BCAJ | Bombay Chartered Accountant Journal

Ultratech Cement Ltd. (31-3-2011)

From Significant Accounting Policies

Depreciation
Assets not owned by the company are amortised over a period of five years or the period specified in the agreement.

From Fixed Assets Schedule
Fixed assets includes assets costing Rs.238.63 crores (Previous year Rs.150.94 crores) not owned by the company.

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NHPC Ltd. (31-3-2011)

From Significant Accounting Policies

Fixed assets

Capital expenditure on assets where neither the land nor the asset is owned by the company is reflected as a distinct item in capital work in progress till the period of completion and thereafter in the fixed assets.

Depreciation
Capital expenditure referred to in Policy 2.3 is amortised over a period of five years from the year in which the first unit of project concerned comes into commercial operation and thereafter from the year in which the relevant asset becomes available for use.

From Notes to Accounts
During the year the company has received the opinion from the Expert Advisory Committee of the Institute of Chartered Accountants of India (EAC of ICAI) and as per opinion of EAC, expenditure incurred for creation of assets not within the control of company should be charged to Profit & Loss account in the year of incurrence itself. The company has represented to the EAC of ICAI that such expenditure, being essential for setting up of a hydro project, should be allowed to be capitalised. Pending receipt of further opinion/communication from the EAC, the accounting treatment as per existing accounting practices/ policies has been continued.

From Auditor’s Report
Further to our comments in the Annexure referred to in Para 3 above, without qualifying our report, we draw attention to (a) ……., (b) ……. and (c) Note No. 12 (Schedule 24 — Notes to Accounts) regarding having referred the issue of capitalisation of expenditure incurred for creation of assets (enabling assets) not within the control of the company, to Expert Advisory Committee of the Institute of Chartered Accountants of India.

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NTPC Ltd. (31-3-2011)

From Significant Accounting Policies

Fixed assets

Capital expenditure on assets not owned by the company is reflected as a distinct item in Capital Work-in-Progress till the period of completion and thereafter in the Fixed Assets.

Depreciation
Capital expenditure on assets not owned by the company is amortised over a period of four years from the month in which the first unit of project concerned comes into commercial operation and thereafter from the month in which the relevant asset becomes available for use. However, similar expenditure for community development is charged off to revenue.

From Notes to Accounts
During the year the company has received an opinion from the Expert Advisory Committee of the Institute of Chartered Accountants of India on accounting treatment of capital expenditure on assets not owned by the company wherein it was opined that such expenditure are to the charged to the statement of Profit & Loss Account as and when incurred. The company has represented that such expenditure being essential for setting up of a project, the same be accounted in line with the existing accounting practice and sought a review. Pending receipt of communication regarding the review, existing treatment has been continued as per existing accounting policy.

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Deferre d taxes an d effec tive tax ra te reconcilia tion — Approach under Ind AS

In this article, we will aim to understand the Ind AS approach towards computing deferred taxes using a simple case study and extending it to understand the effective tax rate reconciliation, one of the important disclosures for taxes under Ind AS 12.

Computation of deferred taxes using the balance-sheet approach

Deferred taxes under Ind AS are computed using the balance-sheet approach. While in principle, the concept of deferred tax is similar to Indian GAAP, the approach adopted for computation is different. This approach is based on the principle that each asset and liability has a value for tax purposes, considered the tax base. Differences between the carrying amount of an asset/liability and its tax base are temporary differences. Deferred tax assets/liabilities are computed using the substantially enacted tax rate on such temporary differences which are either taxable or deductible in the future periods, subject to specific exemptions under Ind AS 12.

Temporary differences are either taxable temporary differences or deductible temporary differences. A taxable temporary difference results in the payment of tax when the carrying amount of an asset or liability is settled. This means that a deferred tax liability will arise when the carrying value of an asset is greater than its tax base, or the carrying value of a liability is less than its tax base. Deductible temporary differences are differences that result in amounts being deductible in determining taxable profit or loss in future periods when the carrying value of an asset or liability is recovered or settled. When the carrying value of a liability is greater than its tax base or the carrying value of an asset is less than its tax base, a deferred tax asset may arise.

Summary of accounting for deferred tax

In summary, the approach for computing deferred tax under Ind AS is as follows:

Determine the tax base of the assets and liabilities
Compare the carrying amounts in the balance sheet with the tax base, and identify all taxable/ deductible temporary differences apart from the specific exceptions under Ind AS
Apply the tax rate to the temporary differences to determine the value of deferred tax assets/ liabilities to be recorded.

Case study

Given below is the balance sheet of an entity as at 31 December 20X2

The first step is to determine the tax base of the above assets and liabilities

Note 1: Land

Consider that under the entity’s tax jurisdiction the indexed cost of land is considered as the cost of land while calculating the profit on sale of such land. Hence the indexed cost of land (tax base) will exceed the book value of land by the indexation benefit provided each year resulting in a deductible temporary difference.

Note 2: Plant and equipment

The original cost of plant and equipment is assumed to be INR 20mn purchased on 1 January 20X2 having an estimated useful life of four years. Depreciation in the books is provided on a straight-line basis. The depreciation rate for tax purposes is 50% and is calculated on a written-down value method. Accordingly, at the end of year 1, the accounting base of Property, Plant and Equipment is INR 15mn and the tax base is INR 10mn resulting in a taxable temporary difference of INR 5mn.

Note 3: Dividend receivable

One of the entity investees has declared a dividend of INR 10mn and the entity has recognised a receivable in its financial statements. In the jurisdiction of the entity, dividends are tax-exempt. In this case, no deferred tax liability is recognised, following either of these analyses:

The tax base of the receivable is zero and therefore there is a temporary difference of INR 10mn; however, the tax rate that will apply is zero when the cash is received. Therefore, no deferred tax liability is recognised.
The tax base of the receivable is INR 10mn since, in substance; the full amount will be tax deductible (i.e., the economic benefits are not taxable). Therefore, no deferred tax liability is recognised as the tax base is equal to the carrying amount of the asset.

Note 4: Trade receivables

The entity has net debtors of INR 6mn after recognising a bad debt provision of INR 2mn in the books. In the jurisdiction of the entity, tax does not allow a deduction for provision of bad debts and allows a deduction only in the year the company records a bad debt write-off. Hence, the tax base for trade receivables is INR 8mn. This results in a deductible temporary difference which will reverse when the debtor is actually written off in the books and tax allows a deduction.

Note 5: Interest receivable

The entity has accrued interest receivable of INR 5 mn, which will be considered as income for tax purposes only when it receives it in cash. Hence the tax base of the receivable equals zero. This difference results in a taxable temporary difference because the amount will be taxed in a future period i.e., when the cash is received.

Note 6: Loan

The entity has taken a loan of INR 12 mn on 31 December 20X2 and has incurred an upfront loan processing fee (transaction cost) of INR 1 mn. As per Ind AS 39, the entity records the loan value, net of the processing fee as INR 11mn. Consider that under the entity’s tax jurisdiction, such costs are allowed as a deduction in the year when they are incurred. Hence the tax base of the loan is INR 12 mn leading to a taxable temporary difference of INR 1 mn. In the future years, there will be a reversal of this difference as and when the transactions costs are charged to the income statement as per the effective interest rate method under Ind AS 39.

Note 7: Business loss

Consider that the entity has incurred book losses during the current period of INR 4 mn. The tax loss of the current year amounts to INR 21.3 mn. These losses can be carried forward for a period of eight years and claimed as a set-off against tax profits earned in the future. The loss during the current year is on account of an identifiable cause that is unlikely to occur in the future periods. The entity determines that it is probable that future tax profits will be available to recover the deferred tax asset recognised on these losses. In this case, there is an asset tax base of INR 21.3 mn while the accounting base is nil leading to a deductible temporary difference.

Thus the deferred tax computation under the balance sheet approach is as shown in table on previous page:

Effective tax rate reconciliation

One of the mandatory disclosures required by Ind AS 12 is the disclosure of the effective tax rate reconciliation. Effective tax rate reconciliation is explained under Ind AS 12 as a numeric reconciliation between the actual tax expense/income i.e., sum of the current and deferred tax; and the expected tax expense/income i.e., product of accounting profit multiplied by the applicable tax rate. There are two approaches to disclose this reconciliation — reconcile the effective tax rate percentage to the actual tax rate percentage or reconcile the absolute actual income tax expense to the expected tax expense. We have adopted the second approach in the illustration below. Continuing the case study above, consider that the computation of taxable income/loss for the entity is as under:

All temporary differences not considered as part of the deferred tax computations since they are neither deductible, nor taxable in future periods (for example, donations and penalties or dividends) or considered additionally under the deferred tax computations, but will impact taxable income in future periods (for example, land indexation) will form part of the effective tax rate reconciliation.

Note that in case the business losses did not meet the deferred tax asset recognition criteria, then this component (non-recognition of deferred tax asset on business losses due to uncertainty) would also have formed part of the effective tax reconciliation.

The approach under Ind AS 12 for computing deferred taxes and related effective tax rate disclosure ensures that all possible tax impacts to be recorded in the financial statements have been determined. It also helps the reader of the financial statements correlate the tax and account-ing position of the company leading to better understanding of the financial statements.

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GAPs in GAAP — Accounting for Rate Regulated Activities

Many governments establish regulatory mechanisms to govern pricing of essential services such as electricity, water, transportation, etc. Such mechanisms endeavour to maintain a balance between protecting the consumers from unreasonable prices and allowing the providers of the services to earn a fair return. These rate-regulation mechanisms result in significant accounting issues for service providers.

Company X, the owner of electricity transmission infrastructure and related assets, has been licensed for twenty years to operate a transmission system in a particular jurisdiction. Only one operator is authorised to manage and operate the transmission system. Company X charges its customers for access to the network at prices that must be approved by the regulator. Pricing structures are defined in the law and related guidelines, and are determined on a ‘cost plus’ basis that is based on budget estimates. Once approved, prices are published and apply to all customers. Prices are not negotiable with individual customers. Prices are set to allow Company X to achieve a fair return on its invested capital and to recover all reasonable costs incurred. At the end of each year, Company X reports to the regulator deviations between the actual and budgeted results. If the regulator approves the differences as ‘reasonable costs’, they are included in the determination of rates for future periods. The key question is that, can an entity recognise this difference which it would attempt to recover through rates for future periods as assets and liabilities?

To deal with this issue, the International Accounting Standards Board (IASB) was working on the proposed IFRS for Rate Regulated Activities. Though the IASB paused its project, the ICAI recently issued the Guidance Note on Accounting for Rate Regulated Activities (GN). It is stated that the GN will apply both under the Indian GAAP and IFRS-converged standards (Ind-AS). Since the GN is still to be cleared by the National Advisory Committee on Accounting Standards (NACAS), the ICAI has not announced its applicability date. The GN applies to those activities of an entity which meet both of the following criteria:

(i) The regulator establishes the price the entity must charge its customers for the goods or services the entity provides, and that price binds the customers.

(ii) The price established by regulation (the rate) is designed to recover the specific costs the entity incurs in providing the regulated goods or services and to earn a specified return (costof- service regulation). The specified return could be a minimum or range and need not be a fixed or guaranteed return. The GN defines the ‘costof- service’ regulation as ‘a form of regulation for setting up an entity’s prices (rates) in which there is a cause-and-effect relationship between the entity’s specific costs and its revenues.’ However, the GN does not deal with regulatory mechanisms which prescribe rates based on targeted or assumed costs, such as industry averages, rather than the entity’s specific costs.

GN acknowledges that the rate regulation of an entity’s business activities creates operational and accounting situations which would not have arisen in the absence of such regulation. With cost-ofservice regulation, there is a direct linkage between the costs that an entity is expected to incur and its expected revenue as the rates are set to allow the entity to recover its expected costs. However, there can be a significant time lag between incurrence of costs by the entity and their recovery through tariffs. Recovery of certain costs may be provided for by regulation either before or after the costs are incurred. Rate regulations are enforceable and, therefore, may create legal rights and obligations for the entity.

The GN requires an entity to recognise regulatory assets and regulatory liabilities. Regulatory assets represent an entity’s right to recover specific previously incurred costs and to earn a specified return, from an aggregate customer base. Regulatory liabilities represent an entity’s obligation to refund previously collected amount and to pay a specified return. The following paragraphs explain the reasons provided in the GN for recognition of rate regulated assets and liabilities.

(1) The Framework, defines an ‘asset’ as follows: “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.” In a cost-of-service regulation, the resource is the right conferred by the regulator whereby the costs incurred by the entity result in future cash flows. In such cases, incurrence of costs creates an enforceable right to set rates at a level that permits the entity to recover those costs, plus a specified return, from an aggregate customer base. For example, if the regulator has approved certain additions to be made by the entity in its assets base during the tariff period, which would be added to the asset base for tariff setting, the entity upon making such additions obtains the right to recover the costs and return as provided in the regulatory framework though the actual recovery through rates may take place in the future. While adjustment of future rates is the mechanism the regulator uses to implement its regulation, the right in itself is a resource arising as a result of past events and from which future cash inflows are expected.

(2) The cause-and-effect relationship between an entity’s costs and its rate-based revenue demonstrates that an asset exists. In this case, the entity’s right that arises as a result of regulation relates to identifiable future cash flows linked to costs it previously incurred, rather than a general expectation of future cash flows based on the existence of predictable demand. The binding regulations/orders of the regulator for recovery of incurred costs together with the actual incurrence of costs by the entity would satisfy the definition of asset as per the Framework since the entity’s right (to recover amounts through future rate adjustments) constitutes a resource arising as a result of past events (incurrence of costs permitted by the regulator for recovery from customers) from which future economic benefits are expected to flow (increased cash flows through rate adjustments).

(3) As regards the ‘control’ criterion in the definition of an asset as per the Framework, it may be argued that though the entity has a right to recover the costs incurred, it does not control the same since it cannot force individual customers to purchase goods or services in future. In this regard, it may be mentioned that the rate regulation governs the entity’s relationship with its customer base as a whole and therefore creates a present right to recover the costs incurred from an aggregate customer base. Although the individual members of that group may change over time, the relationship the regulator oversees is between the entity and the group. The regulator has the authority to permit the entity to set rates at a level that will ensure that the entity receives the expected cash flows from the customers’ base as a whole. Further, the Framework states that control over the future economic benefits is sufficient for an asset to exist, even in the absence of legal rights. The key notion is that the entity has access to a resource and can limit others’ access to that resource which is satisfied in case of the right provided by the regulator to recover incurred costs through future rate adjustments. Any issues regarding recoverability of the amounts should not affect the recognition of the right in the financial statements though they certainly merit consideration in its measurement.

4. The Framework defines a liability as ‘a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.’ In cost-of-service regulation, an obligation arises because of a requirement to refund to customers excess amounts collected in previous periods. In such cases, collecting amounts in excess of costs and the allowed return creates an obligation to return the excess collection to the aggregate customer base. For example, if the tariffs initially set assume a certain level of costs towards energy purchased but the actual costs incurred by the entity are less than such assumed levels, the entity would be obliged to make a refund following the ‘truing up’ exercise by the regulator. Such obligation is a present obligation relating to amounts the entity has already collected from customers owed to the entity’s customer base as a whole, not to individual customers. It is not a possible future obligation because the regulator has the authority to ensure that future cash flows from the customer base as a whole would be reduced to refund amounts previously collected. The obligation exists even though its amount may be uncertain. An economic obligation is something that results in reduced cash inflows, directly or indirectly, as well as something that results in increased cash outflows. Obligations link the entity with what it has to do because obligations are enforceable against the entity by legal or equivalent means.

Potential inconsistency with Framework

The IASB has been working on proposed IFRS for Rate Regulated Activities, since 2008. It issued an exposure draft of proposed IFRS in July 2009; however, it has not been finalised till date and the project has been paused. One key reason for the delay arises from strong view that regulatory assets and regulatory liabilities do not meet the definition of an asset and liability under the IASB Framework for Preparation and Presentation of Financial Statements. The proponents of this view make the following arguments:

1) One of the essential characteristics of a regulatory regime is that entities entering it get access to a large customer base in a market that requires a significant investment in infrastructure (i.e., natural ‘barriers to access’). In return, the entity agrees to accept the ‘economic burden’ of having to comply with operating conditions, one of which is the requirement to have the prices of the goods or services it delivers approved by the regulator. This ‘economic burden’ does not lead to a recognisable liability on day one, but may require the recognition of a liability if it leads to contracts becoming onerous as defined by AS-29 Provisions, Contingent Liabilities and Contingent Assets. Under Indian GAAP, any price paid to receive the right to operate in this regulated market will meet the definition of an intangible asset. However, if the regulator allows an entity to increase its future prices, this is not creating a separate asset, but granting the entity relief from the ‘economic burden’ of its operating conditions to put them partly in the same position as an entity in an unregulated market and allowing them to generate a normal return.

2) A cause-and-effect relationship between a cost incurred and future rate increases may not be sufficient enough to justify the recognition of an asset, as this would apply to every entity reconsidering price setting for future periods based upon current year’s performance. For example, Widget Limited (the company) is
‘widget maker.’ It is not involved in rate regulated activity and does not have one-to-one contract with customers. The company is a dominant market participant having some monopolistic features. The company believes that it has incurred too many raw material costs in the current period. The company may make business decision to increase the price for transactions beginning the next year. The question is whether it is appropriate to recognise the incremental increase in sales price multiplied by the expected volume of sales for next year given that the link/reason the dominant market participant increased its price was because this year’s costs were too high (and therefore this year’s ‘reasonable profit’ expected by equity holders was not achieved).

3) To support recognition of regulatory assets/ liabilities, the GN argues that the regulator negotiates rates on behalf of the whole customer base and a regulated entity therefore is comparable to an entity negotiating future prices with a specific customer, thereby binding both the entity and the customer. However, the contrary view is that rate regulation is a condition of the entity’s entry into the regulated market (i.e., a condition of the operating license) and does not create a separate asset. The entity has control over the right to operate in the regulated market, not over the future behaviour of its customers. Since the regulator did not guarantee the future recovery of any costs incurred, an asset controlled by the entity is not being created.

The Framework for Preparation and Presentation of Financial Statements under Indian GAAP is similar to that under IFRS. Therefore, one may argue that the GN is not in accordance with the Indian Framework, which is the base document and serves as a guiding principle in drafting of standards.

Conclusion

Whilst the author does not believe that the existing asset and liability definitions are met, one can understand why the standard-setter considered the recognition of regulatory assets and regulatory liabilities for entities that meet certain conditions, to provide decision-useful information. The author believes that the only way this can be done under the existing Framework is to state that the proposals in the GN are a departure from the Framework, and to provide clear guidance on the scope of the standard and to prohibit analogising. While all entities have the right to increase or decrease future prices, regulated entities have the following characteristics to justify a departure from the Framework: (a) Their prices and operational decisions are restricted and governed by the law and require regulatory approval.

The economic impact of the regulation is to ensure that the regulated entity earns a specified return. (c) As noted in the GN, the regulator does act on behalf of the aggregate customer base with respect to price. Most importantly, the author believes a departure from the Framework is justified because the requirements would result in financial information that presents the economic effects of the regulation — that the entity will achieve a specified return.

A perusal of publicly available Indian GAAP financial statements of few companies engaged in power distribution indicates that they have recognised regulatory assets/ regulatory liabilities. From an Indian GAAP perspective, the Guidance Note is not expected to have any significant impact on these companies and would not change anything (other than legitimising current accounting practice). Therefore the author believes that the standard-setters should not have issued the Guidance Note in the first place and should actively participate in the ongoing effort of the IASB in developing a global standard for rate regulation.

