in India.

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Joint Ventures: No more proportionate consolidation under IFRS

On 12th May 2011, the International Accounting Standards Board (IASB) issued its new consolidation and related standards, replacing the existing accounting for subsidiaries and joint ventures (now joint arrangements), and making limited amendments in relation to accounting for associates.

In our previous article we had covered IFRS 10, the new standard on consolidated financial statements.

In this article we focus on IFRS 11, Joint Arrangements and IAS 28 (2011), Investments in Associates and Joint Ventures, giving our perspectives on the requirements that are modified and that are expected to have an impact on the preparers and users of IFRS financial statements.

The primary changes introduced under IFRS 11 are:

It carves out from IAS 31 on jointly controlled entities, those cases in which although there is a separate vehicle, that separation is ineffective in certain ways. These arrangements are treated similar to jointly controlled assets/ operations and are now called joint operations; and

Eliminates the free choice of equity accounting or proportionate consolidation for accounting for investments in joint ventures. These must now be accounted always using the equity method.

Identifying joint arrangements

A joint arrangement is an arrangement over which two or more parties have a joint control, being contractually agreed sharing of control i.e., unanimous consent is required for decisions about the relevant activities.

In order to identify a joint arrangement, IFRS 11 requires a two-step analysis to be performed: (1) assess whether collective control exists of an arrangement; and (2) then assess whether the contractual arrangement gives two or more parties joint control over the arrangement.

What is the meaning of control?

IFRS 11 does not define the term ‘control’. As such, reference may be had to the definition of ‘control’ under IFRS 10. As discussed in detail in our last article on IFRS 10, the assessment of control may undergo a change under IFRS 10 as compared to IAS 27 (2008). For instance, only substantive rights held by the investor and others are considered in assessing control. To be substantive, rights need to be exercisable when decisions about the relevant activities need to be made, and their holders need to have a practical ability to exercise the rights. It may be noted that the ‘rights that need to be exercisable when decisions about the relevant activities need to be made’ is different from the current requirement under IAS 27 (2008) of ‘rights that are currently exercisable’.

De facto control in case of joint arrangements

Joint control exists only when it is contractually agreed that decisions about relevant activities require the unanimous consent of the parties that control the arrangement collectively. When, for instance, the parties can demonstrate past experience of voting together in the absence of a contractual agreement to do so, this will not satisfy that requirement. However, it is possible to establish a joint de facto control i.e., control is based on de facto circumstances and the parties sharing control have contractually agreed to share that control.

For instance, A and B hold 24.5% each in Company C, while the remaining 51% shares are held by numerous shareholders, none of them holding more than 1% shares each and do not have any shareholder agreement amongst them. If A and B contractually agree that on decisions relating to the relevant activities of Company C, the casting of their combined voting power of 49% requires their unanimous consent; it may be concluded that A and B have joint control over Company C on a de facto basis.

Key differences from IAS 31

IFRS 11 does not modify the overall definition of an arrangement subject to joint control, although in a few cases, the joint control evaluation may undergo a change on account of application of control definition under IFRS 10.

Classifying joint arrangements

After determining that joint control exists, joint arrangements are divided into two types, each having its own accounting model, defined as follows:

A joint operation is one whereby the jointly controlling parties, known as the joint operators, have rights to the assets and obligations for the liabilities, relating to the arrangement;

A joint venture is one whereby the jointly controlling parties, known as the joint venturers, have rights to the net assets of the arrangement.

The key to determining the type of arrangement, and therefore the subsequent accounting, is the rights and obligations of the parties to the arrangement. For instance, two parties set up a separate entity, whereby the main feature of its legal form is that the parties (and not the entity) have rights to the assets and obligations for the liabilities of the entity, and the contractual arrangement between the parties establishes the parties’ rights to the assets, responsibility for all operational or financial obligations and the sharing of profit or loss. Though the arrangement is structured through a separate entity, as the legal form of the separate vehicle does not confer separation between the parties and the vehicle, the joint arrangement is a joint operation.

An entity determines the type of joint arrangement by considering the structure, the legal form, the contractual arrangement and other facts and circumstances.

Structure of joint arrangements

A joint arrangement not structured through a separate vehicle can be classified only as a joint operation. A separate vehicle is a separately identifiable financial structure, including separate legal entities or entities recognised by statutes, regardless of whether those entities have a legal personality.

A joint arrangement structured through a separate vehicle can be either a joint venture or a joint operation. As such, a separate vehicle is necessary but not a sufficient condition for a joint venture. If there is a separate vehicle, then the remaining tests are applied.

Legal form of the arrangement

If the legal form of the separate vehicle does not confer separation between the parties and the separate vehicle i.e., the assets and liabilities placed in the separate vehicle are the parties’ assets and liabilities, then the joint arrangement is a joint operation.

Contractual arrangement

When the contractual arrangement specifies that the parties have rights to the assets and obligations for the liabilities relating to the arrangement, then the arrangement is a joint operation.

It may be noted that in relation to ‘obligations for the liabilities’, it seems that the contractual obligation for liabilities is something that needs to reflect a primary obligation, rather than a secondary one; and something that represents a non-contingent, ongoing obligation, rather than an obligation that will be settled if and when a certain event occurs (say, a default in case of guarantees issued or calling of uncalled capital).

Other facts and circumstances

The test at this step of the analysis is to identify whether, despite the legal form and contractual arrangements indicating that the arrangement is a joint venture, other facts and circumstances give the parties rights to substantially all of the economic benefits relating to the arrangement and cause the arrangement to depend on the parties on a continuous basis for settling its liabilities, and therefore the arrangement is a joint operation.

In practice, most joint arrangements in India, which are structured as separate companies, may meet the separation criteria and hence qualify as a joint venture and not as a joint operation.

Financial statements of joint venturers

IFRS 11 prescribes accounting treatment for joint operators, whereas IAS 28 (2011) prescribes the accounting treatment for joint venturers.

In its consolidated financial statements, a joint venturer accounts for its interest in the joint venture using the equity method in accordance with IAS 28 (2011), unless under IAS 28 (2011), the entity is exempted from applying the equity method.

Under the equity method, the investment in a joint venture is recognised initially at cost, and subsequently adjusted for the post- acquisition changes in the share of the joint venture’s net assets. The joint venturer’s share of profit or loss and other comprehensive income of the joint venture are included in its profit or loss and other comprehensive income, respectively.

In its separate financial statements, a joint venturer accounts for its interest in the joint venture in accordance with IAS 27 (2011) Separate financial statements i.e., at cost or in accordance with IFRS 9/IAS 39. Such a choice is available even if the joint venturer is exempted from preparing consolidated financial statements. This requirement is in line with the existing requirements.

Key differences from IAS 31

IAS 31 provides an accounting policy choice for a joint controller’s interest in a jointly controlled entity, whereby either the equity method or pro-portionate consolidation can be used. In future, only the equity method shall be permitted. As such, the joint co ntroller’s share of net income and net assets that are adjusted against the individual items of income/expenses/assets/liabilities shall now be presented as a single line item in the statement of financial position and statement of comprehensive income. In other words, a single line ‘Investment in Joint Venture’ and a single line ‘equity profit pick-up’ adjustment on such investments will be recorded.

Financial statements of joint operators

In both its consolidated and separate financial statements, a joint operator recognises its assets, liabilities and transactions, including its share of those incurred jointly. These assets, liabilities and transactions are accounted for in accordance with the relevant IFRS.

Transactions between a joint operator and a joint operation

When a joint operator sells or contributes assets to a joint operation, such transactions are in effect transactions with other parties to the joint operation. The joint operator recognises gains and losses from such transactions only to the extent of the other parties’ interests in the joint operation. The full amount of any loss is recognised immediately by the joint operator, to the extent that these transactions provide evidence of impairment of any assets to be sold or contributed.

When a joint operator purchases assets from a joint operation, it does not recognise its share of the gains or losses until those assets have been sold to a third party. The joint operator’s share of any losses is recognised immediately, to the extent that these transactions provide evidence of impairment of those assets.

Other parties to the joint arrangement
Other parties to the joint venture

For the purpose of consolidated financial statements, the other parties to the joint venture first determine whether they exercise significant influence. If significant influence exists, then the interest is recognised in accordance with IAS 28 (2011); else it is recognised in accordance with IAS 39/IFRS 9.

For separate financial statements, other parties to a joint venture account for their interest in the joint venture in accordance with IAS 39/IFRS 9. If significant influence exists, then the interest may also be recognised at cost.

Other parties a joint operation

The other party to a joint operation accounts for its investment in the same way as a joint operator if it has rights to the assets and obligations for the liabilities. If such a party does not have such rights and obligations, then it accounts for its interest in accordance with the IFRS applicable to that interest for instance IAS 28 (2011) or IAS 39/IFRS 9 as the case may be.

Summary

Overall, the implementation of IFRS 11 will require significant judgment in several respects, while the requirement to apply equity method of accounting to account for interests in joint ventures may have a significant impact on the entity’s financial statements. While the standard is not mandatorily effective until periods beginning on or after 1 January 2013, it is expected that preparers will want to begin evaluating their involvement with joint arrangements sooner than that, as the changes under the new standard generally will call for retrospective application.

At this moment, it is unclear by when the corresponding changes will be introduced under the Ind-AS framework. However, it is advisable for Indian companies to evaluate the impact of this new standard, as it is inevitable that Ind-AS will ultimately incorporate the changes due to the new standard.

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Tata Consultancy Services Ltd. — (31-3-2011)

From Significant Accounting Policies

The Company uses foreign currency forward contracts and currency options to hedge its risks associated with foreign currency fluctuations relating to certain firm commitments and forecasted transactions. The Company designates these hedging instruments as cash flow hedges applying the recognition and measurement principles set out in the Indian Accounting Standard 39 ‘Financial Instruments: Recognition and Measurement’ (Ind AS-39).

The use of hedging instruments is governed by the Company’s policies approved by the Board of Directors, which provide written principles on the use of such financial derivatives consistent with the Company’s risk management strategy.

Hedging instruments are initially measured at fair value, and are re-measured at subsequent reporting dates. Changes in the fair value of these derivatives that are designated and effective as hedges of future cash flows are recognised directly in shareholders’ funds and the ineffective portion is recognised immediately in the profit and loss account.

Changes in the fair value of derivative financial instruments that do not qualify for hedge accounting are recognised in the profit and loss account as they arise.

Hedge accounting is discontinued when the hedging instrument expires or is sold, terminated, or exercised, or no longer qualifies for hedge accounting. At that time for forecasted transactions, any cumulative gain or loss on the hedging instrument recognised in shareholders’ funds is retained there until the forecasted transaction occurs. If a hedged transaction is no longer expected to occur, the net cumulative gain or loss recognised in shareholders’ funds is transferred to the profit and loss account for the period.

From Notes to Accounts The Company, in accordance with its risk management policies and procedures, enters into foreign currency forward contracts and currency option contracts to manage its exposure in foreign exchange rates. The counter-party is generally a bank. These contracts are for a period between one day and eight years.

The Company does not have any outstanding foreign exchange forward contracts, which have been designated as Cash Flow Hedges as at 31 March, 2011 and as at 31 March, 2010.

The Company has the following outstanding derivative instruments as at 31 March, 2011:

The following are outstanding currency option contracts, which have been designated as Cash Flow Hedges, as at:

Net gain on derivative instruments of Rs.20.20 crores recognised in Hedging Reserve as of 31 March, 2011 is expected to be reclassified to the profit and loss account by 31 March, 2012.

The movement in Hedging Reserve during the year ended 31 March, 2011, for derivatives designated as Cash Flow Hedges is as follows:

In addition to the above Cash Flow Hedges, the Company has outstanding foreign exchange forward contracts and currency option contracts with notional amount aggregating Rs.4432.67 crores (31 March, 2010: Rs.3316.41 crores) whose fair value showed a gain of Rs.27.45 crores as at 31 March, 2011 (31 March, 2010: Rs.4.67 crores). Although these contracts are effective as hedges from an economic perspective, they do not qualify for hedge accounting and accordingly these are accounted as derivative instruments at fair value with changes in fair value recorded in the profit (Previous year: exchange gain Rs.91.46 crores) on foreign exchange forward contracts and currency option contracts have been recognised in the year ended 31 March, 2011.

As of the balance sheet date, the Company has net foreign currency exposures that are not hedged by a derivative instrument or otherwise amounting to Rs.857.03 crores (31 March, 2010: Rs.764.85 crores).

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Tata Steel Ltd. — (31-3-2011)

From Significant Accounting Policies

Foreign currency transactions

Foreign Currency Transactions (FCT) and forward exchange contracts used to hedge FCT are initially recognised at the spot rate on the date of the transaction/contract. Monetary assets and liabilities relating to foreign currency transactions and forward exchange contracts remaining unsettled at the end of the year are translated at year-end rates.

The company has opted for accounting the exchange differences arising on reporting of longterm foreign currency monetary items in line with Companies (Accounting Standards) Amendment Rules 2009 relating to Accounting Standard 11 (AS- 11) notified by Government of India on 31 March, 2009. Accordingly the effect of exchange differences on foreign currency loans of the Company is accounted by addition or deduction to the cost of the assets so far it relates to depreciable capital assets and in other cases by transfer to ‘Foreign Currency Monetary Items Translation Difference Account’ to be amortised over the balance period of the long-term monetary items or period up to 31 March, 2011, whichever is earlier.

The differences in translation of FCT and forward exchange contracts used to hedge FCT (excluding the long-term foreign currency monetary items accounted in line with Companies (Accounting Standards) Amendment Rules 2009 on Accounting Standard 11 notified by Government of India on 31 March, 2009) and realised gains and losses, other than those relating to fixed assets are recognised in the Profit and Loss Account. The outstanding derivative contracts at the balance sheet date other than forward exchange contracts used to hedge FCT are valued by marking them to market and losses, if any, are recognised in the Profit and Loss Account.

Exchange difference relating to monetary items that are in substance forming part of the Company’s net investment in non-integral foreign operations are accumulated in Foreign Exchange Fluctuation Reserve Account.

From Notes to Accounts

Profit and Loss Account

The Company has opted for accounting the exchange differences arising on reporting of longterm foreign currency monetary items in line with Companies (Accounting Standards) Amendment Rules 2009 relating to Accounting Standard 11 (AS- 11) notified by Government of India on 31 March, 2009 which allows foreign exchange difference on long-term monetary items to be capitalised to the extent they relate to acquisition of depreciable assets and in other cases to amortise over the period of the monetary asset/liability or the period up to 31 March, 2011, whichever is earlier.

As on 31 March, 2011, Rs. Nil (31-3-2010: Credit of Rs.206.95 crores) remains to be amortised in the ‘Foreign Currency Monetary Items Translation Difference Account’ after taking a credit of Rs.261.44 crores (2009-10: Charge of Rs.85.67 crores) in the Profit & Loss Account and Rs 2.07 crores (net of deferred tax Rs.3.57 crores) [2009-10: Rs.47.35 crores (net of deferred tax Rs.24.38 crores)] adjusted against Securities Premium Account during the current financial year on account of amortisation. The Depreciation for the year ended 31 March, 2011 is higher by Rs.0.48 crore (2009-10: Rs.0.41 crore) and the Profit before taxes for the year ended 31 March, 2011 is higher by Rs.208.99 crores (2009-10: Lower by Rs.561.60 crores).

Other Disclosures

25. Derivative Instruments (I) The Company has entered into the following derivative instruments:

(a) The Company uses foreign currency forward contracts to hedge its risks associated with foreign currency fluctuations. The use of foreign currency forward contracts is governed by the Company’s strategy approved by the Board of Directors, which provide principles on the use of such forward contracts consistent with the Company’s Risk Management Policy. The Company does not use forward contracts for speculative purposes.

Outstanding Short-Term Forward Exchange Contracts entered into by the Company on account of payables:

Outstanding Short-Term Forward Exchange Contracts entered into by the Company on account of receivables:

(Forward exchange contracts outstanding as on 31 March 2011 include Forward Purchase of United States Dollars against Indian National Rupees for contracted imports.)

Outstanding Long-Term Forward Exchange Contracts entered into by the Company:

(Long-Term Forward Exchange Contracts outstanding as on 31 March, 2011 have been used to hedge the Foreign Currency Risk on repayment of External Commercial Borrowings and Export Credit Agency Borrowings of the Company.)

(b) The Company also uses derivative contracts other than forward contracts to hedge the interest rate and currency risk on its capital account. Such transactions are governed by the strategy approved by the Board of Directors which provide principles on the use of these instruments, consistent with the Company’s Risk Management Policy. The Company does not use these contracts for speculative purposes.

Outstanding Interest Rate Swaps to hedge against fluctuations in interest rate changes:

All the above swaps and forward contracts are accounted for as per accounting policies stated in Notes on Balance sheet and Profit and Loss Account, Schedule M 1(f).

(II) The year-end foreign currency exposures that have not been hedged by a derivative instrument of otherwise are given below:

26. Previous year’s figures have been recast/ restated where necessary.

27. Figures in Italics are in respect of the previous year.

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GAPs in GAAP Monetary v. Non-monetary Items

Issue raised in GAPS in GAAP — July 2007 Under revised AS-11 The Effects of Changes in Foreign Exchange Rates, the accounting treatment for monetary items and non-monetary items is different. Monetary items are revalued at each reporting date and the gain or loss is recognised in the income statement. Non-monetary items are reported at the exchange rate at the date of the transaction. They are not revalued at each reporting date and hence there is no exchange gain/loss. Thus the classification of an item as monetary or non-monetary is critical.

Monetary items have been defined as ‘are money held and assets and liabilities to be received or paid in fixed or determinable amounts of money’. Nonmonetary items are defined as ‘assets and liabilities other than monetary items.’ Paragraph 12 of the standard briefly elaborates what monetary and nonmonetary items are, as follows: “Cash, receivables and payables are examples of monetary items. Fixed assets, inventories, and investments in equity shares are examples of non-monetary items.”

The Expert Advisory Committee (EAC) of the ICAI has opined on the issue of monetary and non-monetary items (EAO-VOL-19-1.13). This opinion was given in the context of the pre-revised AS-11, but is relevant under revised AS-11 as well. The issue was whether foreign exchange advances received (and converted into Indian rupees) for export of a fixed quantity of goods, which are adjusted against future supplies, are monetary or non-monetary items.

The EAC noted the definition of ‘monetary items’ as ‘money held and assets and liabilities to be received or paid in fixed or determinable amounts of money’. The EAC was of the view that the words ‘received or paid’ do not necessarily envisage receipt or payment in cash. What is of essence in the definition of monetary items is that the value of the asset or liability should be fixed or determinable in monetary terms. In the present case, the EAC felt that the liability of the company in respect of the advance taken from the foreign customer is fixed in monetary terms, though it will be discharged through exports rather than through payment in cash. As such, the EAC was of the view that the advance received from the foreign customer is a monetary liability. Consequently monetary items denominated in a foreign currency should be revalued at each reporting date and exchange gain/ loss is recognised in the income statement.

Under IAS-21 The Effects of Changes in Foreign Exchange Rates, monetary items are defined as ‘Monetary items are units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency.’ Paragraph 16, of IAS-21 provides further elaboration as follows.

Monetary items Paragraph 16 “The essential feature of a monetary item is a right to receive (or an obligation to deliver) a fixed or determinable number of units of currency. Examples include: pensions and other employee benefits to be paid in cash; provisions that are to be settled in cash; and cash dividends that are recognised as a liability. Similarly, a contract to receive (or deliver) a variable number of the entity’s own equity instruments or a variable amount of assets in which the fair value to be received (or delivered) equals a fixed or determinable number of units of currency is a monetary item. Conversely, 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. Examples include: amounts prepaid for goods and services (e.g. prepaid rent); goodwill; intangible assets; inventories; property, plant and equipment; and provisions that are to be settled by the delivery of a non-monetary asset.”

Therefore as can be seen from the above, though the definition of monetary items and non-monetary items is the same under IAS-21 and AS-11, they have been interpreted differently. The interpretation in paragraph 16 of IAS 21 and that contained in the EAC opinion take the exact opposite position. If one were to apply paragraph 16 above, one would conclude that advance received for future export of goods, is a non-monetary item. However, based on EAC opinion, this would be a monetary item.

Given that Indian GAAP is attempting to converge with IFRS, such interpretation differences would create unnecessary GAAP differences. In the given instance, intuitively, it appears that the right answer is not to revalue the advances received, which has been fully converted into Indian rupees. The advance has been received for future supply of fixed quantities of goods; has been fully converted into Indian rupees, and hence revaluing them at each reporting date and recognising exchange gain/loss is inappropriate. Such exchange gain/loss is merely a book entry that is reversed in the future (as sales in this example). If the recommendation of EAC were to be followed in this instance, it would give rise to a theoretical gain or loss in one period and an opposite effect when the transaction is concluded. This would substantially distort the profit and loss account between two periods.

A similar issue was raised (Query 37, Vol. XXVIII) much later with regards to treatment of advance paid in foreign currency for acquisition of fixed assets. This time the opinion of the EAC is in line with the interpretation in IAS-21. The Committee opined “the words received or paid in the definition of the term monetary items do not necessarily envisage receipt or payment in cash. What is of essence is that the value of the asset or liability should be fixed or determinable in monetary items. Accordingly, where the advance is related to a fixed price contract for the receipt of a specified quantity of goods, it will be a non-monetary asset, since it represents a claim to receive a specified quantity of goods and not a right to receive money.”

The change in the point of view by the EAC in this case, is a step in the right direction and will align the interpretation on this issue with global practice.

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IFRS introduces framework for measuring fair values

On 12 May 2011, the International Accounting Standards Board (IASB) issued IFRS 13 Fair Value Measurement that is intended to replace the fair value measurement guidance contained under various standards with a single authoritative pronouncement on fair value measurement.

In this article we focus on the guidance provided under IFRS 13 in relation to the definition of fair value, the framework for measuring the fair value and certain disclosure requirements, giving our perspectives on the requirements that are modified and that are expected to have an impact on the preparers and users of IFRS financial statements.

IFRS 13 provides elaborate guidance on how to measure the fair value when required or permitted under IFRS. It neither introduces new requirements to measure assets or liabilities at fair value, nor does it eliminate the exceptions to fair value measurements on the grounds of practicality in line with guidance contained under certain standards.

Scope of IFRS 13

The IFRS 13 guidance shall be applied to items of assets, liabilities and equity that are permitted or required to be measured at fair value. However, the guidance contained therein does not apply to the measurement and disclosure requirements in certain cases, such as:

share-based payment transactions within the scope of IFRS 2 Share-based Payment;
leasing transactions within the scope of IAS 17 Leases; and
measurements that have some similarities to fair value but are not fair value, such as net realisable value in IAS 2 Inventories or value in use in IAS 36 Impairment of Assets.

Further, the fair value measurement guidance also does not apply to the disclosure requirements in certain cases, such as:

plan assets measured at fair value in accordance with IAS 19 Employee Benefits;
retirement benefit plan investments measured at fair value in accordance with IAS 26 Accounting and Reporting by Retirement Benefit Plans; and
assets for which recoverable amount is fair value less costs of disposal in accordance with IAS 36.

Measurement principles
Definition of fair value

IFRS 13 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.

Measurement of asset or liability

A fair value measurement of an asset or liability considers the characteristics of that asset or liability (e.g., the condition and location of the asset and restrictions, if any, on its sale or use), if market participants would consider those characteristics when determining the price of the asset or liability at the measurement date.

The transaction

A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date under current market conditions. The hypothetical transaction is considered from the perspective of a market participant that holds the asset or owes the liability, i.e., it does not consider entityspecific factors that might influence an actual transaction. Therefore, the entity need not have the intention or ability to enter into a transaction on that date. An orderly transaction is 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 i.e. it is not a forced transaction, e.g., a forced liquidation or distress sale.

Principal or most advantageous market

The hypothetical transaction to sell the asset or transfer the liability is assumed to take place in the principal market. This is the market with the greatest volume and level of activity for the asset or liability.

In the absence of a principal market, the transaction is assumed to take place in the most advantageous market. This is the market that maximises the amount that would be received to sell the asset or minimises the amount that would be paid to transfer the liability, after considering transaction costs and transport costs. Because different entities may have access to different markets, the principal or most advantageous market for the same asset or liability may vary from one entity to another.

Market participants

Fair value measurement uses assumptions that market participants would use in pricing the asset or liability. Market participants are buyers and sellers in the principal (or most advantageous) market who are independent of each other, knowledgeable about the asset or liability, and willing and able to enter into a transaction for the asset or liability.

Price

Fair value is the price that would apply in a transaction between market participants whether it is observable in an active market or estimated using a valuation technique.

Transaction cost and transportation cost

Although transaction costs are taken into account in identifying the most advantageous market, the price used to measure the fair value of an asset or a liability is not adjusted for transaction costs. This is because they are not a characteristic of the asset or liability and are instead characteristic of a transaction. However, if location is a characteristic of an asset e.g., crude oil held in the Arctic Circle, then the price in the principal or most advantageous market is adjusted for the costs that would be incurred to transport the asset to that market, e.g., costs to transport the crude oil from Arctic Circle to the appropriate market.

Application to non-financial assets — highest and best use and valuation premise

A fair value measurement considers a market participant’s ability to generate economic benefit by using the asset or by selling it to another market participant who will use the asset in its highest and best use. Highest and best use refers to the use of an asset that would maximise the value of the asset, considering uses of the asset that are physically possible, legally permissible and financially feasible. Highest and best use is determined from the perspective of market participants, even if the reporting entity intends a different use. However, an entity need not perform an exhaustive search for other potential uses if there is no evidence to suggest that the current use of an asset is not its highest and best use. The concept of highest and best use is relevant only to the valuation of non-financial assets and does not apply to the valuation of financial assets or liabilities.

Liabilities and equity instruments

The fair value of a liability or an entity’s own equity instrument is measured using quoted prices for the transfer of identical instruments. When such prices are not available, an entity measures fair value from the perspective of a market participant holding the identical item as an asset. If quoted prices in an active market for the corresponding asset are also not available, then other observable inputs are used, such as prices in an inactive market for the asset. Otherwise, an entity uses another valuation technique(s), such as a present value measurement or the pricing of a similar liability or instrument. IFRS 13 retains the principle in IAS 39 that the fair value of a financial liability with a demand feature is not less than the present value of the amount payable on demand.

Fair value at initial recognition

The price paid in a transaction to acquire an asset or received to assume a liability, often referred to as the ‘entry price’, may or may not equal the fair value of that asset or liability based on an exit price. If an IFRS requires or permits an entity to measure an asset or liability initially at fair value and the transaction price differs from fair value, then the entity recognises the resulting gain or loss in profit or loss unless the specific IFRS requires otherwise. Therefore, the recognition of a ‘day one’ gain or loss when the transaction price differs from the fair value will be determined by the particular standard that prescribes the accounting for the asset or liability.

Valuation techniques

The objective of using a valuation technique is to determine the price at which an orderly transaction would take place between market participants at the measurement date. An entity uses valuation techniques that are appropriate in the circumstances and for which sufficient data are available, maximising the use of relevant observable inputs and minimising the use of unobservable inputs. IFRS 13 identifies three valuation approaches: income, market and cost.

Fair value hierarchy

IFRS 13 establishes a fair value hierarchy based on the inputs to valuation technique used to measure fair value to increase consistency and comparability. The inputs are categorised into three levels, with the highest priority given to unadjusted quoted price in active markets for identical assets or liabilities and lowest priority given to unobservable inputs.

The level into which a fair value measurement is classified in its entirety is determined by reference to the observability and significance of the inputs used in the valuation model. The valuation technique often incorporate both observable and unobservable inputs, however the fair value measurement is classified in its entirety into either level 2 or level 3, based on the lowest level input that is significant to the fair value measurement.

The availability of relevant inputs and their relative subjectivity might affect the selection of appropriate valuation techniques. However, the fair value hierarchy prioritises the inputs to valuation techniques, not the valuation techniques used to measure fair value. For example, a fair value measurement developed using a present value technique might be categorised within level 2 or level 3, depending on the inputs that are significant to the entire measurement and the level of the fair value hierarchy within which those inputs are categorised.