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Non-availability of information from foreign branches

Punj Lloyd Ltd. (31-3-2012)

From Notes to Accounts The company’s branch at Libya has fixed assets (net) and current assets aggregating to Rs. 9,909,622 thousand as at March 31, 2011 in relation to certain projects being executed in that country. Due to civil and political disturbances and unrest in Libya, the work on all the projects has stopped, the resources have been demobilised and necessary intimation has been given to the customers. The company has also filed the details of the outstanding assets with the Ministry of External Affairs, Government of India. Pending the outcome of the uncertainty, the aforesaid amounts are being carried forward as realisable.

From Auditors’ Report 6. As stated in Note 19 of schedule ‘M’ to the financial statements, due to civil and political disturbances and unrest in Libya, the work on all the projects in Libya has stopped. There are aggregate assets of Rs.9,909,622 thousand, aggregate revenues of Rs.1,954,565 thousand, profits before tax of Rs.96,816 thousand and cash flows of Rs.1,803,620 thousand for the year then ended in Libya Branch, which have been audited by another auditor in Libya. However, we were unable to perform certain procedures that we considered necessary under the requirements of Statement on Auditing SA600 (Using the work of another auditor) issued by the Institute of Chartered Accountants of India, including obtaining corroborative information and/or audit evidence, in relation to certain components of financial statements of Libya Branch. The ultimate outcome of the above matters cannot presently be ascertained in view of the uncertainty as stated above. Accordingly, we are unable to comment on the consequential effects of the foregoing on the financial statements.

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 and proper returns adequate for the purposes of our audit have been received from branches and unincorporated joint ventures not visited by us except to the extent stated in paragraph 6 above. The branches and unincorporated joint ventures auditors’ reports have been forwarded to us and have been appropriately dealt with;

Without considering our observations in paragraph 6 above, the impact whereof on the Company’s profits is not presently ascertainable, in our opinion and on consideration of reports of other auditors on separate financial statements and on the other financial information and to the best of our information and 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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Issues arising on migration to an ERP software.

Shipping Corporation of India Ltd. (31-3-2011)

From Notes to Accounts
The Company being a shipping company, its activities are based both in shore and in floating ships. The Company has implemented three different ERP packages to take care of both shore and the ship-related transactions and they have gone live from 28-2-2011. The accounts for the period 1-4-2010 to 31-1-2011 (i.e., for ten months) are prepared in the legacy system and for the period 1-2-2011 to 31-3-2011 (i.e., for two months) are prepared in the new system. With all efforts, the system has been implemented and the accounts for the 4th quarter and year ending 31-3-2011 are for the first time prepared under the new system.

In addition to the above, supporting documents for income and expenses are not received by the Company from the agents and transactions have been recorded based on the amount of the advance released/data received from the agents for the month of March 2011.

Necessary accounting effects to rectify the migration errors have been carried out by the management wherever the instances have been observed and the exercise is continuing and the necessary rectification will be made appropriately.

Further to the above, the company is unable to make certain adjustment in respect of the following due to issues arising on migration and uploading of data in the new system:

(i) Translation of certain balances as per policy No. 8(c), wherever rectification entries have been passed post revaluation of the balances of the assets and liabilities,

(ii) The segmental results disclosed segment report may consist certain inter-segment compensating issues,

(iii) In some of the assets, depreciation is accounted where instances of classification in inter-assets class is noticed and date of capitalisation is taken based on best available information,

(iv) Certain transactions relating to payments, etc. reflected in the bank reconciliation statements could not be incorporated,

(v) During the current year aggregate Net Credit balance of Rs.25375.49 lakhs in vendor and accounts payable are shown as Sundry creditors and other liabilities, which up to previous year were disclosed vendor-wise debit and credit separately,

(vi) The foreign currency revaluation effects of various assets and liabilities are included in the debtors, instead of grouping the same with the respective assets and liabilities,

(vii) The second phase of audit by the Comptroller & Auditor General of India, has not been completed due to limitation of time.

The impact of items stated in para (i) to (iv) is not material on the result of the Company. Further the matters stated in para (iv) to (vi) relates to assets and liabilities and grouping thereof under the various heads of the Balance sheet.

From Auditors’ Report

(f) Attention is invited on:

Note. No. 1, Schedule-25 Notes on Accounts, regarding various errors and omissions have been made by the Company during the process of migration/uploading of data post migration in the new accounting software ERP-SAP, in respect of accounting of the income and expenses, assets and liabilities for which necessary rectification has been carried out by the Company.

Further there remain certain items where the company is unable to make appropriate adjustments and the effects of errors and adjustments, if any, as might have been determined to be necessary in the data migrated/uploaded in the accounting software post migration.

It has been further noticed that the Company has:

(i) Not accounted the income and expenditure in respect of unfinished voyages as per accounting policy No. 2(c), having no impact on the profit for the year.

(ii) Non-accounting of foreign currency transactions at the rates as stipulated in accounting policy No. 8(a) for the months of January 2011 and February 2011, instead the same have been accounted at the exchange rates applicable for the month of March 2011.71

(g) Note No. 17 of Schedule-25 ‘Notes to the Accounts’ in respect of balances of Sundry Creditors, Debtors, Loans & Advances and Deposit which are subject to confirmation.

In our opinion and to the best of our information and according to the explanations given to us, subject to our comments in para 4(f) above, the said accounts.

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Disclosure regarding support/comfort letters given for subsidiaries.

Tata Communications Ltd. (31-3-2011)

From Notes to Accounts

Note 4: As on 31 March 2011, the Comfort for the credit facility agreement in respect of various subsidiaries:

The Company has undertaken to the lenders of TCTSL and TCIPL that it shall retain full management control so long as amounts are due to the lenders.

Note 5: The Company has issued a support letter to Tata Communications International Pte. Limited (TCIPL), regarding providing financial support enabling, in turn, TCIPL to issue such support letter to certain subsidiaries having negative net worth as at 31 March 2011 aggregating Rs.1,245.71 crore (2010: Rs.1,508.41 crores) in various geographies in order that they may continue to be accounted for as going concern.

The letters of comfort/support mentioned in 4 and 5 above have been provided in the ordinary course of business and no liability on the Company is expected to materialise in these respect.

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GAPS in GAAP Accounting for BOT contracts

Background

Governments are always
starved of funds. To mitigate this problem, they enter into contracts
with private parties; particularly in the area of public service for the
development, financing, operation and maintenance of infrastructural
facilities such as, roads, bridges, ports, etc. An arrangement typically
involves a private sector entity (an operator) constructing the
infra-structural facilities used to provide the public service and
operating and maintaining those infrastructural facilities for a
specified period of time. The operator is paid for its services over the
period of the arrangement through user fees or the grantor pays
annuity. Such an arrangement is often described as a
‘build-operate-transfer’ (BOT) or a ‘public-to-private service
concession arrangement’. A feature of these service arrangements is:

1.
The grantor (generally the Government or a public sector company)
controls or regulates what services the operator must provide with the
infrastructural facilities, to whom it must provide them, and at what
price; and
2. The grantor controls through ownership, beneficial
entitlement or otherwise any significant residual interest in the
infrastructural facilities if remaining at the end of the term of the
arrangement.

Typically under current Indian GAAP, practice is
that the grantor records the cost of constructing the infra-structure as
fixed assets or in some cases as intangible assets. No profit is
recognised on the construction, since it is not appropriate to recognise
any profit on constructing fixed assets/intangible assets for own use.

However,
if one were to look more deeply into the current Indian GAAP, a more
appropriate accounting interpretation of the arrangement would be as
follows:

1. The infrastructure facilities should not be
recog-nised as property, plant and equipment of the operator, because
the contractual service arrangement does not convey the right to control
the use of the public service infrastructure facilities to the
operator. The operator has access to operate the infrastructure
facilities to provide the public service on behalf of the grantor in
accordance with the terms specified in the contract.

2. Under
the terms of contractual arrangements, the operator acts as a service
provider. The operator constructs infrastructure facilities used to
provide a public service and operates and maintains those infrastructure
facilities (operation services) for a specified period of time.

3.
The operator should recognise and measure revenue in accordance with
Accounting Standard (AS) 7, Construction Contracts and Accounting
Standard (AS) 9, Revenue Recognition for the construction and operating
the services it performs.

If the operator 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, when the amounts are separately
identifiable.

4. Paragraph 34 of AS 26 Intangible Assets
states that “An intangible asset may be acquired in exchange or part
exchange for another asset. In such a case, the cost of the asset
acquired is determined in accordance with the principles laid down in
this regard in AS 10, Accounting for Fixed Assets.” Paragraph 11.1 of AS
10 states 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 also be appropriate to consider
the fair market value of the asset acquired, if this is more clearly
evident.”

5. If the operator provides construction services,
the consideration received or receivable by the operator should be
recognised at its fair value. The consideration may be, rights to a
financial asset (annuities are received from the government), or an
intangible asset (toll charges are collected from public).

6. The operator should recognise a financial asset when it receives annuities from the grantor.

7.
The operator should recognise an intangible asset to the extent that
it receives a right (a licence) to charge users of the public service.

Let’s consider a simple example of how the intangible asset model would work.

Example

The
terms of the arrangement requires an operator to construct a road
within two years and maintain and operate the road to a specified
standard for eight years (i.e. years 3–10). At the end of year 10, the
arrangement will end and the road ownership will continue with the
government. The operator estimates that the costs it will incur to
fulfill its obligations will be as shown in Table 1.

Table 1 — Estimate of Costs

Assume
the operator collects Rs. 200 per year in years 3–10 from users of the
road. The user rates are fixed by the government. Fair value of
construction services is forecast cost plus 5%.

The operator
recognises contract revenue and costs in accordance with AS 7,
Construction Contracts and AS 9, Revenue Recognition. In year 1, for
example, construction costs of Rs. 500, construction revenue of Rs. 525
(cost plus 5 per cent), and hence construc-tion profit of Rs. 25 is
recognised in the statement of profit and loss. The operator provides
construction services to the grantor in exchange for an intangible
asset, i.e. a right to collect tolls from road users in years 3–10. In
accordance with AS 26, Intangible As-sets, the operator recognises the
intangible asset at cost, i.e. the fair value of consideration
transferred to acquire the asset, which is the fair value of the
consideration received or receivable for the construc-tion services
delivered. In accordance with AS 26, the intangible asset is amortised
over the period in which it is expected to be available for use by the
operator, i.e. years 3–10. The depreciable amount of the intangible
asset (Rs. 1,050) is allocated using a straight-line method. The annual
amortisation charge is therefore Rs. 1,050 divided by eight years, i.e.
Rs. 131 per year. The road users pay for the public services at the same
time as they receive them, i.e. when they use the road. The operator
therefore recognises toll revenue when it collects the tolls. The
statement of P&L for years 1-10 will appear as shown in Table 2.

The
above example has been kept simple and numerous other complications
have not been considered such as capitalisation of borrowing costs,
resurfacing obligation, negative grants, revenue sharing arrangements,
etc.

To sum up, it could be said that the current Indian GAAP is
not explicit as to how BOT contracts should be accounted for.
Therefore, there appears to be two methods in which BOT contracts can be
accounted.

Method 1

A classic and conventional
method has been to recognise the construction cost of the infrastructure
as fixed asset and depreciate it over a period of time. The
corresponding revenue on user fees is recognised when user fees are
collected.

Challenges in applying method 2

Scope

Since
the accounting model involved in method 2 is so different from the
traditional ”fixed asset” model, it is critical to determine whether an
arrangement falls within its scope. This is not always straightforward
due to the complexity of the contracts setting out the key terms of the
concession arrangements. One challenge that may arise, is in
deter-mining whether the government body controls any significant
residual interest in the infrastructure asset at the end of the
concession arrangement. Another challenge that may arise in some
circumstances, is to determine whether the government in substance
controls the user price.

Intangible asset, financial asset, or both

The
next step is to determine which of the two ac-counting models
(intangible asset or financial asset) to apply. This decision will have a
significant impact on the revenues recognised from the contract. For
example, it is not uncommon for a contract accounted for by applying the
intangible model to give rise to double the revenues, compared to a
contract with nearly identical cash flows that is accounted for using
the financial asset model. Fortunately, the selection of the model to
apply is not an option. Rather, the model flows from whether the
operator has the right to charge for services (intangible model) or the
right to receive cash flows from the grantor (financial asset). This may
require careful analysis, since a contract that initially appears to
fall within the intangible model may have an element of guaranteed cash
flows. For example, if in the early years of the contract, the
government body guarantees a minimum level of revenues from the
operation of a new expressway to encourage private investment, there may
be both a financial asset and an intangible asset. Accounting for these
“combined model” concessions can become very complex, since costs and
revenues must be divided between the two components of the contract.
Dividing the total consideration into the two components may involve the
use of significant management judgment and estimation.

Estimates and fair values

Accounting
for concession arrangements typically involves an extensive use of
estimates and valuations, which are expected to have a significant
impact on the company’s financial statements. For example, revenues and
costs need to be recognised for the construction of the infrastructure
asset in accordance with AS-7. Since the contract is unlikely to specify
separately the revenue from construction, it is typically necessary to
impute construction revenues by applying an appropriate margin to the
construction costs, and to assign the balance of revenue to operations,
maintenance, etc. Companies may need to use either internal or external
benchmarking for similar construction contracts, since an assessment of
profitability on a service concession arrangement is normally made on an
overall IRR basis and not separately for the construction and operation
phases of the project.

Accounting for negative grants

Certain
arrangements include the provision for negative grants, wherein the
operator is required to make the payment to the grantor during the
duration of the arrangement. The negative grant may be either in the
form of fixed payment (upfront or annual throughout the service
concession arrangement) or in the form of a percentage of revenue earned
during the arrangement. The upfront fixed payment should be treated as
an intangible asset. In the case of annual fixed payment, intangible
assets should be recognised at the present value of the annual amounts.
However, there are mixed practices under Indian GAAP in these matters.
Where the negative grant is in the form of share in the percentage of
revenue earned during concession arrangement, the company should assess
whether the revenue is to be shown on a net or gross basis.

Other factors

Numerous
other issues need to be considered such as capitalisation of borrowing
costs, provision for maintenance obligation, etc. and the efforts
involved in applying method 2 should not be undermined.

Issue

Parent
Ltd is a listed entity. Parent Ltd has set up a special purpose vehicle
(SPV) which is its 100% subsidiary, for the purposes of entering into
an arrangement with NHAI. SPV has entered into BOT contract with NHAI.
As per the Agreement, NHAI has granted an exclusive right to the SPV to
construct, operate and maintain the road for a period of thirty years.
The SPV has sub-contracted the construction for 60% of the road contract
to Parent. In 2012-13, Parent has executed the work of above road
project and the profit margin is approximately 5%. Parent recognises the
margin earned in its stand-alone financial statements. Whether Parent
should eliminate the profit on revenue received from SPV from
construction services provided to the SPV, in its consolidated financial
statements (CFS)?

Response

The response to the
above question will depend on the method the Parent is following with
respect to the accounting of service concession arrangements.

Method 1

If
method 1 as described above is used, Parent should eliminate the profit
on revenue received from SPV from construction services provided to the
SPV, in its

CFS. This is primarily for two reasons. Firstly,
paragraph 10.1 of AS-10 Accounting for Fixed Assets states as follows
“In arriving at the gross book value of self-constructed fixed
assets…………

Any internal profits are eliminated in arriving at such costs.” Secondly, paragraph 16 of AS-21 Consolidated Financial

Statements
states as follows “Intragroup balances and intragroup transactions and
resulting unrealised profits should be eliminated in full.”

Method 2

If
method 2 is applied, Parent should not eliminate the profit on revenue
received from SPV from construction services provided to the SPV, in its
consolidated financial statements; provided method 2 is applied in its
entirety. Under this method, the company applies the principles of the
Guidance Note/IFRIC 12. The group is not controlling the infrastructure,
which in substance has been sold to the grantor in lieu of a right to
use (intangible asset). As the group has sold the infrastructure, an
appropriate profit should be recognised. In other words, the arrangement
is seen as providing construction services to the government, rather
than a construction service provided by the Parent to the SPV.

The
application of accounting treatment above should not be seen as a means
of applying the Indian GAAP principles (method 2) to selectively
recognise the profits that Parent has made on its billing to the SPV.
Rather, it is a holistic application of Indian GAAP principles to the
entire service concession arrangement. Therefore, in addition to the
cost incurred by the SPV on billings by Parent, there may be other cost
incurred in executing the contract. The Indian GAAP principles
enumerated above should be applied to the total construction cost
including those charged by Parent to the SPV. This would mean that in
addition to not eliminating the profit made by the Parent on its billing
to the SPV, Parent would also have to recognise an additional profit
representing the margin on other cost. Further, all service concession
arrangements that fulfils certain specific criteria (and explained in
this article), will have to be accounted for in this manner. In
ad-dition, other matters may need careful consideration such as
provision for maintenance and resurfacing obligation, negative grant,
sharing of revenue with grantor, capitalisation of borrowing cost, etc.

Thus
under method 2, the entire arrangement is recorded based on Guidance
Note/IFRIC 12 principles. There are numerous challenges in applying
method 2 and it is not a straight forward exercise. This may have the
effect of recognising the profit made on the construction services
including the billings of the Parent to the SPV; however, it has too
many other repercussions and accounting consequences (discussed in this
paper) which would need careful consideration.

Method 2
An
alternative method under current Indian GAAP is to recognise the
construction of the infrastructure as a construction service rendered to
the grantor in exchange of an acquisition of a right to use (an
in-tangible asset) or an unconditional right to annuities (a financial
asset). Those principles of current Indian GAAP are more clearly
articulated in the Exposure Draft Guidance Note on Accounting for
Service Concession Arrangements. International Financial Reporting
Standards IFRIC 12 Service Concession Arrangements also has similar
requirements. The working model with respect to this method has been
explained in this article, using a simple example where the construction
service is exchanged for an intangible asset (right to use). There are
numerous challenges in applying method 2, which are described below.
When method 2 is used, it should be applied to all contracts in the
group that meet the requirements set out in the Guidance Note ED/ IFRIC
12.

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GAP in GAAP Accounting for Dividend Distribution Tax

Introduction to Dividend Distribution Tax (DDT)

Prior to 1st June 1997, companies used to pay dividend to their shareholders after withholding tax at prescribed rates. This was the “classic” withholding tax where shareholders were required to include dividend received as part of their income. They were allowed to use tax withheld by the company against tax payable on their own income. Collection of tax from individual shareholders in this manner was cumbersome and involved a lot of paper work. In case of levy of tax on individual shareholders, tax rate varied depending on class of shareholders. For example, corporate shareholders and shareholders in high income group paid tax at a higher rate, whereas shareholders in low income group paid tax at a lower rate or did not pay any tax at all. Also, certain shareholders may not comply with tax law in spirit, resulting in a loss of revenue to the government.

The government realised that it may be easier and faster to collect tax at a single point, i.e. from the company. It, therefore, introduced the concept of Dividend Distribution Tax (DDT). Under DDT, each company distributing dividend is required to pay DDT at the stated rate (currently 15% basic) to the government. Consequently, dividend income has been made tax free in the hands of the shareholders.

DDT paid by the company in this manner, is treated as the final payment of tax in respect of dividend and no further credit, therefore, can be claimed either by the company or by the recipient of the dividend. However, DDT is not required to be paid by the ultimate parent on distribution of profits arising from dividend income earned by it from its subsidiaries (section 115-O). Such exemption is not available for dividend income earned from investment in associates/joint ventures or other companies. Also, no exemption is available to a parent which is a subsidiary of another company.