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. A quoted price in an active market provides the most reliable evidence of fair value and shall be used without adjustment to measure fair value.

An active market is a market in which transactions for the asset or liability takes place with sufficient frequency and volume for pricing information to be provided on an ongoing basis.

Level 2 Inputs

The determination of whether a fair value measurement is categorised into level 2 or level 3 depends on whether the inputs used in the valuation techniques are observable or unobservable and their significance to the fair value measurement.

Level 2 inputs are inputs other than quoted prices included within level 1 that are observable for the asset or liability, either directly or indirectly.

Observable inputs are 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.

Level 3 Inputs

Level 3 inputs are unobservable inputs for the asset or liability. Unobservable inputs are 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.

Inputs into valuation techniques

When selecting the inputs into a valuation technique, an entity selects inputs that are consistent with the characteristics that market participants would take into account in a transaction. A premium or discount, such as a control premium or a discount for lack of control, may be appropriate if it would be considered by market participants in pricing the asset or liability based on the unit of account.

Using quoted prices provided by third parties

IFRS 13 does not preclude the use of quoted prices provided by third parties, such as brokers or pricing services, provided that the prices are developed in accordance with IFRS 13.

Markets that are not active and transactions that are not orderly

IFRS 13 describes factors that may indicate that a market has seen a decrease in the volume or level of activity. An entity evaluates the significance and relevance of factors to determine whether, based on the evidence available, there has been a significant decrease in the volume or level of activity; however, the standard stresses that even if a market is not active, it is not appropriate to conclude that all transactions in that market are not orderly, i.e., are forced or distress sales.

Quoted prices derived from a market that is not active may not be determinative of fair value. In such circumstances, further analysis of the transactions or quoted prices is needed, and a significant adjustment to the transaction or quoted prices may be necessary to measure fair value.

Disclosures
The objective of the disclosures is to provide information that enables financial statement users to assess the methods and inputs used to develop fair value measurements and, for recurring fair value measurements that use significant unobservable inputs (level 3), the effect of the measurements on profit or loss or other comprehensive income.

To meet this objective, an entity provides certain minimum disclosures for each class of assets and liabilities. For non-financial assets and non-financial liabilities that are measured at or based on fair value in the statement of financial position, IFRS 13 requires fair value disclosures that are similar to existing fair value disclosures for financial assets and financial liabilities in IFRS 7. This disclosure is also required for non-recurring fair value measurements (e.g., an asset held for sale). The requirement to disclose a fair value hierarchy and information on valuation techniques is also extended to assets and liabilities which are not measured at fair value in the statement of financial position, but for which fair value is disclosed pursuant to another standard.

In addition, a description of the valuation processes used by the entity for level 3 measurements is required to be disclosed. This includes, for example, how an entity decides its valuation policies and procedures and analyses changes in fair value measurements from period to period. An entity should disclose a narrative description of the sensitivity of level 3 measurements to changes in unobservable inputs, including the effect of any interrelationships between unobservable inputs, as well as quantitative information on significant unobservable inputs used in measuring fair value.

Effective date and transition

An entity should apply IFRS 13 prospectively for annual periods beginning on or after 1 January 2013. Earlier application is permitted with disclosure of that fact.

The disclosure requirements of IFRS 13 need not be applied in comparative information for periods before initial application.

Summary
Overall, the implementation of IFRS 13 will require significant judgment while preparing the entity’s financial statements. The standard is neither mandatorily effective until periods beginning on or after 1st January 2013, nor does it require retrospective application. As such, the comparative disclosures and measurements are not required in line with IFRS 13 in the first period of application.

At this moment, it is unclear by when the corresponding changes will be introduced under the Ind AS framework. However, it is advisable for Indian companies to evaluate the impact of this new standard, as it is inevitable that Ind AS will ultimately incorporate the changes due to the new standard.

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Section A: Disclosures Under Revised Schedule VI

Compiler’s Note:

The Ministry of Company Affairs notified Revised Schedule VI on 28th February 2011. The same is applicable for all companies for financial statements prepared for the financial year commencing from 1st April 2011 onwards.

Paragraph 10 of AS-25 ‘Interim Financial Reporting’ as notified by the Companies (Accounting Standards) Rules, 2006, states that “If an enterprise prepares and presents a complete set of financial statements in its interim financial report, the form and content of those state-ments should conform to the require-ments as applicable to annual complete set of financial statements.” Accordingly, if a company following April-March as its accounting year, prepares complete set of financial statements, it will have to present the same in the Revised Sched-ule VI as applicable for 2011-12.

Infosys Limited follows the practice of preparing full set of financial state-ments for each quarter. In terms of the above, Infosys Limited (which follows April-March as its accounting year) has prepared its financial statements for the quarter ended 30th June 2011. Important extracts from these financial statements prepared in accordance with Revised Schedule VI are being published in two parts.

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GAPs in GAAP — What is substantial period of time?

What is substantial period of time?

Borrowing costs are capitalised during the construction of a qualifying asset, which is an asset that necessarily takes a substantial period of time to get ready for its intended use or sale. The explanation to the definition of the term ‘qualifying asset’ in AS-16 ‘Borrowing Cost’, notified by the Central Government under the Companies (Accounting Standards) Rules, 2006, provides as follows:

Explanation

“What constitutes a substantial period of time primarily depends on the facts and circumstances of each case. However, ordinarily a period of twelve months is considered as substantial period of time unless a shorter or longer period can be justified on the basis of facts and circumstances of the case. In estimating the period, time which an asset takes, technologically and commercially, to get it ready for its intended use or sale is considered.”

Let us see how this explanation was interpreted in the context of the example below.

Example

Salon Ltd. provides health and beauty solutions through its various salons across the country. From the time of acquiring the premises to the development of the salon, a period of three to five months is required and a substantial cost including capital cost on leasehold improvement is incurred on creating the right aesthetic and ambience. The period of three to five months is representative of the time required for similar construction of assets. The amount to be capitalised (if permitted) is material.

Position prior to EAC opinion (which was finalised on 30-5-2008)

In light of the explanation in AS-16, a period of three to five months was considered far below the 12-month threshold level, and hence in many similar situations companies may not have capitalised the bor-rowing expenses to comply with the explanation.

Position after EAC opinion (which was finalised on 30-5-2008)

The above position has changed completely vide an EAC opinion that was finalised on 30-5-2008 but was only published and available recently in Compendium Volume XXVIII. Paragraph 14 of the opinion states: “The committee is of the view that ordinarily, three to five months cannot be considered as a substantial period of time. The company should itself evaluate what constitutes a substantial period of time considering the peculiarities of facts and circumstances of its case, such as nature of the asset being constructed, etc. In this regard, time which an asset takes, technologically and commercially to get it ready for its intended use should be considered. Accordingly, the assets concerned may be considered as qualifying asset as per the provisions of AS-16.”

EAC opined that the borrowing costs could be capitalised by Salon Ltd.

Author’s comments

It may be noted that IAS 23 Borrowing Costs contains similar principles of capitalisation on qualifying asset. Like AS-16, substantial period of time has not been defined but unlike AS-16, there is no 12-month threshold level in IAS 23. Under IAS 23 there is no consensus globally on what constitutes a substantial period of time, though literature suggests a period of six months or more, to be substantial. Under FAS 34 interest cost is capitalised for all assets that require a period of time (not necessarily substantial) to get them ready for their intended use. However, in many cases, the benefit in terms of information about enterprise resources and earnings may not justify the additional accounting and administrative cost involved in providing the information. The benefit may be less than the cost, because the effect of interest capitalisation and its subsequent amortisation or other disposition, compared with the effect of charging it to expense when incurred, would not be material. In that circumstance, FAS 34 does not require interest capitalisation.

The substantial period criteria ensures that enterprises do not spend a lot of time and effort capturing immaterial interest cost for purposes of capitalisation. This aspect is very clear under FAS 34. Therefore if the interest cost is very material the same may be capitalised even if the asset has taken less than 12 months to complete, provided other factors indicate capitalisation is appropriate.

The explanation to AS-16 requires assessing the time which an asset should take technologically and commercially to be ready for its intended use. In fact, under present circumstances where construction period has reduced drastically due to technical innovation, the 12-month period should at best be looked at as a general benchmark and not a conclusive yardstick. It may so happen that an asset under normal circumstances may take more than 12 months to complete. However an enterprise that constructs the asset in 10 months should not be penalised for its efficiency by denying it interest capitalisation and vice versa.

Seen from this perspective, and the mixed practice under IAS 23, the EAC opinion is a step in the right direction as it clarifies that the 12-month period should not be seen as a strict benchmark, and other facts and circumstances should be kept in mind. In that sense, it is more aligned to global practice.

However additional guidance is required with regards to the following issues:

1. The EAC opinion changes the existing thought and practice in this area. In similar situations, if a company had not capitalised borrowing cost in earlier years, would they have to apply the correct treatment retrospectively (from the date AS-16 came into force)?

2. Would retrospective adjustment constitute a change in accounting policy or a rectification of prior period error?

3. Can such change be applied prospectively, given that the EAC opinion establishes a new principle?

4. If it is applied on a prospective basis, should it from the date the EAC finalised the opinion or the date when such an opinion was made public?

More importantly, given that it is intended that India will converge to IFRS, it may be worthwhile for the Institute of Chartered Accountants of India to raise this issue with the International Accounting Standards Board.

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XBRL — FUTURE FINANCIAL LANGUAGE

The Ministry of Corporate Affairs (MCA) has by its Circular No. 9/2011, dated 31st March, 2011, Circular No. 25/2011, dated 12th May, 2011 and Circular No. 37/2011, dated 7th June, 2011. MCA has mandated certain class of companies to file Balance Sheet and Profit & Loss Account along with Directors’ Report and Auditors’ Report for the year 2010-2011 by using XBRL Taxonomy. In the Phase I of its implementation, the following classes of companies have to file the Financial Statements in XBRL form from the year 2010-2011:

All companies listed in India and their Indian subsidiaries;

All companies having a paid capital of Rs.5 crore and above;

All companies having a turnover of Rs.100 crore and above.

However, banking companies, insurance companies, power companies and NBFCs are exempted for XBRL filing, till further orders. Also, vide its Circular No. 26/2011, dated 18th May, 2011, Circular No. 43/2011, dated 7th July, 2011 and Circular No. 57/2011, dated 28th July, 2011 MCA has made it mandatory that the Financial Statements prepared in the XBRL mode shall be certified by a Chartered Accountant or Company Secretary or Cost Accountant in whole-time practice from the year 2010-2011 onwards. The introduction of XBRL filing and its certification by MCA has opened a new avenue for practice for professionals like us. Therefore, it has become necessary that we gear ourselves up for this upcoming challenge. For this what is necessary is the knowledge about XBRL. Let us discuss about XBRL in great depth in the following paragraphs.

What is XBRL?

XBRL stands for eXtensible Business Reporting Language. It is a language for electronic communication of business and financial data which is revolutionising business reporting around the world. It provides major benefits in the preparation, analysis and communication of business information. It offers cost savings, greater efficiency and improved accuracy and reliability to all those involved in supplying or using financial data. It is one of a family of ‘XML’ languages which is becoming a standard means of communicating information between businesses and on the Internet. XBRL is being developed by an international non-profit consortium of approximately 650 major companies, organisations and government agencies. It is an open standard, free of licence fees. It is already being put to practical use in a number of countries and implementation of XBRL is growing rapidly around the world.

A simple explanation

The idea behind XBRL is simple. Instead of treating financial information as a block of text, as in a standard Internet page or a printed document, it provides an identifying tag for each individual item of data. This is computer-readable. For example, company’s net profit has its own unique tag. The introduction of XBRL tags enables automated processing of business information by computer software, cutting out laborious and costly processes of manual re-entry and comparison. Computers can treat XBRL data ‘intelligently’. They can recognise the information in an XBRL document, select it, analyse it, store it, exchange it with other computers and present it automatically in a variety of ways for users. XBRL greatly increases the speed of handling of financial data, reduces the chance of error and permits automatic checking of information.

Companies can use XBRL to save costs and streamline their processes for collecting and reporting financial information. Consumers of financial data, including investors, analysts, financial institutions and regulators, can receive, find, compare and analyse data much more rapidly and efficiently if it is in XBRL format. XBRL can handle data in different languages and accounting standards. It can flexibly be adapted to meet different requirements and uses. Data can be transformed into XBRL by suitable mapping tools or it can be generated in XBRL by appropriate software. How XBRL works? XBRL is a member of the family of languages based on Extensible Markup Language (XML), which is a standard for the electronic exchange of data between businesses and on the Internet.

Under XML, identifying tags are applied to items of data, so that they can be processed efficiently by computer software. XBRL is a powerful and flexible version of XML which has been designed specifically to meet the requirements of business and financial information. It enables unique identifying tags to be applied to items of financial data, such as ‘net profit’. However, these are more than simple identifiers. They provide a range of information about the item, such as whether it is a monetary item, percentage or fraction. XBRL allows labels in any language to be applied to items, as well as accounting references or other subsidiary information. XBRL can show how items are related to one another. It can thus represent how they are calculated. It can also identify whether they fall into particular groupings for organisational or presentation purposes.

Most importantly, XBRL is easily extensible, so companies and other organisations can adapt it to meet a variety of special requirements. The rich and powerful structure of XBRL allows very efficient handling of business data by computer software. It supports all the standard tasks involved in compiling, storing and using business data. Such information can be converted into XBRL by suitable mapping processes or generated in XBRL by software. It can then be searched, selected, exchanged or analysed by computer, or published for ordinary viewing. However, the use of XBRL does not imply an enforced standardisation of financial reporting.

On the contrary, the language is a flexible one which is intended to support all current aspects of reporting in different countries and industries. Its extensible nature means that it can be adjusted to meet particular business requirements even at the individual organisation level.

Differences between XML and XBRL

XML (Extensible Markup Language) uses tags to identify the meaning, context and structure of data. XML is a standard language which is maintained by the World Wide Web Consortium (W3C). It is a complementary format that is platform independent, allowing XML data to be rendered on any device such as a computer, cell phone, PDA or tablet device. It enables rich, structured data to be delivered in a standard, consistent way. XML provides a framework for defining tags (i.e., taxonomy) and the relationship between them (i.e., schema).

XBRL is an XML-based schema that focusses specifically on the requirements of business reporting. XBRL builds upon XML, allowing accountants and regulatory bodies to identify items that are unique to the business reporting environment. The XBRL schema defines how to create XBRL documents and XBRL taxonomies, providing users with a set of business information tags that allows them to identify business information in a consistent way. XBRL is also extensible in that users are able to create their own XBRL taxonomies that define and describe tags unique to a given environment.

Benefits and uses for business

All types of organisations can use XBRL to save costs and improve efficiency in handling business and financial information. Because XBRL is extensible and flexible, it can be adapted to a wide variety of different requirements. All participants in the financial information supply chain can benefit, whether they are preparers, transmitters or users of business data.

By using XBRL, companies and other producers of financial data and business reports can automate the processes of data collection. For example, data from different company divisions with different accounting systems can be assembled quickly, cheaply and efficiently if the sources of information have been upgraded to using XBRL. Once data is gathered in XBRL, different types of reports using varying subsets of the data can be produced with minimum effort. A company finance division, for example, could quickly and reliably generate internal management reports, financial statements for publication, tax and other regulatory filings, as well as credit reports for lenders. Not only can data handling be automated, removing time-consuming, error-prone processes, but the data can be checked by software for accuracy. Small businesses can benefit alongside large ones by standardising and simplifying their assembly and filing of information to the authorities.

Users of data which is received electronically in XBRL, can automate its handling, cutting out time-consuming and costly collation and re-entry of information. Software can also immediately validate the data, highlighting errors and gaps which can immediately be addressed. It can also help in analysing, selecting, and processing the data for re-use. Human effort can switch to higher, more value-added aspects of analysis, review, reporting and decision-making. In this way, investment analysts can save effort, greatly simplify the selection and comparison of data, and deepen their company analysis. Lenders can save costs and speed up their dealings with borrowers. Regulators and government departments can assemble, validate and review data much more efficiently and usefully than they have hitherto been able to do.

In a nutshell, XBRL can be applied to a very wide range of business and financial data. It can handle:

Company internal and external financial reporting.

Business reporting to all types of regulators, including tax and financial authorities, central banks and governments.

Filing of loan reports and applications; credit risk assessments.

Exchange of information between government departments or between other institutions, such as central banks.

Authoritative accounting literature — providing a standard way of describing accounting documents provided by authoritative bodies.

A wide range of other financial and statistical data which needs to be stored, exchanged and analysed.

XBRL in action

Organisations benefitting from XBRL

Various specific types of organisations can benefit from XBRL. They are as follows:

Companies in general;

Regulators;

Stock Exchanges;

Investment analysts;

Loan and credit management departments of banks;

Companies in financial information industry;

Accountants;

Companies in information technology industry.

XBRL taxonomies
XBRL makes the data readable with the help of two documents — the taxonomy and the instance document. Taxonomies are dictionaries that contain the terms used in the financial statements and their corresponding XBRL tags (i.e., electronically readable codes for each item of financial statements). Thus, taxonomies define the elements and their relationships based on the regulatory requirements. Instance document is a file that contains business reporting information and represents a collection of financial facts and reports — specific information using tags from one or more XBRL taxonomies. The instance document is a computer file that contains entity’s data and other entity specific information and is generally not intended to be read by the human eye.

XBRL taxonomies are the reporting-area specific hierarchical dictionaries used by the XBRL community. They define the specific tags that are used for individual items of data (such as ‘Net Profit’), their attributes and their interrelationships. Different taxonomies will be required for different business reporting purposes. Some national jurisdictions may need their own reporting taxonomies to reflect local accounting and

other reporting regulations. Many different organisations, including regulators, specific industries or even companies, may require taxonomies or taxonomy extensions to cover their own specific business reporting needs.

A special taxonomy developed and recommended by XBRL International has also been designed to support collation of detailed, drill-down data focussing on internal reporting within organisations. This is the Global Ledger (GL) taxonomy. The XBRL GL taxonomy allows the representation of anything that is found in a chart of accounts, journal entries or historical transactions, financial and non-financial. It does not require a standardised chart of accounts to gather information, but it can be used to tie legacy charts of accounts and accounting detail to a standardised chart of accounts to improve communications within a business. XBRL GL is reporting-independent, system-independent, permits consolidation of data from multiple departments and provides flexibility overcoming the limitations of other approaches such as Electronic Data Interchange (EDI).

The IASB is developing a taxonomy which reflects IFRS. National XBRL jurisdictions will extend this taxonomy to reflect their particular local implementation of IFRS. Taxonomies will thus be available to enable those reporting under IFRS in different countries to use XBRL, enhancing efficiency and comparability as adoption of IFRS expands around the world.

Taxonomies for Indian companies are developed based on the requirements of:

Schedule VI to the Companies Act, 1956;

Accounting Standards notified under the Companies Act, 1956;

SEBI Listing Agreements.

Taxonomies can be extended to accommodate items/relationship specific to the owner of the information. Taxonomy extension can be in the following forms:

Modification in the existing relationships;

Addition of new elements in the taxonomy;

Combination of above.

It is to be noted that the U.S.A. allows extension of the taxonomies by the users while the U.K. does not allow extension of the taxonomies by the users. Taxonomies issued by the MCA for the Financial Year 2010-2011 cannot be extended/ modified by the users. However, this inconvenience will be removed from the Financial Year 2011-2012 onwards.

Creation of financial statements in XBRL
There are a number of ways to create financial statements in XBRL:

XBRL-aware accounting software products are becoming available which will support the export of data in XBRL form. These tools allow users to map charts of accounts and other structures to XBRL tags.

Statements can be mapped into XBRL using XBRL software tools designed for this purpose.

Data from accounting databases can be extracted in XBRL format. It is not strictly necessary for an accounting software vendor to use XBRL; third party products can achieve the transformation of the data to XBRL.

Applications can transform data in particular formats into XBRL.

XBRL is a format for exchanging information between applications. Therefore each application will store data in whatever form is most effective for its own requirements and import and export information in XBRL format, so that it can be readily imported or exported in turn by other applications. In some applications, for example, the XBRL formatted information being used may be mostly tabular numeric information, hence easily manipulated in a relational database. In other applications, the XBRL information may consist of narrative document-like structures with a lot of text, so that a native XML database may be more appropriate. There is no mandatory relationship between XBRL and any particular database or other processing or storage architecture.

The route which an individual company may take will depend on its requirements and the accounting software and systems it currently uses, among other factors.

Role of Chartered Accountants vis-à-vis XBRL financial statements

After understanding what is XBRL, let us now have a look upon our role as a Chartered Accountant in respect of certification of financial statements in XBRL mode.

The Standards on Audit (SAs) issued by the ICAI apply to an audit of general purpose financial statements. The term general purpose financial statements has been defined in the Preface to the Statements on Accounting Standards, issued by the ICAI as including “Balance Sheet, Statement of Profit and Loss, a Cash Flow Statement (wherever applicable) and statements and explanatory notes which form part thereof, issued for the use of various stakeholders, Governments and their agencies and the public.” In fact, the references to financial statements in the said Preface and the Accounting Standards issued by the ICAI and notified under the Companies Act, 1956, are construed to refer to the general purpose financial statements. Clearly, the XBRL financial statements are out of the purview of the general purpose financial statements as envisaged in the said Preface. The current SAs issued by the ICAI, therefore, do not require the auditor to perform procedures on XBRL data as part of the financial statement audit. Accordingly, the auditor’s report in accordance with these SAs on the financial statements does not cover the process by which XBRL data is tagged or the XBRL data that results from this process, and thus, no assurance is given on the accuracy, consistency and completeness of the XBRL data itself.

Insofar as the SA 720, The Auditor’s Responsibilities relating to Other Information Contained in Audited Financial Statements is concerned, it may be noted that XBRL data does not construe ‘other information’ as envisaged in SA 720, because it is only a machine-readable rendering of the data within the financial statements. Since the filing of this XBRL data is not a discrete document, the requirement of SA 720 to ‘read the other information’ for the purposes of identifying material inconsistencies or material misstatements of fact would not be applicable to XBRL-tagged data.

The Chartered Accountants engaged to certify XBRL financial statements in terms of the aforementioned MCA’s Circulars of 7th July, 2011 and 28th July, 2011, can draw guidance from the principles enunciated in the Guidance Note on Audit Reports and Certificates for Special Purposes, issued by the Institute of Chartered Accountants of India. The Chartered Accountants’ procedures in respect of certification of XBRL financial statements would be as follows:

Completeness — A Chartered Accountant would need to assess whether all the information has been formatted at the required levels as defined by the applicable reporting requirements in the instance document and related files and that only permitted information selected by the entity is included in the XBRL files.

Mapping — A Chartered Accountant needs to examine whether the elements selected are consistent with the meaning of the associated concepts in the source information in accordance with the requirements of the company’s financial reporting framework.

Accuracy — A Chartered Accountant should examine whether the amounts, dates, other attributes (for example, monetary units), and relationships (order and calculations) in the instance document and related files are consis-tent with the source information in accordance with the requirements of the entity’s reporting environment.

Structure — It is essential to structure instance documents and related files in accordance with the requirements to which the entity’s XBRL files are subject.

As the regulatory requirement of certifying the financial statements in XBRL mode has an immediate impact on our profession, the ICAI should issue a Guidance Note on the certification of the financial statements in the XBRL mode, also giving factors to be taken care of while issuing a certificate along with an illustrative format of the certificate to clarify the situation.

Conclusion
To conclude, the usage of XBRL technology will lead to more information exchanges that can be effectively automated by use. XBRL will lead to the best interest of the company or more so for the international business interest globally that warrants the accuracy of all the financial data for the end-users and early collaborative decisions by the companies or those whose interest is involved for acquisition/rights, etc.

XBRL is set to become the standard way of recording, storing and transmitting business financial information. It is capable of use throughout the world, whatever the language of the country concerned, for a wide variety of business purposes. It will deliver major cost savings and gains in efficiency, improving processes in companies, governments and other organisations.

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IFRS — FAULTY FRAMEWORK?

In the UK, the House of Lords report on audit published in March this year created headlines on competition and choice in the audit market and on the audit of banks. While their Lordships made many of their remarks specifically in respect of bank auditing and bank accounting, there were criticisms that were more generic, stemming from the rules-based nature of IFRS and the evidence suggesting that IFRS was an ‘inferior system’, which limited auditors’ scope to exercise ‘prudent judgment’. They went on to recommend that the use of IFRS should not be extended until the ‘long and uncertain process’ of achieving general agreement on IFRS was complete.

Considering that all publicly-held companies in the UK are required to report using IFRS, these are damning criticisms and ones that bear wider examination. While there is a general agreement that IFRS is a theoretically sound framework for financial reporting, practice suggests that all is not well. The reality is that companies are effectively using their own individual financial reporting frameworks when they communicate with the market. GAAP measures tend not to be broadcast, but frequent reference is made to ‘adjusted (EBITDA) (Earnings Before Interest, Taxes, Depreciation and Amortisation)’. The more cynical might suggest that everyone adjusts their EBITDA to suit themselves and that it forms a sort of ‘earnings before the bad stuff’. However, many auditors insist that GAAP figures have equal prominence with non- GAAP measures, the reality is that analysts and the media reflect other measures, such as free cashflow and maintainable earnings.

There are also a number of areas where business people intuitively distrust IFRS and those tend to relate to areas where the economics implicit in accounting judgments fail to reflect the business decisions behind them.

For instance, in IFRS, the excess of the acquisition cost over the individual net tangible asset values of a business acquired represents a number of intangible assets, whereas under UK GAAP it was all bundled together as goodwill. The values attributed to brands, customer lists and other such intangible assets, all require separate valuation exercises using theoretical models and a number of variable inputs.

The resulting values can vary greatly, depending on the inputs used. I have rarely met anyone in business who ascribes values to intangible assets in such a way, when considering a business acquisition or otherwise, and it is hardly surprising that doing so for accounting purposes causes a degree of the financial reporting outputs to be distrusted.

This distrust of formal financial reporting has contributed to the annual report becoming more a document of record than a live source of information. Companies are now more sophisticated and have a number of channels through which information is given to the market. When taken in conjunction with the blandness and sheer volume of narrative reporting and disclosures in annual reports, it is little wonder that some now see them as anachronistic.

What is to be done? On IFRS, I remain convinced that it is the nearest thing to a conceptual framework that can work globally and scalably for different sizes of companies. However, there are areas where it has become overly complex and produces results that just do not make sense to people in business. These need a long hard look, particularly around asset and liability valuation, impairment, intangibles, share options and deferred taxation. It should be fundamental that an accounting framework is scalable so that we can actually have comparability between companies that have different ownership characteristics, but which might otherwise be identical. IFRS can be put in this position if its complexities are resolved and if its rebalances use fundamental principles to give weight to prudence, comparability, reliability and understandability.

If the Lords’ report can start a sensible debate around IFRS and financial reporting more generally, it will have been worthwhile, irrespective of its sharp analysis of the competitive framework of audit.

[Source : James Roberts, Accountancy, May 2011 (excerpted)]

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Qualification regarding overdue amounts from Customers

Assam Company India Ltd. (31-12-2010)

From Notes to Accounts

Sundry Debtors include an overdue above one year of Rs.2,777.64 lacs, which in the opinion of the management is good and recoverable.

From Auditors’ Report

We draw your attention to Note no. 30 on Schedule no. 13, regarding overdue amounts, aggregating to Rs.2,777.64 lacs at the year-end, due from certain customers which, according to the Management, are recoverable. However, the Management could not provide sufficient and appropriate evidence as to the realisability of the aforesaid overdue amount for our examination and we are unable to concur with the Management’s assertion in this respect that adequate consideration has been given to the concept of prudence set out in Accounting Standard 1 — Disclosure of Accounting Policies. The amount of overdue debts that may be required to be provided for, and impact thereof on the reported profit before tax for the year, debtors’ balance and Reserves and Surplus balance at the year-end, could not be determined.