DDT is applicable irrespective of whether dividend is paid out of retained earnings or from current income. DDT is payable even if no income-tax is payable on the total income; for example, a company that is exempt from tax in respect of its entire income still has to pay DDT, or a company pays DDT even if distribution was out of capital; though those instances may be rare.

Accounting for DDT under Indian GAAP in standalone financial statements

The accounting for DDT under Indian GAAP is prescribed by the “Guidance Note on Accounting for Corporate Dividend Tax”. As per this Guidance Note, DDT is presented separately in the P&L, below the line. This guidance was provided prior to revised Schedule VI. Under revised Schedule VI, DDT is adjusted directly in Reserves & Surplus, under the caption P&L Surplus. The guidance note justifies the presentation of DDT below the line as follows – “The liability in respect of DDT arises only if the profits are distributed as dividends, whereas the normal income-tax liability arises on the earnings of the taxable profits. Since DDT liability relates to distribution of profits as dividends which are disclosed below the line, it is appropriate that the liability in respect of DDT should also be disclosed below the line as a separate item. It is felt that such a disclosure would give a proper picture regarding payments involved with reference to dividends.”

Accounting for DDT under IFRS in stand alone financial statements

It is highly debatable under IFRS, whether DDT in the standalone financial statements is a below the line or above the line adjustment. In other words, is DDT an income tax charge to be debited to P&L or is it a transaction cost of distributing dividend to shareholders, and hence, is a P&L appropriation or Reserves & Surplus adjustment.

The argument supporting a P&L charge under IFRS is as follows:

1 Paragraph 52A and 52B of IAS 12 Income Taxes clearly treats DDT as an additional income tax to be charged to the P&L A/c.

52A – In some jurisdictions, income taxes are payable at a higher or lower rate, if part or all of the net profit or retained earnings is paid out as a dividend to shareholders of the entity. In some other jurisdictions, income taxes may be refundable or payable if part or all of the net profit or retained earnings is paid out as a dividend to shareholders of the entity. In these circumstances, current and deferred tax assets and liabilities are measured at the tax rate applicable to undistributed profits.

52B – In the circumstances described in paragraph 52A, the income tax consequences of dividends are recognised when a liability to pay the dividend is recognised. The income tax consequences of dividends are more directly linked to past transactions or events than to distributions to owners. Therefore, the income tax consequences of dividends are recognised in profit or loss for the period as required by paragraph 58, except to the extent that the income tax consequences of dividends arise from the circumstances described in paragraph 58(a) and (b).

2 Paragraph 65A of IAS 12 states as follows – “When an entity pays dividends to its shareholders, it may be required to pay a portion of the dividends to taxation authorities on behalf of shareholders. In many jurisdictions, this amount is referred to as a withholding tax. Such an amount paid or payable to taxation authorities is charged to equity as a part of the dividends.” Some may argue that DDT is not paid on behalf of the shareholders, because they do not get any credit for it. The shareholders do not get the credit for the tax paid by the entity on dividend distribution. The obligation to pay tax is on the entity and not on the recipient. Further, there is no principalagency relationship between the paying entity and the recipient. In other words, the tax is on the entity and on the profits made by the entity.

The arguments supporting a below the line adjustment (also referred to as equity or P&L appropriation adjustment) are as follows:

1 IFRIC at its May 2009 meeting, considered an issue relating to classification of tonnage taxes. The IFRIC was of the view that IAS 12 applies to income taxes, which are defined as taxes based on taxable profit. Taking a cue from the IFRIC conclusion, it can be argued that DDT is not an income tax scoped in IAS 12. Firstly, a company may not have taxable profit or it may have incurred tax losses. If such a company declares dividend, it needs to pay DDT on dividend declared. This indicates DDT has nothing to do with the existence of taxable profits. Secondly, DDT was introduced in India, without a corresponding reduction in the applicable corporate tax rate. Thus, DDT has no interaction with other tax affairs of the company. Lastly, the government’s objective for introduction of DDT was not to levy differential tax on profits distributed by a company. Rather, its intention is to make tax collection process on dividends more efficient. DDT is payable only if dividends are distributed to shareholders and its introduction was coupled with abolition of tax payable on dividend. Thus, DDT is not in the nature of an income tax expense under IAS 12.

2 As per The Conceptual Framework for Financial Reporting, “expenses” do not include decreases in equity relating to distributions to equity participants. DDT liability arises only on distribution of dividend to shareholders. Thus it is in the nature of transaction cost directly related to transactions with shareholders in their capacity as shareholders and should be charged directly to equity.

3 Support for treating DDT as an equity adjustment can also be found in paragraph 109 of IAS 1 reproduced here – “Changes in an entity’s equity between the beginning and the end of the reporting period reflect the increase or decrease in its net assets during the period. Except for changes resulting from transactions with owners in their capacity as owners (such as equity contributions, reacquisitions of the entity’s own equity instruments and dividends) and transaction costs directly related to such transactions, the overall change in equity during a period represents the total amount of income and expense, including gains and losses, generated by the entity’s activities during that period.”

4 Support for treating DDT as an equity adjustment can also be found in paragraph 35 of IAS 32 reproduced here – “Interest, dividends, losses and gains relating to a financial instrument or a component that is a financial liability, shall be recognised as income or expense in profit or loss. Distributions to holders of an equity instrument shall be debited by the entity directly to equity, net of any related income tax benefit. Transaction costs of an equity transaction shall be accounted for as a deduction from equity, net of any related income tax benefit.” It may be noted that this paragraph has now been amended to remove the reference to income-tax; and consequently to bring income-tax purely in the scope of IAS 12 only.

Although DDT is paid by the company, the economic substance is similar to the company withholding the tax and paying it on behalf of the shareholders. The shareholder has the entire dividend income exempt from tax, to reduce the administrative effort to track the flow from the company to the shareholder. In other words, DDT in substance is a type of with-holding tax borne by the shareholder that should be accounted as a deduction from equity.

Almost all companies in India that prepare IFRS financial statements treat DDT as an equity adjustment rather than as an income-tax charge.

Accounting for DDT in the consolidated financial statements (CFS) under IFRS & Indian GAAP

There is an interesting but very significant difference when it comes to presentation of DDT at the CFS level under IFRS. Consider an example, where a group comprises of a parent, a 100% subsidiary and the parents investment in a joint venture. The joint venture pays dividend to the parent and the corresponding DDT is paid to the government.

In the CFS, the group would account for its proportionate share of the DDT (paid by the joint venture) as an income -tax charge in the P&L account (and not as a P&L appropriation or equity adjustment). The reason for this treatment is that it is a cost of moving cash from one entity to another in a group. In the standalone accounts of the joint venture, when the dividends are paid to the ultimate shareholder (the parent company in this case) from the perspective of the joint venture, the DDT is reflected as an equity adjustment, and one of the arguments for doing so was that in substance, it is tax paid on behalf of shareholders. In the CFS, even if the DDT paid by the joint venture was on behalf of the parent, the parent does not get any tax credit for the same. In other words, at the group (CFS) level, there is ultimately a tax outflow, for which no tax credit is available. Hence, the same is charged to the P&L account as an income tax charge. In India, almost all companies preparing IFRS CFS, adopt this approach. However, strangely, this approach is not followed by most companies in the CFS prepared under Indian GAAP. This is perhaps done erroneously and due to lack of understanding of the standards, which needs to be rectified by appropriate intervention from the Institute of Chartered Accountants of India.

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Changes in ownership — Approach under Ind AS

Currently under Indian GAAP, presenting consolidated financial statements is not mandatory for all entities. Only listed entities are required to present consolidated financial statements as per SEBI regulations. Ind AS requires mandatory preparation of consolidated financial statements by all companies, which have subsidiaries. In this article, we aim to understand the accounting for changes in stake held in subsidiaries and associates in the consolidated financial statements of a parent entity.

A. Changes in stake held in a subsidiary without loss of control

When there is a change (increase or decrease) in parent’s ownership in a subsidiary without loss of control, such change is accounted for as a transaction with owners in their own capacity i.e., any acquisition of minority interest is recorded as a capital transaction.

As a result, no gain or loss on such changes is recognised in the income statement. Also, no change in the carrying amounts of assets (including goodwill) or liabilities is recognised as a result of such transactions. Any difference between the consideration paid and the acquired minority interest is adjusted against reserves.

Example 1

Acquisition by parent of Non-Controlling Interest (NCI) of a subsidiary that has other comprehensive income Company P owns 80% of the shares in Company S. On 1st January 2011, P acquires an additional 10% of S for cash of INR 350. The carrying amount of the NCI in S before the acquisition is INR 500, which includes 100 in respect of the NCI’s portion of gains recognised in other comprehensive income in relation to foreign exchange movements.

In P’s consolidated financial statements the decrease in NCI in S is recorded as follows:

The amounts are based on the following calculation:

Example 2

Disposal of shares in an existing subsidiary without losing control

Company P owns 100% of the shares in Company S. On 1st January 2011, P sells 10% of S for cash of INR 350, thereby reducing its interest to 90%. The carrying amount of the net assets of S (including goodwill) in the consolidated financial statements of P on 1st January 2011 before the sale is INR 3,000. S has no other comprehensive income.

In P’s consolidated financial statements the sale of the 10% interest in S is recorded as follows:

The amounts are based on the following calculation:

P recognises the difference between the adjustment to the carrying amount of NCI and the fair value of the consideration received directly in equity. No adjustments are made to the recognised amounts of assets, including goodwill, and liabilities.

Example 3

Subsidiary issues new shares — Control retained but ownership interest changes

Company S has 100 ordinary shares outstanding and the carrying amount of its equity (net assets) is INR 400. Company P owns 90% of S, i.e., 90 shares. S has no other comprehensive income. S issues 20 new ordinary shares to a third party for INR 150 in cash, as a result of which:

S’s net assets increase to INR 550.
P’s ownership interest in S reduces from 90% to 75% (P now owns 90 shares out of 120 issued).
NCI in S increases from INR 40 (400 x 10%) to INR 137.5 (550 x 25%). In P’s consolidated financial statements the increase in NCI in S arising from the issue of shares is recorded as follows:

One of the common situations under which a subsidiary issues new shares which affect the parent’s percentage holding is when employees exercise share options granted to them under Employee Stock Option Plan (ESOP) schemes. Similar to example 3 above, there is a change in ownership interest but control is retained. Therefore, the accounting treatment in the consolidated financial statements to record the change in shareholding is similar to example 3 above.

B. Control acquired by purchasing additional stake in an existing equity method investment

Sometimes controlling stake in an entity is obtained in stages, for example Entity A acquires 20% of interest in entity B on 1st January 2009 and thereafter on 1st January 2010, entity A acquires another 40%.

In such cases, the fair value of any non-controlling equity interest in the acquiree that is held immediately prior to obtaining control is used in the determination of goodwill, i.e., it is re-measured to fair value at the acquisition date with any resulting gain or loss recognised in profit or loss. The basis of fair valuing the original interest is that the economic nature of the investment changes and hence this is akin to disposing of the original investment and recording a new investment in the books.

In such step acquisitions

the previously-held non-controlling equity interest is re-measured to its fair value at the acquisition date, with any resulting gain or loss recognised in profit or loss;
the acquirer de-recognises the previouslyheld non-controlling equity interest and recognises 100% of the acquiree’s identifiable assets acquired and liabilities assumed; and
any amounts recognised in other comprehensive income relating to the previously-held equity interest are recognised on the same basis as would be required if the acquirer had disposed of the previously-held equity interest.

Example 4:

Associate becomes subsidiary

On 1st January 2011, Company P acquired 30% of the voting ordinary shares of Company S for INR 50,000. P accounts its investment in S under Ind AS-28 Investments in Associates.

At 31st December 2011, P recognised equity accounted earnings of INR 8,500 in profit or loss. The carrying amount of the investment in the associate on 31st December 2011 was therefore INR 58,500 (50,000 + 8,500). On 1st January 2011, P acquires the remaining 70% of S for cash of INR 200,000. At this date the fair value of the 30% interest owned already is INR 70,000 and the fair value of S’s identifiable assets and liabilities is INR 250,000.

The transaction would be accounted for as follows:

Note 1

Calculation of goodwill

Note 2

Calculation of gain on previously held interest in S recognised in profit and loss

Another example where similar accounting treatment as above would be followed is when control is obtained through the acquiree repurchasing its own shares. For example, an investor holds a non-controlling equity investment in an investee. If the investee buys back enough of its own shares such that the investor obtains control of the investee, then the investor company needs to adopt consolidation procedures and account the investee company as a subsidiary i.e., Entity A owns 40% interest in entity B. On 1st January 2011, B repurchases a number of its shares such that A’s ownership interest increases to 65%. The repurchase transaction results in A obtaining control of B.

C. Dilution of ownership interest by disposal of shares resulting in loss of control

Under Ind AS, when a change in controlling interest results in loss of control (e.g., due to sale of investment in the subsidiary), such a change is accounted for in two parts.

Firstly de-recognise the net assets and good-will of the subsidiary and recognise the relating gain or loss in income statement (by comparing it to the fair value of consideration received).

Secondly, recognise any balance investment in the former subsidiary at fair value.

Example 5

Subsidiary becomes associate

Entity A owns 60% of the shares in Entity B. On 1st January 2011, Entity A disposes of a 30% interest in Entity B and loses control over Entity B. The consideration received for the sale of shares of Entity B is INR 700. At the date that Entity A disposes of a 30% interest in Entity B, the carrying amount of the net assets of Entity B is INR 2000. The amount of non-controlling interest in the consolidated financial statements of Entity A on 1st January 2011 is INR 800. The fair value of the remaining 30% investment is determined to be INR 700.

Entity A would record the following entry to reflect its disposal of a 30% interest in Entity B at 1st January 2011:

Debit

Credit

Cash
(fair value of consideration

received)

700

Equity
(non-controlling interest)

800

Investment
in Entity B

(at
fair value)

700

Net
assets of Entity B

(including
goodwill)

2000

Gain
on disposal

200

The gain represents the increase in the fair value of the retained 30% investment of INR 100 [700 — (30% x 2,000)], plus the gain on the sale of the 30% interest disposed of INR 100 [700 — (30% x INR 2,000)].

The remaining interest of 30% represents an associate, the fair value of INR 700 represents the cost on initial recognition and Ind AS 28 — Account

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Hedge Accounting for Foreign Currency Firm Commitments under Indian GAAP

Introduction

Institute of Chartered Accountants of India
(ICAI) had come out with an announcement in February 2011, on
Application of AS 30, Financial instruments: Recognition and
Measurement. It was clarified that ‘the prepares of Financial Statements
are encouraged to follow the principles enunciated in accounting
treatments contained in AS 30’. This is subject to any existing
accounting standard or any regulatory requirement, which will prevail
over AS 30. Thus, considering the above exception, an entity can only
follow ‘Hedge Accounting’ only to a certain extent i.e. only for forward
contracts for highly probable future transactions or firm commitments
in foreign currency, as these are excluded from the scope of AS 11.

This
Article brings out the aspect of hedging currency exposure during the
commitment period, by applying cash flow hedge accounting, taking a
currency forward contract as an example for the concept, accounting and
measurement; with limited application of AS 30, in line with ICAI’s
announcement in February 2011 in comparison to accounting such contract
without applying AS 30.

To begin with, till the time Ind AS
implementation dates are notified, entities can take the benefit of
following hedge accounting and avoid volatility in income statement that
arises from mark to market of forward contracts, taken for highly
probable forecast transactions or firm commitments.

Entities
enter into foreign exchange transactions during its regular course of
business. These foreign exchange transactions include purchase &
sale of goods and services as well as financing transactions such as
foreign currency borrowings to leverage the interest rates of the
international market. It is to be noted that these entities continue to
operate in India and are thus exposed to foreign exchange fluctuation.

Foreign Currency Exposure in a Business
Let
us consider an entity that has started a trading business with a $100
loan, received on 1/4/xx when the rate was Rs. 45. Thus the total loan
amount received in is Rs. 4,500. The same amount was invested to buy
goods for trade in the Indian domestic market. Assume the repayment
period of 12 months and margin of 10%, the entity could recover Rs.
4,950 (Rs. 4,500 investment and Rs. 450 profit) over a period of 12
months. If the exchange rate remains constant, there is no risk or
exposure to the entity on foreign exchange borrowings. It will be able
to retain Rs. 450 in its own bank account and repay the $100 loan by
transferring Rs. 4,500 to the lending bank.

In the above case,
if the exchange rate depreciates to Rs. 50, the expected cash obligation
for repayment of $100 loan will be Rs. 5,000. In this case, the entity
would lose the entire margin earned from its pure business and incur a
loss of Rs. 50 (Rs. 4,950 – Rs. 5,000).

The above example
considers one side exposure of foreign exchange. If the business was to
trade the goods in the international market with the dollar, it would
have been able to get some natural offset on exchange fluctuations on
the revenue front. This is because the debtors would have also got
converted in Rupees at a higher rate. Thus, the loss would have
restricted only to the extent of mismatch in foreign currency inflows
and outflows.

What is Hedge?
In simple terms, it is a
technique or an approach whereby the entity in the above example can
secure or protect its profit margin, even when the exchange rate
depreciates to Rs. 50. However, if the exchange rate goes to Rs. 40, the
opportunity to take advantage of the exchange is lost. Thus, the profit
may not increase but will remain intact.

It is to note that
hedging is not about gaining or losing. It is about fixing the price
risk, like freezing the volatility for the future. It can be on account
of interest rates, commodity prices, currency, etc.

“Hedge is a way of protecting oneself against financial loss or other adverse circumstances” – Oxford Dictionary

“A hedge
is an investment position intended to offset potential losses that may
be incurred by a companion investment. In simple language, Hedge
(Hedging Technique) is used to reduce any substantial losses suffered by
an individual or an organization.” – Wikipedia

An entity
can protect its profits and meet its business plan by entering into
various types of derivative contracts. Exposure on foreign currency can
be hedged by forward contracts, future contracts and currency options,
etc. These contracts can be entered into with various banks as counter
parties.

The entity can buy these contracts from market
participants such as banks who charge certain costs that include the
interest differential and transaction fees. This cost is known as
‘premium’. In above example discussed, the entity could protect its
margin by paying a premium, say Rs. 50, and thus, secure a net margin of
Rs. 400 irrespective of change in exchange rates.

Hedge Accounting:
“A hedging instrument
is a designated derivative or (for a hedge of the risk of changes in
foreign currency exchange rates only) a designated nonderivative
financial asset or non-derivative financial liability whose fair value
or cash flows are expected to offset changes in the fair value or cash
flows of a designated hedged item.

“A hedged item is an
asset, liability, firm commitment, highly probable forecast transaction
or net investment in a foreign operation that (a) exposes the entity to
risk of changes in fair value or future cash flows and (b) is designated
as being hedged”. (Paragraph 8 of AS 30)

The objective of Hedge accounting is to offset the gain/loss of the Hedge instrument with that of the hedge item.

A
hedge taken by way of a forward contract can be of two types, namely
cash flow hedge or fair value hedge. The governing factor for
identifying the correct type of designation is dependent on the hedged
item and goes with the objective of hedge accounting.

“Cash flow hedge is a hedge of the exposure to variability in cash flows that:

(i)
is attributable to a particular risk associated with a recognised asset
or liability (such as all or some future interest payments on variable
rate debt) or a highly probable forecast transaction and

(ii) could affect profit or loss.

Fair
value hedge is a hedge of the exposure to changes in fair value of a
recognised asset or liability or an unrecognised firm commitment, or an
identified portion of such an asset, liability or firm commitment, that
is attributable to a particular risk and could affect profit or loss.” (Paragraph 86 of AS 30)

“A hedge of the foreign currency risk of a firm commitment may be accounted for as a fair value hedge or as a cash flow hedge.” (Paragraph 97 of AS 30)

As an exception to the identification of a type of hedge, entities can choose to account derivatives taken such as forward contracts, to hedge the foreign currency exposure on raw material or capital commitments, as either a ‘cash flow hedge’ or a ‘fair value hedge’.

As seen from various practical implementations, an entity usually chooses to designate such forward contracts as a cash flow hedge. This designation allows posting of mark to market (MTM) gains and losses in ‘hedging reserve’, which is part of reserves and surplus, without impacting the profit & loss account. Since the transaction will happen in the future, there is no offset available in the current period’s profit & loss account and hence, it is more logical to defer the impact till the transaction happens.

The documentation, accounting treatment and hedge effectiveness testing can be done on the assumption that the hedge is entered into prior to booking the asset and related liability in the accounts, i.e. there is only a commitment at the point the hedge is entered into.

Sample documentation for hedging a foreign currency exposure on firm commitment for purchase of raw material is illustrated in Table 2.

Table 2: Documentation for Hedging of a Foreign Currency Exposure

COMPLETED BY: ______________________________________

DATE: _________________

Application of AS 30 under existing Indian GAAP as per ICAI’s announcement:

ICAI vide its circular dated 11th February 2011, has clarified that in respect of the financial statements or other financial information for the accounting periods commencing on or after 1st April 2009 and ending on or before 31st March 2011, the status of AS 30 would be as below:

(i) To the extent of accounting treatments covered by any of the existing notified accounting standards (for eg. AS 11, AS 13 etc,) the existing accounting standards would continue to prevail over AS 30.

(ii) In cases where a relevant regulatory authority has prescribed specific regulatory requirements (e.g. Loan impairment, investment classification or accounting for securitisations by the RBI, etc), the prescribed regulatory requirements would continue to prevail over AS 30.

(iii) The preparers of the financial statements are encouraged to follow the principles enunciated in the accounting treatments contained in AS 30. The aforesaid is, however, subject to (i) and (ii) above.

From 1st April 2011 onwards
(i) the entities to which converged Indian accounting standards will be applied as per the roadmap issued by MCA, the Indian Accounting Standard (Ind AS) 39, Financial Instruments; Recognition and Measurement, will apply.

(ii) for entities other than those covered under paragraph (i) above, the status of AS 30 will continue as clarified in paragraph above.

Let us take an example of an Indian entity:
– Entered into a $ 100 payable commitment to import raw material on 1st January, 20xx
– Delivery of raw material is on 31st December, 20xx and payment on the same date.
– On 1st January, 20xx, the entity enters into a forward contract to hedge the foreign currency risk
– As part of the treasury policy, the entity first enters a shorter period contract till 30th June, 20xx
– Rolls it over on 30th June, 20xx to meet the cash outflow on 31st December, 20xx
– Refer Table 3 for details of exchange rates and MTMs on various dates.

Note:
a. Forward rates mentioned in the above table are the Mark to Market (MTM) rates. They are arrived at by considering the spot rate with reference to reporting date plus premium quoted for balance maturity of each contract on that date.

b. Forward rate and spot rate on final settlement is same because
the balance period in that case for premium quote is Zero.
c. Entity has designated the forward to hedge ‘forward rates’ and has been fully effective during the period.

Accounting Schema as follows:

1st January, 20xx:
The contract has zero value; therefore no entry is required. The commitment is also not yet recognised. The hedge is designated as cash flow hedge in line with the choice available under para 97 of AS 30 read with notification issued by ICAI in February 2011.

Example: A Forward cover is taken on 01/01/xx with maturity of 30/06/xx @ Rs. 42.5/$ for $100. There would be no accounting entry as on 01/01/xx.

31st March, 20xx:
The commitment is not yet recognised. MTM gain/loss on cover till the date of period closing would be recognised in hedging reserve (Equity), following cash flow hedge accounting.

As on 31/03/xx, forward cover for maturity of 30/06/xx is available @ Rs. 43.50/$, thus MTM gain of Rs. 1.00/$ (MTM forward rate – Original forward rate) would be accounted as under.

31/03/11 Debit Derivative Asset 100
Credit Hedging Reserve 100

30th June, 20xx:
The commitment is not yet recognised hence the cover is rolled forward. The rolled forward contract is treated as a new contract, part of the existing hedge strategy. It is still a Cash flow hedge.

[Paragraph 112a of AS 30:”……replacement or rollover of a hedging instrument into another hedging instrument is not an expiration or termination if such replacement or rollover is part of the entity’s documented hedging strategy”.]

As on 30/06/xx, the rolled forward rate is Rs. 44/$ for maturity of 31/12/xx when the spot rate is Rs. 43.75/$, thus following entries are passed:

a. For booking Settlement gain on cover (43.75/$ – 43.50/$) (i.e. Spot value – last MTM forward rate)

30/06/xx Debit Derivative Asset 25
Credit Hedging Reserve 25

b. Rollover gain received from bank (43.75/$ – 42.50/$) (i.e. Spot value – Original forward value)

30/06/xx Debit Bank 125
Credit Derivative Asset 125

30th September, 20xx :

The commitment is not yet recognised. MTM gain/ loss on cover till the date of period closing would be recognised in hedging reserve (Equity), following cash flow hedge accounting.

As on 30/09/xx, forward cover with maturity of 31/12/xx is available @ Rs. 44.50/$. Thus, MTM gain of Rs. 0.50/$ . (MTM forward rate $44.50– original forward rate of the rolled over contract $ 44.00)

30/09/xx Debit Derivative Asset 50
Credit Hedging Reserve 50

31st December, 20xx :

a. Record the purchase at spot rate of 43.5/$:

31/12/xx Debit Raw Material 4,350
Credit Liability 4,350

b. For booking MTM Settlement loss (43.50/$ – 44.50/$) (i.e. Spot value – last MTM forward rate)

31/12/xx Debit Hedging Reserve 100
Credit Derivative Asset 100

c. Record the payment of the liability to vendor

31/12/xx Debit Liability 4,350
Credit Bank 4,350

d. Net Settlement loss paid to bank (43.5/$ – 44.0/$) (i.e. Spot value – Original forward value)

31/12/xx Debit Derivative Asset 50
Credit Bank 50

e. Balance in hedging reserve transferred to income statement

31/12/xx Debit Hedging Reserve 75
Credit Cost of Goods Sold 75

The commitment recognised in books at the rate mentioned in Bill of lading and the change in fair value of forward contract from the date of inception to the date of recognising commitment is allocated to cost of raw material consumed.

“Paragraph 109b of AS 30: “It removes the as-sociated gains and losses that were recognised in other comprehensive income in accordance with paragraph 106, and includes them in the initial cost or other carrying amount of the asset or liability”

Note: As per AS 30 para 109b, head of Profit & Loss Account would depend upon the nature of underlying for which the cover the taken. Since AS 2 on Inventory Valuation does not permit MTM as part of valuation for unsold goods, the MTM will be released from hedging reserve to profit & loss account as and when the inventory is consumed. Thus the MTM will remain in Hedging Reserve till the underlying transaction is debited in Profit & loss account. This essentially in line with option available under para 109a of AS 30.

Refer table 4 for various accounts at a glance for entries passed above at various dates.

Commercial Analysis

It can be seen in the above example, that the organisation had an exposure on import of raw material. The exposure started from the date when it entered into a firm commitment and ended when the actual outflow is made.

The exchange rate has been volatile during the period as it moved upwards from Rs. 42.5/$ as on 01/1 to Rs. 44.25/$ on 30/9 before closing at Rs. 43.5/$ on 31/12. The company decided to fix its outflow on the date of its commitment and entered into a forward contract to buy dollars at Rs..42.5 per dollar. Subsequently the same contract was rolled over for meeting the scheduled payment to the creditor by incurring 0.25 paisa premium per dollar bought. The Company’s exposure was hedged by two contracts at the effective cost of Rs. 42.75 per dollar. These types of two contracts are common where the underlying exposure is longer.

The Company’s cost of raw material has not been impacted on account of the volatilities in foreign exchange rate and is accounted at Rs. 4,275. Refer Table 5 below to understand the effective rate per $.

The above entries hold true even when the entity has a commitment for capital asset. The raw material account in the above example will be replaced by fixed asset account/depreciation.

Accounting without Application of AS 30 Principles

The forward contract being taken for a firm commitment, will not fall under AS 11. It will have to follow the conservative principles of AS 1 as laid down by ICAI in its announcement on 29-03-08.

“In case an entity does not follow AS 30, keeping in view the principle of prudence as enunciated in 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.”

In the above example, as on 31st March, the MTM is a gain and hence, there is no accounting entry for this contract. Had there been a loss in the contract, entity would have provided for the same.

The auditors would consider making appropriate disclosures in their reports if the aforesaid accounting treatment and disclosures are not made.

One may note that ICAI’s announcement dated 16-12-05 on disclosure continues to apply in both scenarios (i.e. AS 30 is applied or ICAI announcement dated 29-03-08 is followed). Thus, enterprises continue to make the following disclosures regarding Derivative

Instruments in their financial statements irrespective of accounting choice:

1. category-wise quantitative data about derivative instruments that are outstanding at the balance sheet date,

2. the purpose, viz., hedging or speculation, for which such derivative instruments have been acquired, and

3. the foreign currency exposures that are not hedged by a derivative instrument or otherwise.

A. Industry Applications

Mahindra & Mahindra Ltd (March 2012)

Derivative Instruments and Hedge Accounting:

The Company uses foreign currency forward contracts/options to hedge its risks associated with foreign currency fluctuations relating to certain forecasted transactions. Effective 1st April, 2007, the company designates some of these as cash flow hedges, applying the recognition and measurement principles set out in the Accounting Standard 30 “Financial Instruments: Recognition and Measurements”(AS 30).

Foreign currency forward contract/option derivative 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 reserves and the ineffective portion is recognised immediately in Profit & Loss Account.

The accumulated gains and losses on the derivatives in reserves are transferred to Profit and Loss Account in the same period in which gains or losses on the item hedged are recognised in Profit & Loss Account.

Changes in the fair value of derivative financial instruments that do not qualify for hedge accounting are recognised in the Profit & Loss Account as they arise.

Great Eastern Shipping (March 2012)
Derivative Financial Instruments and Hedging

Cash Flow Hedge:

Commodity future contracts, forward exchange contracts entered into to hedge foreign currency risks of firm commitments or highly probable fore-cast transactions, forward rate options, interest rate swaps and currency swaps which do not form an integral part of the loans, that qualify as cash flow hedges, are recorded in accordance with the principles of hedge accounting enunciated in Accounting Standard (AS) 30–Financial Instruments: Recognition and Measurement as issued by the Institute of Chartered Accountant of India. The gains or losses on designated hedging instruments that qualify as effective hedges is recorded in the Hedging Reserve Account and is recognised in the Statement of Profit and Loss in the same period or periods during which the hedged transaction affects profit and loss or is transferred to the cost of the hedged non-monetary asset upon acquisition. Gains or losses on the ineffective transactions are immediately recognised in the Statement of Profit and Loss. When a forecasted transaction is no longer expected to occur, the gains and losses that were previously recognised in the Hedging Reserve, are transferred to the Statement of Profit and Loss immediately.

Companies that have adopted AS 30 under Indian GAAP include Essar Shipping Limited, First Source Solutions, Tata Coffee, Sterlite Industries (I) Limited, etc.

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Section A : Disclosure in Notes to Accounts under Revised Schedule VI for Long Term Borowings and details thereof

3.1 Non-convertible Debentures referred above to the extent of:
(a) Rs.1,593 crore are secured by way of first mortgage/charge on the immovable properties situated at Hazira Complex and at Jamnagar Complex (other than SEZ unit) of the Company.
(b) Rs.5,000 crore are secured by way of first mortgage/charge on the immovable properties situated at Jamnagar Complex (other than SEZ unit) of the Company.
(c) Rs.1,720 crore are secured by way of first mortgage/charge on all the properties situated at Hazira Complex and at Patalganga Complex of the Company.
(d) Rs.110 crore are secured by way of first mortgage/charge on certain properties situated at village Mouje Dhanot, District Kalol in the State of Gujarat and on fixed assets situated at Hoshiarpur Complex of the Company.
(e) Rs.50 crore are secured by way of first mortgage/charge on certain properties situated at Ahmedabad in the State of Gujarat and on fixed assets situated at Nagpur Complex of the Company.
(f) Rs.44 crore are secured by way of first mortgage/ charge on certain properties situated at Surat in the State of Gujarat and on fixed assets situated at Allahabad Complex of the Company.
(g) Rs.51 crore are secured by way of first mortgage/ charge on movable and immovable properties situated at Thane in the State of Maharashtra and on movable properties situated at Baulpur Complex of the Company.
(h) Rs.500 crore are secured by way of first mortgage/charge on the immovable properties situated at Jamnagar Complex (SEZ unit) of the Company.

3.2 Maturity profile and rate of interest of Non-convertible Debentures are as set out below:

3.3 Finance Lease obligations are secured against leased assets

3.4 Maturity profile and rate of interest of bonds are as set out below:

3.5 Maturity profile of Unsecured Term Loans are as set out below:

Bajaj Electricals Ltd. (31-3-2012)

Long-term Borrowings

4.2 Sales Tax Deferral
Terms of repayment: Sales Tax deferral liability/loan is repayable free of interest over predefined instalments from the initial date of deferment of liability, as per respective schemes of incentive.

Petronet LNG Ltd. (31-3-2012)
Long-term Borrowings

Note:

1. Secured by first ranking mortgage and first charge on pari-passu basis on all movable and immovable properties, both present and future including current assets except on trade receivables on which second charge is created on pari-passu basis.

2. Term of repayment and interest are as follows:

3. In respect of external commercial borrowings of INRNaN million from International Finance Corporation Washington D.C., USA and INRNaN million from Proparco, France, outstanding as on 31st March, 2012, the Company has entered into derivative contracts to hedge the loan including interest. This has the effect of freezing the rupee equivalent of this liability as reflected under the Borrowings. Thus there is no impact of in the Profit & Loss, arising out of exchange fluctuations for the duration of the loan. Consequently, there is no restatement of the loan taken in foreign currency. The interest payable in Indian Rupees on the derivative contracts is accounted for in the Statement of Profit & Loss.

Uttam Galva Steels Ltd. (31-3-2012)
Note 3 long-term borrowing (Rs. in crores)

(i) Details of terms of repayment for the Secured Non-convertible Redeemable Debentures issued by the Company and security provided in respect thereof:

(ii) Details of terms of repayment for the Secured Long-term Borrowings and security provided in respect thereof:

(1) 11.25% Non-convertible Redeemable Debentures are secured by first pari-passu mortgage of all immovable property and hypothecation of all movable properties including movable machineries, machinery spares, tools and accessories both present and future except packing machine supplied by PESMEL Finland.

(2) Term loans from Banks and Financial Institutions namely, Axis Bank, Bank of Baroda, Dena Bank, Exim Bank of India, Oriental Bank of Commerce, Punjab National Bank, State Bank of India, Syndicate Bank, State Bank of Hyderabad, IDFC and ICICI Bank Limited are secured by mortgage and the lenders have paripassu charge on all the present and future movable and immovable assets of the Company except packing machine supplied by PESMEL Finland, but not limited to plant and machinery, machinery spares, tools and accessories in possession or not, stored, or to be brought in companies premises or lying at any other place of the companies representative affiliates and all the intangible assets of the Company. The above security will rank pari-passu amongst the lenders.

(3) ECB loans from ICICI Bank Limited are secured by mortgage of all immovable property and hypothecation of all movable properties including movable machineries, machineries spares, tools and accessories both present and future except packing machine supplied by PESMEL Finland.

(4) ECA from Nordea Bank is secured by hypothecation of packing machine supplied by PESMEL Finland.

(5) Term loan from ICICI Bank Limited, IFCI, LIC, GIC, and UII ranking pari-passu are secured by mortgage of all immovable property and hy-pothecation of all movable properties including movable machineries, machineries spares, tools and accessories both present and future except packing machine supplied by PESMEL Finland. 25,02,500 Equity shares (previous year 25,02,500 equity shares) held by Promoters are pledged against term loan of Rs.9.55 crore availed from ICICI Bank Limited.

15 Ramco Industries Ltd. (31-3-2012)

Long-term
Borrowings

Term
Loan from

Banks
Secured

11,409.37

9,056.18

Deposits
from Public

9.85

11.58

Total

11,419.22

9,067.76

(1)Long-term Loans of Rs.11409.37 lac borrowed from banks for expansion of Textile and Wind Mill Division under TUF Scheme are secured by pari-passu first charge on the fixed assets and pari-passu second charge on the current assets of the company.

In
lacs

Rate of

Outstanding

Repayment schedule

interest

as on

31-3-2012

2013-14

2014-15

2015-16

2016-17

13.25%

164.20

131.20

33.00

0.00

13.25%

768.69

400.00

368.69

0.00

12.25%

5000.00

2500.00

0.00

4.77%

3052.50

2416.56

635.94

0.00

12.25%

68.92

45.84

23.08

0.00

12.50%

245.10

89.13

66.84

0.00

11.75%

2109.96

529.40

521.76

Total

11409.37

6112.13

4179.24

596.24

521.76

(2) External Commercial Borrowing Loan of USD 6.00 million amounting to Rs.3052.50 lac borrowed from DBS Bank Ltd., Singapore is secured by pari-passu first charge on fixed assets and pari-passu second charge on current assets in favourof Security Trustee DBS Bank Ltd., Chennai.

As per requirements of Accounting Standard 11, ECB Loan has been valued at 50.875 per USD, at the closing rate on 31-3-2012.

This has resulted in a notional loss of Rs.375.50 lac which has been accounted as per Notification dated 31-3-2009 and 11th May, 2011 amending the Accounting Standard AS-11 relating to the Effects of Foreign Exchange Rates as 79.85 lac towards interest and 295.65 lac towards fixed assets.

(3) The Working Capital Borrowings of the Company are secured by hypothecation of stocks of raw materials, work-in progress, stores, spares and finished goods and book debts and second charge on fixed assets.

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AUDITOR’S DILEMMAS!

Introduction
It is well known that any kind of external supervision cannot replace rigorous self-evaluation in any profession. However, the need for supervision and monitoring is universally recognised. The role of an auditor is very critical from an external verification and supervision point of view. This role has changed quite dramatically over a period of time, during which the expectations from the auditor have increased exponentially. Numerous studies have shown that there are considerable differences between what the public expects from an audit and what the auditing profession believes that the auditor should do. The expectation gap resulting from this is a major source of concern for the audit profession since the greater the gap in expectations, the lower is the credibility and prestige associated with audit. It is an issue for the public at large, because the proper functioning of a market economy depends heavily on confidence in the audited financial statements. The role of the statutory auditor should consider the needs and the expectations of the users to the extent that they are reasonable, as well as his ability to respond to those needs and expectations.

In the backdrop of the above, an auditor faces several dilemmas in practising his profession and conducting the audit process primarily because of the complexities of the business transactions, regulatory requirements, nature of his job, and the varying expectations of the stakeholders. This article summarises some of those dilemmas, for better understanding of the ground level issues relating to the audit profession and the dynamics surrounding the same.

Profession Vs Business
In simple terms, business generally involves an activity relating to purchase and sale of goods with an objective of earning profit, whereas a profession renders specialised services for a reward called a fee.