Further to our comments in the annexure referred to the paragraph 3 above, we report that:

(a) Except for the matter referred to in paragraph 4 above, we have obtained all the information and explanations which, to the best of our knowledge and belief, were necessary for the purposes of our audit;

(b) In our opinion, except for the indeterminate effects of the matter referred to in paragraph 4 above, proper books of account as required by law have been kept by the Company so far as appears from our examination of those books;

(c) The Balance Sheet, Profit and Loss Account and Cash Flow Statement dealt with by this report are in agreement with the books of account;

(d) In our opinion, except for the matter referred to in paragraph 4 above, the Balance Sheet, Profit and Loss Account and Cash Flow Statement dealt with by this report comply with the accounting standards referred to in sub-section (3C) of section 211 of the Act;

(e) On the basis of written representations received from the directors, as on 31st December, 2010 and taken on record by the Board of Directors, none of the directors is disqualified as on 31st December, 2010 from being appointed as a director in terms of clause (g) of sub-section (1) of section 274 of the Act;

(f) In our opinion and to the best of our information and according to the explanations given to us, the financial statements, together with the notes thereon and attached thereto, give, in the prescribed manner, the information required by the Act, and, except for the indeterminate effects of the matter referred to in paragraph 4 above, give a true and fair view in conformity with the accounting principles generally excepted in India:

From Directors’ Report

Auditors’ observations

The remarks in the Auditors’ Report are already explained in the Notes to the Accounts and as such, does not call for any further explanation or elucidation.

The Board, however, deliberated at length with the Statutory Auditors suggestion to provide for export realisation amount which is overdue. Taking into account the 18 years-long association with the Debtors, their track record of making full payment of export dues in the past and considering their request to grant them further time to pay overdue amount the Board thought it prudent not to provide in these Accounts.

Non-Consolidation of Employee Welfare Trust while preparing CFS

Network 18 Media & Investments Ltd. (CFS) (31-3-2011)

From Notes to Accounts

The financials of Network 18 Group Senior Professionals Welfare Trust, a trust formed for the welfare of past and present employees (including directors) of the Company and its subsidiaries have not been consolidated since, as per the management, it is not likely that any economic benefit will flow to the group from that Trust.

From Auditors’

Report Attention is drawn to:

(a) Note 1(C) of Schedule 17 to the financial statements regarding the non-consolidation of Network 18 Group Senior Professionals Welfare Trust as the management does not expect any economic benefit will flow to the group from that Trust.

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Qualifications in Corporate Governance Report

Assam Company India Ltd. (31-12-2010) Himanshu V. Kishnadwala Chartered Accountant From published accounts From Auditors Certificate regarding compliance of Conditions of Corporate Governance

3. In our opinion and to the best of our information and according to the explanations given to us, we certify that the Company has complied with the conditions of Corporate Governance as stipulated in the above-mentioned Listing Agreement except in respect of the following items:

(a) During the period 25th November, 2009 to 6th May, 2010 the audit committee of the Board of Directors had only two directors instead of three directors.

(b) The quorum for the meeting of the audit committee of the Board of Directors held on 29th January, 2010 had only one independent member instead of two independent directors.

(c) As stated in paragraph 4 of the Report of Corporation Governance, the Chairman of the audit committee has not attended the last Annual General Meeting.

(d) The Report on Corporate Governance has not disclosed the non-compliance by the Company in respect of delayed and/or non-submission of the Limited Review Report of the Statutory Auditors on the unaudited results to the stock exchanges during the last three years.

(e) The Company has not submitted the certificate from auditors or practising company secretaries regarding compliance of conditions of corporate governance along with the annual report filed by the Company for the year ended 31st December, 2009 to the stock exchanges.

From Directors’

Report Auditors’ observations

In accordance with the Listing Agreement with the Stock Exchanges the Report on Corporate Governance in accordance with Clause 49 of the Listing Agreement along with the Auditors Certificate is attached.

The remarks in the Auditor’s Certificate are explained hereunder:

1. Clause 3(a), 3(b):

In terms of Clause 49(I)(c)(iv) of the Listing Agreement, the Board may appoint a new independent director within a period of not more than 180 days from the day of such removal or resignation of a Director as the case may be. This requirement has been complied with.

2. Clause 3(c): This remark has already explained in the Report of Corporate Governance, 2010.

3. Clause 3(d): The Limited Review Report shall be forwarded to the concerned authorities on receipt from the Statutory Auditors.

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Disclosures regarding Hybrid Perpetual Securities.

Tata Steel Ltd. (31-3-2011)

From Notes to Accounts [Note 9(c)]

The Company has raised Rs.1,500 crores through the issue of Hybrid Perpetual Securities in March 2011. These securities are perpetual in nature with no maturity or redemption and are callable only at the option of the Company. The distribution on the securities, which may be deferred at the option of the Company under certain circumstances, is set at 11.80% p.a., with a step-up provision if the securities are not called after 10 years. As these securities are perpetual in nature and ranked senior only to share capital of the Company, these are not classified as ‘debt’ and the distribution on such securities amounting to Rs.4.54 crores (net of tax) not considered in ‘Net Finance Charges’.

Extract from Profit and Loss Account

Profit after Taxes 6,865.69 5,046.80

Distribution on Hybrid Perpetual Securities (net of tax Rs.2.25 crores (2009-10 nil) 4.54 — 6,681.15 5,046.80

Balance brought 12,772.65 9,496.70
forward from last year

Extract from Balance 46,944.63 36,961.80
Sheet Total Shareholders’ Funds

Hybrid Perpetual Securities [See Note 9(c) —] 1,500.00 —

Loans xxxx xxxx

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GAPs in GAAP — Amortisation Method for Intangibles

In the case of BOT type contracts, which are covered by a service concession agreement (SCA), and which are accounted for as intangibles, a question arises as to what is the most appropriate method for amortisation. Though this article is set out in the context of a toll road, it would also be applicable in many other cases of intangible assets.

Paragraphs 72 & 73 of AS-26, Intangible Assets set out the requirements with respect to the amortisation method.

72. The amortisation method used should reflect the pattern in which the asset’s economic benefits are consumed by the enterprise. If that pattern cannot be determined reliably, the straight-line method should be used.

73. A variety of amortisation methods can be used to allocate the depreciable amount of an asset on a systematic basis over its useful life. These methods include the straight-line method, the diminishing balance method and the unit of production method. The method used for an asset is selected based on the expected pattern of consumption of economic benefits and is consistently applied from period to period, unless there is a change in the expected pattern of consumption of economic benefits to be derived from that asset. There will rarely, if ever, be persuasive evidence to support an amortisation method for intangible assets that results in a lower amount of accumulated amortisation than under the straight-line method.

View 1

A revenue-based amortisation method better reflects the economic reality of the underlying terms of the SCA. This is particularly welcome in the case of the SCA where the tariff is lower in initial years, but the future increases in tariff will effectively recover the capital invested.

View 2

A time-based amortisation method i.e., the SLM is most appropriate as it reflects the duration of the SCA.

View 3

An amortisation method that reflects the usage of the toll road, for example, let’s say, during the entire duration of the SCA, 10 million trucks and 20 million cars are likely to use the toll road. For simplicity’s sake, let’s also assume that one truck’s consumption of economic benefits (in terms of wear and tear of the toll road, etc.) is twice that of one car. In other words one truck is equal to two cars for the purposes of amortisation. The toll road cost Rs.40 million. In the first year 1 million trucks and 2 million cars use the toll road. If we equal one truck to two cars, the amortisation would be 1/10th (4 million units/40 million units) of Rs.40 million, which is equal to Rs.4 million. This is the unit of production method. Which view is acceptable would be based on how the phrase ‘the method used for an asset is selected based on the expected pattern of consumption of economic benefits’ is interpreted.

Proponents of View 1 interpret the concept of consumption of economic benefits inherent in the licence as the generation of economic benefits arising from the asset’s use. Consequently, the generation of future revenues, future profits are appropriate parameters that could be used to reflect the way the asset is consumed. The application of this method involves an amortisation formula which uses a ratio of actual revenue to estimated revenue as the amortisation basis. Revenue is derived from an interaction between quantity and price, consequently the application of this amortisation method is considered a ‘derived computation’ which involves the use of ‘units of production’ (e.g., traffic volumes in the case of toll-roads) and toll rates. This method also gives a more consistent profit margin.

Proponents of View 2 feel that the contractual agreement only gives the operator the right of use, therefore, the amortisation method for the SCA should be focussed on the use of the contractual right more than on the use of the underlying tangible asset (the toll-road). Consequently, the focus appears to be on the right itself to operate the infrastructure for a certain period and is ‘consumed’ through the passage of time and consequently, a straight-line method of amortisation is more appropriate.

Proponents of View 3 observe that the economic benefits of an asset in an SCA are its ability to be used to provide the public service. The operator does not control the underlying asset and recognises an intangible asset to the extent that it receives a right (licence) to charge users of the public service. In some cases, the operator must return the underlying asset to the grantor in a wearable/ useable condition. Consequently, the physical wearing out of the underlying asset is relevant to the operation of the SCA even if an intangible asset, rather than the physical asset, is recognised in the financial statement. A volume-based method reflects this wearing out better than a time-based method. Further, the wearing out of the underlying asset is not affected by the revenue generated by each unit produced/used. For example, each car on a toll road has the same impact on the wearing out of the road, though the toll fee would have increased over the years for the car. Consequently, proponents of this view would support a units of production method, because it better reflects the pattern of consumption of the economic benefits embodied in the intangible asset.

Overall the author feels that a unit of production method better reflects the use of the underlying asset of a concession arrangement than an approach based on the passage of time. The author believes that View 1 is not acceptable. Paragraph 72 & 73 of AS-26 are clear that the amortisation method should ‘reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity’ and the focus should not be on the generation of economic benefits such as revenue. Revenue is not necessarily a feature of the intangible asset being amortised, because revenue is not necessarily a measure of the results of using an intangible asset in isolation but might incorporate the use of other assets, people and processes; and (b) revenue from the use of an asset does not necessarily reflect the pattern of consumption of the benefits inherent in the intangible asset itself. A revenue-based approach is used only in limited cases for assets that generate revenues directly and independently from other assets.

This is the case for example of film rights that are amortised in the proportion that revenue in the year bears to the estimated ultimate revenue, after provision for any anticipated shortfall. In light of the discussions above, the author feels that View 3 is the preferred method, View 2 is acceptable and View 1 is unacceptable.

I would urge the Institute to issue a clarification as BOT type contracts are becoming the norm in such transactions and the clarification would also bring uniformity in accounting policy/practice and will encourage ‘comparability’ the avowed objective of accounting standard.

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IFRS introduces a single control model for asesing control over investes

On 12th May 2011, the IASB issued its new suite of consolidation and related standards, replacing the existing accounting for subsidiaries and joint ventures (now joint arrangements), and making limited amendments in relation to associates. In this article we focus on IFRS 10 Consolidated Financial Statements

and IAS 27 (2011) Separate Financial Statements, giving our perspectives on the requirements that are modified and that are expected to have an impact on the preparers and users of IFRS financial statements.

New suite of standards

Key

IFRS 10 Consolidated Financial Statements ? IFRS 11 Joint Arrangements

IFRS 12 Disclosure of Interests in Other Entities

IAS 27 (2011) Separate Financial Statements

IAS 28 (2011) Investments in Associates and Joint Ventures

IFRS 10 supersedes IAS 27 Consolidated and Separate Financial Statements and SIC-12 Consolidation — Special Purpose Entities; while the requirements of IAS 27 (2008) relating to the separate financial statements are retained in IAS 27 (2011).

Change in control criteria In a nutshell, IFRS 10 provides similar guidance in relation to the exemptions from preparing consolidated financial statements and the consolidated procedures as contained in IAS 27 (2008); the major change introduced by IFRS 10 is in relation to the definition of control over the investee.

The definition of a subsidiary under IAS 27 (2008) focusses on the concept of control and has two parts, both of which need to be met in order to conclude that one entity controls another, i.e., (a) the power to govern the financial and operating policies of an entity, and (b) to obtain benefits from its activities.

Under IFRS 10, 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. Thus, an investor controls an investee 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 nvestor’s returns.

The exposure to risks and rewards of an investee does not on its own, determine that the investor has control over an investee; it is one of the factors of the control analysis.

Control is assessed on a continuous basis, i.e., it is reassessed as facts and circumstances change. A change in market conditions does not trigger a reassessment of the control conclusion unless it changes one or more of the elements of control (e.g., whether potential voting rights are substantive).

In assessing control over an investee, the investor considers the purpose and design of the investee so as to identify the investee’s relevant activities, how decisions about such activities are made, who has the current ability to direct those activities and who receives returns therefrom.

New single control model

To assess control over the investee under the new single control model under IFRS 10, the following factors may be considered:

(1) Identify the investee;
(2) Identify the relevant activities of the investee;
(3) Indentify how decisions about the relevant activities are made;
(4) Assess whether the investor has power over the relevant activities;
(5) Assess whether the investor is exposed to variability in returns;
(6) Assess whether there a link between power and returns.

The investor considers all relevant facts and circumstances when assessing control over the investee. The approach comprises a collection of indicators of control, but no hierarchy is provided in the approach. In cases where the investor has majority of the voting rights over the investee, the assessment of control may be straightforward; while in certain other cases, a more detailed analysis of all facts and circumstances of the case needs to be made before concluding on the investor’s control over the investee.

Let us understand each of the above-mentioned six factors of the new control model:

Identify the investee

IFRS 10 requires the investor to assess control over the investee, which is a separate legal entity. However, in certain cases, the investor may acquire control over specified assets and liabilities of an entity, such that those specified assets and liabilities may be considered as a deemed separate entity. Such deemed entities are referred to as ‘Silo’ for the purpose of applying the consolidation standard. Specified assets and liabilities qualify as ‘Silo’ if:

In substance, the assets, liabilities and equity of the silo are separate from the overall entity such that none of those assets can be used to pay other obligations of the entity and those assets are the only source of payment for specified liabilities of the silo; and

Parties other than those with the specified liability, have no rights or obligations related to the specified assets or residual cash flows from those assets.

Where one party controls a silo, the other parties exclude the silo when assessing control over the separate legal entity.

Key changes from IAS 27 (2008)

Under IAS 27 (2008), control under is assessed at the level of the separate legal entity; whereas under IFRS 10, the control may also be assessed at the level of silo.

Identify the relevant activities of the investee

For the purpose of IFRS 10, the term ‘relevant activities’ imply activities of the investee that significantly affect the investee’s returns.

Range of activities

For many investees, a range of operating and financing activities significantly affect their returns such as (a) selling and purchasing of goods or services; (b) managing financial assets during their life (including upon default); (c) selecting, acquiring or disposing of assets; (d) researching and developing new products or processes; and (e) determining a funding structure or obtaining funding.

In such cases, the decisions affecting the returns may be linked to decisions such as establishing operating and capital decisions of the investee, including budgets; and appointing and remunerating an investee’s key management personnel or service providers and terminating their services or employment.

Relevant activities occur only when particular circumstances arise or events occur

There can also be investees for which relevant activities occur only when particular circumstances arise or events occur, as the direction of activities is predetermined until this date. In such cases, only the decisions about the investee’s activities when those circumstances or events occur can significantly affect its returns and thus be relevant activities.

As can be noted above, determination of activities that significantly affect the returns of an investee will be highly judgmental in some cases.

Key difference from IAS 27 (2008)

Unlike IFRS 10, IAS 27 (2008) does not include any guidance on the relevant activities of an investee for the purpose of assessing control.

Identify how decisions about the relevant activities are made

To determine control over the investee, IFRS 10 requires the investor to assess whether the investee is controlled by means of voting instruments or is controlled by means of other rights. Depending on the means of control, a different analysis is per-formed to assess which Investor has control over the Investee.

Assess whether the investor has power over the relevant activities

An investor has power over an investee when the investor has existing rights that give it the current ability to direct the activities that significantly affect the investee’s returns. As the definition of power is based on ability, power does not need to be exercised.

In assessing whether the rights held by an investor give it power, the following are considered:

Substantive rights

Only substantive rights held by the investor and oth-ers are considered. To be substantive, rights need to be exercisable when decisions about the relevant activities need to be made, and their holders need to have a practical ability to exercise the rights.

It may be noted that the ‘rights that need to be exercisable when decisions about the relevant activities need to be made’ is different from the current requirement under IAS 27 (2008) of ‘rights that are currently exercisable’. For instance, Entity A has an option to acquire a majority stake in Entity B and the option, which is deep in the money, is exercisable in 25 days’ time. Any shareholder of Entity B can call for a general meeting of the Company by giving a notice of 30 days. Thus in the given case, by the time the general meeting will be held, Entity A would have obtained the majority stake in Entity B and thereby the control (presuming the voting rights are considered relevant). This is different from IAS 27 (2008) where the control would be established only when the option becomes exercisable i.e., after 25 days. Thus, the revised control model may change the date of obtaining control over an investee.

Under IAS 27 (2008), the management’s intentions with respect to the exercise of potential voting rights are ignored in assessing control, because these intentions do not affect the existence of the ability to exercise power. Further, the exercise price of potential voting rights and the financial capability of the holder to exercise them also are ignored. As such, the intent of the parties is not considered when determining whether the rights are currently exercis-able. It seems that IFRS 10 would require the intent of the party who writes or purchases the potential voting rights would be taken into account when assessing whether the rights are substantive.

Protective rights are related to fundamental changes in the activities of an investee or apply only in exceptional circumstances. They cannot give their holders power or prevent others from having power.

IFRS 10 provides guidance on the rights of other parties, and in particular on protective rights. IAS 27 (2008) does not provide any such guidance and as such, guidance is mainly drawn from US GAAP.

Voting rights

An investor can have power over an investee when the investee’s relevant activities are directed through voting rights in the following situations:

? the investor holds the majority of the voting rights, and these rights are substantive; or
? the investor holds less than half of the voting rights but: (1) has an agreement with other shareholders; (2) holds rights arising from other contractual arrangements; (3) holds substan-tive potential voting rights; (4) holds rights sufficient to unilaterally direct the relevant activities of the investee (de facto power); or

(5) holds a combination of those.

The above guidance on voting rights under IFRS 10 is similar to that prescribed by IAS 27 (2008).

De facto control
The investor had de facto control over the investee, because its rights are sufficient to give it power as it has the practical ability to direct the relevant activities unilaterally.

Assessing whether an investor de facto has power over an investee is a two-step process:

? In the first step, the investor considers all facts and circumstances, including the size of its holding of voting rights relative to the size and dispersion of the holdings of other shareholders.

As a result, if the investor holds significantly more rights than any other shareholder and the other shareholdings are widely dispersed, then the investor may have sufficient information to conclude that it has power over the investee. In other cases, it may be clear that the investor does not control the investee. If the first step is not conclusive, then additional facts and circumstances are analysed in the second step.

? In the second step, the investor considers whether the other shareholders are passive in nature as demonstrated by voting patterns at previous shareholders’ meetings. Assessing the voting patterns at previous shareholders’ meeting may require consideration of the number of shareholders that typically come to the meeting to vote i.e., the usual quorum in shareholder’s meeting, and not how other shareholders vote i.e., whether they usually vote the same way as the investor.

If, after this second step, the conclusion is not clear, then the investor does not control the investee.

Assessing de facto control involves exercise of man-agement judgment. The areas involving higher level of management judgment includes:

? Determining whether the current shareholding in the Investee is sufficient;

? Determining whether the other shareholding is sufficiently dispersed; and

? Determining the exact date when the de facto control is obtained. It may be noted that the investor may not have any evidence of de facto control as at the date of acquiring investments. The evidence of de facto control may be obtained only after the initial stages of holding of an investment in the investee.

IAS 27 (2008) does not provide guidance on control whether it should be based on only the power to govern; or in addition to power to govern, the evaluation of control take into account the de facto circumstances. In practice, the reporting entities have an accounting policy choice whether to assess control based on power to govern or, based on de facto circumstances in addition to power to govern. IFRS 10 requires consideration of de facto circumstances as part of the control analysis, and as such eliminates the said accounting policy choice.

Rights other than voting

When holders of voting rights as a group do not have the ability to significantly affect the investee’s returns, the investor considers the purpose and design of the investee and the following three factors:

?   evidence that the investor has the practical ability to direct the relevant activities unilater-ally;
?   indications that the investor has a special relationship with the investee;
?   whether the investor has a large exposure to variability in returns.

The first of these three factors is given the greatest weight in the analysis.

Assess whether the investor is exposed to variability in returns

The investor also should consider whether it is exposed, or has rights, to variability in returns from its involvement with the investee. Returns are defined broadly, and include distributions of economic benefits and changes in the value of the investment, as well as fees, remunerations, tax benefits, economies of scale, cost savings and other synergies.

Assess whether there a link between power and returns

Delegated power

In order to have control, an investor needs to have the ability to use its power over the investee to affect returns for the investor’s own benefit, i.e., there needs to be a link between power and returns.

An investor that has decision-making power over an investee determines whether it acts as an agent or as a principal when assessing whether it controls an investee. If the decision-maker is an agent, then the link between power and returns is absent and the decision maker’s delegated power is deemed to be held by its principal(s).

To determine whether it is an agent, the decision-maker considers:

(1) whether a single party holds substantive rights to remove the decision-maker without cause; if this the case, then the decision maker is an agent;

(2) whether its remuneration is on an arm’s-length terms; if this is not the case, then the decision-maker is a principal;

(3) the overall relationship between itself and other parties through a series of factors if neither (1) nor (2) is conclusive. These factors include:

?   the scope of its decision-making authority over the investee;
?   substantive rights held by other parties;
?   the decision-maker’s remuneration (level of linkage with the investee’s performance); and
?   its exposure to variability of returns because of other interests that it holds in the investee.

Different weightage is applied to each of the factors depending on particular facts and circumstances. The last two factors, i.e., remuneration and other interests held, are sometimes considered in aggregate in IFRS 10 and referred to as the decision-maker’s ‘economic interests’. The greater the magnitude of and variability associated with its economic interests, the more likely it is that the decision-maker is a principal.

Relationship with other parties

The investor determines whether other parties that have an interest in the investee are acting on behalf of the investor. When this is the case, the investor considers the decision-making rights held by these parties together with its own rights to assess whether it controls the investee.

Consolidation procedures

The consolidation procedures under IFRS 10 are similar to the consolidation procedures prescribed under IAS 27 (2008). This also includes accounting for loss of control over an investee.

Separate financial statements

The requirements of IAS 27 (2008) relating to separate financial statements have been retained in IAS 27 (2011).

Effective date and transitional requirements

Effective date
IFRS 10 and IAS 27 (2011) are effective for annual periods beginning on or after 1st January 2013. Early adoption is permitted provided that the entire consolidation suite is adopted at the same time.

Summary

Overall, the implementation of IFRS 10 will require significant judgment in several respects. While the standard is not mandatorily effective until periods beginning on or after 1 January 2013, it is expected that preparers will want to begin evaluating their involvement with investees under the new consolidation standard sooner than that, as the changes in the consolidation conclusion under the new standard generally will call for retrospective application.

At this moment, it is unclear by when the corresponding changes will be introduced under Ind AS framework. However, it is advisable for the companies to continue the process of estimating the impact of the convergence on their business, especially in the light of continuous changes to IFRS.

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The Paper Products Ltd. (31-12-2010)

From Notes to Accounts:
(a) Directors’ remuneration:

(i) The above does not include gratuity and leave encashment benefits as the provisions for these are determined for the Company as a whole and therefore separate amounts for the directors are not available.

(ii) Chairman and Managing Director, Chief Executive Office and Executive Director and Executive Director and Chief Operating Officer of the Company are entitled to options under ‘Option Right Plan’ and shares under the ‘Share Ownership Plan’ of Huhtamaki Oyj (the ultimate holding company) which entitles the holder of the option rights to subscribe to the shares of the ultimate holding company at a future date, at a price fixed based on the fair market prices of the shares during specified period plus certain percentage of market value on the exercise date and the recipient of grants under share ownership plan is entitled to receive shares at nil cost, respectively. The schemes detailed above are assessed, managed and administered by the ultimate holding company and there is no cost charged to the Company. The charge taken by Huhtamaki Oyj in its accounts for the year ended 31st December 2010 for these options and shares is Rs.7,193 Thousand (previous year Rs.11,214 Thousand).

(iii) The above remuneration does not include the remuneration of the Chairman and Managing Director of the Company of Rs.11,812 Thousand (previous year Rs.4,196 Thousand) which is received from Huhtamaki Oyj, the ultimate parent company, for his role as Executive Vice-President (‘EVP’) — Flexibles Packaging Global, Huhtamaki Oyj.

(b) Computation of net profit in accordance with sections 198, 349 and 350 of the Companies Act, 1956 and commission payable to Directors as shown in Table 1 on previous page:

The Company depreciates its fixed assets as enumerated in Schedule 16 Policy III wherein estimated useful lives for certain assets are lower than implicit estimated useful lives prescribed by Schedule XIV of the Companies Act, 1956. Thus, the depreciation charge in the books is higher than the minimum prescribed by the Companies Act, 1956. This higher depreciation charges has been considered as deduction for the Computation of Managerial Remuneration above.

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Macmillan Publishers India Ltd. (31-12-2010)

From Notes to Accounts:
8. The remuneration of the Managing Director and Whole-time Director has been approved by shareholders at the Extra Ordinary General Meeting held on 23rd October 2008. An application seeking Central Government’s approval for the remuneration of Managing Director and Whole-Time Director has been filed to comply with provisions of section 309 read with Schedule XIII of the Companies Act, 1956. The approval of the Central Government is awaited.

From Auditors’ Report:
(v) Attention is invited to Note No. III(8) of Schedule 18 regarding the payment of remuneration to the Managing Director and Whole-time Director, which is subject to approval of the Central Government.

(vi) Subject to the matter referred to in paragraph (v) above in our opinion and to the best of our information according to the explanations given to us, the said accounts give the information required by the Companies Act, 1956 in the manner so required and give a true and fair view in conformity with the accounting principles generally accepted in India.

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Ranbaxy Laboratories Ltd. (31-12-2010)

From Notes to Accounts:

(a) Director’s remuneration*

(i) Liabilities in respect of gratuity pension and leave encashment (for one of the directors) as the same is determined on an actuarial basis for the company as a whole.

(ii) Compensation cost of Rs. nil for the loss of office to a director (previous year Rs.481.38).

Mr. Arun Sawhney was appointed as the Managing Director of the Company with effect from 20th August 2010 for a period of three years. The appointment and remuneration of Mr. Arun Sawhney as the Managing Director has been approved by the Board of Directors, but the requisite regulatory approval from shareholders is yet to be obtained. In accordance with the remuneration determined by the Board of Directors, Rs.32.91 (including commission) has been accounted for as an expense in the Profit and Loss Accounts for the year ended 31st December 2010.

From Auditors’ Report: (f) Without qualifying our report, we draw attention to Note 14 of Schedule 23 of the financial statements, wherein it is stated that the appointment and remuneration of Mr. Arun Sawhney as the Managing Director of the Company with effect from 20 August 2010 has been approved by the Board of Directors, but the requisite regulatory approval from shareholders is yet to be obtained. In accordance with the remuneration determined by the Board of Directors, Rs.32.91 million (including commission) has been accounted for as an expense in the Profit and Loss Account for the year ended 31st December 2010.

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Gaps in GAAP Change In Terms Of An Operating Lease Agreement

Issue Consider the following example involving change in terms of an operating lease. Entity Z is the lessee in an operating lease. The lease term is 10 years. Annual rent is Rs.200, with a fixed escalation of 5% each year. This results in a straight-lined annual lease expense of Rs.252. At the end of year 5, Entity Z and the landlord agree to modify the lease terms. The fixed escalation of 5% is replaced with CPI-linked escalation. The base rent for this purpose is the escalated rent at year 5 under the original terms (Rs.243). At the end of year 5, Entity Z has accrued rent of Rs.153 in its balance sheet as a consequence of straight-lining (prior to any adjustment to reflect the new terms). Entity Z’s accounting policy for contingent rents on operating leases is to expense them in the period to which they relate. The CPI-based escalation clause is considered to be a closely-related embedded derivative and is therefore not separated from the host contract. How is the modification recognised?

Alternative views

AS-19 has no specific guidance on the measurement implications of amending the terms of a lease. Therefore several views are possible, each of which have their own advantages and disadvantages. Also see appendix for the calculations.

View 1: Cancellation and new lease

View 1 treats the modification to the lease contract as a cancellation of the existing lease along with a new lease. AS-19.10 states that “Lease classification is made at the inception of the lease. If at any time the lessee and the lessor agree to change the provisions of the lease, other than by renewing the lease, in a manner that would have resulted in a different classification of the lease under the criteria in paragraphs 5 to 9 had the changed terms been in effect at the inception of the lease, the revised agreement is considered as a new agreement over its revised term. Changes in estimates (for example, changes in estimates of the economic life or of the residual value of the leased asset) or changes in circumstances (for example, default by the lessee), however, do not give rise to a new classification of a lease for accounting purposes.” The wording of AS- 19.10 and its reference to a ‘new agreement’ might be viewed as providing support for this approach (albeit acknowledging that this paragraph addresses reassessment of lease classification and is therefore not directly on point).

As a consequence:

the accrued rent of Rs.153 arising out of straight-lining is released to profit & loss in its entirety at the end of year 5

a new minimum lease payment (MLP) is determined prospectively as Rs.243 per annum. This amount is straight-lined as the non-contingent portion of the annual lease expense in years 6-10

the effect of the CPI adjustment is recognised in each annual period, being the cumulative effect of CPI from year 6 onwards.

One argument against this approach is that it is questionable that it results in a pattern of lease expense that reflects the time pattern of the lessee’s benefits in accordance with AS-19.23 which states that “Lease payments under an operating lease should be recognised as an expense in the statement of profit and loss 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.”

Moreover, it is also questionable that the revision to the lease terms is in substance a cancellation of an existing lease.

View 2: Continuation of lease — revise SLM expense based on adjusted MLPs

View 2 treats the revised lease terms in years 6-10 as a continuation of the original lease. However, the MLPs are now different and the straight-line calculation should reflect this. One method is to determine the new total MLPs for the entire lease (i.e., years 1-10) under the revised terms. A straightline expense is determined for the fixed portion based on that amount.

As a consequence:

a revised straight-line (non-contingent) annual lease expense of Rs.232 per annum is determined based on the revised total MLPs

the accrued rent at the end of year 5 is adjusted. The revised accrual is the difference between the cumulative expense based on Rs.232 and the actual payments up to year 5. This results in Rs.96 being released to P&L instead of the entire Rs.152 under view 1

the effect of the annual CPI adjustment is recognised in each annual period as per view 1.

View 3: Continuation of lease — use original SLM and adjust for variation between original rent and revised rent each period

Like view 2, view 3 treats the revised lease terms in years 6-10 as a continuation of the original lease. However, under view 3 the contingent adjustment is characterised as the variation between the original payment each year and the revised payment. This might be argued to be a better representation of the substance of the revision, which swaps fixed escalation for index-based escalation.

As a consequence:

the accrued rent at year 5 is not adjusted

the original straight-lined annual lease expense of Rs.252 continues to be recognised as the non-contingent portion

the contingent portion in years 6-10 is the difference between the original cash rent for that year based on 5% escalation and the revised cash rent based on CPI.

Conclusion

Each of the above views is essentially unsupported in the standard, and have their own merits and drawbacks. Nevertheless View 3 appears to be the most logical as it results in a better reflection of substance of the change in the operating lease arrangement and is a better representative of the time pattern of the user’s benefit. Appendix

Original Lease Term & Expense Profile

Year

MLP’s

Accrual

Cumulative

expenses

accrued

200.00

251.56

-51.56

210.00

251.56

-41.56

-93.12

220.50

251.56

-31.06

-124.17

231.53

251.56

-20.03

-144.21

243.10

251.56

-8.46

-152.66

255.26

251.56

3.70

-148.96

268.02

251.56

16.46

-132.50

281.42

251.56

29.86

-102.64

295.49

251.56

43.93

-58.71

310.27

251.56

58.71

0.00

Total

2515.58

0.00

Revised Lease Term &
Expense Profile

Year

MLP’s

CPI

Cash

rent

200.00

251.56

210.00

251.56

220.50

251.56

231.53

251.56

243.10

98.89

154.08

251.56

243.10

1.05

255.26

244.22

251.56

243.10

1.06

270.57

259.53

254.11

243.10

1.07

289.51

278.47

259.65

243.10

1.06

306.88

295.84

262.95

243.10

1.05

322.23

311.19

263.52

Total

2320.63

2549.57

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Carve-outs Under IND-AS

With its press release dated 25th February 2011, the Ministry of Corporate Affairs (MCA) notified 35 Indian Accounting Standards converged with IFRS (Ind-AS), thereby eliminating the speculation on the contents of the final standards. However, the press release does not contain the date of implementation of the converged standards. The MCA has clarified that the date of implementation shall be notified at a later date after various issues, including tax-related ones, are resolved.

The final standards notified by the MCA are substantially similar to the current IFRS standards. However, there are certain changes made to the Ind-AS standards as part of the convergence (rather than adoption) process to suit more appropriately to the Indian environment. These changes can be classified into the following categories:

Mandatory differences as compared to IFRS
Removal of accounting policy choices available under IFRS
Additional accounting policy options provided, which are not in compliance with IFRS requirements
Certain IFRS guidance to be adopted with separate (deferred) implementation dates.

This article attempts to explain the first category of carve-outs i.e., mandatory differences with IFRS and their impact on the financial statements. We will cover the other categories of carve-outs in our subsequent articles.

Foreign currency convertible bonds (FCCB):

Position under IFRS:
FCCB involve an exchange of a fixed number of shares for a fixed consideration that is denominated in foreign currency. Since the cash flows of the issuer entity in its own functional currency (i.e., in rupees) is variable due to changes in exchange rates, FCCB do not meet the definition of an equity instrument under IFRS. Thus, under IFRS, FCCB are classified as hybrid instruments and are initially split between the conversion option (embedded derivative) and the loan liability.

Conversion option: The conversion option is treated like a derivative and is initially recorded at its fair value. Like all derivatives, the conversion option is subsequently marked-to-market (MTM) at every reporting date and the impact is recognised in the income statement.

Loan liability: The loan liability is initially recorded as the difference between the proceeds and the amount allocated to the conversion option. Interest is thereafter recorded based on imputed interest rates. Further, the loan is adjusted for exchange rate movements that are recognised in the income statement.

Position under Ind-AS:
The Ind-AS has modified the definition of financial liabilities under Ind-AS 32 (vis-à-vis IAS 32) to exclude from its definition, the option to convert the foreign currency denominated borrowings into a fixed number of shares at a fixed exercise price (in any currency). Thus, these instruments will be split initially into the loan liability and the conversion option (as discussed above), but the conversion option will be recognised as equity (as against a derivative under IFRS) and therefore will not remeasured subsequently i.e., no subsequent MTM.

Key implications of the carve-out:
The key implication of this is that the conversion option is not subsequently MTM under Ind-AS, while such MTM is required under IFRS.

Under IFRS, the changes in the fair value of the conversion option may have a significant impact and result in volatility in profits. Further, the impact on the profits for the year is inversely related to the movement in the underlying share price; i.e., if the fair value of the underlying shares rises, MTM of the conversion option would lead to losses to be recognised in the income statement and vice-versa.

Under Ind-AS, since the conversion option is recognised as equity and is not remeasured subsequently, the carve-out eliminates the volatility in profits on account of the changes in the underlying share prices of the company.

Let us understand the impact of the carve-out with the help of an example:

On 1st April 2012, Company A (INR functional currency) issued 10,000 convertible bonds of USD 100 each with a coupon rate of 4% p.a. (interest payable annually in arrears). The total proceeds collected aggregated to USD 1 million. Each USD 100 bond is convertible, at the holder’s discretion, at any time prior to maturity on 31st March 2017, into 1,000 ordinary shares of Rs.10 each. For simplicity, transaction costs and deferred taxes are ignored. The following information on the exchange rate (spot) and fair value of conversion option (option) may be relevant:

Under IFRS, proceeds collected would be required to be split into loan liability and the conversion option. The total proceeds from the issue of USD 1 million aggregates to Rs.45 million based on a conversion rate of USD 1 = Rs.45. On initial recognition, the conversion option would be recognised at its fair value (i.e., Rs.4.5 million or 0.1 million USD) and the remaining proceeds (i.e., Rs.40.5 million or 0.9 million USD) would be recognised as loan liability.

The Company shall compute an effective interest rate based on the loan principal received (i.e., 0.9 million USD), loan principal on maturity (USD 1 million) and payments to be made for interest costs @ 4% p.a. on the loan principal of USD 1 million. The effective interest rate in this case works out to 6.4% p.a. The interest cost p.a. shall be computed based on outstanding loan principal (in foreign currency) and the effective interest rate of 6.4% p.a. converted at average exchange rates during the year. Further, the loan liability shall be translated at exchange rate as at the reporting date, with the exchange differences recognised in the income statement.

The conversion option on initial recognition aggregated to Rs.4.5 million, while the fair value of the conversion option as at the end of the year aggregates to Rs.9.2 million i.e., an increase by Rs.4.7 million. IFRS requires such a change in the fair value of conversion option to be recognised in the income statement.

Let us consider the movements in the carrying values of the conversion option and the loan liability:

Under IFRS

There are three costs recognised in the income statement i.e., interest cost on the loan, the exchange differences on the loan and the MTM gains/losses on the conversion option.

Under Ind-AS, the accounting for the loan liability is same as under IFRS. However, the conversion option is to be recognised as equity. As stated above, for simplicity we have ignored the transaction costs and deferred taxes. On initial recognition, the fair value of the conversion option (i.e., Rs.4.5 million) shall be recognised as equity. As at the end of the first year i.e., 31st March 2013, there is no further adjustment required on account of the fair value movements of the conversion option.

The costs to the company on account of FCCB under Ind-AS will be the interest cost and exchange gains/losses on the loan components of the instrument, with the conversion option not being remeasured for changes in its fair value.

Under Ind-AS

Agreements for sale of real estate (IFRIC 15):
Position under IFRS:

IFRIC 15 focusses on the accounting for revenue recognition by entities that undertake the construction of real estate. IFRIC 15 provides guidance on determining whether revenue from the construction of real estate should be accounted for in accordance with IAS 11 (Construction contract) or IAS 18 (Sale of goods), and the timing of revenue recognition.

IFRIC 15 clarifies that IAS 11 is applied to agreements for the construction of real estate that meet the definitio

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Asian Paints (India) Ltd. (31-3-2010)

From Notes to Accounts:

20. Exceptional items:

(a) Exceptional item of current year includes Rs.5.77 crores being the write-back of provision for diminution in the value of investments in the Company’s wholly-owned subsidiary Asian Paints (International) Limited, Mauritius in consequent to the buyback of 41,00,000 shares at US$ 1 per share by Asian Paints (International) Limited.

(b) Exceptional item of current year includes Rs.19.69 crores being the reversal of provision made towards diminution in the value of investments in the Company’s wholly-owned subsidiary Asian Paints (International) Limited. Mauritius, based on management’s assessment of the fair value of its investments.

(c) Exceptional item of previous year consists of provision of Rs.5.90 crores towards diminution in the value of the Company’s long-term investment in its subsidiary Asian Paints (Bangladesh) Ltd. made through its whollyowned subsidiary Asian Paints (International) Ltd. based on the management’s assessment of the fair value of its investment. Deferred tax asset on the above provision was not recognised.

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Tata Communications Ltd. (31-3-2010)

From Notes to Accounts:

4. In terms of the agreements entered into between Tata Teleservices Ltd. (‘TTSL’), Tata Sons Ltd. (‘TSL’) and NTT DoCoMo, Inc. of Japan (Strategic Partners-SP), TSL gave an option to the Company to sell 36,542,378 equity shares in TTSL to the SP, as part of a secondary sale of 253,163,941 equity shares effected along with a primary issue of 843,879,801 shares by TTSL to the SP. Accordingly, the Company realised Rs.424.22 crores on sale of these shares resulting in a profit of Rs.346.65 crores which has been reflected as an exceptional item in the profit and loss account for the current year.

11. On 27th August, 2008, the Arbitration Tribunal (the ‘Tribunal’) of the International Chamber of Commerce, Hague handed down a final award in the arbitration proceedings brought by Reliance Globalcom Limited (‘Reliance’), formerly known as ‘FLAG Telecom’, against the Company relating to the Flag Europe Asia Cable System. The Tribunal directed the Company to pay Rs.95.60 crores (US$ 21.45 million) (2008: Rs. NIL) as final settlement against US$ 385 million claimed by Reliance. The amount of Rs.95.60 cores has been charged to profit and loss account and has been disclosed as an exception item.

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Ramco Industries Ltd. (31-3-2010)

From Notes to Accounts:

Consequent to the decision to exit Plastic Storage Tanks business, the difference between estimated resale value of assets of this division an value reflected in the books has been accounted towards impairment loss in terms of AS-28.

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MARICO Ltd. (31-3-2010) (Consolidated Financial Statements)

From Notes to Accounts:

(13) (a) The exceptional items stated in the Profit and Loss account are as under:

(b) During the year, upon completion of necessary compliances under FEMA regulations, the Company divested its stake in Sundari LLC (Sundari) on 8th June, 2009. Sundari ceased to be subsidiary of the Company from the said date. Accordingly, the financial statements of Sundari have been consolidated with that of Marico Limited for the period from 1st April, 2009 to 8th June, 2009. The net effect of the divestment of Rs.4.05 crores is charged to the Profit and Loss account and reflected as ‘Exceptional item’ (detailed hereunder):

(c) Kaya Ltd., a wholly-owned subsidiary of the Company, had launched the Kaya Life prototype to offer customers holistic weight management solutions and had opened five ‘Kaya Life’ centres in Mumbai and Kaya Middle East FZE, a step-down subsidiary of the Company had also opened one centre in the Middle East during the past three years. While clients had been experiencing effective results on both weight loss and inch loss, the prototype had less than expected progress in building a sustainable business model. Hence, the Management took a strategic decision of closing down the centres in March, 2010. Consequently, the Group has made an aggregate provision of Rs.5.74 crore towards impairment of assets of Rs.2.91 crore and other related estimated liabilities of Rs.2.83 crore towards employees’ termination, lease termination costs, customer refunds and stock written down relating to these centres for the year ended 31st March, 2010. (Refer note 23 below)

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Ambuja Cements Ltd. (31-12-2010)

From Notes to Accounts:

During the current year, the Company has estimated provision for slow and non-moving spares based on age of the inventory. Accordingly, the Company has recognised a provision of Rs.61.03 crores as at 31st December, 2010. The provision based on such parameters applied to spares inventory at the beginning of the year amounting to Rs.46.10 crores has been disclosed as an exceptional item in the profit and loss account.

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Registration — Family settlement — Document reciting past events need not be registered — Registration Act, section 17(1) (b), 49.

[ Ram Singh v. Smt. Kesar Kanwar & Ors., AIR 2011 Rajasthan 24]

The petitioner-plaintiff was not allowed to exhibit two documents in a suit, namely, family settlement and a map annexed thereto on the ground that the same were not registered and duly stamped. The petitioner contented that it was not required for a settlement to be registered with the Office of the Registrar as these documents were simply a recitation of past events.

The Court relying on the decision of Roshan Singh v. Zile Singh, AIR 1988 SC 881, held that while an instrument of partition which operates or is intended to operate as a declared volition constituting or severing ownership and causes a change of legal relation to the property divided amongst the parties to it, requires registration u/s. 17(1)(b) of the Act, a writing which merely recites that there has in time past been a partition, is not a declaration of will, but a mere statement of fact, and it does not require registration. The essence of the matter is whether the deed is a part of the partition transaction or contains merely in incidental recital of a previously completed transaction. The use of the past tense does not necessarily indicate that it is merely a recital of a past transaction. It is equally well settled that a mere list of properties allotted at a partition is not an instrument of partition and does not require registration. Section 17(1)(b) lays down that a document for which registration is compulsory should by its own force, operate or purport to operate to create or declare some right in immovable property. Therefore, a mere recital of what has already taken place cannot be held to declare any right and there would be no necessity of registering such a document.

Two propositions therefore flow : Firstly, a partition may be effected orally; but if it is subsequently reduced into a form of a document and that document purports by itself to effect a division and embodies all the terms of bargain, it will be necessary to register it. If it be not registered, section 49 of the Act will prevent its being admitted in evidence. Secondly, evidence of the factum of partition will not be admissible by reason of section 91 of the Evidence Act, 1872. Partition lists which are mere records of a previously completed partition between the parties, will be admitted in evidence even though they are unregistered to prove the fact of partition.

In view of the aforesaid, the Court allowed the writ petition.

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Muslim Law — Properties purchased by female exclusively belongs to her and can be divided only between her children — No concept of jointness of nucleus.

[ Mukhtar Ahmad and Anr. v. Mahmudi Khatoon & Anr., AIR 2011 Jharkhand 28]

The appellant and respondents (1-6) are brothers and sisters and are governed by Hanife School of Muslim Law. The other respondents are sons and daughters of second wife and other relatives. The suit was filed by one of the sisters against the brother and other sisters to get partition with respect to certain properties.

The properties in dispute were recorded in the name of mother Bibi Jainab (first wife). The father of the appellants and defendants had executed one of the properties to his wife in lieu of dawar debt. The Trial Court held that the plaintiff was entitled to get partition. The appeal was filed contending that the Trial Court has wrongly decided the issue considering the principles of Hindu law, where a property is not the absolute property of a female, if the source, from which the property has been purchased, is proved to be of the joint family or by the husband, then it will not be considered to the property of the female. But in the Muslim law, all the properties in the name of muslim lady belong to her, irrespective of source of money, from which it was purchased. The plaintiff is the full-blood sister of the defendants, thus, the plaintiff and the defendants are the legal heirs and successors of their deceased father, Md. Yakub and deceased mother, Jainab Khatoon. The partition suit was filed for preparing of separate ‘takhta’ for the plaintiff after granting a decree of 1/12th share in the properties of her father, Md. Yakub and her mother, Jainab.

The defendant alleged that no property is joint as claimed by the plaintiff. They also claimed that after the death of their parents, the parties have amicably settled their properties and the defendant and the plaintiff was allotted specific share.

The Court referred to certain salient features of Muslim law of succession which distinguish it from modern Hindu law of inheritance, the Muslim law of succession is basically different from the parallel indigenous systems of India. The doctrine of janmswatvavada (right by birth), which constitutes the foundation of the Mitakshara law of succession, is wholly unknown to Muslim law. The law of inheritance in Islam is relatively close to the classical Dayabhaga law, though it differs also from that on several fundamental points. The modern Hindu law of succession as laid down in the Hindu Succession Act, 1956 is, however, much different from both the aforesaid classical systems; it has a remarkable proximity, in certain respects, to the Muslim law of inheritance.

Whatever property one inherits (whether from his ancestors or from others) is, at Muslim law, one’s absolute property — whether that person is a man or a woman. In Muslim law, so long as a person is alive, he or she is the absolute owner of his or her property; nobody else (including a son) has any right, whatsoever, in it. It is only when the owner dies and never before that the legal rights of the heirs accrue. There is, therefore, no question of a would-be heir dealing in any way with his future right to inherit.

The Indian legal concepts of ‘joint’ or ‘undivided’ family, ‘coparcenary’, karta, ‘survivorship’, and ‘partition’, etc., have no place in the law of Islam. A father and his son living together do not constitute a ‘joint family’; the father is the master of his property. The same is the position of brothers or others living together.

Unlike the classical Indian law, female sex is no bar to inherit property. No woman is excluded from inheritance only on the basis of sex. Women have, like men, right to inherit property independently, not merely to receive maintenance or hold property ‘in lieu of maintenance’. Moreover, every woman who inherits some property is, like a man, its absolute owner; there is no concept of either streedhan or a woman’s ‘limited estate’ reverting to others upon her death. The same scheme of succession applies whether the deceased was male or a female.

Since all properties in the name of a female belongs to her exclusively and there is no concept of jointness of nucleus or any concept that the property is purchased from joint nucleus of the head of the joint family, hence, all the properties which are exclusively purchased by sale deed by Bibi Jainab in her name can be divided only between her children. Thus, the plaintiff would be granted 1/10th share in the property belonging to Bibi Jainab. A property which was belonging to the father will be divided amongst all the 17 parties in the ratio of 1/17th each and a separate takhta would be carved out.

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Legal representative — Not legally wedded wife — Right to apply for compensation — Civil Procedure Code, section 2(11).

[ Heeralal Giri v. Ramratan & Ors., AIR 2011 Chhattisgarh 22]

Seema Bai (since deceased), was dashed by the driver of Marshal Jeep by driving the said vehicle rashly and negligently, due to which she succumbed to the injuries sustained in the said accident.

The Tribunal on a close scrutiny of the evidence led, material placed and submissions made, held that deceased Seema Bai was not legally wedded wife of the appellant; the appellant not being legal representative of the deceased; nor was the appellant dependent upon her, is not entitled to file claim petition u/s. 166 of the Motor Vehicles Act, and dismissed the claim petition. The appeal was filed by the appellant claiming compensation for the death of deceased Seema Bai.

The Court observed that the fact that deceased Seema Bai was not legally married wife of the appellant is not in dispute. Admittedly, one Kaushalya Bai is the legally wedded wife residing with the appellant. It was also not in dispute that the appellant was not dependant upon the deceased.

As per section 5(i) of Hindu Marriage Act, 1955, a marriage may be solemnised between any two Hindus if neither party has a spouse living at the time of marriage.

U/s. 166 of the MV Act, an application for compensation arising out of an accident of the nature specified in Ss.(i) of section 165 may be made where death has resulted from the accident, by all or any of the legal representative of the deceased.

According to section 2(11) of the Code of Civil Procedure, ‘legal representative’ means a person who in law represents the estate of a deceased person, and includes any person who intermeddles with the estate of the deceased and where a party sues or is sued in a representative character the person on whom the estate devolves on the death of the party so suing or sued. Almost in similar terms is the definition of legal representative under the Arbitration and Conciliation Act, 1996, i.e., u/s. 2(1)(g). The term legal representative has not been defined in the Motor Vehicles Act.

The word ‘legal representative’ occurring in section 166 of the MV Act, has the same meaning as defined u/s. 2(11) of the Code of Civil Procedure. Now if the same definition of legal representative is applied to the facts and circumstances of the present case, it was crystal clear that the appellant, admittedly was not dependent upon the deceased, is neither a person who in law represents the estate of deceased Seema Bai, nor is a successor in interest of the deceased. Therefore, if the definition of legal representative as provided u/s. 2(11) of the Code of Civil Procedure is taken in its widest amplitude even then the appellant cannot be termed as a legal representative of the deceased entitled to file claim petition before the Tribunal under the MV Act and thus, the order of the Tribunal was upheld.

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Evidence — Tape-recorded conversation — Admissible in evidence.

[Havovi Kersi Sethna v. Kersi Gustad Sethna, 2011 Vol. 113(1) Bom. L.R. 0479]

Parties are wife and husband. The petition for divorce between the parties and other ancillary reliefs was pending trial. The wife, who is the petitioner, is under cross-examination. The husband relies upon certain handwritten diaries of the wife as well as a compact disk (CD) on which conversation between the wife and the husband has been recorded by the husband on certain dates. The husband has produced the transcript of the said conversation. The wife admits the handwriting in her diaries. The parties are at dispute with regard to the taped conversation on the CD. It is contended on behalf of the wife that the taped conversation cannot be relied upon as a document. It is also contended by the wife that the affidavit of documents was not filed and the instrument on which the initial conversation was recorded is not produced. The wife has neither admitted nor denied the conversation. The husband seeks to use it in her cross-examination.

The Court referred to the elementary principle of recording evidence which must be first considered. Evidence consists of examination-in-chief and cross-examination. A party is required to offer for inspection and produce the documents relied upon by him in support of his case. This is required in his examination-in-chief. This contains the oral and documentary evidence.

The Court further observed that the accuracy of the tape-recorded conversation is of utmost importance since the document, which is a CD having tape-recorded conversation, is liable to erasure or mutilation. Thus it would be for the defendant to show that it was the original recording. This could be done by producing the initial record or the original electronic record. This original electronic record, which is primary evidence, is the instrument on which the original conversation is recorded. The defendant has not produced that evidence. The defendant has not shown the mechanical/ electronic process by which the CD was obtained. The defendant has relied upon the CD per se. That, being a copy, is secondary evidence. At the stage at which the CD is sought to be produced (that is in the cross-examination of the plaintiff), the defendant is permitted not to produce the original electronic record. The copy of such record, being the CD, can itself be used for confrontation in the cross-examination. Much will depend upon the answers in the cross-examination by the plaintiff. If however, the defendant desires to set up a specific case, for which the evidence is contained in the CD, he would be required to satisfy the test of accuracy by producing the original electronic record.

It must be mentioned that evidence is to be considered from three aspects; admissibility of evidence, recording of evidence and appreciation of evidence. It is settled law that tape-recorded conversation is admissible in evidence. What must be of importance is how the tape-recorded conversation is to be recorded as evidence and appreciated thereafter. Recording can be in the cross-examination of the other side and/or in the evidence of the recorder himself. The appreciation of evidence would require consideration of the aforesaid three requirements; identification, relevancy and accuracy. It is left to the defendant to pass those tests. If the tests are not passed, the tape-recorded conversation would be of no use in effect ultimately.

The requirement of sealing the recorded conversation would not be applicable in this case. That requirement is of essence in a criminal case where during investigation the conversation of a party is recorded by the investigating officer. He would certainly be required to seal the tape-recorded conversation and keep it in a safe custody so as to play before the Court at the time of the trial. It has nevertheless to be shown to be accurate and untampered with.

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Adoption — Validity — Will proved by examination of attesting witness and scribe of Will — Hindu Adoption and Maintenance Act, section 6 and section 16, Succession Act section 63.

[ Saroja v. Santhilkumar & Ors., AIR 2011 SC 642]

It was the case of the plaintiffs that plaintiff No. 2 who was the daughter of late Arumugha Mudaliar and plaintiff No. 1 was the son of plaintiff No. 2, i.e., grandson of late Arumugha Mudaliar. Arumugha Mudaliar had three children, namely, Mangalam, Saraswathi and Jayasubramanian. Jayasubramanian, the only son had expired in 1982. As the son of late Arumugha Mudaliar had expired, he had adopted Santhilkumar, his grand-son, the son of his daughter Saraswathi and plaintiff No. 1, by executing an adoption deed after doing necessary rituals required to be performed under Hindu Law. Late Arumugha Mudaliar had thereafter executed a registered Will whereby the properties referred along with other properties had been bequeathed and properties referred to in the schedule attached to the plaint had been disposed of in favour of his daughter Saraswathi and his grandson Santhilkumar, i.e., the plaintiffs.

As the defendants i.e., the present appellant and respondent Nos. 3 and 4 were interfering with or were likely to interfere with the possession of the properties referred to, a suit was filed by Saraswathi and her son Santhilkumar who was minor at the relevant time. The said suit was dismissed for the reason that the Trial Court did not believe that Santhilkumar was properly adopted by late Arumugha Mudaliar and the properties which had been bequeathed in the will were ancestral properties and, therefore, late Arumugha Mudaliar did not have absolute right to dispose of the same.