Whether a Chartered Accountant when acting in his capacity as an auditor is performing the role of a professional or like any other service provider selling his service or as a businessman? The border line between the two is very thin and many times, an auditor has to balance the same carefully. Whilst, in a competitive environment, he has to necessarily carry out his job in a manner which makes commercial sense for him, and he should never forget the fact that audit is statutorily required in order to serve the interests of the general public and various other stakeholders.

The role of the statutory auditor has recently been the subject of serious debates worldwide. In view of the number of major financial failures, questions have been raised concerning the function of the statutory audit and the independence of the auditor. In recent years, concern has been expressed about the threats which have developed to the auditor’s independence. Several surveys have reported that companies were increasingly prepared to challenge their auditors, to shop for opinions, to seek legal advice on their auditors’ views and to change auditors. Some reports concluded that, given the competitive pressures, it would be idealistic to assume that all auditors are at all times unmindful of the risk of losing business. Criticism has been voiced that the professionalism of the audit function has diminished, in favour of a more “business-like” and “accommodative” attitude.

In view of these perceptions, there is a compelling need for the auditor to keep in mind the core principles of a profession, which should never be compromised at any cost inspite of business compulsions.

Propriety Focus Vs. Accounting Focus
What is the role of an auditor regarding propriety matters? Is he responsible for matters of impropriety? Can he take a blind view on such matters? Performing audits with a propriety focus poses serious challenges in carrying out the audits especially of private entities. Whilst the expectations from the regulators and other stakeholders could demand comfort from the auditors on propriety aspects as well, meeting such expectations totally through the audit process for private entities is usually a big challenge. Identification of acts of impropriety also poses challenges to the auditor in view of the subjectivities involved.

However, the auditor should perform the required procedures in accordance with the auditing standards, to ensure that there is no cause of concern relating to propriety aspects within the defined boundary and if there are any propriety issues, the same need to be reported to those in charge of governance.

Fraud Specialist Vs. Financial Accountant
Until recently, the standard quote on the role of the auditor was to say that an auditor’s prime role is not to prevent or detect fraud, which is, in any event, impossible. Regulatory bodies in many countries have issued auditing guidelines related to the statutory auditor’s responsibility in relation to fraud, other irregularities and errors. In India, Auditing Standard SA 240 – “The Auditor’s Responsibilities relating to fraud in an audit of the financial statements” specify the responsibilities of the auditor.

It is a known fact that the management of an entity has the primary responsibility for the prevention and detection of fraud, other irregularities and errors which is seen as part of the management’s stewardship role. The auditor’s responsibility is to plan, perform and evaluate his audit work so as to have a reasonable expectation of detecting material misstatements in the accounts, whether they are caused by fraud, other irregularities or errors.

If a fraud is identified in an entity post audit completion, the first and the foremost important question raised by everyone is the role of the auditor and the effectiveness of his audit. Inspite of such allegations, the fact remains that the auditor is not an investigating specialist challenging and suspecting each and every transaction, which would change the entire purpose of the audit and the true nature of the profession. However, in view of the peculiarity of the role played by him, an auditor has to be cognizant of this aspect and he needs to perform procedures to ensure that there are no significant frauds impacting the true and fair view of the financial statements.

Representation to the Auditor Vs. Information to the Reader of the Financial Statements
While executing the audit, an auditor many times faces a situation where he has to rely on the representations made by the auditee/management. At times, such representations have far reaching implications on the financial statements. One has to remember that, whilst obtaining representations from the auditee/management is a required audit procedure, it does not absolve the auditor from his responsibilities.

A typical dilemma that could arise during the audit process, is the extent of disclosures that are required to be made in the financial statements or in the audit report, regarding such representations having a material impact on the financial statements. Careful evaluation needs to be made as regards the representations made by the auditee/management on significant matters, having a material impact as to whether such representations are part of the audit documentation or the same should be made available to any reader of the financial statements by way of an appropriate disclosure in the financial statement or in the audit report. For example, if a provision is made for an item based on a technical evaluation, which is very significant to the financial statements, the need for disclosing that fact along with the basis, rationale and significant assumptions driving such provisions etc., need to be evaluated by the auditor.

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GAPS in GAAP — Account ing for Government Grant

Government Grants are common in India and therefore accounting for Government Grant could have a significant impact on financial statements. Firstly, whether there is a grant or not; and if there is a grant whether the same is a fixed asset-related grant, revenue grant or promoters contribution will have to be decided. If the grant is a revenue grant, then its immediate impact is recorded in the P&L account, if the grant is a fixed asset grant, the grant income is released systematically to the P&L account in proportion to the depreciation on the related fixed asset. Alternatively, the grant is reduced from the amount of fixed asset capitalised, which will have the same P&L effect. Government grant in the nature of promoter’s contribution is treated as equivalent of shareholders fund and credited to the capital reserve. Needless, to say, the accounting will not only have a significant impact on the financial statements, but will also have a significant incometax impact, including MAT computation. Therefore the manner in which the government grant is accounted for becomes critical.

In this article the author discusses an EAC opinion on the issue of whether a sales tax exemption under a scheme of the government is a grant or not. This article does not discuss the issue on the nature of the grant, whether fixed asset-related or revenue grant or promoters contribution. The issue of whether sales tax exemption scheme is a grant came to the Expert Advisory Committee (EAC) of the ICAI for an opinion (EAO-VOL-20-05). In the said fact pattern, the company was entitled to sales tax exemption over a period of three years, subject to an upper monetary limit. The upper limit was computed based on the additional investment in plant, machinery and building required for expansion. The EAC considered the definition of government grant in AS-12 Accounting for Government Grants.

As per paragraph 3.2 ‘government grant’ is defined as “Government grants are assistance by government in cash or kind to an enterprise for past or future compliance with certain conditions. They exclude those forms of government assistance which cannot reasonably have a value placed upon them and transactions with government, which cannot be distinguished from the normal trading transactions of the enterprise”. The EAC felt that sales tax exemption is not assistance in cash or kind and is therefore not a government grant within the meaning of this term under AS-12.

As such AS-12 is not applicable to sales tax exemption. However, there was no further elaboration on this point. The EAC further noted the definition of Revenue in AS-9 Revenue Recognition and was of the view that the entire sales proceed of the company constitutes revenue. It is immaterial whether the sale proceeds result from sales at normal prices or at higher than normal prices that the unit is able to charge due to sales tax exemption.

In the author’s view, sales tax exemption is a government grant for the following reasons:

(1) It is a sacrifice by the government for achieving a particular social objective (e.g., dispersion of industry). The upper limit on the grant is clearly quantified. It may not be possible to quantify the sales tax exemption for the entire period of grant upfront; nonetheless, it is possible to quantify the amount of exemption included in each sales transaction. The grant is provided subject to fulfilment of certain conditions.

(2) The manner in which a grant is received does not affect the accounting method to be adopted in regard to the grant. Thus a grant is accounted for in the same manner, whether it is received in cash or as a reduction of a liability to the government.

(3) Government grants exclude assistance provided by the government which cannot reasonably have a value placed upon them and transactions with government which cannot be distinguished from the normal trading transactions of the entity. Examples of these assistance are free technical or marketing advice and the provision of guarantees, etc. Sales tax exemption is a scheme granted by the government, subject to fulfilment of conditions relating to investment and operation in underdeveloped areas. Sales tax foregone by the government is in substance a transfer of resources by the government to the company.

In accordance with the EAC opinion, the grant will be included in the revenue amount. Going by the author’s view, the grant would be included in other income if it is concluded that it is a revenue-related grant. If the grant is concluded to be a fixed assetrelated grant it would be presented as deferred income and released over time in proportion to the depreciation of the relevant asset. Alternatively it would be reduced from the fixed asset, which would have the same impact.

As can be seen the accounting and presentation of the grant will not only have a significant impact on the financial statements, but also on the tax and MAT computation. This is therefore an issue, the ICAI would need to reconsider.

levitra

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Avoiding Common Errors in XBRL Financial Statements

“Tagging” of financial information by using eXtensible Business Reporting Language, an accounting specific mark-up language creates XBRL financial statements which can be stored in a financial database such as MCA-21. XBRL tagging process converts the financial information contained in document in PDF, Word or Excel format to a document or file with electronic codes which makes the document computer readable as well as searchable. Once the tagged financial statements are stored in a financial database like MCA-21, not only the financial data in those XBRL financial statements can be compared or analysed by use of computer systems but investors, investment analysts or other users can also download it and carry out comparison and analysis more quickly and efficiently than with data stored in traditional formats such as PDF.

Many people have a misconception that tagging of financial information/data in XBRL is similar to converting a Word document into PDF format and that tagged financial information/data is as accurate as the underlying information/data in the source documents. This is an inappropriate analogy, because the process of tagging financial information involves judgment of the person creating XBRL financial statements and there is a potential for intentional or unintentional errors in the XBRL documents which could result in inaccurate, incomplete or misleading information. This is a problem because it is the XBRL tagged data which not only will be used by the regulators e.g. Ministry of Corporate Affairs, for comparison & analysis purpose but will also be used by investors, investment analysts etc. Therefore, completeness, accuracy and consistency of XBRL tagged data is of paramount importance.

As with any new technology, XBRL, a new financial reporting technology also brings new risks. XBRL can’t be read by the human eye. The data in XBRL is filtered through rendering applications or viewers to visually present tagged data. Companies can easily underestimate the challenges posed by XBRL and make mistakes along the way. This article describes common errors appearing in XBRL financial statements filed at MCA-21 and how these can be prevented. Practitioners can use this information to get an insight into the challenges of XBRL Instance creation and providing assurance over XBRL financial statements being filed at MCA-21. To gain a better insight into the challenges faced by the companies in XBRL filings, we examined the XBRL financial statements of a few listed Companies on a test check basis. As a part of this initiative, we downloaded Form 23AC-XBRL & Form 23ACA-XBRL of the Companies from MCA-21 and detached XBRL financial statements attached to these forms and then compared XBRL financial statements rendered by MCA Validation Tool with the financial statements in traditional format, tracing the errors to the XBRL documents containing the computer code.

Completeness Errors

The Company’s XBRL financial statements are required to fairly present the audited financial statements in traditional format. Therefore, all information and data that is contained in the audited financial statements or additional information required to be reported under the scope of tagging defined by Ministry of Corporate Affairs needs to be formatted in XBRL financial statements.

Examples

Some examples of lack of completeness are: (i) Financial information/data of all subsidiaries not formatted in XBRL financial statements. (ii) Financial information/ data of all related party transactions not formatted in XBRL financial statements. (iii) Parenthetical information, for example tax deducted at source on rent, not tagged in XBRL financial statements. (iv) Detailed Tagging of Notes to Accounts wherever required, if not done also falls under completeness error. (v) Not tagging complete “Cash Flow Statement.” (vi) Not tagging the “Foot notes” in financial statements. “Foot Notes” in financial statements provide additional information which helps in having a better understanding of financial information. The absence of “Foot Notes” in financial statements can not only make the task of understanding the financial information difficult, but user could also reach erroneous conclusions.

Solution

A careful tracing of all financial information/data from source documents to rendered XBRL financial statements can detect many such errors. However, this cannot detect all completeness errors because there is some information/data which is required to be formatted in XBRL financial statements, but the same is not reported in traditional financial statements.

Accuracy Errors

Accuracy of numerical data including amounts, signs, reporting periods and units of measurements is critical for the reliability of data in XBRL financial statements. Accuracy errors, though less common than other type of errors, are more serious in nature because the erroneous data not only distorts the financial statements but is also not suitable for downloading in software for comparison and analysis purpose. In a closed taxonomy environment, XBRL Instance documents cannot truly present the audited financial statements, because many times reporting entity may be required to tag a line item in the financial statements with the residuary tag or club two or more line items together. Although, this doesn’t affect the mathematical accuracy of the financial statements, the data may not be suitable for comparison and analysis purposes.

Example

Data entry errors in reporting amount of Profit & Loss Account under the group heading “Reserves & Surplus” and “Loans & Advances” in the Balance Sheet. Duty Drawback”, “Export Incentive” “Other Claim Receivable” all clubbed together and tagged with “Other Receivables”.

Solution

A careful tracing of all financial statement data to the rendered XBRL financial statements can detect errors in values. However, attribute accuracy needs to be checked by verifying all contextual information. A foot note can be added in XBRL financial statements which can provide a break-up of all line items clubbed and mapped with one taxonomy element or with the residuary tag.

Mapping Errors

Mapping is the process of selecting the right element in Indian GAAP Taxonomy for each line item in the financial statement. Mapping errors can result in misleading information and the user of data could reach to an erroneous conclusion.

Examples

“Loss on Sale of Fixed Assets” tagged with “Loss on Sale of Long Term Investments” although a tag “Loss on Sale of Fixed Assets” is available in the taxonomy. “Interest Accrued but not due on Fixed Deposit” tagged with “Other Cash Bank Balance”. Another example of mapping error is “Deferred Tax Liability (Net)” tagged with “Net Deferred Tax Assets” with a negative sign or vice versa. Although, it doesn’t create any mismatch in the assets & liabilities, it distorts the view of the Balance Sheet.

Solution

Although good XBRL Tools have an in-built feature for searching taxonomy element which can assist in mapping, the importance of judgment involved in the process can’t be undermined. A precise understanding of the Company’s financial statements and of Indian GAAP Taxonomy is required to ensure the correct mapping of line items in financial statements with taxonomy elements.

Validation Errors

The final step in preparing XBRL financial statements for submission to MCA-21 involves:-

(i) Validation Test and

(ii) Pre-scrutiny Test

MCA Validation Tool checks and identifies most, but not all, errors. For example, it does not check the financial information/data in ‘Block Tagging’. It verifies the mathematical accuracy and mandatory information/data in XBRL financial statements.

Pre-scrutiny Test conducts server side validation of the data in XBRL financial statements. An XBRL financial statement must pass the “Validation Test” before the “Pre-scrutiny Test” can be conducted.

Examples

Corporate Identity Number (CIN) of an Associate entity not provided in XBRL financial statements. Another example of validation error is “Basis of Presentation of Accounts” not tagged.

Solution

Validation Test on XBRL financial statements should be conducted on the latest available MCA Validation Tool. In case the validation test throws any errors, the same should be removed before uploading at MCA-21. After the XBRL Instance passes the validation test, Pre-scrutiny Test should be conducted and if there are any errors, the same should be removed before uploading of XBRL financial statements at MCA-21.

Rendering Errors

`Rendering’ is a necessary evil. Tagged data needs to be rendered in order to see it. This puts undue focus on presentation vis-à-vis MCA compliant XBRL and use for financial analysis. This is contrary to the original purpose of XBRL. Many filers have noticed during the last filing year that XBRL rendering has not been as accurate as they would prefer it to be. We tend to think of financial reporting in a visual way – in a way we can view it. That is the old way of thinking about financial reporting. “Tagging” of financial statements provide a choice to the users to grab the entire financial statement or individual values in isolation.

Examples

Financial information/data in “Block Tagging” is not properly rendered making the information illegible e.g. information/ data in foreign currency transactions in Notes to Accounts. Another example of rendering error is of certain foot notes attached to the values which are visible in XBRL Viewer but not rendered in the PDF file.

Solution

Rendering errors are mainly related to XBRL software used in generating XBRL financial statements and vendors of software need to look into this aspect. Rendering engine also needs improvement to properly render the information in XBRL Viewer as well as in PDF files. However, the preparer can also improve the formatting of information/data in XBRL financial statements.

Conclusion

It is of prime importance for companies to be aware of these potential errors, whether their XBRL financial statements are prepared in-house or prepared by a third party service provider. There is a legal liability attached to XBRL mandate for companies and its officers in default for submission of inaccurate or false data in XBRL financial statements. There is also a provision for disciplinary complaint against the practitioners to the professional bodies for deficiency in certification of XBRL financial statements. The deficiency in XBRL financial statements could invite avoidable litigation and adversely affect company’s goodwill.

shailesh.kwebmaker

Ind AS: Functional Currency and Consequential Impact on Deferred Tax

Executive summary

This
article covers the ‘Functional Currency’ aspect differentiating with
‘Presentation Currency’ as laid in Ind AS 21, which will be a new
concept when India converges to IFRS.

It also highlights the
consequential impact of having two sets of functional currencies (one
for GAAP reporting and other Tax submissions) on deferred tax
computation under Ind AS 12, which again is based on a new approach
i.e., ‘Temporary difference’ as against ‘Timing difference’ under
existing AS-22.

Temporary difference is essentially arrived at by
comparing the balance sheet under tax books with financial books. This
approach is also known as ‘Balance Sheet approach’ and the approach in
AS-22 is termed as ‘P&L approach’.

Introduction

India
has laid down the convergence plan of ‘Indian Accounting Standards’
(AS) with ‘International Financial Reporting Standards’ i.e., IFRS in a
phased manner. The first phase implementation was expected to begin from
April 1, 2011 but due to practical challenges, the implementation is
delayed. ICAI, as part of convergence approach, has come out with 35 Ind
AS which are the same as IFRS except for the carve-outs. The Ministry
of Corporate Affairs (MCA) has notified 35 Ind ASs on February 25, 2011.

Amongst these standards, there is one standard that has the potential
to entirely turn the Indian financial statements topsy turvy and that is
IAS 21 i.e., Ind AS 21. The consequential impact of this standard on
deferred taxes, is not part of the carve-outs and hence would need due
care while the standard is implemented in India.

Currency for accounting and presentation

While
all Indian entities prepare books of accounts in Indian Rupees, we have
never thought of preparing our books in any other currency. There may
be some who did wish of using currency other than Indian Rupee (INR) on
account of huge foreign exchange exposures, but they did not have any
guidance or literature to support them. The spot will now be addressed
in ‘Ind AS 21 — The Effects of Changes in Foreign Exchange Rates’.

Once
India starts converging to Ind AS, we will have this standard on
effects of exchange fluctuations, which has considered the aspect of
huge volatility and exposures to operations due foreign currency (i.e.,
other than INR). It requires the managements of companies to adopt a
suitable currency for maintaining their accounts. Since the entities may
vary their exposures to currency in different years, the standard has
mandated the assessment of such book-keeping currency every year.

If any
other currency, say, USD is considered as the currency that influences
the primary economic environment, managements will have to prepare
themselves to consider INR as foreign currency exposure and mark to
market all INR monetary assets and liability at each balance sheet date.

Ind AS 21 — ‘The Effects of Changes in Foreign Exchange Rates’ is a
standard that brings a new dimension to the financial statements
prepared in India. Now, the book-keeping currency i.e., Functional
currency will no more be optional or default INR, it will be governed by
specific principles laid down under the standard and functional
currency can be different than the presentation currency.

Functional currency

Let
us appreciate the governing principles of functional currency under Ind
AS 21:

“Functional currency is the currency of the primary economic
environment in which the entity operates.” (para 7)

“The primary
economic environment in which an entity operates is normally the one in
which it primarily generates and expends cash. An entity considers the
following factors in determining its functional currency:

(a) the
currency:

(i) that mainly influences sales prices for goods and
services (this will often be the currency in which sales prices for its
goods and services are denominated and settled); and

(ii) of the country whose competitive forces and regulations mainly determine the sales prices of its goods and services.

(b)
the currency that mainly influences labour, material and other costs of
providing goods or services (this will often be the currency in which
such costs are denominated and settled).” (para 8) Ind AS 21 defines the
functional currency and differentiates it from the presentation
currency. The primary factor that drives the choice of currency is
influenced by stream of revenue and operating costs. Additional factors
that the standard requires to examine are the currency of loan
obligations.