On appeal the Court observed that so far as the adoption of Santhilkumar was concerned, the said adoption had been duly established before the Trial Court. Late Arumugha Mudaliar had followed the rituals required as per the provision of Hindu Law while adopting Santhilkumar as his son. There was sufficient evidence before the Trial Court to establish that Santhilkumar had been validly adopted by late Arumugha Mudaliar. Shri Kandasamy , a witness, had been examined in detail, who had placed on record photographs taken at the time of the ceremony. The said witness had given details about the rituals performed and the persons who were present at the time of the adoption ceremony and the deed of adoption had also been registered. The aforestated facts leave no doubt in mind that the adoption was valid. Even the photographs and negatives of the photographs which had been taken at the time of adoption are forming part of the record. In such a set of circumstances, there was no reason to disbelieve the adoption. Therefore, it was held that Santhilkumar was the legally adopted son of late Arumugha Mudaliar.

So far as execution of the Will was concerned, the said Will had been duly registered. For the purpose of proving the Will, one of the attesting witnesses of the Will, namely, Umar Datta had been examined. In his deposition, he had stated that he was present when the said Will was being written by Kalyanasundaram. The scribe of the Will had also been examined. Thus the Will was proved. The decree of the Trial Court was set aside.

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GAPS in GAAP — AS-16 Borrowing costs

The definition of borrowing costs under AS-16 is an inclusive definition and not an exclusive definition. However, they must meet the basic criterion in the standard, i.e., that they are costs that are directly attributable to the acquisition, construction or production of a qualifying asset. As per AS-16 borrowing costs may include:
(a) interest and commitment charges on bank borrowings and other short-term and long-term borrowings;

(b) amortisation of discounts or premiums relating to borrowings;

(d) finance charges in respect of assets acquired under finance leases or under other similar arrangements; and because the definition of borrowing costs is an inclusive one, numerous interpretative issues arise. For example, would borrowing costs include hedging costs ? Let me explain my point with the help of a simple example using a commonly encountered floating to fixed interest rate swap (IRS).

Example:

Floating to fixed IRS

Company X is constructing a factory and expects it to take 18 months to complete. To finance the construction, on 1st January 2011 the entity takes an eighteen-month, Rs.10,000,000 variable-rated term loan due on 30th June 2012. Interest payment dates and interest rate reset dates occur on 1st January and 1st July until maturity. The principal is due at maturity. Also on 1st January 2011, the entity enters into an eighteen-month IRS with a notional amount of Rs.10,000,000 from which it will receive periodic payments at the floating rate and make periodic payments at a fixed rate of 10% per annum, with settlement and rate reset dates every 30th June and 31st December. The fair value of the swap is zero at inception. During the eighteen-month period, floating interest rates are as follows:

Under the IRS, Company X receives interest at the market floating rate as above and pays at 10% on the nominal amount of Rs.10,000,000 throughout the period.

At 31st December 2011 the swap has a fair value of Rs.40,000, reflecting the fact that it is now in the money as Company X is expected to receive a net cash inflow of this amount in the period until the instrument is terminated. There are no further changes in interest rates prior to the maturity of the swap. The fair value of the swap declines to zero at 30th June 2012. In this example for sake of simplicity we assume hedge is 100% effective, issue costs are nil and exclude the effect of discounting.

The cash flows incurred by the entity on its borrowing and IRS are as follows:

There are a number of different ways in which Company X could theoretically calculate the borrowing costs eligible for capitalisation, including the following:
(i) The IRS meets the conditions for, and Company X applies, hedge accounting. The finance costs eligible for capitalisation as borrowing costs will be Rs.1,000,000 in the year to 31st December 2011 and Rs.500,000 in the period ended 30th June 2012.
(ii) Company X applies hedge accounting, but chooses to ignore it for the purposes of treating them as borrowing costs. Thus it capitalises Rs.925,000 in the year to 31st December 2011 and Rs.540,000 in the period ended 30th June 2012.
(iii) Company X does not apply hedge accounting. Therefore, it will reflect the fair value of the swap in income in the year ended 31st December 2011, reducing the net finance costs by Rs.40,000 to Rs.960,000 and increasing the finance costs by an equivalent amount in 2012 to Rs.540,000.
(iv) Company X does not apply hedge accounting. However, it considers that it is inappropriate to reflect the fair value of the swap in borrowing costs eligible for capitalisation, so it capitalises costs based on the net cash cost on an accruals accounting basis. In this case this will give the same result as in (i) above.
(v) Company X does not apply hedge accounting and considers only the costs incurred on the borrowing, not the IRS, as eligible for capitalisation. The borrowing costs eligible for capitalisation would be Rs.925,000 in 2011 and Rs.540,000 in 2012.

All the above views have their own arguments for and against, although the preparer will need to consider what method is more appropriate in the circumstances. For example, the following points may be considered by the preparer:
1. The decision to hedge interest cost results in the fixation of interest cost at a fixed level and are directly attributable to the construction of the factory. Therefore, method (ii) may not carry much support.

2. To use method (iv) it is necessary to demonstrate that the derivative financial instrument is directly attributable to the construction of a qualifying asset. In making this assessment it is clearly necessary to consider the term of the derivative and this method may not be practicable if the derivative has a different term to the underlying directly attributable borrowing.

3. In this example, method (v) appears to be inconsistent with the underlying principles of AS-16 — which is that the costs eligible for capitalisation are those costs that could have been avoided if the expenditure on the qualifying asset had not been made — and is not therefore appropriate. However, it may not be possible to demonstrate that specific derivative financial instruments are directly attributable to particular qualifying assets, rather than being used by the entity to manage its interest rate exposure on a more general basis. In such a case, method (v) may be an acceptable treatment. Method (iii) may not be appropriate in any case. Whatever policy is chosen by the entity, it needs to be consistently applied in similar situations.

The bigger issue is: in the era of accounting standards — is this diversity warranted and/or desirable?

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Scheme of Amalgamation — Sanction of Court — Companies Act, section 391(2), 394.

[Sesa Industries Ltd. v. Krishna H. Bajaj & Ors., AIR 2011 SC 1070]

A resolution was passed by the Board of Directors of SIL to amalgamate SIL with SGL, effective from 1st April, 2005. In pursuance thereof, SIL and SGL filed respective company applications in the Bombay High Court seeking the Court’s permission to convene a general body meeting. In the year 2006 the High Court allowed SIL and SGL to convene meetings for seeking approval of shareholders. The shareholders of SIL & SGL by 99% majority approved the scheme of amalgamation. Only the respondent No. 1 was the sole shareholder who had objected. Petitions were filed in the High Court for according approval to the scheme. Official Liquidator also filed his report. The objection of report were dismissed and subsequent appeals against the same were dismissed. Thereafter the Company Judge sanctioned the scheme of amalgamation. Aggrieved by the above order the Respondent No. 1 filed an appeal whereby the Division Bench set aside the Company Judge order. Hence the appeals were filed by SLP before the Apex Court.

The Court observed that when a scheme of amalgamation/ merger of a company is placed before the Court for its sanction, in the first instance the Court has to direct holding of meetings in the manner stipulated in section 391 of the Act. Thereafter before sanctioning such a scheme, even though approved by a majority of the concerned members or creditors, the Court has to be satisfied that the company or any other person moving such an application for sanction under sub-section (2) of section 391 has disclosed all the relevant matters mentioned in the proviso to the said sub-section. First proviso to section 394 of the Act stipulates that no scheme of amalgamation of a company, which is being wound up, with any other company, shall be sanctioned by the Court unless the Court has received a report from the Company Law Board or the Registrar to the effect that the affairs of the company have not been conducted in a manner prejudicial to the interests of its members or to public interest. Similarly, second proviso to the said section provides that no order for the dissolution of any transferor company under clause (iv) of subsection (1) of section 394 of the Act shall be made unless the official liquidator has, on scrutiny of the books and papers of the company, made a report to the Court that the affairs of the company have not been conducted in a manner prejudicial to the interests of its members or to public interest. Thus, section 394 of the Act casts an obligation on the Court to be satisfied that the scheme of amalgamation or merger is not prejudicial to the interest of its members or to public interest.

Therefore, while it is trite to say that the Court called upon to sanction a scheme of amalgamation would not act as a court of appeal and sit in judgment over the informed view of the concerned parties to the scheme, as the same is best left to the corporate and commercial wisdom of the parties concerned, yet it is clearly discernible from a conjoint reading of the aforesaid provisions that the Court before whom the scheme is placed, is not expected to put its seal of approval on the scheme merely because the majority of the shareholders have voted in favour of the scheme. Since the scheme which gets sanctioned by the Court would be binding on the dissenting minority shareholders or creditors, the Court is obliged to examine the scheme in its proper perspective together with its various manifestations and ramifications with a view to finding out whether the scheme is fair, just and reasonable to the concerned members and is not contrary to any law or public policy.

An Official Liquidator acts as a watchdog of the Company Court, is reposed with the duty of satisfying the Court that the affairs of the company, being dissolved, have not been carried out in a manner prejudicial to the interests of its members and the interest of the public at large. It, therefore, follows that for examining the questions as to why the transferor-company came into existence; for what purpose it was set up; who were its promoters; who were controlling it; what object was sought to be achieved by dissolving it and merging with another company, by way of a scheme of amalgamation, the report of an official liquidator is of seminal importance and in fact facilitates the Company Judge to record its satisfaction as to whether or not the affairs of the transferor company had been carried on in a manner prejudicial to the interest of the minority and to the public interest.

In the instant case concurrent finding of fact was recorded that information supplied was sufficient. However, the official liquidator failed to incorporate contents of inspection report u/s.209A in his affidavit. The official liquidator thereby failed to discharge the statutory burden placed on him under the second proviso to section 394(1) of the Act.

However the sanction of scheme cannot be held up merely because the conduct of official liquidator is blameworthy. In the instant case the findings in the report u/s.209A of the Act were placed before the Company Judge, and he had considered the same while sanctioning the scheme of amalgamation. Therefore, in the facts and circumstances of the instant case, the Company Judge had, before him, all material facts which had a direct bearing on the sanction of the amalgamation scheme, despite the aforestated lapse on the part of the Official Liquidator. The Company Judge, having examined all material facts, was justified in sanctioning the scheme of amalgamation.

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Powers of Attorney — Right of audience before Court — Power of Attorney Act, 1882, section 2.

[Varsha A. Maheshwari (Mrs) v. M/s. Bhushan Steel Ltd. & Anr., AIR 2011 Bombay 58.]

Shri Ajay Maheshwari, holding the power of attorney on behalf of the appellant Mrs. Varsha Maheshwari, his wife, claimed to be heard on her behalf. Shri Maheshwari asserted his right to be heard by the Court on the basis of the power of attorney executed by his wife. His contention was that since the Power of Attorney empowered him ‘to act and appear’ on behalf of his wife, it conferred a right of audience before the Court.

Shri Maheshwari, holder of power of attorney, relied upon the judgment of the Supreme Court in the case of Janki Vashdeo Bhojwani & Anr. v. Indusind Bank Ltd., reported at 2005 SCC 439, where the Supreme Court held that the right of power of attorney is to appear, plead and act on behalf of the party and can state on oath whatever knowledge he has about the case, but he cannot become a witness on behalf of the party. He can only appear in his personal capacity.

As to the circumstances in which a person may be permitted by the Court to appear, act and plead, the Bombay High Court referred to a judgment of the Supreme Court delivered by Justice V. R. Krishna Iyer, in the case of Harishankar Rastogi v. Girdhari Sharma & Anr., reported at AIR 1978 SC 1019, wherein the Supreme Court held that a private person who was not an advocate, has no right to barge into the Court and claim to argue for a party. He must get the prior permission of the Court for which the motion must come from the party himself.

In the later judgment in the case of T. C. Mathai v. District & Sessions Judge, reported at (1999) 3 SCC 614, the Supreme Court had followed the view in Harishankar Rastogi v. Girdhari Sharma & Anr., (supra) and upheld it.

The Court held that a person holding a power of attorney on behalf of a party authorising him to appear, act or plead for him before a Court of law is not entitled to a right of audience before a Court of law and cannot be heard as a representative of the party unless specifically permitted by the Court to do so upon a proper application moved by the party himself. As regards the application of the appellant Mrs. Varsha Ajay Maheshwari was concerned, having regard to the fact that the person seeking to represent her was her husband who was well versed with the circumstances of the case and being a person who had entered into all transactions relevant for the decision of the present dispute, he was permitted to address the Court in the matter.

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Doctrine of merger — Precedent — Maintainability of review petition before High Court — When SLP dismissed by Apex Court against the main judgment of High Court — Constitution of India, Article 136.

[Gangadhara Palo v. Revenue Divisional Officer, (2011) (266) ELT 3 (SC)]

The main judgment of the High Court was dated 19th June, 2001 dismissing the writ petition of the appellant herein, the appellant thereafter filed a special leave petition to the Apex Court which was dismissed on 17th September, 2001.

The order of the Apex Court dismissing the special leave petition simply states “The special leave petition is dismissed”. Thus, the order gives no reasons.

Thereafter a review petition was filed before the High Court. The question arose as regards the maintainability of the review petition. The review petition was dismissed by the High Court.

On appeal to Supreme Court it was observed that it will make no difference whether the review petition was filed in the High Court before the dismissal of the special leave petition or after the dismissal of the special leave petition. The important question really was whether the judgment of the High Court has merged into the judgment of the Supreme Court by the doctrine of merger or not.

When the Apex Court dismisses a special leave petition by giving some reasons, however meagre (it can be even of just one sentence), there will be a merger of the judgment of the High Court into the order of the Supreme Court dismissing the special leave petition. According to the doctrine of merger, the judgment of the Lower Court merges in to the judgment of the Higher Court. Hence, if some reasons, however meager, are given by the Apex Court while dismissing the special leave petition, then by the doctrine of merger, the judgment of the High Court merges into the judgment of the Apex Court and after merger there is no judgment of the High Court. Hence, there can be no review of a judgment which does not even exist.

The situation is totally different where a special leave petition is dismissed without giving any reasons whatsoever. It is well settled that special leave under Article 136 of the Constitution of India is a discretionary remedy, and hence a special leave petition can be dismissed for a variety of reasons and not necessarily on merits. One cannot say what was in the mind of the Court while dismissing the special leave petition without giving any reasons. Hence, when a special leave petition is dismissed without giving any reasons, there is no merger of the judgment of the High Court with the order of this Court. Hence, the judgment of the High Court can be reviewed since it continues to exist, though the scope of the review petition is limited to errors apparent on the face of the record. If, on the other hand, a special leave petition is dismissed with reasons, however meagre (it can be even of just one sentence), there is a merger of the judgment of the High Court in the order of the Supreme Court.

A judgment which continues to exist can obviously be reviewed, though of course the scope of the review is limited to errors apparent on the face of the record, but it cannot be said that the review petition is not maintainable at all.

A precedent is a decision which lays down some principle of law. A mere stray observation of the Court, would not amount to a precedent. Thus, a stray observation of the Court while dismissing the SLP was not a precedent.

The power of review cannot be taken away as that has been conferred by the statute or the Constitution. The review petition was remanded back to the High Court to decide on merits in accordance with law.

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Inherent powers of Court — Every procedure is permissible for a Court for doing justice unless express prohibited — CPC section 151.

[Rajendra Prasad Gupta v. Prakash Chandra Mishra and Others, (2011) 2 SCC 705]

The appellant was the plaintiff in a suit filed before the Court of the Civil Judge, Varanasi. He filed an application to withdraw the said suit. Subsequently he changed his mind and before an order could be passed in the withdrawal application he filed an application praying for withdrawal of the earlier withdrawal application. The second application was dismissed and that order was upheld by the High Court.

The Supreme Court held that rules of procedure are handmaids of justice. Section 151 of the Code of Code of Civil Procedure gives inherent powers to the Court to do justice. That provision has to be interpreted to mean that every procedure is permitted to the Court for doing justice unless expressly prohibited, and not that every procedure is prohibited unless expressly permitted. Courts are not to act upon the principle that every procedure is to be taken as prohibited unless it is expressly provided for by the Code, but on the converse principle that every procedure is to be understood as permissible till it is shown to be prohibited by the law. As a matter of general principle prohibition cannot be presumed. There is no express bar in filing an application for withdrawal of the withdrawal application.

The application praying for withdrawal of the withdrawal application was maintainable.

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Computer-Assisted Audit Tools (CAATs) — Use of CAATs for Ope rational Rev iew of Plant Maintenance

Preface:

Nancy is Director — Analytics with GRC Analytics Inc. GRC Analytics Inc. are market leaders in the field of governance, risk management and control analytics for the last decade and pioneers in the implementation of audit process and data analytical tools. In a short span of time this bellwether firm had managed to establish a footprint in the accounting, finance and business assurance segment which were the erstwhile arena for large accounting and audit majors. This fast-paced growth was fuelled by a group of techno-finance professionals who delivered consistent value propositions to all their clients by riding on the backbone of contemporary assurance technology.

GRC Analytics Inc. leveraged audit technology like general audit softwares, data mining tools, work paper administration tools, reporting applications, enterprise continuous control monitoring applications and enterprise risk management applications to deliver value-added, high-return valuefor- money results to all the clients from retail to manufacturing, to information technology and healthcare.

GRC Analytics Inc. was solely responsible for overseeing all data analytic projects and applied knowledge management research projects for the firm.

In a recent Internal Audit — Engineering & Technology conclave, Nancy was presenting on the role of ‘Use of CAATs for Operational Audits and Assurance’.

Introduction:
Nancy began by providing the backdrop to the use of CAATs for the operational review of central plant maintenance activities at an engineering industry.

The Central Maintenance Cell (CMC) of a manufacturing company was entrusted with breakdown maintenance and preventive maintenance for ten plant centres in the company. The COO of the company was interested in studying and reviewing problem areas and potential threats in the maintenance process. He instructed the Head-CMC, to provide Nancy and her team with maintenance data for undertaking specialised business analysis.

The Head-CMC in turn provided Nancy with an electronic dump containing the following file layout:

Presentation on operational review of plant maintenance through CAATs:

Nancy wanted to drive home the efficacy of general audit tools to the conclave of participants comprising internal auditors, technical auditors, investigators, risk managers, IT security professionals and more. She decided to help the participants visualise the utility of audit tools (GAS) through a few live plant maintenance case studies and discussions. These case studies served as a primer for a general awareness and appreciation amongst the participants.

Case studies presented were:

(a) Plants experiencing frequent Breakdown Maintenance (BM):

Nancy summarised the electronic dump on the plant code and plant description along with filtered criteria to extract all maintenance codes containing ‘BM’.

She performed this summarisation to arrive at count of breakdown maintenance instances for each plant centre.

With the summarisation file in place she finally performed a top records filter to capture the ‘Top 5’ plant centres by highest frequency of breakdown maintenance.

Armed with this information, the Head-CMC was able to investigate and diagnose the reasons for high breakdowns on specific plant centres by looking at the age, usage, history of maintenance, nature of maintenance, plant output quality and allied details.

(b) Plants experiencing Breakdown Maintenance (BM) immediately after Preventive Maintenance (PM) in the same month:

Nancy appended a new field to the electronic dump and captured the month of maintenance against each maintenance transaction activity.

She then went on to perform a duplicate (exclusion) test on the plant code, plant description and month with the field that must be different being maintenance code.

The resultant report provided a listing of plants being halted for ‘BM’ immediately after ‘PM’ in the same month.

With the instances generated, the Head-CMC was able to investigate and diagnose the reasons for sudden breakdowns after preventive maintenance by studying the nature of preventive maintenance undertaken and the quality of maintenance spares used.

(c) Plants halted for Breakdown Maintenance (BM) beyond 24 hours:

Nancy appended a new field to the electronic dump and captured the time taken to complete each maintenance activity by simply arriving at the difference between the ‘Maintenance start time’ and ‘Maintenance end time’.

She then applied a filter to list plants under ‘BM’ for more than 24 hours.

Finally Nancy converted the filtered report of ‘Above 24 Hour BM cases’ into a frequency distribution as below:

This frequency distribution allowed the Head-CMC to focus on pain areas in the plant maintenance process.

Conclusion:
Nancy culminated her presentation by reiterating that general audit tools are time-tested, stable, robust, powerful, internationally acclaimed and user-friendly applications designed by auditors for auditors.

She added that no tool is a ready substitute for the internal and technical auditor’s acumen and judgment, but is a powerful, cost-effective facilitator.

She encouraged all the internal and technical auditors present to embrace tools and reap the benefits of an idea whose time has come.

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Need for optimal choice of accounting policies under Ind-AS

The final standards notified by the MCA are substantially similar to the current IFRS standards. However, there are certain changes made to the Ind-AS standards as part of the convergence (rather than adoption) process to make them suitable to the Indian environment. These changes can be classified into the following categories:

Mandatory differences as compared to IFRS;
Removal of accounting policy choices available under IFRS;
Additional accounting policy options provided, which are not in compliance with IFRS requirements;
Certain IFRS guidance to be adopted with separate (deferred) implementation dates.

Our previous article explained the first category of carve-outs i.e., mandatory differences with IFRS and their impact on the financial statements. This article attempts to cover the other categories of carve-outs, whose primary focus is on accounting policies.

I. Removal of accounting policy choices available under IFRS:

This category of carve-outs pertain to several areas where IFRS offers multiple policy choices while Ind- AS restricts these policy choices.

This category of carve-outs do not result in deviations from IFRS, as they represent permitted policy choices. However, while following the policies prescribed under Ind AS will result in conformity with IFRS, these carve-outs could pose a challenge for Indian companies, if global peers follow other alternative policies (such as fair value model for investment property); if such companies are a part of a global group that follows other alternative policies; or if the Indian company has previously followed other alternative policies for IFRS reporting to overseas stakeholders.

Presentation of profit and loss account based on single statement or two-statement approach:

Position under IFRS:

IFRS provides entities with an accounting policy choice in relation to the presentation of income statement. The reporting entity can present comprehensive income as:

a single statement of comprehensive income (which includes all components of profit or loss and other comprehensive income); or
in the form of two statements i.e., an income statement (which displays components of profit or loss) followed immediately by a separate ‘statement of comprehensive income’ (which begins with profit or loss as reported in the income statement and discloses components of other comprehensive income aggregating to total comprehensive income for the period).

Position under Ind-AS:

Ind-AS requires entities to present the profit and loss account based on the single-statement approach. The two-statement approach is not permitted under Ind-AS.

Presentation of expenses based on nature or function:

Position under IFRS:
Expenses in the profit and loss account are classified according to their nature or function.

When expenses are classified according to function, expenses are generally allocated to cost of sales, selling, administrative or any other functions of the reporting entity.

There is no guidance in IFRS on how specific expenses are allocated to functions. An entity establishes its own definitions of functions such as cost of sales, selling and administrative activities, and applies these definitions consistently. Additional information based on the nature of expenses (e.g., depreciation, amortisation and staff costs) is disclosed in the notes to the financial statements.

When classification by nature is used, expenses are aggregated according to their nature (e.g., purchases of materials, transport costs, depreciation and amortisation, staff costs and advertising costs).

Position under Ind-AS:

Ind-AS permits presentation of expenses based on the nature of expenses only. As such, presentation of expenses based on function is not permitted.

Presentation of dividend/interest received and paid in the cash flow statement:

Position under IFRS:

Interest paid/received and dividends received are usually classified as operating cash flows for a financial institution. For other entities, IFRS provides entities with an accounting policy choice whereby:

Interest paid and interest and dividends received may be classified as operating cash flows, because they enter into the determination of profit or loss.
Alternatively, interest paid and interest and dividends received may be classified as financing cash flows and investing cash flows, respectively, because they are costs of obtaining financial resources or returns on investments.

Position under Ind-AS:

Ind-AS requires interest paid and interest and dividends received to be classified as financing cash flows and investing cash flows, respectively.

Investment property: Cost model and fair value model:

Position under IFRS:

All investment properties are initially measured at cost. Subsequent to initial recognition, an entity chooses an accounting policy to be applied consistently, either to:

measure all investment property using the fair value model; or
measure all investment property using the cost model.

Where an entity has adopted a fair value model, all changes in fair value subsequent to initial recognition are recognised in the profit and loss account.

Position under Ind-AS:

Ind-AS prohibits use of fair value model for investment property.

Actuarial gains and losses:

Position under IFRS:

Under IFRS, actuarial gains and losses on defined benefit plans can be recognised using various acceptable policy choices. Thus, such actuarial gains or losses can either be recognised in other comprehensive income; or recognised immediately in the profit and loss account; or amortised into the profit and loss account using the corridor approach (or any other systematic method which results in faster recognition than the corridor approach).

Position under Ind-AS:

Ind-AS does not permit immediate recognition of actuarial gains or losses in the profit and loss account or amortisation through the profit and loss account. It requires actuarial gains or losses to be recognised directly in other comprehensive income.

Presentation of government grants related to assets:

Position under IFRS: Two methods of presentation in financial statements of grants related to assets are regarded as acceptable alternatives:

grants presented as deferred income and recognised in profit or loss on a systematic basis over the useful life of the asset.
grants adjusted against the carrying value of the asset. The grant is recognised in profit or loss over the life of a depreciable asset as a reduced depreciation expense.

Position under Ind-AS:

Ind-AS requires government grants related to assets to be presented in the balance sheet by setting up the grant as deferred income. Recognition as a reduction from the asset is not permitted.

Measurement of non-monetary grants:

Position under IFRS:

A government grant may take the form of a transfer of a non-monetary asset, such as land or other resources, for the use of the entity. If a government grant is in the form of a non-monetary asset, then an entity chooses an accounting policy, to be applied consistently, to recognise the asset and grant at either the fair value of the non-monetary asset or at the nominal amount paid.

Position under Ind-AS:

In case of non-monetary grants, the fair value of the non-monetary asset is assessed and both the grant and the asset are accounted for at that fair value.

II. Additional accounting policy choices:

This category of carve-outs represent an area where a company can either elect to follow policies aligned to IFRS, or alternate policies that diverge from IFRS.

This category of carve-outs represents an area where each individual company needs to apply careful thought and consideration. Thus, if companies want to achieve full compliance with IFRS, they would need to elect accounting policies that are aligned to IFRS. On the other hand, if compliance with IFRS is not relevant for the company, it may elect other policies that are divergent with IFRS. While assessing these policy choices, companies need to evaluate not just their current environment, but future plans (for instance, plans for a future overseas listing or fund-raising).

Such carve-outs include the following:

Exchange differences on long-term foreign currency monetary items:

Position under IFRS:

Foreign exchange gains and losses generally are recognised in the profit or loss.

Position under Ind-AS:

Ind-AS has retained the above position under IFRS. Additionally, it has provided an option to recognise unrealised exchange differences on long-term monetary assets and liabilities to be recognised directly in equity and accumulated in a separate component of equity. The amount so accumulated shall be transferred to profit or loss over the period of maturity of such long-term monetary items in an appropriate manner.

Deemed cost exemption for Property, Plant and Equipment (PPE):

Position under IFRS:

On transition to IFRS, an entity has the following choices with respect to PPE for computing deemed cost under IFRS:

Revalue individual, some or all items of PPE to its fair value as at the transition date.

In case assets are revalued under the previous GAAP, then those revalued amounts can be considered as a deemed cost, provided that that revalued amounts are broadly comparable (i) to the fair values as at the date of revaluation, or (ii) cost or depreciated cost in accordance with IFRS adjusted to reflect, for instance, the changes in the general or specific price index.

Event-driven (such as on account of IPO or Privatisation) fair values may be considered as deemed cost.

Position under Ind-AS:

Apart from the options provided under IFRS, Ind-AS provides an additional option to continue Indian GAAP carrying values of all items of PPE as at the transition date without any modification, except for recognising asset retirement obligations. This exemption, if exercised, is required to be applied to all items of PPE without exception.

III. Certain guidance to be adopted with separate (deferred) implementation dates:

The Ind-AS standards currently notified defer the application of guidance on accounting for embedded lease arrangements and service concession arrangements. It is expected that such guidance will become mandatory at a later date.

Similarly, the Ind-AS on accounting for exploration and evaluation of mineral resources shall be notified at a later date.