“Many reporting entities comprise a number of
individual entities (e.g., A group is made up of a parent and one or
more subsidiaries). Various types of entities, whether members of a
group or otherwise, may have investments in associates or joint
ventures. They may also have branches. It is necessary for the results
and financial position of each individual entity included in the
reporting entity to be translated into the currency in which the
reporting entity presents its financial statements. This Standard
permits the presentation currency of a reporting entity to be any
currency (or currencies). The results and financial position of any
individual entity within the reporting entity whose functional currency
differs from the presentation currency are translated in accordance with
paragraphs 38- 50.” (para 10)

Under existing AS-11 definitions, foreign
currency is a currency other than the reporting currency, and reporting
currency is the currency used for reporting financial statements.
The
rules of translating the subsidiary accounts into reporting currency
are similar to those under Ind AS 21, which prescribes using closing
rate for balance sheet items and transaction rate or average rate for
income statement items (para 38-50).

Point of difference

Under Indian
GAAP, a currency used for preparing as well as reporting i.e.,
presenting financial statements to regulatory authorities, lenders,
investors, etc. is foreign currency is no other than INR. There is no
concept of having the currency to report financial statements
(presentation currency) different from the currency in which books of
accounts are to be maintained (functional currency).

Functional currency: Industry perspective

Under Indian GAAP there is no concept of functional currency identification. It however has reference to ‘Reporting Currency’, which is expected to be the same currency of the country in which it is domiciled.

The definition of functional currency in Ind AS will encompass all the companies whose primary economic environment is not the Indian economy.

The impact of this standard will be more evident on commodity market-linked companies engaged in mining, refining, and trading products, whose primary revenue is governed by international commodity prices prevail-ing on London Metal Exchange in US Dollars. Another industry that may be impacted by the implementation of Ind AS will be Business Process Outsourcing Companies and Software Companies whose primary revenue is again governed in terms of Dollars and Euros. Oil and Gas companies are also prone to get functional currency assessment and application in India since the oil prices are quoted in USD per barrel globally.

It will also be impacting the bullion companies that are listed on Indian stock exchanges and others that are planning to list soon on Indian and international bourses. The revenues of these companies are always traded in USD in India and internationally.

Domestic prices for sales within India, of these companies though in INR, are arrived at by first considering the respective International prices in USD and then making certain adjustments such as duty differentials, domestic market premium, freight differentials, competitive discounts, etc. which in industry terms is called as ‘Shadow Gap’ pricing.

Each company will have to apply its own judgment and access all the criteria of primary environment and other additional factors that influence the choice of its functional currency.

Challenges on adoption of functional currency other than INR in India:

(1) If the accounting records of these Indian companies are to be prepared under Ind AS, then the financial statements will altogether give a different picture. Since currency fluctuation on, say, USD may now sit in transaction amounts and change company’s profitability.

(2) Change in mindset and budgets required.

(3) Will lead to difficulty in decision-making processes by Indian managements specifically in assessing its foreign exchange exposure which so far was on currencies other than INR.

(4) Continuing a parallel accounting system for Income Tax submission since Direct Tax Code does not provide for similar changes.

(5) Updation/modification to ERP solutions. It is also worth noting that accounting softwares such as SAP have a functionality to address the dual currency accounting which can take care of both tax reporting using INR as functional currency and IFRS reporting using any other currency.

(6) Accounting for deferred tax and unwanted volatility in income statement.

Indian Industry including managements, lenders, investors, analysts of financial statements will have to prepare for seeing a currency different than INR as accounting currency in annual financial statements. Many companies internationally have adopted this standard which aligned their accounting currency i.e., functional currency in line with their respective primary economic environments.

In the international markets most of the transactions happen in US Dollars and India is now a part of a global economic platform and thus is very much influenced by USD in its financial statements. The impact is more evident in industries that are primarily dependent on USD and whose profitability is affected by any change in USD: INR exchange rate such as Mining & Metals, Oil & Gas, Software exports and Business Processing Operations among others.

Let us now appreciate the challenge in point 6 above, on how deferred tax is impacted by change in functional currency from INR

Ind AS 12: Income Taxes

A deferred tax asset or liability shall be recognised for all taxable temporary differences.

‘Temporary differences’ are differences between the carrying amount of an asset or liability in the balance sheet and its tax base. The ‘tax base’ of an asset or liability is the amount attributed to that asset or liability for tax purposes.

The primary approach of accounting of deferred tax under Ind AS is using the balance sheet approach. For example, revaluation of fixed assets under Indian the GAAP with no corresponding revaluation in tax books i.e., tax base has no impact on deferred tax computation under AS-22 since the revaluation impact is only a balance sheet adjustment with corresponding impact directly in reserves.

Under Ind AS 12, even though the revaluation does not impact the income statement, there is a requirement to adjust the deferred tax and post the net impact in revaluation reserve. This is because this originates a temporary difference on comparison between the balance sheet value of asset and tax base for that particular asset. This is true for all such differences between the balance sheet value and tax base, that have a potential of reversal either in tax books such as 43B items or financial books itself such as revaluation adjustments.

While comparing the balance sheet values and tax base, the following paragraph of Ind AS 12 brings out the impact of functional currency on deferred tax computation.

“The non-monetary assets and liabilities of an entity are measured in its functional currency (see Ind AS 21 The Effects of Changes in Foreign Exchange Rates). If the entity’s taxable profit or tax loss (and, hence, the tax base of its non -monetary assets and liabilities) is determined in a different currency, changes in the exchange rate give rise to temporary differences that result in a recognised deferred tax liability or (subject to paragraph 24) asset. The resulting deferred tax is charged or credited to profit or loss.” (Para 41)

The application of this paragraph will not trigger if the currency in which the company maintains its books of accounts i.e., functional currency and the ones used for calculating taxable profit under tax laws is the same i.e., INR for India. It is pertinent to note that choosing a different currency for presentation of financial statements to stock market, lender, investors, etc., will not attract application of paragraph 41 of Ind AS 12.

However, with the change in accounting standard wherein the accounting records may have to be made under, say, USD (considering primary economic environment criteria under Ind AS 21) and taxable profit or loss is to be calculated under INR, this may cause the temporary difference if the USD:INR exchange rates changes at every balance sheet date.

We will take an example to understand the implications of functional currency on deferred tax.

(1) Entity A has INR as tax currency and USD as functional currency.
(2) The value of non-monetary assets as maintained for tax books in INR is Rs.3,150 and as maintained with USD as functional currency stood at $77.73.

The transactions under both sets of books were accounted at respective historical exchange rates and thus the INR numbers of tax books when divided by USD numbers of financial books, will give historical transaction rates, thus different from the closing rate.

(3) The original and subsequent cost under tax base for the assets are the same as that in financials books, with the exception to the difference that originates due to application of para 41 of Ind AS 12.

(4) Example considers only non-monetary assets assuming monetary assets are valued at closing rate and thus would not lead to any difference while comparing the tax base using translation rate.

(5) The exchange rate at March 31 is 1 USD = Rs. 50 and tax rate is 33.99%

Closing deferred tax status of deferred tax liability as on March 31, XXXX of Entity A is as shown in Table 1:

Deferred tax under Ind AS will be calculated as follows:

Under Ind AS, the deferred taxes are measured in the functional currency

As can be seen from the above calculation, the translation of tax base using closing rate has led to a difference of $14.73. It is pertinent to note that this difference is only for deferred tax computation and not for accounting in the financial books.

The notional comparison has reduced the tax base in USD by 14.73 and this leads to creation of a deferred tax liability with a corresponding deferred tax expense in the income statement. The impact of $ 5.01 over net assets of $ 63 will be a material impact on the profits of the company. It will vary depending upon the value of non monetary assets as on the reporting date and movement of exchange rates during the period.

There would not have been any temporary difference in the above example if the functional currency was INR, since tax base and book base would have been the same.

Impact of accounting of deferred tax such functional currency difference

(1) The accounting for deferred tax on account of such notional differences creates high volatility in the income statement.

(2) The gain/loss on account of such treatment has no corresponding charge/income in the income statement. It is accounted based on pure out of books comparison of exchange rates on non-monetary items. ($14.05 is notional only for comparison but tax of $ 5.01 is real for accounting.)

(3) This item has no bearing to operations or profit; instead it pulls down/up financial results from operations due to tax provision and thus calls for suitable disclosures in financial statements to explain the earnings per share to investors, analysts, etc.

It is pertinent to note that i.e. US GAAP, Financial Accounting Standard (FAS) 109 prohibits recognition of a deferred tax liability or asset for differences related to assets and liabilities that, under FASB Statement No. 52, Foreign Currency Translation, are re-measured from the local currency into the functional currency using historical exchange rates and that result from (a) changes in exchange rates or (b) indexing for tax purposes.

On the one hand Ind AS 21 aims to reduce the volatility in results on account of currency exposure and on the other hand Ind AS 12 brings in volatility in income taxes on account of notional difference created on account of comparing the balance sheet value and tax base in functional currency at the closing date.

Thus, choice of functional currency other than that used for tax reporting will lead to such temporary differences and will continue to exist until book currency and tax currency are aligned.

Change in functional currency
“When there is a change in an entity’s functional currency, the entity shall apply the translation procedures applicable to the new functional currency prospectively from the date of the change.”

The entity will have to assess the criteria for deciding the functional currency year and apply the accounting impacts for change prospectively. Here the country’s policies also would influence the decision such as restrictions on holding foreign currency and INR being the only legal tender in India.

The entity will also have to explain in notes to financial statement as to why it considers such change in its functional currency.

Presentation currency
Ind AS 21 allows the entity to present its financial statements in any currency and does not restrict any one currency. However, considering the Indian requirements for ROC filing, tax submission, stock exchange filings, etc. the presentation currency will be preferred to be INR.

INR as the presentation currency in Indian market will also be preferred currency for reporting to facilitate easy comparability with its peer group. This can be achieved by either following the rules of translation (using average rate for income statement and closing rate of balance sheet) which will give rise to translation reserve or convenient translation using a single rate for all the items in the balance sheet and income statement.

International precedence
In order to relate to the new concept, financial statements of some international companies who have gone through the change in functional currency may be referred. Following relevant excerpts are for reference:

“StatoilHydro (OSE:STL; NYSE:STO) changed the company structure as per 1st January 2009. The parent company, StatoilHydro ASA, and two subsidiaries, consequently changed their functional currencies to USD from the same date.

The accounts for these companies are therefore now recorded in USD, while the presentation currency for the Group remains NOK. The changes in functional currencies have no cash impact.

The companies changing functional currency will no longer have currency exchange effects, deriving from USD denominated monetary assets and liabilities, related to the ‘Net financial items’. Conversely, monetary assets and liabilities, denominated in other currencies than USD, may now generate such currency effects.”

Radiance Electronics Limited, Singapore
“Certain subsidiaries of the Group have changed their functional currency from SGD and RMB to USD in FY2008A. Revenue for these subsidiaries is mainly denominated in USD while purchases are mostly made in USD. Administrative expenses are denominated based on their country of domicile and are mainly in SGD and RMB.

While the factors used to determine its functional currencies are mixed, the Company is of the opinion that USD best reflects the economic substance of the underlying transactions and circumstances relevant to the foregoing subsidiaries. Accordingly, the subsidiaries adopt USD as its functional currency with effect from the current financial year ended 31st December 2008. This change shall be applied retrospectively to the prior years.

The Company and the Group continues to present its financial statements in SGD consistent with prior years.”

For deferred tax implications under IFRS Tenaris S.A.’s annual financial statements may be referred. It carries a note in its financial statements under ‘Tax reconciliation note’ to explain the investors and readers on the volatility caused due to tax accounting.

Tax note from Tenaris S.A. 2008 financial statements

“Tenaris applies the liability method to recognise deferred income tax expense on temporary differences between the tax bases of assets and their carrying amounts in the financial statements. By application of this method, Tenaris recognises gains and losses on deferred income tax due to the effect of the change in the value of the Argentine Peso on the tax bases of the fixed assets of its Argentine subsidiaries, which have the U.S. Dollar as their functional currency. These gains and losses are required by IFRS even though the devalued tax basis of the relevant assets will result in a reduced Dollar value of amortisation deductions for tax purposes in future periods throughout the useful life of those assets. As a result, the resulting deferred income tax charge does not represent a separate obligation of Tenaris that is due and payable in any of the relevant periods.”

Internationally it was easier for companies to adopt a change in currency of accounting since these are fully convertible economies i.e., they can operate bank accounts in foreign currency. Thus the change in mindset was comparatively easier, however the common challenge was again ERP which had to be equipped with dual currency reporting for tax purposes.

With respect to deferred taxes, we can see that note in financial statements was given to explain notional volatility to guide the analysts and readers of financial statements.

Forward path
It will be a challenging journey for Indian corporates who will adopt Converged IFRS i.e., ‘Ind AS’ and will have to consider the implications of these standards on its accounting and reporting requirements.

From stability of profitability and ultimately EPS perspective, the companies may avoid the volatility of currency exposure, but may not escape the volatility created by foreign exchange rates in computing deferred taxes. In order to explain the volatility on deferred tax front, companies may prefer to give note disclosures as given by international peers.

Alternative approach: Ind AS 12 ‘Income Taxes’
Considering the amount of volatility of foreign exchange rates with INR and its notional impact on financial statements, the Institute of Chartered Accountants of India can consider a ‘Carve-out’ while converging to IAS 12 or represent to International Accounting Standards Board for granting an exemption under IAS 12 which will flow in Ind AS 12. This is keeping in mind the deferment of Ind AS implementation in India and practical hardships that will be faced by Indian multinational congloromates.

shailesh.kwebmaker

GAPs in GAP — Foreign Exchange Differences — Capitalisation/Amortisation

The Central Government has notified two amendments dated 29 December 2011 to AS-11 The Effects of Changes in Foreign Exchange Rates. Given below is a brief overview of these two amendments, practical issues arising thereon and the author’s perspective.

Overview of the first amendment The first amendment extends the sunset date for the use of option given in paragraph 46 of AS-11 whereby a company can opt to capitalise/amortise exchange difference arising on longterm foreign currency monetary items. It substitutes the words ‘in respect of accounting period commencing on or after 7 December 2006 and ending on or before 31 March 2012,’ in paragraph 46, by the words ‘in respect of accounting periods commencing on or after 7 December 2006 and ending on or before 31 March 2020.’

Overview of the second amendment The second Notification inserts a new paragraph, viz., paragraph 46A, in AS-11. This paragraph deals with accounting for both companies which had exercised option given in paragraph 46 of AS-11 as well as any other company which had not exercised that option. According to this paragraph, a company may choose to adopt the following treatment in respect of accounting periods commencing on or after 1 April 2011:

(i) Foreign exchange differences arising on longterm foreign currency monetary items related to acquisition of a fixed asset are capitalised and depreciated over the remaining useful life of the asset.

(ii) Foreign exchange differences arising on other long-term foreign currency monetary items are accumulated in the ‘Foreign Currency Monetary Item Translation Difference Account’ and amortised over the remaining life of the concerned monetary item.

The option once elected is irrevocable. Like paragraph 46, paragraph 46A also does not apply to exchange differences arising on long-term foreign currency monetary items that in substance form part of a company’s net investment in non-integral foreign operation.

Main issues There are numerous questions on the interplay of these two amendments and the manner in which they would work in consonance with each other. Lets us understand what is clear and what is confusing.

What is clear?
(1) Those companies that were hitherto amortising/ capitalising exchange differences can continue to do so till 2020.

(2) Those companies that were hitherto not amortising/capitalising exchange differences can avail of the new option in paragraph 46A. Such an option is available on a prospective basis for the remaining life of the loan and is not restricted to 2020.

What is confusing?
(1) Those companies that were hitherto amortising/capitalising exchange differences can continue to do so till 2020 under paragraph 46. The amortisation was done restricting the amortisation period to 2012. If the company wishes to continue with paragraph 46, the amortisation period is extended because of the extension from 2012 to 2020. It is not clear whether the amortisation on the loan is calculated on a retrospective basis or on a prospective basis over the balance amortisation period.

(2) Can a company, which had earlier exercised the option given in paragraph 46, now opt out of that exemption on the grounds that it chose the option because it was restricted to 31-3-2011 and not 31- 3-2020? Hence, can it start recognising exchange differences on foreign currency monetary items, including long-term items, immediately in profit or loss?

(3) It is not clear if companies that were amortising/ capitalising exchange differences under paragraph 46 can switch over to paragraph 46A. How the two paragraphs (46 & 46A) will work in consonance with each other? Let us assume that a company has taken a foreign currency loan, not related to acquisition of fixed asset, whose term extends till 31 March 2025. Will the company amortise exchange differences arising on such loan till 31 March 2020 or till 31 March 2025? The manner in which paragraph 46A is drafted appears to allow both existing option users and new option users to capitalise/amortise exchange differences on a prospective basis. If that is true, what is the relevance of paragraph 46?

(4) In paragraph 46, the sunset date has been used at two places: one for the date range during which the option given can be used and the second to specify the period up to which the balance in the ‘Foreign Currency Monetary Item Translation Difference Account’ needs to be amortised. The Notification dated 29 December 2011 has extended the sunset date to 31 March 2020 at the first place. However, a similar change has not been made with regard to the second date. The strict legal and technical interpretation of the paragraph suggests that a company can continue using the option given in paragraph 46 till accounting periods ending on or before 31 March 2020. However, there cannot be any balance in the ‘Foreign Currency Monetary Item Translation Difference Account’, created for exchange differences arising on long-term monetary items not related to acquisition of a depreciable capital asset, post 31 March 2011. In practical terms, this means that after 31 March 2011, a company will be able to use the option given in paragraph 46 only for capitalisation of exchange differences arising on long-term monetary item related to acquisition of a depreciable asset. Other exchange differences will be immediately recognised in the P&L Account. Whilst this may be the strict legal interpretation of the paragraph, certain companies may question whether it really reflects the intention of the regulator. They may also argue that the amendment intends to extend the option given in its entirety. Hence, they can also amortise any balance in the ‘Foreign Currency Monetary Item Translation Difference Account’ till 31 March 2020. Many companies are taking this approach.

The MCA or the Institute of Chartered Accountants of India, will need to clarify the above issues.

levitra

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Tax Accounting Standards: A New Framework for Computing Taxable Income

Background

The provisions of the
Income Tax Act, 1961 (‘the Act’) presently govern the computation of
taxable profits; however, the Act does not comprehensively specify the
accounting principles to be followed for this purpose. In this context,
the Central Government, empowered u/s. 145(2) of the Act, notified only
two accounting standards, on ‘Disclosure of Accounting Policies’ and
‘Disclosure of Prior Period Items and Extraordinary Items and Changes in
Accounting Policies’.

Litigation pertaining to various
accounting related matters continues between the tax authorities and
companies that seek to follow the guidance in Accounting Standards (AS)
issued by the Institute of Chartered Accountants of India (ICAI) and the
Ministry of Corporate Affairs (MCA). There is consequential
uncertainty. With the impending convergence with International Financial
Reporting Standards in India (Ind AS), this issue assumes greater
importance. In this context, the Central Board of Direct Taxes (CBDT)
constituted the Accounting Standard Committee (the Committee) in
December 2010, with the following terms of reference:

1 To study
the harmonisation of Accounting Standards issued by the ICAI with
regard to the direct tax laws in India, and suggest Accounting Standards
which need to be adopted u/s. 145 (2) of the Act, along with relevant
modifications;

2 To suggest a 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

3 To suggest appropriate amendments to the Act in view of transition to Ind AS regime.

The
Ministry of Finance subsequently issued a Discussion Paper on Tax
Accounting Standards on 17th October, 2011 with draft recommendations by
the Committee and draft Tax Accounting Standards (TAS) on ‘Construction
Contracts’ and ‘Government Grants’. Key matters are discussed below.