Summary:

While Ind-AS financial statements presented for the first transition period cannot be fully compliant with IFRS (since comparatives would not be presented), Ind-AS financial statements for subsequent years can be made fully compliant with IFRS, if a company chooses optimal accounting policies and does not adopt the diluted alternatives available under Ind-AS. This is assuming that a company is not impacted by the mandatory deviations.

It is advisable for the companies to continue the process of estimating the exact impact of the convergence on their business, especially in the light of mandatory carve-outs and other non-mandatory differences with IFRS that are now clear on account of the notification of the final standards. Companies that otherwise need to fully comply with IFRS issued by the IASB (for example, because their securities are listed in overseas markets that require IFRS) need to carefully evaluate the impact of such carve-outs.

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Independent assurance statement

Infosys Technologies Ltd. — (31-3-2010)

Introduction:
Det Norske Veritas AS (DNV) has been commissioned by the management of Infosys Technologies Limited (Infosys) to carry out an assurance engagement on the Infosys Sustainability Report 2009-10 (the Report). This engagement focussed on qualitative and quantitative information provided in the report, and underlying management and reporting processes. It was carried out in accordance with the DNV protocol for Verification of Sustainability Reporting (VeriSustain).

The intended users of this assurance statement are the readers of the Infosys 2009-2010 Sustainability Report. The Management of Infosys is responsible for all information provided in the Report as well as the processes for collecting, analysing and reporting that information. DNV’s responsibility regarding this verification is to Infosys only, in accordance with the scope of work carried out. DNV disclaims any liability or responsibility to a third party for decisions, whether investment or otherwise, based on this Assurance Statement.

Scope of assurance:
The scope of work agreed upon with Infosys included the verification of the content, focus and quality of the information presented in the report, against the moderate level assurance requirements in VeriSustain, covering the period April 2009 to March 2010. In particular, this assurance engagement included:

Review of the policies, initiatives and practices described in the Report as well as references made in the Report to the Annual Report and corporate website;
Review of the Report against Global Reporting Initiative Sustainability Reporting Guidelines Version 3.0 (GRI G3) and confirmation of the Application Level;
Review of the processes for defining the focus and content of the report;
Verification of the reliability of information and performance data presented in the Report;
Visits to the Infosys’ head-office in Bangalore and development centres in Bangalore, Mysore and Chennai, India.

Verification methodology:
This engagement was carried out between August and September 2010 by a multidisciplinary team of qualified and experienced DNV sustainability report assurance professionals. DNV states its independence and impartiality with regards to this engagement. DNV confirms that throughout the reporting period there were no services provided which could impair our independence and objectivity and also maintained complete impartiality towards people interviewed during the assignment.

The Report has been evaluated against the principles of Materiality, Stakeholder Inclusiveness, Completeness, Responsiveness, Reliability and Neutrality, as set out in VeriSustain, and the GRI G3 Application Levels.

During the assurance engagement, DNV has taken a risk-based approach, meaning that we concentrated our verification efforts on the issues of high material relevance to Infosys’ business and stakeholders. As part of the engagement we have challenged the sustainability-related statements and claims made in the Report and assessed the robustness of the underlying data management system, information flow and controls. For example, we have:

Examined and reviewed documents, data and other information made available to DNV by Infosys;
Conducted interviews with three members of the board including Chairman of the board and Chief Operating Officer;
Conducted interviews with 39 representatives of the Company (including members of the Infosys Sustainability Council, data owners and representatives from different divisions and functions);
Performed sample-based reviews of the mechanisms for implementing the Company’s own sustainability-related policies and stakeholder engagements as described in the Report, and for determining material issues to be included in the Report;
Performed sample-based audits of the processes for generating, gathering and managing the quantitative and qualitative data included in the Report;
Reviewed the process of acquiring information and economic-financial data from the 2009-10 certified consolidated balance sheet.

Conclusions:
In our opinion, the Report is an appropriate and reliable representation of the Infosys sustainability- related policies, management systems and performance for the period 2009-10. The Report, along with the referenced information in the Annual Report and on the Company website, meets the general content and quality requirements of the GRI G3, and DNV confirms that the GRI requirements for Application Level ‘A+’ have been met. We have evaluated the Report’s adherence to the following principles on a scale of ‘Good’, ‘Acceptable’ and ‘Needs Improvement’:

Materiality: Acceptable. Infosys has strengthened the materiality determination process with the identified three key focus areas of Social Contract, Resource Efficiency and Green Innovation. But the process needs to be implemented across each division and location with due consideration of short, medium and long-term impacts.

Stakeholder Inclusiveness: Good. The Company has established a process of collating inputs from various stakeholders. A multi-stakeholder based, objective-oriented engagement approach is also evident in the field of adoption of cleaner energy and higher education.

Completeness: Acceptable. The reporting boundary is limited for many parameters (page 9) and does not cover the entirety of Infosys. Infosys shall incrementally improve to aid reporting to reflect the global organisation’s footprint. But within the reporting boundary defined by Infosys, we do not believe that the Report omits relevant information that would influence stakeholder assessments or decisions.

Responsiveness: Acceptable. Infosys has responded to the material issues and to its stakeholders through its policies, management systems and processes. However, this can be improved by expanding the goal setting process to cover more material issues and appropriate performance indicators.

Reliability: Good. No systematic or material errors have been detected for data and information verified. The identified minor discrepancies were corrected. However, there is scope for improving the process to reduce potential for errors.

Neutrality: Acceptable. The information contained in the Report is presented in a balanced manner, in terms of content and tone. Overall the Report is transparent, but can be further improved by more detailed disclosures in the employee sections.

Recommendations:
In addition to the improvement opportunities stated above, DNV recommends that Infosys:

Identifies sustainability indicators beyond those available in the GRI, drawing from the materiality process and incorporating them with measurable targets in future reports to remain in line with international practices.
Formalises the functioning of the Sustainability Council and integrates the same to existing and relating governance mechanisms.

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GapS in GAAP — Accounting for Jointly Controlled Entities that have Minority Interest

Background:

Entities A, B and C have equal ownership (33.33%) in Entity D, which they all account for as an interest in an associate (commonly known as equity method). Now A and B, enter into an arrangement under which they will form a Newco (a newly formed shell company), in which they will each have a 50% interest in return for contributing their shares in Entity D. Consequently, after completion of the transaction, Newco has a 66.7% controlling interest in Entity D and, in its consolidated financial statements (CFS), will record minority interest for investor C’s interest in Entity D.

Entities A and B when exchanging their shares in Entity D for shares in Newco, also enter into a contract which results in them having joint control (as defined in AS-27 ‘Financial Reporting of Interests in Joint Ventures’) over Newco. A and B both apply proportionate consolidation for Jointly Controlled Entities (JCE) in the CFS.

Question:
In the CFS of A and B, should the proportionate consolidation be restricted to the effective interests (33.33%) that Entities A and B each have in Entity D, or to 50% of all line items in Newco’s financial statements (including the minority interest) ?

View 1:
Entities A and B will recognise only their effective interests (33.33%) in Entity D. Proponents of this view use the definition of proportionate consolidation to support the argument. As per AS-27 Proportionate consolidation “is a method of accounting and reporting whereby a venturer’s share of each of the assets, liabilities, income and expenses of a jointly controlled entity is reported as separate line items in the venturer’s financial statements.” This definition refers only to the venturer’s share of each of the assets, liabilities, income and expenses of a JCE, and that minority interest does not meet the definition of any of these items. Further, paragraph 30 of AS-27 may also support this view, “When reporting an interest in a jointly controlled entity in consolidated financial statements, it is essential that a venturer reflects the substance and economic reality of the arrangement, rather than the joint venture’s particular structure or form. In a jointly controlled entity, a venturer has control over its share of future economic benefits through its share of the assets and liabilities of the venture. This substance and economic reality is reflected in the consolidated financial statements of the venturer when the venturer reports its interests in the assets, liabilities, income and expenses of the jointly controlled entity by using proportionate consolidation.”

View 2:
Proponents of view 2 (50% proportionate consolidation) point out to paragraph 31 of AS-27 ‘. . . . Many of the procedures appropriate for the application of proportionate consolidation are similar to the procedures for the consolidation of investments in subsidiaries, which are set out in AS-21 Consolidated Financial Statements’. Therefore, it is considered that this results in a requirement for the inclusion of all line items, including those relating to minority interest, for the purposes of proportionate consolidation.

View 3:
Entities A and B have an accounting policy choice, as the accounting guidance is not definitive.

Author’s view:
If the formation of Newco has no substance other than to house the JV and to achieve a gross-up presentation in the CFS of Entity A and B that includes minority interest, then view 1 (33% consolidation) may be a more appropriate accounting treatment. If however, the Newco did have substance (for example, it may be planned to raise funds or list NewCo) then view 2 (50% consolidation) could be favorably argued. In other words, substance over form should prevail.

Nevertheless, this is an issue that ultimately the standard-setters should resolve.

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XBRL Assurance

Last couple of years have witnessed an increased pace of adoption of XBRL as a standard for digital financial reporting across the world. Various regulators and government bodies are increasingly implementing XBRL for regulatory filings viz. The Securities Exchange Commission of USA, Her Majesty Revenues & Customs of UK, The Canadian Securities Administrators of Canada, FSA of Japan, and The Securities Regulatory Commission of China, etc. The Ministry of Corporate Affairs of India has also mandated submission of financial statements by selected companies in XBRL format.

The anticipated growth of XBRL use and its potential to replace traditional financial statements and electronic version of such financial statements in HTML or PDF format raises important assurance issues related to the information in ‘XBRL Instance Documents.’ Many companies that are currently providing their information using XBRL are doing so with limited quality assurance due to a lack of guidance on the best practices and limited auditor involvement. This poses a significant threat to the reliability and quality of XBRL-tagged financial data.

Auditors currently attest to the material accuracy of the financial statements using generally accepted principles of accounting (GAAP) as the criteria against which the financial statements prepared by the management are evaluated. Attestation on the financial statements does not apply to the current process of creating XBRL Instances, and it is not clear what criteria would be used by the auditors or others as they provide assurance services in XBRL environment. In contrast to a traditional financial audit, the subject-matter in an XBRL assurance engagement would be on the XBRL ‘documents,’ which are computer-readable files created in the tagging process.

There is a misconception that tagging of information in XBRL is similar to converting a Word document into PDF file and that tagged XBRL data is as accurate as the underlying information in the source documents from which it has been created and hence Assurance on XBRL Instance is like the original to a zerox copy being certified. This is an inappropriate analogy, because the process of tagging involves judgment and there is potential for intentional or unintentional errors that could result in inaccurate, incomplete, and/or misleading information. This is a problem because it is the XBRL-tagged data that will ultimately be consumed and used for decision-making purpose. Therefore, completeness, accuracy or consistency of the XBRL-tagged data is of paramount importance.

Potential risk in XBRL instances

XBRL instance documents provide financial data for a company for a particular reporting period along with comparative financial data for previous reporting period. The potential errors in an XBRL instance document which contribute risk in XBRL instance document in an open taxonomy (where taxonomy extensions are allowed) or closed taxonomy (where taxonomy extensions are not allowed) environment could be as under:

Information on Identity of reporting entity could be wrong or might have changed from previous year. It will make the retrieval and comparison of financial data more difficult for the users.

Nature of financial data could be wrong e.g., audited or unaudited, budged or actual, revised or re-grouped or re-casted, etc. It will make the comparison of financial data difficult.

Information on reporting period could be wrong e.g., an XBRL instance document with a reporting period of Q 3 2011 erroneously puts the reporting period as Q 3 2001. ? Currency could be wrong e.g., an XBRL instance document filed in India with all monetary values in US Dollars will make the task of comparison difficult. Of course the comparison can be done after converting all monetary values in Indian Rupees, but then there is a risk involved in the currency conversion.

Precision or scaling in monetary values contained in an XBRL instance document could lead to inaccurate data not suitable for comparison and analysis purposes e.g., Turnover of Rs.1,65,85,987 will be rounded off to Rs.2 crores if the precision measure taken in XBRL Instance document is ‘Rs. in Crores.’

Segment information could be wrong or might have changed from previous year. It can make the segment comparison difficult for the user.

Technical reference information in XBRL Instance document can point at wrong taxonomy which will make it difficult to compare with other XBRL filings.

XBRL validation is a pre-requisite for the regulators and users of XBRL data. They can’t commence using XBRL data unless XBRL Instance document passes the validation test.

Base reference information could be wrong e.g., pointing to XBRL taxonomy on computer’s hard disk instead of official XBRL taxonomy.

Selection of wrong tags for reporting financial data in XBRL instance document will not only make the XBRL data inaccurate, but will also make it less usable.

Reporting wrong data in XBRL instance document even though the tag selection is right, will make the XBRL data inaccurate and less reliable.

Failing to mark-up a concept will lead to some vital information missing in XBRL instance document.

Closed taxonomy risks mainly consist of integrity and accuracy of data. Since, taxonomy extensions are not allowed in a closed taxonomy, the filer needs to tag the financial data with the residuary tag which could lead to wrong conclusions e.g., if a filer doesn’t find any suitable tag for a line item in his Profit & Loss Account, he needs to tag it with ‘Other Income’ or ‘Other Expenditure’. The filer could also use a wrong version of taxonomy for XBRL instance generation.

Open taxonomy risks mainly relate to creation of a new taxonomy element (taxonomy extension). The filer could create a duplicate element for a concept that already has an element in the base taxonomy or could create an inappropriate or misleading taxonomy element. The taxonomy extension may not comply with the rules of XML and XBRL. The filer could use prohibited name in taxonomy extension.

Evaluating the quality of XBRL formatted information

The quality of XBRL files is an important concern to the users of these files. The errors in XBRL files will have varying consequences based on the potential errors that could occur while preparing XBRL files; the following four principles and criteria have been developed for assessment of quality of XBRL files:

Completeness
All required information and data as defined by the entity’s reporting environment is formatted in the XBRL Instance document and is complete in all respect.

Mapping
The elements viz. line items, domain members and axis selected in the XBRL file are consistent with the associated concepts in the source documents.

Accuracy
The amount, date and other attributes e.g., monetary units are consistent with the source documents.

Structure
XBRL files are structured in accordance with the requirements of the entity’s reporting requirements.

Approach to XBRL assurance
Srivastava & Kogan had presented a conceptual framework of assertion for XBRL instance documents for XBRL filings at SEC.

The auditor needs to carry out Agreed Upon Procedures (AUP) and report his findings on the followings:

Whether the XBRL instance document has captured all the facts and data of the financial statement in traditional format or not?

Whether the XBRL instance document contains any fact or data which is not present in the financial statement in traditional format or not?

Whether all the element values and attribute values (context, unit, etc.) in XBRL instance document correctly represent the data in the financial statement in traditional format or not?

Whether the XBRL instance document complies with all XML syntax rules or not?

Whether the XBRL instance document complies with all rules of XBRL and referenced XBRL taxonomies or not?

Whether the XBRL tagging in the instance document properly represents the fact/data in the financial statement in traditional format or not?

Whether the XBRL instance document references correct version and industry specific taxonomy or not?

Whether the taxonomy extensions created and used in the XBRL instance document comply will all rules of XML and XBRL or not?

Whether the new elements in the XBRL taxonomy are not duplicate or misleading or not?

Whether the Linkbases used in the XBRL taxonomy extensions are appropriate or not?

Control Tests and Substantive Tests
Control Tests and Substantive Tests need to be designed and applied to mitigate the risks in XBRL instance documents.

Control tests

The Auditors are familiar with internal controls over the accounting processes. However, in the case of assurance over XBRL instance document, internal controls over XBRL tagging process need to be checked. The control tests need to be applied on:

(i) the effectiveness of the XBRL tool that has been used to generate XBRL instance document; and
(ii) the effectiveness of the validation tool

Substantive tests

In traditional audit sampling, the auditor is expected to specify either tolerable error or tolerable deviation rate and a desired reliability in order to determine a sample size sufficient to meet the audit objectives. However, in the case of audit of an XBRL instance document, since the objective of sampling is to determine whether tagging process has resulted in a material misstatement; an attribute sampling approach would not be appropriate. One can imagine a situation where a single wrong tagging results in a material misstatement or where numerous wrong tagging aggregates to an immaterial amount of error.

Materiality

The current auditing processes for examining and reporting on financial statements are designed to ascertain that, ‘taken as a whole’, the financial statements are free from any material misstatement and present a ‘true and fair view’ of the state of affairs of any company. The concept of materiality in the context of traditional audit of financial statements refers to the probable impact on the judgment of a reasonable person of an omission or misstatement in financial statement. In conjunction with auditors risk assessment, materiality’s role in planning a financial statement audit is to determine the allocation of audit efforts and in the opinion formation phase of the audit to evaluate the implications of the audit evidence on the financial statements ‘taken as a whole’. However, in case of XBRL, where a single inappropriate or mis-leading tag could result in the XBRL document ‘taken as a whole’ being materially misstated, the concept of materiality can’t be applied the way it is being applied to the audit of traditional financial statements.

In audit of XBRL instance document, two kinds of materiality need to be considered:

(i) Materiality for the entire financial statement; and
(ii) Materiality for each line item in the XBRL instance document.

Since the materiality concept used in the audit of financial statement is at the aggregate level, the implied materiality in the XBRL instance document is also at the aggregate level. However, since users of XBRL data are going to use each line item separately in their decisions, they will perceive each line item to be accurate in isolation. This would lead to erroneous decisions.

Conclusion

The focal point of XBRL assurance is the evaluation of the accuracy and validity of the XBRL tags applied to the line items in the financial statement of the company. In order to perform these evaluation, the auditors need to have the knowledge of what constitutes an error in XBRL instance document, what is the potential risk in XBRL instance document, how control tests and substantive tests should be applied in XBRL environment, and how materiality should be conceived and applied to XBRL instance document.

References
1. Bovee, M., A. Kogan, K. Nelson, R. Srivastava, M. Vasarhelyi. 2005. Financial Reporting and Auditing Agent with Net Knowl-edge (FRAANK) and extensible Business Reporting Language (XBRL) Journal of Information Systems, Vol. 19. No. 1
2. Boritz, J. E. and W. G. No. 2007. Auditing an XBRL Instance Document: The Case of United Technologies Corporation

3. Plumee & Plumee (2008) Assurance on XBRL for Financial Reporting

4. AICPA — Proposed Principles & Criteria for XBRL Formatted Information

5. Rajendra P. Srivastava & Alexander Kogan (2008) — Assur-ance on XBRL Instance Document: A Conceptual Framework of Assertions

6. AICPA — Performing Agreed Upon Procedures Engagements That Address The Completeness, Accuracy or Consistency of XBRL Tagged Data
7. ICAEW — Draft Technical Release for Performing Agreed Upon Procedures Engagements That Address XBRL Tagged Data Included Within Financial Statements Prepared in An iXBRL Format.

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Acounting of Foreign Currency Fluctuations

This case study is to consider the appropriate accounting of forex fluctuations arising from the various transactions in USD and Euros and the forward contracts entered into by a company and the auditors verification process for the same.

Facts
Force India Ltd. (FIL) is a public company having two divisions:

(a) Manufacturing Division where high-tech products are manufactured for the IT sector. This division has two plants employing more than 500 employees. Exports constitute more than 50% earnings for this division. Most of the manufacturing equipment required for the two plants are imported;

(b) ITES Division where medical transcription and medical billing services are rendered. This division is spread over three locations and employs more than 700 employees. The entire billing of this division (on monthly basis) is to customers located outside India and in most cases, there are long-term contracts entered into with these customers.

Transactions of imports/exports of the manufacturing division are predominantly denominated in USD, whereas for the ITES division entirely denominated in Euros.

In view of the multi-currency exposure, the recent volatility in the exchange rates and since the CFO of FIL had a deep understanding of the forex markets, FIL has entered into the following contracts:

(i) Forward contracts for USD for the net exposure of the manufacturing division for the next 18 months. These contracts mature on a monthly basis and have no co-relation to the payments to be made for imports or export realisations.

(ii) Forward contracts for Euros for the receivables of the ITES division (including projected receivables for future billings). These contracts mature on a monthly basis.

(iii) Contracts at the MCX for USD.

FIL closes its financial statements on 31st December every year. As at 31st December 2011, the following information is available:

(a) Net realised and unrealised loss on forward contracts in USD Rs.15 lakh and Rs.160 lakh respectively;

(b) Net realised and unrealised loss of forward contracts in Euros Rs.5 lakh and Rs.75 lakh, respectively;

Discuss the treatment of the aforesaid losses as well as the foreign currency exposures for receivables/ payables of FIL in the financial statements for the year 2011.

Discussion and solution

1. An entity can have exposure to foreign currency fluctuations in the following situations:

(a) Long-term or short-term forex loans taken for acquisition of fixed assets — whether from India or outside India;

(b) For sales/purchases in forex;

(d) On forward contracts entered into for speculative purposes.

2. In the given case, the company has exposure to foreign currency fluctuations on account of the following:

(a) Sales from manufacturing division and services rendered from ITES division;

(b) Imports of equipment for the manufacturing division;

(d) Forward contracts entered into in Euros for the ITES division;

(e) Contracts entered into at MCX.

3. In each of the above cases, the company has realised gains/losses during the year 2011 as well as unrealised or mark-to-market (MTM) losses as at 31st December 2011.

4. Accounting treatment of forex exposures is primarily determined by the following:

(a) Accounting Standard (AS) 11 ‘The Effects of Changes in Foreign Exchange Rates’ as notified by the Companies (Accounting Standards) Rules, 2006;

(b) Amendments thereto by Notifications issued in March 2009, May 2011 and December 2011;

(d) Accounting Standard 30 ‘Financial Instruments: Recognition and Measurement’ issued by ICAI. Though AS-30 is not yet notified under the Companies (Accounting Standards) Rules, 2006, the same can be voluntarily adopted so far as it does not conflict with any other notified accounting standard or any existing regulatory and statutory requirement.

5. The amendments to AS-11 as referred to in 4(b) above relate to accounting for forex fluctuations for loans (other than short-term) in foreign currency for acquisition fixed assets. In the given case study, there are no such loans obtained by FIL and hence these amendments are not applicable.

6. Monetary items are defined by para 7.11 of AS-11 as ‘money held and assets and liabilities to be received or paid in fixed or determinable amounts of money’. In the given case, debtors arising from export sales as well as rendering of services and creditors arising from imports would be monetary items since they would be received or paid in fixed or determinable amounts of money.

7. As per para 13 of AS-11, ‘exchange differences arising on the settlement of monetary items or on reporting an enterprise’s monetary items at rates different from those at which they were initially recorded during the period, or reported in previous financial statements, should be recognised as income or as expenses in the period in which they arise’.

8. The above-referred para 13 of AS-11 would be applicable to foreign currency fluctuations as referred to in para 2(a) and 2(b) in the case above. All exchange differences on settlement of these items or on restatement at the year-end would thus need to be transferred to the statement of profit and loss.

9. Accounting treatment for forward contracts in foreign currency entered into by an entity is to be done as per paras 36 and 37 of AS-11. The said paras are as under:

“36. An enterprise may enter into a forward exchange contract or another financial instrument that is in substance a forward exchange contract, which is not intended for trading or speculation purposes, to establish the amount of the reporting currency required or available at the settlement date of a transaction. The premium or discount arising at the inception of such a forward exchange contract should be amortised as expense or income over the life of the contract. Exchange differences on such a contract should be recognised in the statement of profit and loss in the reporting period in which the exchange rates change. Any profit or loss arising on cancellation or renewal of such a forward exchange contract should be recognised as income or as expense for the period.

37. The risks associated with changes in exchange rates may be mitigated by entering into forward exchange contracts. Any premium or discount arising at the inception of a forward exchange contract is accounted for separately from the exchange differences on the forward exchange contract. The premium or discount that arises on entering into the contract is measured by the difference between the exchange rate at the date of the inception of the forward exchange contract and the forward rate specified in the contract. Exchange difference on a forward exchange contract is the difference between (a) the foreign currency amount of the contract translated at the exchange rate at the reporting date, or the settlement date where the transaction is settled during the reporting period, and (b) the same foreign currency amount translated at the latter of the date of inception of the forward exchange contract and the last reporting date.”

10. As can be seen from the above, paras 36 and 37 of AS-11 prescribe the treatment for forward contracts which are backed by transactions as on the settlement date. In case, however, an entity has entered into contracts which are intended for trading or speculation, these paras would not be applicable. Thus, in all cases where paras 36 and 37 are applicable, the realised and/or unrealised profits/losses on such contracts would need to be recognised in the statement of profit and loss.

11. Paras 38 and 39 of AS-11 further state as under:

“38. A gain or loss on a forward exchange contract to which paragraph 36 does not apply should be computed by multiplying the foreign currency amount of the forward exchange contract by the difference between the forward rate available at the reporting date for the remaining maturity of the contract and the contracted forward rate (or the forward rate last used to measure a gain or loss on that contract for an earlier period). The gain or loss so computed should be recognised in the statement of profit and loss for the period. The premium or discount on the forward exchange contract is not recognised separately.

39. In recording a forward exchange contract intended for trading or speculation purposes, the premium or discount on the contract is ignored and at each balance sheet date, the value of the contract is marked to its current market value and the gain or loss on the contract is recognised.”

12. As can be seen from the above, paras 38 and 39 of AS-11 prescribe the treatment for forward contracts which are intended for trading or speculation purpose. Thus, in all cases where paras 38 and 39 are applicable, the gain/loss computed in terms of these paras would need to be recognised in the statement of profit and loss.

13. Besides contracts covered by paras 36, 37, 38 and 39 of AS-11, there could be other forward con-tracts which a company may enter into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction. Accounting treatment for such contracts is not covered by AS-11 since these are neither backed by actual transactions, nor intended for trading or speculation.

14. Accounting of such contracts which are entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction would be covered by the ICAI announcement of March 2008. The said announcement lays down 2 options which can be followed by a company to account for such contracts. The 2 options are:

(a) The mark-to-market (MTM) loss in case of such transactions should be provided for in the statement of profit and loss following the principle of prudence as enunciated in AS-1 ‘Disclosure of Accounting Policies’ — the gains arising on MTM, however, need not be provided;
(b) Adopt AS-30 on a voluntary basis. Paras 80 to 113 of AS-30 provide for recognition and measurement of forward contracts intended for hedging and which are not covered by AS-11. These paras provide that in case the forward contracts fall within the definition of an ‘effective hedge’ within the meaning of AS-30, the MTM gains/losses on such contracts can be transferred to a ‘Hedging Reserve Account’ and carried forward in the balance sheet rather than recognise them in the statement of profit and loss account. To qualify as an ‘effective hedge’, however, there has to be close relationship between the date of maturity of the forward contract and the realisation of the underlying ‘hedged item’ i.e., the export receivables. There are also stringent documentation requirements laid down by AS-30 to prove the effectiveness of a hedge. On settlement or cancellation of these contracts, the eventual gains/losses would need to be transferred to the statement of profit and loss account.

15. The ICAI announcement also mentions that in case one of the above 2 options is not followed and there is a MTM loss as at the year-end on such contracts, appropriate disclosures should be made by the auditor in his report. Since the announcement only mentions ‘appropriate disclosures’, such disclosures may not amount to a qualification in the report of the auditors.

16. In the given case, in the situation mentioned in para 2(c) above, the company has entered into contracts to cover its exposure in USD for exports of goods and import of equipment. As per the information available, these contracts do not have any co-relation with the receivables/payables, but they are backed by actual transactions of exports/imports since these are entered into in respect of the net exposure of the manufacturing division. In such a case, the accounting treatment would need to be as per paras 36 and 37 of AS-11 (as discussed in paras 9 and 10 above). Thus, the realised as well as unrealised losses on such contracts would need to be accounted for in the statement of profit and loss.

17. In the given case, in the situation mentioned in para 2(d) above, the company has entered into contracts to cover its exposure in Euros for exports of services. As per the information available, some of these contracts are backed by actual export receivables, but the remaining contracts are to cover future exports of services. Since these contracts mature on a monthly basis, there seems to be a co-relation between the receivables (as in most cases of export of ITES services the billings are on regular pre-determined intervals).