Approach for Formulation of Tax Accounting Standards

On
deliberation by the Committee on whether all the standards issued by
ICAI should be considered for harmonisation, it observed that some
standards were not relevant from the perspective of computing taxable
income, because the Act contains specific requirements for matters
covered by these standards or these standards mainly relate to
disclosures in financial statements. Also accounting standards
pertaining to consolidated financial statements i.e. AS 21, 23 and 27
were not relevant, since consolidated financial statements are not
relevant under the Act.

Further, accounting standards such as AS
30, 31 and 32 relating to financial instruments, have not been notified
under the Companies Act, 1956 and are therefore not currently mandatory
in nature, were also not considered for harmonisation. Other reasons
for not evaluating these standards were the uncertain status of these
standards and their limited application to the area of derivatives and
hedge accounting. The accounting issues related to derivatives are
partly covered by the TAS on Accounting Policies.

The Committee
also recommended TAS for the areas where currently no accounting
standards have been issued by ICAI and guidance for computation of
taxable income is required. Consequently, TAS may be issued in the
future for areas such as: i) Share based payment ii) Revenue recognition
by real estate developers iii) Service concession arrangements iv)
Exploration for and evaluation of mineral resources.

Following are various other considerations and recommendations by the Committee:

TAS to be applicable only to those taxpayers that follow the mercantile system for tax purposes; 1

Return of income and Form 3CD to be modified to determine whether the
taxable income is computed in accordance with TAS. This could be
achieved by requiring reconciliation between the income as per the
statutory financial statements and the income as computed per TAS;

Disclosure requirements prescribed in individual TAS and their inclusion in the return of income;

Transitional provisions, wherever required, to be notified along with
TAS to avoid situations wherein income arising from a particular
transactions is taxed neither in the pre-TAS period nor in the post-TAS
period or may be taxable in both the periods. For example, if the
assessee has claimed lease rentals as a deduction in the pre-TAS period
for assets obtained on finance lease, basis for claiming deduction of
depreciation and interest cost in the post-TAS period will need to be
clarified by the transition guidance.

Final recommendations
The
final recommendations of the Committee are included in a report that
was issued for public comment on 26th October, 2012 which also contains
drafts of 14 individual TAS (including TAS on Construction Contracts and
Government Grants that were initially issued in October 2011).

The Committee recommended that:

TAS needs to be in harmony with the provisions of the Act;

TAS needs to lay down specific rules to enable computation of taxable income with certainty and clarity;

TAS to remove alternatives, to the extent possible;

AS issued by ICAI could not be notified under the Act without modification and hence, the TAS to modify AS;

TAS should be applicable only to computation of taxable income and
taxpayers will not be required to maintain separate books of accounts on
the basis of TAS;

TAS to apply to all taxpayers without
specifying any thresholds relating to turnover/income in order to bring
uniformity in computation of taxable income;

In case of a conflict between the Act and TAS, the provisions of the Act will prevail;

Transition provisions to be notified with each TAS as relevant, in order to prevent any tax leakage or any double taxation;

Appropriate modifications be made to the return of income to monitor
TAS compliance. Modification of Form 3CD so that tax auditor is required
to certify computation of taxable income in compliance with TAS;

Amendments to be made to the Act to provide certainty on issue of
allowability of depreciation on goodwill arising on amalgamation,
allowability of the provision made for the payment of pension on
retirement or termination of an employee.

Significant impact areas
A
few of the important implications around accounting policies,
inventories, prior period expenses, construction contracts, revenue
recognition and fixed assets are covered below. Impacts for other areas
such as the effects of changes in foreign exchange rates, government
grants, securities, borrowing costs, leases, intangible assets and
provisions, contingent liabilities and contingent assets will be covered
in our next article.

Accounting policies

AS 1
considers prudence as an important factor in selection and application
of accounting policies and requires provisions for all known liabilities
and losses on best estimate basis. Unlike AS 1, TAS eliminates the
concept of prudence and disallows recognition of any such provisions of
expected losses or mark to market (MTM) losses, unless specifically
provided under TAS. Consequently, fair valuation gain/loss provisions on
derivatives or other instruments would not be allowed under TAS.

Unlike AS 1, TAS does not permit a change in accounting policy merely
on account of ‘more appropriate presentation’ and requires reasonable
cause to do so. What constitutes ‘reasonable cause’ would require
judgement by management and tax authorities.

TAS does not provide any specific guidance on how the impact of any such change in policies should be included in the computation of income.

Valuation of inventories

Under current practice, on conversion of capital asset into stock-in-trade, the fair value on the date of conversion is deemed to be consideration and accordingly treated as the cost of stock-in-trade. The definition of cost for valuation of inventory per TAS does not specifically address this situation and it is possible that such deemed cost may not be allowed post implementation of the TAS;

TAS specifies that opening stock will be valued as at the close of the immediately preceding previous year. This nullifies the impact of judicial decisions which provided that opening stock should be valued on the ‘same basis’ as closing stock, in cases where there is a change in policy for inventory valuation during the year;

Events occurring after the end of the previous year

Similar to AS 4, TAS also allows adjustment for events till the date of approval of the financial statements by the Board of Directors or other approving authority for a non-corporate entity. This may result in a change in current practice where such adjustments are permitted for events till the date of filing the return of income.

Prior period expense

No specific guidance is provided on prior period income in TAS. This seems to be in line with the current practice, whereby prior period income is subjected to tax in the current year.

Prior period expenses are explicitly covered under TAS and provide that no deduction can be allowed in the current year. In line with the current practice, even if the prior period expense can be claimed as a deduction for the year to which it pertains (pursuant to a revised return), there are practical limitations on filing a revised return in all such cases e.g. a revised return can be filed only for the two immediately preceding previous years.

Construction contracts

Percentage of completion method for revenue recognition is mandatory under TAS and accordingly, use of the completed contract method is no longer permitted.

Although TAS permits non-recognition of margins during the early stages of a contract, it prohibits such deferral if the stage of completion exceeds 25 %.

Unlike AS 7, TAS does not permit recognition of expected losses on onerous contracts.

Under TAS, any incidental income in the nature of interest, dividend or capital gains cannot be reduced from the contract cost; however, other incidental income can be reduced from the costs.

Unlike AS 7, TAS does not permit non-recognition of revenue due to uncertainty in collection. If other conditions for revenue recognition per TAS are met, revenue needs to be recognised. A corresponding bad debt expense deduction can be claimed in accordance with the provisions of the Act.

Revenue recognition

Unlike AS 9, TAS does not require revenue to be measurable or collectible at the time of sale (there is an exception for price escalation claims and export incentives). As such, revenue will have to be recognised even if the sales proceeds are not collectible. A corresponding bad debt expense deduction can be claimed in accordance with the provisions of the Act.

Unlike AS 9, TAS requires revenue recognition for all services based on percentage of completion method. As such, completed contract method as per AS 9 is no longer permitted under TAS. Though the TAS does not clarify whether expected losses on onerous service contracts should be recognised on a proportionate basis or in their entirety, given the provisions in the TAS on Construction Contracts and Accounting Policies, it is likely that such expected losses cannot be provided.

AS 9 contains certain illustrations that provide more clarity on application of revenue recognition principles to specific types of transactions. For example, a sale and repurchase agreement may be in substance a financing arrangement, or an upfront membership fee may be consideration for future discounted products or services. Since similar illustrations are not included in TAS, the position around such specific transactions may be unclear.

Unlike AS 9, TAS does not contain guidance on recognition of revenue as a principal or as an agent (gross vs. net). This may impact turnover determination u/s. 44AB, coverage under presumptive taxation and other similar cases where determination of gross turnover is relevant under the Act.

A separate TAS for revenue recognition for real estate developers is supposed to be issued as per Committee recommendation. Until that time, inconsistent practices may continue to exist in the manner in which real estate developers apply the principles of TAS.

Tangible fixed assets

AS 16 provides for capitalisation of exchange differences along with the underlying asset to the extent that such exchange differences qualify as borrowing costs or when the company has adopted the notifications on AS 11 issued by the Ministry of Corporate Affairs that permit such capitalisation. TAS reiterates the fact that capitalisation of exchange differences relating to fixed assets shall be in accordance with section 43A of the Act that states that any increase/ decrease in the liability in Indian currency shall be recognised only at the time of payment, which could be materially different from the provisions of AS 10, AS 16 and AS 11.

TAS provides that the actual cost in cases where an asset is acquired in exchange for another asset, shares or securities shall be the lower of the fair market value of the asset acquired or the assets/securities given up/issued. However AS 10 requires that its actual cost shall be determined by reference to the fair market value of the consideration given or asset acquired whichever is more clearly evident.

TAS prescribes maintenance of a Fixed Asset Register with specific disclosures. Currently, non-corporate assessees may not be maintaining Fixed Asset Registers in the prescribed format.

Conclusion

The Final committee report with draft TAS will provide a comprehensive framework for companies to determine their taxable income each year, by adjusting their accounting profits as many of the difference between AS and TAS will harmonise the computation basis for taxable profits with the existing provisions of the Act. This represents a significant progress in providing a consistent basis for computation of taxable income.

Some of the changes could extensively impact certain companies, as the TAS provisions would provide guidance on areas that are subject matters of considerable litigation and areas where there is no guidance under the current tax provisions. Depending upon the tax positions taken by a company these provisions would have an impact on the taxable profits under TAS regime.

Although TAS purports to remove one of the hurdles to implementation of Ind AS by providing independent framework regardless if GAAP followed (Indian GAAP or Ind AS), the issue of impact on computation of the Minimum Alternate Tax (MAT), which is based on the accounting profits still remains open, due to uncertainty around the adoption of Ind AS.

Finally, the key challenge lies in thorough implementation of the TAS framework by the tax authorities and the judiciary. This would go a long way in achieving tax uniformity and consistency across different companies.

Editor’s Note: One of the authors is a member of the Accounting Standards Committee.

shailesh.kwebmaker

Y. H. Malegam Report on MFI Sector — A summary

Microfinance has been always seen as an economic development tool for the downtrodden and poorest section of society. In its social objective, it is one of the most useful tools to battle poverty and give an equal chance to those who can contribute to the economy, but need help. In its simplest sense, it helps a financially backward person with no or little collateral to set up his own business by providing finance at convenient rates and repayment tenure. Over time it had moved on to many more services for financial inclusion and literacy.

For this reason, the Microfinance sector was in high regard. The Microfinance sector has seen an upheaval in recent times. However, since the advent of new Micro Finance Institutions (MFIs) with a more profit-linked and lesser social incentive, the sector has seen changes. The sector which was in limelight for its rapid growth and success in financial inclusion was suddenly seen in a bad light because of its alleged coercive practices. These practices got highlighted with suicides by certain borrowers in Andhra Pradesh, the state that has the largest chunk of MFIs. Andhra Pradesh passed an Ordinance bill and followed it up with a State Act to regulate the working of these MFIs. The Reserve Bank of India also set up a Committee under the chairmanship of Mr. Y. H. Malegam to study the issues and concerns in the Micro-finance sector. This Committee tabled its report on the 19th January 2011. This article summarises the main points coming out from this Report.

Introduction: The Committee has come out with a detailed report on the Microfinance sector — the reasons for the current crisis and possible redressal provisions. The Committee had the following objectives:

(i) To review the definition of ‘micro-finance’ and ‘MFIs’;
(ii) To examine the alleged malpractices conducted by these MFIs especially with respect to interest rates and means of recovery;
(iii) To specify the scope of regulation by RBI of these MFIs and suggest a proper regulatory framework;
(iv) To examine the prevalent money-lending legislation at the state level and other relevant laws;
(v) To analyse what role the associations and bodies of MFIs can play in enhancing transparency of MFIs;
(vi) To suggest a redressal machinery;
(vii) To examine the conditions for allowing priority- sector lending to MFIs.

The sub-Committee had confined itself to only the lending aspect of MFIs and not the other services like insurance, money transfers, etc. Further, the report commented on the unique characteristics of loans given by this sector, namely, that the borrowers are low-income groups, amounts are small, there is no collateral, the tenure is short and repayments are frequent.

The main players in the Microfinance sector are the Self-Help Groups (SHG) linked with the banks and Joint Liability Groups (JLG) linked with NBFCs. Both these types of groups are created by individuals who create savings, act as supporters as well as put peer pressure on each other in the group for effective utilisation of loans given by banks.

The need for regulation: Most of the NBFCs were non-profit organisations which had started the work with a purely social objective. However, over time some of these turned into for profit NBFCs. This attracted purely business-oriented entities to enter into the sector as they saw that there was a profit to be made from these activities. Such NBFCs also attracted a lot of private equity.

The Committee brings out the fact that though these NBFCs were handling a large amount of loan portfolio, no specific regulations were present. The Committee in its report has therefore stressed on the need for regulation of such NBFCs as a separate category of NBFCs operating in the MFI sector. The main reasons for this suggestion were that the borrowers were a particularly vulnerable section of society; the NBFCs compete against both the established SHG-Bank linkage programme and other NBFCs; credit to the MFI sector is important for financial inclusion; and banks have a significant exposure to loans given to such NBFCs.

For all the above reasons, the Committee has suggested a creation of a separate category for such NBFCs to be designated as ‘NBFC-MFI’ with a specific definition:

“A company (other than a company licensed u/s.25 of the Companies Act, 1956) which provides financial services predominantly to low-income borrowers with loans of small amounts, for short terms, on unsecured basis, mainly for income-generating activities, with repayment schedules which are more frequent than those normally stipulated by commercial banks and which further conforms to the regulations specified in that behalf.”

Conditions to be met: The Committee has also specified quite a few conditions which an NBFC has to meet for it to be classified as a ‘NBFC-MFI’. These conditions have been put in place after the Committee went through certain statistics and ground realities prevalent in this sector. The conditions are:

(i) 90% of the assets of an NBFC-MFI should be in the form of loans to the Microfinance sector.
(ii) These loans are to be given to a borrower whose annual household income does not exceed Rs.50,000.
(iii) The amount of loan and total outstanding of the borrower should not exceed Rs.25,000.
(iv) The tenure of the loan should be more than 12 months in case of loans lesser than Rs.15,000 and more than 24 months other cases.
(v) There should be no penalty on the borrower for pre-payment of these loans.
(vi) The loan is to be without collateral.
(vii) The total amount of loans given for non-income generating activities should not exceed 25%.
(viii) The repayment schedule would be at the choice of the borrower.
(ix) Other services provided by the MFIs should be regulated.
However, fulfilling all these conditions would mean a change in the existing business model of the MFIs. Therefore, these conditions are the main bone of contention for existing MFIs, who find them to be quite draconian.

Alleviation of other main concerns: The above conditions would essentially regulate the kind of loans given by such MFIs and the types of incomes earned by them. However, the main areas of concern with respect to MFIs are not yet addressed. Therefore the Committee has listed down each of these areas and suggested redressal provisions:

Pricing of interest: The very high rates of interest charged by certain MFIs were the main reason for the current upheaval. Therefore, the Committee has noted that interest rates should tread a fine balance between affordability of the clients and sustainability for the MFIs. Looking at the vulnerability of the borrowers, the Committee felt it necessary to put down a controlling rate of interest to be charged by such MFIs. However, instead of a fixed rate, the Committee has suggested for a margin cap which would regulate the difference in the cost of funds for the MFI and the rate of interest charged to the borrower. For deciding the cap, the Committee has gone into the financials of certain large and small MFIs and analysed several parameters and costs. It has suggested a margin cap of 10% for MFIs with a loan portfolio exceeding Rs.100 crores and 12% for those within. This cap would be applicable at an aggregate level and not for individual loans. The MFI would be free to decide the individual loan rate within an overall limit of 24%.

Transparency:

The Committee noticed that MFIs, apart from a base interest charge, also levy a variety of other charges in the form of an upfront registration or enrolment fee, loan protection fee, etc. The Committee has suggested that MFIs should only charge an insurance premium and an upfront fee not exceeding 1% of the gross loan amount apart from the base interest.
Further, it has suggested that for effective transparency, every borrower should be presented with a loan card which shows the effective rate of interest and other terms to the loan. The effective rate of interest should also be prominently displayed in all the offices, literature and website of the MFI. It has also denied charging of any upfront security deposit and standardised loan agreements.

Ghost borrowers:

Because of competition amongst MFIs, a deluge of loans are available to the borrower. This results in multiple lending and over-borrowing. This is exacerbated by the fact that loans disbursed have inadequate moratorium period before re-payment starts. Therefore, the repayment would start before the income is generated. This would prompt the borrower to either go in for additional borrowing, or repay from the loan amount itself. Further, MFIs use existing SHGs to reduce transaction costs. Thus the borrowers are tempted to take additional loans.

To alleviate these concerns the Committee has proposed that MFIs should only lend to group members; the borrower must not be a member of another group; not more than two MFIs should lend to the same borrower; and there must be a minimum period of moratorium. Where loans are borrowed in violation of these conditions, recovery of the loan should be deferred till all existing loans are repaid.

To reduce the problem of ghost borrowers, the Committee further recommends that all sanctioning and disbursement of loans should be done only at a central location under close supervision.

Another important tool necessary in the prevention of multiple lending is the availability of information of outstanding loans of an existing borrower. Therefore, a database to capture all outstanding loans as also the composition of existing SHGs and JLGs is recommended.

Coercive recovery practices:

The Committee has noticed the reports made of coercive methods exercised by the MFIs, their agents or employees for recovery of loans. It maintains that the main reasons for use of such coercive methods are linked with the issues of multiple lending, uncontrollable growth and employment of recovery agents.

The Committee has proposed several measures to resolve this issue:

i. Primary responsibility that coercive methods are not used should rest with the MFI. In case of default, the MFI should be charged with severe penalties.

ii. The regulator must monitor whether the MFIs have a proper code of conduct and system for training of field staff. The MFI should have a proper Grievance Redressal Procedure.

iii. Filed staff should be allowed to make recoveries only at a group level at a central place to be designated.

iv. An appropriate mechanism to introduce independent Ombudsmen should be examined by RBI.

Apart from the above, the Committee has recommended that the regulator should publish a Client Protection Code for MFIs and mandate its acceptance and observance not only by the MFIs themselves, but also by the credit providing banks and financial institutions. This Code should incor-porate the relevant provisions of the Fair Practices Guidelines prescribed by the RBI for NBFCs.

Improving efficiency:

The Committee has gone beyond recommending measures to alleviate only the main concerns of the MFI sector. It has also suggested some steps for improving the overall efficiency of the MFIs.

The key areas highlighted to improvement in efficiency are operating systems, documentation and procedures, training and corporate governance.

To this end, it has called for increased investment by MFIs in information technology to achieve bet-ter control, simplify procedures and reduce costs. Further, it has suggested inculcation of profes-sional inputs in the formation of SHGs and JLGs, imparting of skill development and training, and in handholding of the group after it is formed.

To decrease transaction costs by achieving better economies of scale and to improve control it was felt by the Committee that MFIs should obtain optimal size of operation. For this if consolidation in the sector may be inevitable.

On the basis of a capital adequacy ratio of 15% on a basic investment portfolio of Rs. 100 crores, the Committee has suggested for a minimum net worth of Rs.15 crores.

The Committee has underscored the importance of alleviation of the poor along with reasonable profits to investors in the MFI sector. These twin objectives call for a fine balance and therefore all MFIs should have a good system of corporate governance.

The Committee has recommended inclusion of independent board members; monitoring by the board of organisational level policies; and relevant disclosures in the financial statements.

The Committee has also recognised the fact that MFIs have a very large exposure to the banking system. More than 75% of their funds are sourced from banks. Therefore, adequate safeguards must be in place to maintain solvency.