18. The accounting treatment for contracts which are backed by receivables would be covered by para 36/37 of AS-11 and would be as discussed in para 16 above. However, in case of contracts which are for future billings, these would be in the nature of hedge for the foreign currency risk of a firm commitment or a highly probable forecast transaction. These would be accounted as per the ICAI announcement (as discussed in paras 14 and 15 above). Thus, FIL would have an option to either provide the MTM loss on such contracts or adopt AS-30 and transfer the loss to a ‘Hedging Reserve’.

19. In the given case, in the situation mentioned in para 2(e) above, the company has entered into contracts at the MCX for USD. These contracts, though apparently, entered into for trading or speculative purposes, in this case, seem to be entered into for hedging the forex exposures of FIL. If the contracts were entered into for trading or specula-tive purposes, the accounting treatment would be as per paras 38/39 of AS-11. However the contracts seem to be backed by actual transactions of exports/imports. In such a case, the accounting treatment would be as per paras 36/37 of AS-11. In either case, the realised as well the unrealised (or MTM) losses would need to be transferred to the statement of profit and loss.

20. The duty of the statutory auditor in the above case would be as under:

(a) For situations in 2(a) and 2(b) above, verification whether appropriate closing rates are considered for determining the forex fluctuations and whether the same are accounted in the statement of profit and loss;

(b) For situation mentioned in 2(c) above, verification of open forward contracts in USD and whether the same are clearly backed by actual transactions of exports/imports on a net basis;

(i) Verification and adequate documentation whether AS-11 or AS-30 would be applicable to the forward contracts entered into;

(ii) verification of open forward contracts in Euros and whether they constitute an ‘effective hedge’ vis-à-vis the receivables/ future receivables as envisaged by AS-30 and whether the company had adequate internal documentation at the time of entering into these contracts so as to constitute an ‘effective hedge’;

(d) For situation mentioned in 2(e) above, verification of whether the contracts entered into at MCX were towards hedging of open exposures in USD or whether these were for trading or speculation;

(e) Adequate audit documentation for all the above with reasoning and supporting to be kept as part of audit working papers.

Editor’s Note: The case study is based on the case studies presented by the author at the Residential Refresher Course of BCA.

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Section A : Audit Report isued under SA 700 (Revised ), SA 705 and SA 706

Compiler’s Note

The Institute of Chartered Accountants of India (ICAI) had issued Standards on Auditing (SA): SA 700 (revised) Forming an Opinion and Reporting on Financial Statements,
SA 705 Modifications to the Opinion in the Independent Auditor’s Report,
SA 706 Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report

These standards were effective for audits of financial statements for periods beginning on or after 1st April, 2011. Following these 3 SAs would change the format in which audit reports were to be issued.

ICAI vide an announcement dated 17th April 2012, however, postponed the application of these standards to audits of financial statements for periods beginning on or after 1st April, 2012. The reason for the postponement as mentioned in the ICAI announcement was that regular CPE and other programmes to familiarise the practising members with the requirements of the new standards were necessary and only after ensuring adequate education, publicity and familiarisation, the said standards would be made mandatory.

Some companies, however, had already adopted financial statements before the date of the ICAI postponement and in such cases the statutory auditors had already issued their report in terms of SA 700, SA 705 and SA 706.

Given below is an audit report dated 13th April 2012, issued using the new SAs.

Independent Auditor’s Report

To the Board of Directors of Infosys Limited (formerly Infosys Technologies Limited)

Report on the Financial Statements

We have audited the accompanying financial statements of Infosys Limited (‘the Company’), which comprise the Balance Sheet as at 31 March 2012, the Statement of Profit and Loss of the Company for the quarter and year then ended, the Cash Flow Statement of the Company for the year then ended and a summary of significant accounting policies and other explanatory information.

Management’s responsibility for the Financial Statements

Management is responsible for the preparation of these financial statements that give a true and fair view of the financial position, financial performance and cash flows of the Company in accordance with the Accounting Standards referred to in s.s (3C) of section 211 of the Companies Act, 1956 (‘the Act’). This responsibility includes the design, implementation and maintenance of internal control relevant to the preparation and presentation of the financial statements that give a true and fair view and are free from material misstatement, whether due to fraud or error.

Auditor’s responsibility

Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the Standards on Auditing issued by the Institute of Chartered Accountants of India. Those Standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the Company’s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of the accounting estimates made by management, as well as evaluating the overall presentation of the financial statements.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

Opinion

In our opinion and to the best of our information and according to the explanations given to us, the financial statements give the information required by the Act in the manner so required and give a true and fair view in conformity with the accounting principles generally accepted in India:

(i) in the case of the Balance Sheet, of the state of affairs of the Company as at 31st March 2012;

(ii) in the case of the Statement of Profit and Loss, of the profit for the quarter and year ended on that date; and

(iii) in the case of the Cash Flow Statement, of the cash flows for the year ended on that date.

Report on Other Legal and Regulatory Requirements As required by section 227(3) of the Act, we report that:

(a) we have obtained all the information and explanations which to the best of our knowledge and belief were necessary for the purpose of our audit;

(b) in our opinion proper books of account as required by law have been kept by the Company so far as appears from our examination of those books;

(c) the Balance Sheet, Statement of Profit and Loss and Cash Flow Statement dealt with by this Report are in agreement with the books of account; and

(d) in our opinion, the Balance Sheet, Statement of Profit and Loss and Cash Flow Statement comply with the Accounting Standards referred to in s.s (3C) of section 211 of the Companies Act, 1956. n

levitra

shailesh.kwebmaker

GAPs in GAAP — FAQs on Revised Schedule VI

The issuance of Revised Schedule VI to the Companies Act applicable from 1-4-2011 was a landmark event in financial reporting in India. As could be expected, there were numerous interpretation issues that arose. To address them the Institute of Chartered Accountants of India (ICAI) issued the Guidance Note on the Revised Schedule VI to the Companies Act, 1956 (GNRVI). Further, in May 2011 Frequently Asked Questions FAQ — Revised Schedule VI was posted on the ICAI website to provide further guidance. At the time of writing this article, none of the following was clear with respect to the FAQ’s — (a) the unit of ICAI that issued the FAQ’s (b) the review process — whether the Accounting Standard Board or the Technical Directorate of the ICAI reviewed the FAQ’s, and most importantly (c) the authority attached to the FAQ’s.

In this article, we take a look at some of the contentious FAQ’s.

A company, having December year-end, will prepare its first revised Schedule VI financial statements for statutory purposes for the period 1 January to 31 December 2012. Whether such a company needs to prepare its tax financial statements for the period from 1 April 2011 to 31 March 2012 in accordance with revised Schedule VI or pre-revised Schedule VI?

Response in FAQ

It is only proper that accounts for tax filing purposes are also prepared in the Revised Schedule VI format for the year ended 31 March 2012.

Author’s view with respect to companies to which MAT is applicable

S.s (2) of section 115JB states as follows “Every assessee, being a company, shall, for the purposes of this section, prepare its profit and loss account for the relevant previous year in accordance with the provisions of Part II and III of Schedule VI to the Companies Act 1956 . . . . . . ” The Finance Act, 2012, enacted recently, has removed reference to part III from section 115JB of the Income-tax Act. This amendment is applicable for A.Y. 2013-14, i.e., for tax financial year 2012-13.

From the above amendment to section 115JB, it is clear that a company will use revised Schedule VI format for preparing its tax financial statements for the tax financial year 2012-13 (i.e., 1 April 2012 to 31 March 2013). For preparing tax financial statements for the tax financial year 2011-12 (i.e. 1 April 2011 to 31 March 2012), the fact that the Finance Act removes reference to part III of schedule VI only for previous year beginning 1 April 2012 suggests that the company may need to prepare its tax financial statements for the period 1 April 2011 to 31 March 2012 in accordance with pre-revised Schedule VI. This appears to be a straight forward interpretation of the amendment to the Income-tax Act.

Note: Generally in determining the tax liability, it should not matter whether the accounts are prepared in accordance with pre-revised Schedule VI or revised Schedule VI. However, in certain situations it may have a significant impact, for example, where the company has to pay MAT . The P&L account in pre-revised Schedule VI had the P&L appropriation account. Therefore typically certain adjustments to reserves (e.g., debenture redemption reserve) would appear in the P&L appropriation account, and the net balance would be added to the retained earnings in the balance sheet. In the revised Schedule VI, the P&L ends with PAT (profit after tax) and all the appropriations are carried out under the caption ‘Reserves’ in the balance sheet. For determining the book profits under 115JB, and consequently the MAT liability, one would achieve different results if one were to start with PAT (under revised Schedule VI) or start with the net appropriated P&L (under pre-revised Schedule VI) and treat debenture redemption reserve as an allowable expenditure (in accordance with certain favourable judicial precedents) for determining book profits for MAT purposes.

There is a breach of major debt covenant as on the balance sheet date relating to long-term borrowing. This allows the lender to demand immediate repayment of loan; however, the lender has not demanded repayment till the authorisation of financial statements for issue. Can the company continue to classify the loan as current? Will the classification be different if the lender has waived the breach before authorisation of financial statements for issue?

Response in FAQ

As per the Guidance Note on the Revised Schedule VI, a breach is considered to impact the noncurrent nature of the loan only if the loan has been irrevocably recalled. Hence, in the Indian context, long-term loans, which have a minor or major breach in terms, will be considered as current only if the loans have been irrevocably recalled before authorisation of the financial statements for issue.

Author’s view

In accordance with revised Schedule VI, a liability is classified as non-current if and only if the borrower has unconditional right to defer its payment for atleast 12 months at the reporting date. GNRVI clarifies that if a term loan becomes repayable on demand because of violation of a minor debt covenant (for e.g., submission of quarterly financial information), the company can continue to classify the same as non-current unless the lender has demanded repayment before approval of financial statements.

GNRVI does not clarify the classification where a company has violated a major debt covenant as on the reporting date. However, a reading of GNRVI suggests that the exemption is given only with regard to violation of minor debt covenants and not for violation of major covenants. Thus, if major debt covenant is violated, there can be three situations — (a) the banker has asked for repayment before approval of financial statements, (b) the banker has not asked for repayment and has not forgiven the violation before approval of financial statements, and (c) the banker has forgiven the violation before the approval of financial statements. In situations (a) and (b), the author believes that the loan should be classified as current liability. In situation (c), where the banker has actually forgiven the violation before approval of financial statements, one may argue that the intention of the ICAI is that a company should continue to classify the loan as non-current, if the possibility of loan being recalled is negligible. Subsequent waiver of breach confirms this aspect and therefore the company may continue to classify the loan as non-current.

Thus, there is a difference in view, with respect to situation (b). In the author’s view and based on the GNRVI, the same would be treated as current. However, as per the FAQ’s, the same would be treated as non-current.

How would rollover/refinance arrangement entered for a loan, which was otherwise required to be repaid in six months, impact current/non-current classification of the loan? Consider three scenarios: (a) rollover is with the same lender on the same terms, (b) rollover is with the same lender but on substantially different terms, and (c) rollover is with a different lender on similar/different terms? In all three cases, the rollover is for non-current period.

Response in FAQ

In general, the classification of the loan will be based on the tenure of the loan. Thus, in all the above cases, if the original term of the loan is short term, the loan would be treated as only current, irrespective of the rollover/refinance arrangement. However, in exceptional cases, there may be a need to apply significant judgment on substance over form. In such cases, categorisation could vary as appropriate.

Author’s view

If the rollover arrangements are with the same lender at the same or similar terms, the company will continue to classify the loan as non-current, provided that the rollover arrangement was in existence at the balance sheet date. If the rollover arrangement has been entered into with a different lender either on similar or different terms, the arrangement is more akin to extinguishment of the original loan and refinancing the same with a new loan. Hence, in such cases, the existing loan should be classified as current liability. If the rollover arrangement is entered into with the same lender but on substantially different terms, the position is not clear. We understand that the matter is under debate at the IASB level and mixed practices are being followed globally as well. Keeping this in view, one may argue that it can classify the loan as non-current, provided that the rollover arrangement was in existence at the balance sheet date.

The author believes that view taken in the ICAI FAQ is technically flawed, since rollover of loan with the same lender on the same terms for non-current period clearly results in non-current classification. This is because it is not due to be settled within the 12 months after the reporting date and the company has an unconditional right to defer settlement of the liability for atleast 12 months after the reporting date.

The company has received security deposit from its customers/dealers. Either the company or the dealer can terminate the agreement by giving 2 months’ notice. The deposits are refundable within one month of the termination. However, based on past experience, it is noted that deposits refunded in a year are not material, i.e., 1% to 2% of amount outstanding. The intention of the company is to continue long term relationship with their dealers. Can the company classify such security deposits as non-current liability?

Response in FAQ

As per Revised Schedule VI, a liability is classified as current if the company does not have an unconditional right to defer its settlement for at least 12 months after the reporting date. This will apply generally. However, in specific cases, based on the commercial practice, say for example electricity deposit collected by the department, though stated on paper to be payable on demand, the company’s records would show otherwise as these are generally not claimed in short term. Treating them as non-current may be appropriate and may have to be considered accordingly. A similar criterion will apply to other deposits received, for example, under cancellable leases.

Author’s view

As per revised Schedule VI, a liability is classified as current if the company does not have an unconditional right to defer its settlement for at least 12 months after the reporting date. In the given case, the company does not have such right since the customer/dealer can terminate the agreement by giving 2 months notice and deposit has to be refunded within 1 month of termination. Hence, the security deposit should be classified as current liability. The intention of the company to not terminate the agreement or past experience is not relevant.

In case of provision for gratuity and leave encashment, can current and non-current portions be bifurcated on the basis of actuarial valuation?

Response in FAQ

The actuary should be specifically requested to indicate the current and non-current portions, based on which the disclosure is to be made.

Author’s view

Paragraph 7.3(b) of GNRVI states as below:

“In case of accumulated leave outstanding as on the reporting date, the employees have already earned the right to avail the leave and they are normally entitled to avail the leave at any time during the year. To the extent, the employee has unconditional right to avail the leave, the same needs to be classified as ‘current’ even though the same is measured as ‘other long-term employee benefit’ as per AS-15. However, whether the right to defer the employee’s leave is available unconditionally with the company needs to be evaluated on a case to case basis — based on the terms of Employee Contract and Leave Policy, Employer’s right to postpone/ deny the leave, restriction to avail leave in the next year for a maximum number of days, etc. In case of such complexities the amount of Non-current and Current portions of leave obligation should normally be determined by a qualified Actuary.”

The author believes that ICAI FAQ needs to be read with GNRVI and it cannot override paragraph 7.3(b) of GNRVI. Hence, there is no question of any part of leave liability being classified as non-current liability, if a company does not have a right to postpone/ deny the leave for 12 months. In other words, if an actuary is appointed to do this classification, he or she should apply the principles set out in paragraph 7.3(b) of GNRVI.

Conclusion

In light of the above arguments, the author would request the ICAI to reconsider and reissue some of the FAQ’s.

shailesh.kwebmaker

The Concept of Propriety’— Dynamics & Challenges for Auditors

Introduction

There is a saying that “we take propriety to encompass not only financial rectitude, but a sense of the appropriate values and behaviour”. Though the concept of propriety is generally associated with public sector activities, the time has now come to apply this concept even in the private sector due to the enhanced application of the ‘Agency Theory’ which requires an eloquent demonstration of the roles and responsibilities of the professional management running a company to all the stakeholders. With the changing environment, the expectations of the society have also changed and as a result, there is a greater emphasis on conformance with prescribed values, customs, procedures and practices, keeping in mind the public interest and greater application of prudence. This has resulted in an expectation of applying the concept of propriety in all the transactions carried out by the corporates and an endorsement of the same by an independent person. Consequently, the Statutory Auditors of the company, being independent, are expected to fill this vacuum. However, the Statutory Auditors focus more on the true and fair view of the financial statements and generally do not deal with the propriety aspects in depth due to various limitations and challenges. Whilst the auditors can certainly consider this emerging expectation as part of their audit process to the extent the same is significant and impacts the financial statements, there are certain practical challenges in dealing with the same. This article focusses on the concept of propriety along with its relevance for audits, propriety expectations from the auditors, responsibilities of the auditors in general, practical challenges in application of the concept of propriety in audits, audit defense to propriety concerns and the nuances of reporting propriety concerns by the auditors. This article is not intended to elucidate the responsibilities of the auditors regarding the frauds, if any, committed by the management.

What is Propriety?

In general, there is no fixed definition of the term ‘propriety’ which keeps changing, reflecting the changing expectations of society. The literal dictionary meaning of the term propriety encompasses ‘appropriateness’, ‘rightness’, ‘correctness in behaviour or morals’, ‘conformity with convention in conduct’, ‘the standards of behaviour considered correct by polite society’.

The core principles of the concept of propriety could be summarised as under:

Integrity
Openness
Objectivity
Honesty
Selflessness

The concept of propriety can be related to various other concepts which are commonly known. To list a few:

Accountability
Legality
Probity
Value for money
Fraud & Corruption
Governance
lInternal Control Environment

Practically, there is also a reasonable degree of overlap amongst application of these concepts and all the above can be analysed from the broad umbrella of propriety.

Propriety expectations from Auditors in India

Whenever the auditors carry out a Propriety Audit, they not only evaluate the underlying evidence, but also attempt to examine the regularity, reasonability, prudence and impact of various acts. In India, the audits performed by the Comptroller & Auditor General (C&AG) focus more on the propriety aspects and check the conformity with the established financial propriety standards.

Though the expectations of the statutory audit conducted under the provisions of the Companies Act, 1956 do not necessarily mandate a propriety focus on the part of the auditors, various amendments made to the Companies Act, 1956, specifically on the reporting requirements in the Auditors’ Report under the Companies (Auditor’s Report) Order, 2003 over a period of time indicate move in that direction. Certain illustrative instances of the same are given below:

Auditors’ responsibility to inquire on the terms and conditions of the loans and advances to identify whether they are prejudicial to the interests of the company and its members.
Reporting on transactions of the company which are represented merely by book entries and are prejudicial to the interests of the Company.
Reporting on whether personal expenses have been charged to the revenue account.
Reporting on reasonability of the pricing mechanism on transactions where directors are interested.
Reporting on preferential allotment of shares to interested parties and the impact of the pricing on the interests of the entity.
Reporting on the disqualification of the directors u/s.274(1)(g) of the Companies Act, 1956.
Reporting on the frauds by or on the company.

In addition to the aforesaid reporting requirements, propriety expectations are also embedded in the Accounting Standards such as reporting requirements related to the Related Party Transactions in accordance with the AS-18. Needless to add, the Companies Act, 1956 contains several provisions relating to propriety elements such as greater level of monitoring/approval for transactions with directors/other interested parties, remuneration paid to directors, etc.

Responsibility of the Auditors

The Statutory Auditors who conduct their audit in accordance with the Auditing Standards for reporting on the true and fair view of the financial statements may not necessarily be in a position to meet the propriety expectations of society in totality due to their role/legal boundaries. In this regard, it is worth noting that propriety challenges would invariably result in fraud on the company or by the company which needs to be reported and considered by the Auditors. As per the Generally Accepted Auditing Standards in India, the Auditors should always conduct the engagement with a mindset that recognises the possibility that a material misstatement due to fraud could be present, regardless of any past experiences with the entity and regardless of their belief about the management’s honesty and integrity.

The relevant/specific Auditing Standards which need to be considered by the Auditors in responding to the propriety challenges are as under: SA 240 — The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements
SA 250 — Consideration of Laws and Regulations in an Audit of Financial Statements ? SA 260 — Communication with those in charge of Governance
SA 265 — Communicating Deficiencies in internal control to those charged with Governance and Management
SA 315 — Identifying and Assessing the Risk of Material Misstatement Through Understanding the Entity and its Environment
SA 330 — The Auditor’s Responses to Assessed Risks.

The primary responsibility for prevention and detection of fraud and error rests with both those charged with governance and the management of an entity. The objective of an audit of financial statements prepared in accordance with the framework of recognised accounting policies and practices and relevant statutory requirements, if any, is to enable the auditors to express an opinion on them. An audit conducted in accordance with the Generally Accepted Auditing Standards in India is designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatements, whether caused by fraud or error. The fact that an audit is carried out may act as a deterrent, but the auditors are not and cannot be held responsible for prevention and detection of fraud and error.

A Financial Statement Audit conducted in accordance with the applicable auditing framework does not guarantee that all material misstatements will be detected because of such factors as the use of judgment, the use of testing, the inherent limitations of internal controls and the fact that much of the evidence available to the auditors is persuasive rather than conclusive in nature. For these reasons, the Auditors are able to obtain only a reasonable assurance that material misstatements in the financial statements will be detected.

In view of the above, the responsibility of the Statutory Auditors towards the propriety aspects would be more limited and focussed on specific aspects of reporting and need not necessarily extend to the entire gamut of the transactions carried out by a company. However, propriety concerns, if any, noticed by the Auditors during their audit process should be given adequate importance and should not be overlooked. They should consider the same as part of assessing the risk associated with the entity and the environment in which it functions, and should deal with the same appropriately, including reporting to those in charge of governance, wherever required.

Propriety challenges for Auditors
Propriety is concerned with compliance with expectations of conduct and behaviour, which although not written into legislation or regulations, are generally accepted as being central to the management of the affairs of an entity. Acts of impropriety will be concerned with specific misconduct, knowingly perpetrated for personal or political gain. Similar acts, undertaken with lack of knowledge and motivation, are on the other hand, omissions of propriety. The effects on an entity are often the same but the auditors may need to bear this distinction in mind. Whether an act constitutes improper behaviour within the generally accepted standards of conduct expected in business is often a matter of interpretation and professional judgment. Invariably, the question of proving the propriety element would depend on facts and circumstances of the case. The availability of the proof and its adequacy is a matter of personal judgment of the Auditor.

Root cause for propriety issues
Propriety issues arise in entities due to the following:

Corporate culture

Poorly designed or operated internal controls

Ignorance of the rules or expectations of proper behaviour, especially in small and medium-sized entities

Urge to achieve targets/results in the short-term

Greed

Symptoms for propriety issues
The propriety challenges for the auditors could take different dimensions depending on the nature of the entity and the activities carried out by it. The symptoms of propriety concerns could arise from various matters such as:

Absence of business rationale for significant transactions

Lack of transparency in awarding contracts

Liberal/flexible arrangements with contractors

Transactions without written contracts

Entering into side agreements/arrangements with contracting parties

Avoidance of proper tendering procedures

Excessive involvement of agencies/ third parties

Having an overriding authority with few individuals for allowing exceptions

Situations where there is a conflict of interest

Large infructuous expenses triggering propriety concerns

Abnormally high hospitality expenses

Lack of conclusive evidence regarding the ultimate usage of funds

Weak Audit Committee/Board Members who are silent spectators

Absence of appropriate disclosures in the financial statements

Lack of sanctity for the Internal Audit/other audit observations.

Acts of impropriety
By studying the symptoms carefully, the Auditor may identify transactions where there are propriety concerns for the entity. Though the acts of propriety may vary from entity to entity depending on the nature, environment, etc., instances of the acts of impropriety could take any of the following dimensions:

Facilitation payments, bribes, speed money paid for expediting clearances, getting things done fast which are coloured differently.

Awarding contracts at a price lower than the expected value.

Exorbitant service charges which are not commensurate with the services rendered.

Excessive remuneration to promoters/directors which does not commensurate with the services rendered.

Preferential treatment in making appointments either of contractors or of staff.

Misuse of office for personal purposes.

Foreign travel by senior management and board members without proper justification or clear benefit to the entity.

Inflating the payments to vendors for services rendered/goods delivered where the vendors make certain improper payments on behalf of the entity which triggers propriety issues.

Disposal of scrap at a value much lower than its realisable value.

Selling shares held by a company to another company at a consideration above cost but substantially below the market value.

Structuring the transactions with group companies which are de facto related parties in a manner that does not apparently fit into the definition of related party.

Recruitment of employees based on recommendations of authorities as a quid pro quo for consideration received.

Though the propriety concerns could be factored in by the Auditors as part of their audit process, there are a number of factors that significantly limit the extent to which an audit of financial statements can be expected to identify impropriety, including:

Multiple versions of the concept of propriety and its meaning

Absence of adequate evidence of conducting the business

Concealment and collusion

Difficulties in identification of impropriety elements by an outsider

Application of the concept of materiality by the auditors

Actual/Perceived scope limitation on the part of the audit process

Skills required on the part of the auditors for identifying transactions involving impropriety

Lack of clarity in the statutory provisions dealing with the roles and responsibilities of the auditors.

In view of the various challenges listed above, it may not be possible for the Statutory Auditors to confirm propriety aspects of all the transactions entered into by the entity as part of his audit. Hence, subsequent discovery of acts of impropriety by the entity audited may not imply inadequate/ improper audit.

Audit Defense for Propriety Concerns
Whilst external Auditors of companies are not required to perform specific procedures for the purpose of identifying improprieties as part of their audit of the financial statements, they should remain alert to instances of significant possible or actual non-compliance with general standards of public conduct. In particular, the Auditors may develop a general appreciation of the framework of governance and standards of conduct within which the company conducts its activities during the course of their audit to gain an understanding of the overall internal control environment. This can be an important potential source of information on any impropriety.

As part of the Auditor’s responsibility to assess the overall internal control environment, the Auditor is required to assess inherent risk, taking account of factors relevant to the entity as a whole. In this regard, the Statutory Auditors could:

Familiarise themselves with the general regulations, rules and other guidance relating to the conduct of the company’s business.

A thorough understanding of the company and its business and a review of its financial control environment.

Enquire of the management about the company’s policies and procedures regarding the implementation of code of conduct and instructions, while having regard to whether the policies and procedures are comprehensive and up to date.

Discuss with the management and internal auditors the policies or procedures adopted for promulgating and monitoring compliance with relevant codes and instructions.

Read minutes of the board and management meetings to pick up matters of propriety concern.

Read the newspaper articles related to the company.

Review the arrangements for whistle-blowing.

Discuss with client staff in various departments including operations.

Focus on areas, if any, which have not been reviewed by them for a number of years.

Introduce surprise elements in the audit process.

The Auditors may also discuss their plan to perform the stipulated audit procedures to identify any propriety concerns with the Audit Committee/ those in charge of governance. This by itself could create moral pressure on the environment as well as on the management. In the process of identifying the propriety concerns, the Auditors should not go overboard and over audit the entity which may not be warranted.

The Auditors may also closely assess the following to form their opinion regarding the entity’s response towards propriety challenges:

Tone at the top in dealing with the matters of impropriety.

Extent of evangelism of the principles of propriety amongst the employees by the management through code of conduct/ ethical training, etc.

Process of obtaining compliance declarations from the management to confirm the propriety elements for all the contracts/transactions entered into by the company.

Extent of interference by the promoters with the professional management personnel.

Sanctity given to various processes and procedures.

Reporting by the Auditors
If there are impropriety symptoms identified in the course of enquiry/discussion or verification by the Auditors, it is appropriate for them to report the same to the management or even to those in charge of governance and to consider their impact on audit risk. When the Auditors become aware of any failure of propriety, they should aim to understand its nature and the circumstances under which it has occurred and sufficient additional information should be obtained to evaluate the possible impropriety. If the Auditors consider that the impropriety could be significant, they may perform appropriate additional procedures and document the results.

The extent of additional procedures the auditors decide to perform in response to impropriety is a matter of professional judgment and depends on:

Its impact on the financial statements

Nature of the impropriety

Persons involved

Likelihood that the impropriety may have led to loss of funds

Likelihood that the suspected impropriety involves fraud

Extent to which further procedures can be expected to clarify the situation

Extent to which the impropriety indicates that other impropriety or mismanagement may be present

Likelihood of the need to report.

Where there is suspicion of impropriety but an absence of evidence, the Auditors may consider drawing the management’s attention to the possibility of introducing procedures that would generate evidence were the suspicion to be well founded.

To explain this concept further with an example, if the management has entered into a contract for disposing of the scrap for a value which is less than its actual realisable value for benefiting somebody, the amount received and recorded as per the books and pursuant to the contract, duly approved by an appropriate authority, need not necessarily pose an accounting challenge; however, the real value of the transaction has not been reflected in the books of account due to an act of impropriety which would definitely trigger an audit concern. This has to be investigated further and the same has to be appropriately dealt with.

Significant matters of impropriety would require appropriate reporting by the Auditors not only in their Audit Report but also communication to those in charge of governance. At the earliest suitable opportunity, the Auditors should discuss their findings at an appropriate level of management whom they do not suspect of involvement with the impropriety. Wherever there is an Audit Committee, the auditors should also discuss their findings with them.

If the auditors consider that impropriety may have or has occurred, they may need to reconsider their assessments of audit risk and the validity of the management’s representations. For example, a series of suspected or actual instances of impropriety that are not significant financially may be symptomatic of the management’s general disregard for proper conduct and hence may cast doubt on the general integrity of the management.

The method of reporting on audit work relating to propriety will vary depending on the nature of the work undertaken and its results. The auditors may also consider communicating the propriety concerns, if any, primarily due to internal control lapses to the management through a management letter. The auditors should also request the managements to place the management letters along with the management’s responses before the Audit Committee.

Conclusion
Impropriety is considered as one of the serious evils in all the countries and in particular in the developing countries. Governments in various countries are attempting to enact/strengthen various laws to combat impropriety. They are aware of the fact that the first stage in the dynamics of the rule of law is the framing of effective rules and laws, which are equipped to hinder the ever-rising escalation of the impropriety graph. There is nothing in this world which can guarantee high standards of propriety but appropriate safeguards can be put in place to minimise the risk of impropriety occurring or remaining undetected. These safeguards include:

Clear expectations of standards of individual behavior.

Appropriate internal controls to provide checks and balances against individual misconduct.

External supervision to hold the organisation accountable.

Above all, such safeguards help to create a climate and culture in which high standards of propriety is valued.

In India, the proposed Companies Bill, 2011 contains various provisions relating to propriety aspects, including a provision of direct reporting of frauds by the Auditors to the appropriate authority which would enhance the role and the responsibilities of the Auditors considerably and is in the direction of thrusting propriety principles as part of the audit expectation. The Auditors should be cognizant of propriety concerns and the expectations of society in discharging their professional duties within the legal framework which would go a long way in setting the standards for audit excellence.

Reference material

Indian Auditing Standards

Report of the Public Audit Forum, UK

Nolan Committee Report, UK

Various Research Reports on Audit process available for General public.

shailesh.kwebmaker

Introduction to the New Revenue Recognition Standard Issued by IASB

The IASB issued the first exposure draft of the new revenue recognition standard in June 2010. This new standard is a joint project of the IASB and FASB to clarify the principles for recognising revenue from contracts with customers. It intends to provide a single revenue recognition model which integrates the numerous revenue recognition guidances under US GAAP and the broader principles provided under IFRS to improve comparability over a range of industries, companies and geographical boundaries. The revenue recognition model under this exposure draft is a step-by-step analysis of contracts focussing on control i.e.,

identify the contract with the customer;

identify separate performance obligations in the contract;

determine and allocate the transaction price; and

recognise revenue when or as each performance obligation is satisfied by transferring control of a good or service to the customer.

Nearly thousand comment letters were received in response to this exposure draft. Considering the representations, the IASB issued a revised exposure draft in November 2011. One of the principles that the revised draft clarifies is on distinguishing when control of a good or service is transferred over a period of time or at a point in time. This article focusses on this aspect of the revised exposure draft in relation to its implications on revenue recognition for real estate companies.

Implications of IASB’s revised revenue recognition exposure draft for real estate companies

One of the most debated matter in India’s convergence with IFRS was point of revenue recognition from sale of real estate, more commonly known as the application of IFRIC 15 principles. The assessment of IASB’s IFRIC 15 principles which deals with agreements for the construction of Real Estate would lead to most real estate companies in India accounting for sale of apartments/flats as sale of goods and recognising revenue on completion of the contract i.e., transfer of physical possession of the units to the customer as opposed to accounting for these as construction contracts using the percentage completion method. This would have a major impact on the performance measures of real estate companies. Consequently, when Ind AS were issued in February 2011, the Ind AS on construction contracts had a carve-out from the IASB principles to include development of real estate as a construction contract and accrue revenues using the percentage completion method.

IFRIC 15 principles have been debated internationally. Malaysia and Philippines had also deferred applicability of IFRIC 15 when they adopted IFRS while Singapore decided to issue a modified IFRIC 15 providing specific guidance in the context of legal situations prevailing in that country. The issue under debate was that IFRIC 15 principles were leading to a completed contract method of accounting sometimes due to the legal framework of a country for instance, continuous transfer of legal title of the work in progress was legally not allowed in many jurisdictions and hence leading to a completed contract method of accounting although that was not the substance of these transactions. In that case, the profit and loss account of the developers will not truly reflect the performance of the business, as during the years the real estate project development continues, no revenue will be recognised and all revenue will be recognised in the year when possession is given.

IFRIC 15 principles were incorporated in the original exposure draft of revenue recognition standard. However, based on the representations and comment letters received, the IASB in its revised exposure draft has changed criterion for determining whether performance obligations are being satisfied over a period of time impacting the timing of revenue recognition from the sale of real estate.

The earlier principles of IFRIC 15 allowed the percentage completion method when either the unit is based on a customer-specific design or it could be demonstrated that there is a continuous transfer of units while construction progresses which is evidenced:

— if construction activity takes place on land owned by the buyer;
— the buyer cannot put the incomplete property back to the developer;
— on premature termination the buyer retains the work in progress and the developer has the right to be paid for the work performed; or
— the agreement gives the buyer the right to take over the work in progress during construction.

These criterions have been changed significantly under the revised exposure draft. Under the revised exposure draft, performance obligations of the company can be met over a period of time if the entity:

(a) creates or enhances an asset (for example, work in progress) that the customer controls as the asset is created or enhanced. Or

(b) does not create an asset with an alternative use to the entity and at least one of the following criteria is met:

(i) the customer simultaneously receives and consumes the benefits of the entity’s performance as the entity performs or

(ii) another entity would not need to substantially re-perform the work the entity has completed to date if that other entity were to fulfil the remaining obligation to the customer, or

(iii) the entity has a right to payment for performance completed to date and it expects to fulfil the contract as promised.

Most typical Indian real estate contracts for sale of apartments are for specific unit sales to customers, require progress payments based on completion of work and are intended to be fulfilled which would fall under the above criterion of satisfying performance obligations over time.

The following example illustrates the above criterion:

Example 1:

Company Z is developing residential real estate and starts marketing individual units (apartments). Z has entered into the minimum number of contracts that are needed to begin construction. A customer enters into a binding sales contract for a specified unit that is not yet ready for occupancy. As per the contract, the customer pays a non-refundable deposit at inception of the contract and agrees to make progress payments throughout the contract. Those payments are intended to at least compensate Z for performance completed to date and are refundable only if Z fails to deliver the completed unit.

Z receives the final payment on delivery of possession of the unit to the customer. To finance the payments, the customer borrows from a financial institution that makes the payments directly to Z on behalf of the customer. The lender has full recourse against the customer. The customer can sell his or her interest in the partially completed unit, which would require approval of the lender but not Z. The customer is able to specify minor variations to the basic design, but cannot specify or alter major structural elements of the unit’s design. The contract precludes Z from transferring the specified unit to another customer.

The apartment created by the Z’s performance does not have an alternative use to Z, because it would lead to breach of contract with the customer. Z concludes that it has a right to payment for performance completed to date, because the customer is obliged to compensate Z for its performance rather than only a loss of profit if the contract is terminated. In addition, Z expects to fulfil the contract as promised. Hence, Z has a performance obligation that it satisfies over time.

The new rules are more pragmatic and will enable percentage completion method for real estate where the criterions are met. This essentially means that Indian real estate companies need to reassess the implications of revenue recognition under the revised exposure draft to understand whether their contracts would meet the conditions of satisfying performance obligations over time. It is important to analyse in which exact cases the new principles would allow percentage completion method. This would also then eliminate the need for a carve-out under Ind AS. Comment period for this exposure draft is open until 13 March 2012. This should be regarded as an opportunity to voice out any concerns or clarifications to the IASB so that the standard achieves global acceptance.

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Revenue Recognition

Revenue has been defined as income that arises in
the ordinary course of activities of the entity i.e., from sale of goods
or services. Ind AS 18 on Revenue Recognition prescribes certain
general principles for revenue recognition from transactions involving
sale of goods, rendering of services and the use of entity’s assets that
generate fees such as royalties, dividend and interest. Revenue is
recognised when it is probable that economic benefits of the transaction
will flow to an entity and costs are identifiable and can be measured
reliably. In this article, we aim to understand certain key principles
of revenue recognition prescribed under Ind AS 18 in case of multiple
element arrangements, customer loyalty programmes, transfer of assets
from customers and sale on extended credit terms by way of examples.
Multiple deliverable contracts:

Companies at times offer a broad range
of products and services to its customers. These arrangements are
sometimes negotiated with the customer through a single contract which
contains multiple deliverables that are separately identifiable and have
stand-alone value to the customer, for example an automobile company
sells vehicles to a customer along with an optional extended warranty of
three years for a composite price. In accounting for revenue in case of
multiple deliverable arrangements the company should identify
‘separately identifiable components’ for which revenue is recognised at
varied points of time as per the contract. The consideration for these
separate elements should be allocated on a fair value basis using either
the ‘Fair value method’ or the ‘Relative fair value method’. Under the
fair value method, the revenue equivalent to the fair value of all
undelivered contract is deferred, and the difference between total
contract price and deferred revenue is recognised as revenue on
delivered components. Under the relative fair value method, the total
contract price is allocated to each contract deliverable in the ratio of
their fair values as a percentage to the aggregate fair values of all
individual contract deliverables.

Let us consider the concept of
multiple deliverable arrangements by way of an example — Example 1:
Multiple deliverables A company sells a vehicle along with a contract
for an optional three-year extended warranty bundled along with it for a
contract value of INR 570,000. The fair value of the extended warranty
services is INR 60,000. The fair value of the vehicle without the
extended warranty services is INR 540,000. The entire consideration is
required to be paid upfront.
Relative fair value method

Step 1: The above contract can be broken into the following identifiable components:

Step 2: Allocation of revenue based on their relative fair values — Contract value: INR 570,000

It
may be noted here that the aggregate fair value of delivered components
is INR 600,000 while the aggregate contract price is INR 570,000. As
such, there is a discount of 5% (i.e., 30,000/ 600,000) on the overall
contract as compared to its market price. Under the relative fair value
method, this discount of 5% is applied to each deliverable for revenue
recognition purposes. As such, the consideration allocated to vehicle is
INR 513,000 (i.e., 95% of INR 540,000) and that allocated to extended
warranty is INR 57,000 (i.e., 95% of INR 60,000).

Fair value method

It
may be noted here that under the fair value method, the consideration
allocated to the undelivered component is its entire fair value and the
remaining contract price is allocated to the delivered component. As
such, the consideration allocated to the extended warranty (i.e.,
undelivered component) shall be INR 60,000 while the remaining
consideration of INR 510,000 (i.e., INR 570,000 — INR 60,000) shall be
allocated to the sale of vehicle.

Customer loyalty programmes:

A
range of businesses, such as supermarkets, retailers, airlines,
telecommunication operators, credit card providers and hotels offer
customer loyalty programmes, which comprise of loyalty points or ‘award
credits’. Such award credits or loyalty points may be linked to
individual purchases or groups of purchases, or to continued custom over
a specified period. The customer usually redeems these award credits
for free or discounted goods or services.

For a programme to be accounted as a customer loyalty programme, it needs to contain two essential features:

— the entity (seller) grants award credits to a customer as part of a sales transaction; and

—
subject to meeting any other conditions, the customer can redeem the
award credits for free or discounted goods or services in the future.

For
instance, a customer receives a complimentary product with every tenth
product bought from the entity (seller). As the customer purchases each
of the first ten products, they are earning the right to receive a free
good in the future, i.e., each sales transaction earns the customer
credits that go towards free goods in the future.

In accounting
for customer loyalty programmes the company estimates the fair value of
the award credits, generated through its loyalty programmes. The
consideration (for goods sold on which award credits are issued) is
allocated to the award credits based on either the fair value method or
the relative fair value method (as discussed above). Revenue is
recognised for the delivered goods based on the sale consideration
allocated to the goods sold while the sale consideration allocated to
the award credits are recognised when the award credits are redeemed.

Let us understand the above principles with the help of an example —

Example
2: Customer loyalty programmes Company Q runs a loyalty scheme that
rewards customers’ spend at its stores. As per the scheme, customers are
granted 10 award credits for every INR 100 spent in Q’s store.
Customers can redeem their accumulated points towards a discount on the
price of a new product in Q’s stores. The loyalty points are valid for
three years.

During 2012, Q had sales of INR 1,000,000 and
accordingly granted 100,000 loyalty points to its customers. The
management expected only 80,000 loyalty points to be redeemed and that
the cost per point redeemed would be INR 0.8 per point. The management
has adopted fair value method for allocation of consideration to the
multiple deliverables i.e., initial sale of goods and award credits. Q
records the following entries in 2012 in relation to the loyalty points
granted in 2012:

Redemption of award credits in Year 1

During
2012, 30,000 points were redeemed, and at the end of the reporting
period, management still expected a total of 80,000 points to be
redeemed, i.e., a further 50,000 points will be redeemed over the next
two years.

At the end of the reporting period, the balance of
the deferred revenue is INR 40,000 [(50,000/ 80,000) x 64,000].
Therefore, the difference in the deferred revenue balance is recognised
as revenue for the year.

Redemption in year 2: change in estimates

During 2013, 35,000 points are redeemed, and at the end of the year management expects a total of 85,000 points to be redeemed, i.e., an increase of 5,000 over the original estimate. The redemption rate is revised based on the new total expected redemptions. As such, at the end of year 2, 20,000 award credits would remain outstanding i.e., 85,000 – 30,000 – 35,000, after considering the revised total award credits to be utilised and actual redemption of award credits.

At the end of the year, the balance of deferred revenue for 20,000 loyalty points shall be INR 15,059 [(20,000/85,000) x 64,000] which shall represent the closing balance in deferred revenue account. The differential amount in deferred rev-enue account of INR 24,941 (i.e., 64,000 – 24,000 – 15,059) shall be transferred to revenue. Q records the following entry in 2013 in relation to the loyalty points granted in 2012:

Alternatively, on a cumulative basis INR 48,941 is released from deferred revenue account to revenue, which can be calculated as (65,000/85,000) x 64,000.

The remaining balance in deferred revenue account of INR 15,059 shall be recognised as revenue in the year 2014.

Transfer of assets from customers:

Ind AS 18 provides guidance on transfer of property, plant and equipment (or cash for its acquisition) for entities that receive such assets from their customers in return for ongoing supply of goods or services. As such, the principles contained hereunder do not apply to gratuitous transfers of assets i.e., transfer of assets without consideration. Further, the guidance also cannot be applied to transfers that are in the nature of government grants or those covered under the service concession arrangements.

If it is concluded that the company has obtained control over the asset transferred by the customer, the company should recognise (debit) the transferred asset as its own asset (though it may not have the ownership). The corresponding impact of the transfer should be recognised as either revenue or deferred revenue, depending upon the obligations assumed by the company in lieu of the transferred asset.

Timing of revenue recognition

In determining the timing of revenue recognition, the entity (recipient) considers:

what performance obligations it has as a result of receiving the customer contribution;

whether these performance obligations should be separated for revenue recognition purposes; and

when revenue related to each separately identifiable performance obligation should be recognised.

The accounting for transfer of assets from customers involves an analysis whether the control over the transferred asset is obtained by the company and if the control is transferred the asset will be recognised in the company’s balance sheet. The company is required to determine the obligations assumed by the company in lieu of the transfer of control over the transferred asset and if the above-mentioned obligations are in the nature of ongoing services, then revenue attributable to those obligations is deferred and recognised as the underlying services are rendered and obligations fulfilled where as to the extent that the obligations are fulfilled at the inception of the contract, revenue shall be recognised upfront. The assets transferred by the customer shall be depreciated over the useful life of the asset.

Let us understand the above principles with the help of an example

Example 3: Transfer of assets from customers

Company M enters into an agreement with Company N to outsource some of its manufacturing process. As part of the arrangement, Company M will transfer its machinery to Company N.

Based on a report submitted by independent valuer, the fair value of assets transferred is INR 100,000. Initially, Company N must use the equipment to provide the service required by the outsourcing agreement. Company N is responsible for maintaining the equipment and replacing it when it decides to do so. The useful life of the equipment is 5 years. The outsourcing agreement requires service to be provided for 5 years for a fixed price of INR 30,000 per year, which is lower than the price that Company N would have charged if the equipment had not been transferred. In such case the fixed price would have been INR 50,000 per annum.

Pursuant to a detailed analysis, Company N determines that the control over the equipment is transferred in its favour. Hence, Company N would have to initially recognise the asset at its fair value in accordance with Ind AS 16. Further, Company N would also have to recognise the revenue over the period of the services performed i.e., over 5 years. (Refer Table 1)

Table 1: Recognition of Revenue over Period
of Service Performed

INR

Particulars

Year 1

Year 2

Year 3

Year 4

Year
5

Asset A/c

Dr.

100,000

To Deferred Revenue A/c

(100,000)

(Being transfer of control over the assets from
customer in lieu of rendering ongoing services)

Bank A/c

Dr.

30,000

Deferred Revenue A/c

Dr.

20,000

(100,000/5)

To Revenue

(50,000)

(Being revenue recognised)

Depreciation A/c

Dr.

20,000

To Accumulated Depreciation

(20,000)

(Being depreciation provided over 5 years)

Extended credit terms:
When payment for goods sold or services rendered is deferred beyond the normal credit terms, and the company does not charge a market interest rate, the arrangement effectively constitutes a sale with financing arrangement and revenue should be recognised at the current cash price. The length of normal credit terms depends on the industry and economic environment in which the company operates.

Example 4: Sale on extended credit terms

Company K sells equipment to Company L for a total consideration of INR 1,000,000. The payment for this sale is deferred over a period of five years with regular payments of INR 200,000 each year to be made by Company L to Company K. No interest is charged by Company K to Company L and the normal credit terms of Company K are four months from the date of sale. The current cash price for the goods sold is INR 758,157. Considering the current cash price and the five annual payments of INR 200,000, the effective interest rate on the transaction works out to 10% p.a.

The sale by Company K to Company L is on deferred payment basis and beyond its normal credit terms. The total consideration under the terms of the arrangement is INR 1,000,000. However, revenue should be recognised at the current cash price i.e., the price at which the goods will be sold without such extended credit terms. The difference between the current cash price and the total consideration should be recognised as finance income over the extended credit period.

Accordingly, the revenue on the date of the transaction shall be recognised at its current cash price of INR 758,157. The difference INR 241,843 (i.e., INR 1,000,000 – INR 758,157) will be recognised as finance income over the period of the contract using the effective interest rate method.

The recognition of finance income based on effective interest rate of 10% is computed as shown in Table 2

Table 2: Recognition of Finance Income based on Effective Interest

Year

Opening Value

Interest

Payments

Closing Value

(A)

(B) = (A * 10%)

(C)

(D)=(A+B+C)

Year 1

7,58,157

75,816

-2,00,000

6,33,973

Year 2

6,33,973

63,397

-2,00,000

4,97,370

Year 3

4,97,370

49,737

-2,00,000

3,47,107

Year 4

3,47,107

34,711

-2,00,000

1,81,818

Year 5

1,81,818

18,182

-2,00,000

Total interest

241,843

Journal entries

INR

Particulars

Year 1

Year 2

Year 3

Year 4

Year 5

Debtors A/c

Dr.

758,157

To Sales A/c

(758,157)

(Being revenue recognised)

Debtor A/c

Dr.

75,816

63,397

49,737

34,711

18,182

To Finance Income

(75,816)

(63,397)

(49,737)

(34,711)

(18,182)

(Being finance income
recognised over the extended credit period)

Bank A/c

Dr.

200,000

To Debtor A/c

(200,000)

(Being amount collected from debtors)

Summary:

Revenue recognition principles prescribed under Ind AS 18 and discussed in this article vary significantly from the currently applicable AS 9 – Revenue Recognition. The application of these principles will require significant judgment in several aspects while preparing an entity’s financial statement.

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Revenue Recognition by Real Estate Developers — An Important carve-out in Ind-AS

Revenue recognition for real estate developers is one of the most critical carve-outs considered by standard-setters when framing Ind-AS, in accordance with the plan to converge with IFRS. Ind AS requires real estate developers to recognise revenue on a percentage completion method in accordance with ‘construction contract’ accounting principles, as against IFRS, which would require accounting on completion similar to ‘sale of goods’ in most cases depending on the contracts with customers. Further, the Institute of Chartered Accountants of India (ICAI) on 13th December 2011 issued an exposure draft of the Guidance Note (GN) on Recognition of Revenue by Real Estate Developers. This GN seeks to supersede the existing GN of ICAI of June 2006. Currently, the accounting practices followed by real estate companies for revenue recognition are very diverse and this GN seeks to align the current practices by giving bright-lines for determining the eligibility of real estate transactions for revenue recognition.

The GN should be applied to all transactions in real estate commencing or entered into on or after 1st April 2012. The GN also gives an early adoption option, provided that it is applied to all transactions commencing on or were entered into on or after the earlier adoption date.

This GN mandates the application of POC method [as defined in Accounting Standard (AS) 7, Construction Contracts] in respect of real estate transactions where the economic substance is similar to construction-type contracts. It gives the following indicators for determining if the economic substance of the transactions is similar to construction type contracts:

(a) The period of such projects is in excess of 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-type 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.

The GN also specifies that the POC method is applied only when all the following conditions are fulfilled:

(a) All critical approvals necessary for commencement of the project have been obtained;

(b) When the stage of completion reaches a reasonable level of development. Rebuttable presumption — reasonable level is not achieved if the expenditure incurred on project costs is less than 25% of the construction and development costs;

(d) At least 10% of the total revenue as per the agreements of sale or any other legally enforceable documents are realised at the reporting date.

Therefore, companies need to assess the eligibility of individual project based on the above parameters at each reporting period before any revenue can be recognised from them. Unless and until all the above conditions are met, revenue cannot be recognised from a project. In the calculation of stage of completion of 25% for point (b) above, only actual construction costs can be included and other costs (i.e., cost of land and development rights and borrowing costs) are excluded. Hence, the GN focusses on actual physical construction activities rather than costs. However, this calculation of stage of completion is only for determining if the project is an eligible project for revenue recognition. Once it is determined that a particular project is an eligible project, revenue can be recognised based on a POC calculation that is different from the calculation done for deciding eligibility. Put differently, revenue recognition can be based on a higher POC, calculated by taking total actual costs including cost of land and development rights. While this is not explicitly mentioned in the GN it is coming out from the illustration appended to the GN.

The GN also puts an additional overall restriction on recognition of revenue when there are outstanding defaults in payment by customers. It says that the recognition of revenue by reference to POC should not at any point exceed the estimated total revenue from eligible contracts. Eligible contracts for this purpose are those meeting the above four POC criteria plus where there are no outstanding defaults of the payment terms. The GN does not define ‘outstanding default’ and hence, a question arises if the ‘outstanding default’ to be determined as at the period ends only or post balance sheet payments should also be considered? For example, there was a default in payment by a customer before the period end, but the customer has paid and regularised the account post the period end before the financial statements approved. It is not clear from the GN whether this will be considered as an ‘outstanding default’ as at the period end.

Example
ABC Limited is in the business of real estate development and sale. On 1st April 2010, ABC started a project to construct and sell 100 flats of 1,000 sq.ft. each. Cost of construction, including directly attributable costs is Rs.3,000 per sq.ft. Cost of land and development right is Rs.30 crore. Actual figures for the year ended 31st March 2011 are given in Table 1:

Rs. in crores

Sales — 30 flats at
an average sales price of Rs.7,000 per sq.ft.

21.00

Collection from
customers — 40%

8.40

Actual construction
costs, including direct and indirect overheads

15.00

Total revised
estimated balance costs to complete

17.00

POC for determining
if the project is eligible for revenue recognition (actual construction

costs/total estimated
construction costs)

46.88%

POC for recognition
of revenue (cost of land and development rights + actual construction

costs/Total revised
estimated costs including land and development costs)

72.58%

Since the project meets all revenue recognition preconditions as per the GN (i.e., actual construction costs exceed 25% of the total estimated construction costs, 25% of the total revenue secured by sale con-tracts and 10% collection), revenue can be recognised from the project for the year ended 31st March 2011. The Table 2 shows the calculation of revenue, costs and work in progress to be recognised in the financial statements for the year ended 31st March 2011:

Rs. in crores

Revenue to be
recognised

(30 x 7,000 x 1,000 x
72.58%)

15.24

Project costs [(30 +
15) x 30,000

sq.ft./100,000
sq.ft.)]

13.50

Work in progress (30
+ 15 – 13.50)

31.50

In case there were defaults in payment by 10 flat holders out of the total 30, the additional computation shown in Table 3 is to be done to determine if the revenue recognition of Rs.15.24 crore is appropriate.

Rs. in crores

Revenue to be
recognised

(as above)

15.24

Estimated total
revenue from

eligible contracts

(20 flats x 1,000
sq.ft. x Rs.7,000

per sq.ft.)

14.00

Work in progress (30 + 15 – 13.50)

31.50

Since the revenue as per the POC workings of Rs.15.24 crore is higher than the estimated total revenue from eligible contracts of Rs.14 crore, revenue recognition should be restricted to Rs.14 crore and correspondingly cost of projects to be recognised in the profit and loss should also be adjusted.

This guidance note will enhance consistency in the accounting practices of real estate developers and in particular the application of the percentage completion method. This however remains a very important ‘carve-out’ and will have a significant impact on companies who wish to prepare and report their financial statements under IFRS.

Editor’s Note: It is understood that the Guidance Note on Recognition of Revenue by Real Estate Developers has been finalised and is expected to be issued shortly.

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Bharat Heavy Electricals Ltd. (31-3-2011)

From Significant Accounting Policies

Depreciation
At erection/project sites: The cost of roads, bridges and culverts is fully amortised over the tenure of the contract, while sheds, railway sidings, electrical installations and other similar enabling works (other than purely temporary erections, wooden structures) are so depreciated after retaining 10% as residual value.

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Indian Oil Corporation Ltd. (31-3-2011)

From Significant Accounting Policies

Depreciation
Expenditure on items like electricity transmission lines, railway sidings, roads, culverts, etc. the ownership of which is not with the company are charged off to revenue in the year of incurrence of such expenditure.

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Bharat Petroleum Corporation Ltd. (31-3-2011)

From Significant Accounting Policies

Fixed assets
Expenditure incurred generally during construction period of projects on assets like electricity transmission lines, roads, culverts, etc. the ownership of which is not with the company are charged to revenue in the accounting period of incurrence of such expenditure.

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Ambuja Cement Ltd. (31-12-2010)

From Significant Accounting Policies

Depreciation
The cost of fixed assets, constructed by the company, but ownership of which belongs to government/local authorities, is amortised at the rate of depreciation specified in Schedule XIV to the Companies Act, 1956.

Expenditure on power lines, ownership of which belongs to the State Electricity Boards, is amortised over the period as permitted in the Electricity Supply Act, 1948.

Expenditure on marine structures, ownership of which belongs to the Maritime Boards, is amortised over the period of agreement.

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ACC Ltd. (31-12-2010)

From Significant Accounting Policies

Depreciation
Capital assets whose ownership does not vest in the company have been depreciated over the period of five years.

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Tata Steel Ltd. (31-3-2011)

From Significant Accounting Policies

Depreciation
Capital assets whose ownership does not vest in the company is depreciated over their estimated useful life or five years, whichever is less.

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