The Committee has recommended appropriate prudential norms which should be different from other NBFCs looking at the unique nature of loans disbursed by MFIs. The Committee has suggested specific rates for provisioning of outstanding loans. Further, it has recommended maintenance of a higher capital adequacy ratio of 15% as compared to the existing 12% considering the high-gearing and high rate of growth.

It has been appreciated that interest rates can be lowered only if greater competition both from within the MFIs and without from other agencies should be encouraged. To this end, the Committee has recommended that bank lending to this sector should be significantly increased.

Currently all loans to MFIs are considered as prior-ity sector lending. As there is no control on end use and there is significant diversion of funds, it had been suggested to the Committee that MFIs should not enjoy the priority sector status.

However, the Committee has pointed out in its report that removal of this status may not be required if other recommendations made by it are implemented. In fact, competition within banks for meeting targets for lending to priority sector could reduce interest rates. But, those MFIs which do not comply with the proposed regulations should be denied the priority sector lending status.

The Committee has noted that in addition to direct borrowing the MFIs had assigned or securitised sig-nificant portions of the loan portfolio with banks, mutual funds and others. It has asked for full disclosure of such assignments and securitisations to be made in the financial statements of MFIs. Further, for the calculation of capital adequacy, wherever the assignment or securitisation is with recourse, full value should be considered as risk-based assets; and where the same are without re-course, value of credit enhancement given should be deducted from the net-owned funds. Banks should also ensure, before acquiring assigned or securitised loans, that loans have been made by the MFIs in accordance with the regulations.

The Committee mentions that a widening of the funding base for MFIs is needed. This is because there is a huge demand for MFIs. However, non-profit entities could not meet this demand. When for profit entities emerged, venture capital funds were not allowed to invest in MFIs and private equity rushed in. This has resulted in demand for higher profits with consequent higher interest rates and other areas of concern.

Therefore, the Committee has recommended establishment of a ‘Domestic Social Capital Fund’ targeted towards social investors who are willing to earn lesser returns of around 10 to 12%. This fund would invest in MFIs satisfying the social performance norms laid down by the fund.

For all the above measures towards alleviation of the areas of concern and improving efficiency, the Committee has noted that success would depend on the extent of compliance. To this end, it has suggested monitoring of compliance with the regulations will have to be borne by four agencies.

The primary responsibility would rest with the MFI itself and the management should be penalised in the event of non-compliance. The next level of monitoring would be by the industry associations which would prescribe penalties for non-compliance with their Code of Conduct. Banks can also play part with surveillance through their branches. The Committee has called on the RBI for considerably enhancing its existing supervisory organisation dealing with such NBFCs. It should also have the power to remove from office the CEO and/or director in the event of persistent violation of the regulations.

The Committee has also provided for certain suggested reliefs for MFIs.

Several states have money-lending Acts which are several decades old. These Acts do not specifically exempt NBFCs unlike banks and cooperatives. These NBFCs are already regulated by the RBI. The Committee has therefore recommended for exemption of these MFIs from the provisions of the money-lending acts.

The Central Government has drafted a ‘Micro Finance (Development and Regulation) Bill, 2010’ which will apply to all microfinance organisations except for banks, co- operatives, etc. The Committee has suggested some changes in the bill for exemption of smaller entities, functioning of NABARD as a regulator and market player, and disallowance of business of providing thrift services by MFIs.

As mentioned in the beginning, the Andhra Pradesh Government has enacted a specific legislation to regulate the MFIs operating with the state. The Committee has expressed that as most of the conditions set by this Act are already recommended by the Committee, a separate Act may not be needed.

Finally, the Committee has recommended that 1st April 2011 should be kept as the cut-off date for implementation of their recommendations. They have insisted that the recommendation as to the rate of interest should in any case be made effective to all loans given by MFIs after 31st March 2011. Certain relaxation as to other arrangements can be given by RBI, especially where MFIs may have to form separate entities confined to only microfinance activities.

Conclusion:

As can be seen, the Committee has gone in-depth on the issues faced by the Microfinance sector and has called for far-reaching changes. These changes, if accepted by the RBI, would materially alter the operation of MFIs in India. As would be expected, MFIs have strongly criticised the provisions suggested by the Committee. The specification of maximum interest rates that can be charged has irked the MFIs in particular. Mr. Malegam has mentioned in interviews that a limit is necessary. What this limit should be, can be decided by the RBI. The decision on these recommendations now lies with the RBI. As per news reports, the RBI is expected to give its view on the report by end of April 2011.

shailesh.kwebmaker

Foreign judgment — Decision on merits would be conclusive — Hence enforceable in India — CPC, section 13(b).

Foreign judgment — Decision on merits would be conclusive — Hence enforceable in India — CPC, section 13(b).

[Karnail Singh Sandhar v. M/s. Sandhar and Kang Ltd., AIR 2011 (NOC) 69 (P & H)]

The petitioner filed a claim against Sandhar & Kang Ltd. & Ors. in the High Court of Justice, Chancery Division, UK. The petitioner and defendant had establish a business partnership for trading in food retails. In or about 1986, the petitioner and defendants fell out, the petitioner resigned as a director and shareholder of the company and was paid £350,000 for his shareholding in the company. However, the petitioner remained registered as a holder of the legal estate in the property and the Chester Road property with defendants in equal shares. After his resignation, the petitioner left UK and settled at Canada and obtained Canadian citizenship. Without the knowledge and consent of the petitioner, the defendants sold the property. The petitioner returned to the UK and discovered the aforesaid transfers. The petitioner filed necessary proceeding against the defendants in respect of the property.

On 3-5-2007, the High Court of Justice issued a judgment by way of a minute of order whereby the petitioner was directed to pay the costs. On 14-2-2008, the Appellate Court dismissed the appeal by way of an order and directed the petitioner to pay costs incurred by the defendants in relation to the Court of Appeal proceedings related to the Court of Appeal order. That after the aforesaid orders passed by the Courts at UK, the respondent/decree-holder filed an execution in the Court at Ontario, Canada as the petitioner was a citizen of Canada. The said execution was pending but no recovery could be effected. Nothing could be recovered from the petitioner even in UK.

Litigation between the parties on execution in India.

On 11- 6-2008, the respondent filed an execution in the Court of learned District Judge, Sangrur for execution of the decrees to recover costs of £ 50,000 as the property of the petitioner is situated at Sangrur. The learned District Judge, Sangrur, vide its impugned order dated 26-2-2010 rejected the plea raised by the petitioner and held that the application for execution of the foreign judgments is maintainable.

The petitioner invoked the revisional jurisdiction of the Court under Article 227 of the Constitution of India to challenge the impugned order dated 6-2-2010 upholding the maintainability of the execution application filed by the respondent who had sought to execute foreign judgments at Sangrur in India.

The Court held that section 13(b) of the Civil Procedure Code (CPC) provides that a foreign judgment shall be conclusive as to any matter thereby directly decided between the parties, but there are certain exceptions which are provided in clause (a) to (f) in which clause (b) provides that a judgment shall not be conclusive if it is not rendered on the merits of the case.

It was held that the judgment passed by the High Court of Justice and the Court of Appeal of the U.K., which were sought to be executed in the present case, were judgments on merits and it is also held that in order to decide a case on merits in a case which is decided under a summary procedure after considering the evidence available on record led by the parties, it would be a decision on merits to be covered u/s.13(b) of the CPC.

Hence, in view of it was held that costs order imposing costs a foreign Court was a decree which could be executed in the Court in India u/s.44-A of the CPC. Simultaneous execution petition in India and Foreign Court not barred specially when decree holder has stated that nothing has been recovered from execution filed in other Court.

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Property, Plant and Equipment – Changes under Ind AS

Property, plant and equipment (PPE) comprise a significant portion of the total assets of an entity and therefore are important in the presentation of the entity’s financial position. In addition, the determination of whether expenditure represents an asset or an expense, can have a material effect on an entity’s reported results.

Currently, under Indian GAAP, accounting for PPE is covered by AS 10 ‘Accounting for Fixed Assets’. The other standards and regulations which are applicable to the accounting for PPE include AS 6 ‘Depreciation Accounting’ AS 16 ‘Borrowing Costs’, AS 11- The Effects of Changes in Foreign Exchange Rates and certain notifications of the Ministry of Corporate Affairs (MCA).

Under Ind AS, the accounting for PPE is covered by Ind AS 16 – ‘Property, Plant and Equipment’ along with guidance under Ind AS 23 – ‘Borrowing Costs’, and Ind AS 21 – ‘The Effects of Changes in Foreign Exchange Rates.

In this article, we will examine and illustrate some of the key differences in practice between Ind AS and Indian GAAP, as it is currently applicable, with respect to the accounting of PPE.

General and Administrative Overheads:

Under the current Indian GAAP, certain general and administrative expenses which are specifically attributable to the cost of the asset or construction of a project are capitalised as part of the cost of the asset. These expenses are generally in the nature of start-up costs or pre-operating expenses.

As per Ind AS 16, costs eligible for capitalisation are the cost of the asset, duties and non refundable purchase taxes, less trade discounts and rebates. It includes those costs which are directly attributable to bringing the asset to the location and condition necessary for it to be capable of operating in a manner intended by management. This capitalised cost of the asset does not include general and administrative overheads.

Foreign Exchange Differences:

As per the revised AS–11 and subsequent MCA notifications, foreign exchange differences on foreign currency long term monetary items related to acquisition of a depreciable capital asset may be capitalised to the cost of the asset and depreciated over the balance life of the asset. This is an irrevocable option which the entities have, currently under the modified AS 11.

Under Ind AS, there is no such guidance and all foreign exchange differences on acquisition of assets are expensed to the income statement. Capitalisation is not permitted. Thus, there would be a difference in the capitalised value of the property, plant and equipment under Ind AS with a corresponding impact to the depreciation amount in the income statement.

Asset Retirement Obligations:

At present, there is a divergence in practice under Indian GAAP such that certain companies do not upfront recognise the cost of dismantling or removing the asset or restoring the site on which the asset was located to its original condition. Such obligations are recorded in the financial statements, only when the liability is incurred.

Ind AS 16 provides that the cost of the asset also includes the initial estimate of the costs of dismantling and removing the item, and restoring the site to its original condition. Hence, the cost of the asset should include an amount equivalent to the present value of the liability recognised for the cost of dismantling or removing the asset and of restoring the asset to its original condition as per initial estimates of the management. Interest, which is imputed in the transaction, shall be recognised subsequently through the profit and loss account. The total cost of the asset (original cost plus the present value of the obligation) shall be depreciated as per the useful life estimated by the management.

Let us understand this concept through the following example:

Example 1:

Company A is a chemical manufacturing company, which has recently installed an asset at its manufacturing facility. The cost of the asset is Rs. 100 lakh and the Company is expected to incur certain restoration costs on the land on which the asset is located at the end of five years. The Company follows the straight line method of depreciation. The Company estimates that the restoration costs shall be Rs. 20 lakh. The current market rate of interest is 10%. Hence, the Company estimates that the present value of the obligation on day one at an interest rate of 10% shall be Rs. 12.42 lakh (approx).

– Initial measurement

As per the provisions of Ind AS 16, the Company will capitalise the asset at a value of Rs. 112.42 lakh (Rs. 100 lakh of its initial capitalised value of the asset and Rs. 12.42 lakh of its estimate of restoration costs). It will also record a provision of Rs. 12.42 lakh towards this liability. The accounting entry will be as shown in Table 1.

Table 1 – Initial Measurement Entries (Rs. in lakh)

– Subsequent measurement

The company follows a straight line method of depreciation and hence, would recognize the depreciation expense as shown in Table 2.

Table 2 – Deprication (Rs. in lakh)

The provision has been recognised at its present value of Rs. 12.42 lakh. However, payment to be made at the end of the year 5 is Rs. 20 lakh. Accordingly, at the discount rate of 10% determined earlier, the provision shall be accreted through the income statement to Rs. 20 lakh at the end of the fifth year. For detailed calculation of the accretion amounts, please refer to the Table 3:

Table 3 – Accretion to Provision for Restoration Cost (Rs. in lakh)

Accounting entry:

*Every year

Income statement a/c (imputed interest) Dr.

To Provision for restoration costs Cr.

At the end of year 5

Provision for restoration costs a/c Dr. (Rs. 20 lakh)

To Cash/Bank a/c Cr. (Rs. 20 lakh)

Deferred Payment Terms:

Under Indian GAAP, the capitalised cost of the PPE is the transaction value – the value agreed to be paid for the cost of the asset. Hence, deferred payment terms do not affect the capitalised value of the asset.

The accounting practice prescribed under Ind AS 16 differs from Indian GAAP. It defines that the cost of acquisition of the asset is equal to its cash price or cash equivalents paid or the fair value of other consideration given to acquire the asset. Thus, in a scenario where the terms of acquisition, payment is deferred over a period of time, the asset would have to be recognised initially at its present value. This would also apply where companies retain retention money for a particular asset. This has been further explained through the example given below:

Example 2:

Company C purchases an asset at a cost of Rs. 66 lakh with a useful life of six years. The normal trade practice in the industry is for the purchaser to retain a certain amount of the cost of the asset which is payable two years from the date of purchase. Accordingly, Company C agrees to pay Rs. 60 lakh and to hold Rs. 6 lakh as retention money payable after two years from the date of purchase.

The market rate of interest on the date of the transaction is 9%. Accordingly, the present value of the retention money discounted at 9% for two years amounts to Rs. 5,05,008. The accounting entries in the books of Company C are as shown in Table 4:

Table 4 – Accounting for Retention Money in Asset Purchase

Depreciation shall be computed and accounted for on the capitalised value of the asset Rs. 6,505,008 over the estimated useful life of the asset – 6 years.

Borrowing Costs:

Differences in practice with respect to borrowing cost capitalisation between Indian GAAP and Ind AS include:

Guidance under Indian GAAP and Ind AS state that ‘Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset should be capitalised as part of the cost of that asset.’ Hence, to qualify for capitalisation of borrowing costs, the asset should take a ‘substantial period of time’ to get ready for its intended use or sale. While the definitions of a qualifying asset are predominantly the same, there is a bright line of 12 months given under Indian GAAP for ‘substantial period of time’, whereas under Ind AS there is no bright line given. An assessment of substantial period of time is based on management’s best estimate. Thus, the borrowing costs qualifying for capitalisation may differ under Indian GAAP and Ind AS.

Secondly, capitalisation of borrowing costs under Indian GAAP is based on the contractual rate of interest of loans borrowed. However, under Ind AS, such capitalisation is based on the effective interest rate of loans borrowed. An effective interest rate is computed after taking into consideration amortisation of loan processing fees and other upfront charges on availing the loan facility.

Depreciation:

Under Indian GAAP currently, a company may choose to depreciate its assets in the financial statements, using only the written down value or straight line method. The rates for such depreciation are governed by Schedule XIV to the Companies Act, 1956 and as a practice, most companies adopt the rates of depreciation prescribed in the Schedule.

Ind AS requires a company to follow that method of depreciation that best reflects the pattern in which, the future economic benefits are expected to be consumed by the company. Depreciation as per this method is based on the useful life of the asset which is an estimate by the management, which may be different from the rates entities use as per Schedule XIV at present. The residual value and the useful life of an asset, need to be reviewed at least at each financial year-end, and if expectations differ from previous estimates, the changes are to be accounted for as a change in an accounting estimate. Further, a change in the depreciation method shall also be treated as a change in accounting estimate and effected prospectively.

There may be certain components of an asset which are significant and have different useful lives. Ind AS requires a company to depreciate these components, separately based on an estimate of their useful lives. Such components include major inspection costs or overhaul charges. This approach towards measurement of depreciation, amortises the cost of replacement of key components during overhauls in a systematic manner.

Example 3

AJ Engineering Limited purchases an asset for its manufacturing activities. The total cost of the asset is Rs. 100 lakh and its useful life is six years. The asset has three main components – Component A with a cost of Rs. 60 lakh and a useful life of six years, Component B with a cost of Rs. 30 lakh and a useful life of three years and Component C with a cost of Rs. 10 lakh and a useful life of two years. The management believes that the straight line method of depreciation, most appropriately reflects the pattern in which future economic benefits shall flow to the company. Components B and C are replaced when their useful life has been exhausted.

The capitalised cost of the asset is Rs. 100 lakh. In the second year and third year, components C and B will be derecognised respectively, and replaced by fresh components and depreciated over their estimated useful lives i.e. two and three years. The measurement of depreciation shall be as shown in Table 5:

Table
5 – Depreciation under Component Approach (Rs in lakh)

Particulars

Remarks

Year
1

Year
2

Year
3

Year
4

Year
5

Year
6

Total

Cost

100

(10)

(30)

(10)

Replacement of Compo-

nents

Depreciation

Component A

Useful life –

(10)

(60)

6
years

Component B

Useful life –

(10)

(30)

3
years

Component B (replaced)

Useful life –

(10)

(30)

3
years

Component C

Useful life –

(5)

(10)

2
years

Component C (replaced)

Useful life –

(5)

(20)

2
years

Depreciation
charge for

(25)

(150)

the year

Upon de-recognition and recognition of components, the accounting entries as shown in Table 6 shall be passed:

Table 6 – Accounting Entries on De-recognition (Rs. in lakh)

Particulars

Dr/

Amount

Derecognition
of

Component B at end

of year 3

Accumulated Deprecia-

Dr.

tion A/c

To Asset A/c (Compo-

Cr.

nent B)

(Being: De-recognition

of Component B at

the expiry of its
use-

ful life)

Recognition
of new

Component B in year

Asset A/c (Component

Dr.

To Bank A/c

Similar entries will need to be considered for Component C.

Example 4

Company P runs a merchant shipping business and has just acquired a new ship for Rs. 40 lakh. The useful life of the ship is 15 years, but it will be dry-docked every three years and a major overhaul shall be carried out. At the acquisition date, the dry-docking costs for similar ships that are three years old, is approximately Rs. 8 lakh.

Hence, while capitalising the ship in the books, the dry-docking costs shall be considered as a separate component, with a useful life of three years and amounting to Rs. 8 lakh. The bal-ance amount, shall be capitalised to the value of the ship – Rs. 32 lakh (assuming there are no other components).

Thus, at the end of the third year, Rs. 8 lakh shall be fully depreciated and the company will incur dry docking costs as anticipated. Accounting for this is done as shown in Table 7 and Table 8:

Table
7 – Accounting for ship and depreciation thereon (Rs. in lakh)

Particulars

Year 1

Year 2

Year 3

Year 4-15

Total

Cost

4,000,000

Dry Docking

800,000

(Component

Balance

3,200,000

Component

Deprecia-

tion

Compo-

266,667

266,666

800,000

nent A

(800,000/3)

Compo-

213,334

213,333

2,560,0000

3,200,000

nent B

Conclusion:

The principles of accounting for PPE under Ind AS as discussed in this article, vary in a number of aspects vis-à-vis Indian GAAP. The application of these principles shall require training and educating the employees as well as aligning reporting systems and internal controls to enable the entity to report their property, plant and equipment amounts appropriately and accurately.

shailesh.kwebmaker

Has Indian GAAP Outlived its Utility?

With no sight of International Financial Reporting Standards (IFRS) being implemented in India, we are back to looking at whether Indian GAAP fulfills investors and other stakeholder expectations of providing reliable financial information.

Bad standards result in bad accounting
Consider an arrangement where there is an agreement between two parties to jointly share control. The board of directors has equal representation of directors from both parties. Both parties own 50% shares each. Under Indian GAAP, joint control would result in proportionate consolidation. However, it is possible for both parties to achieve full consolidation. One party can do this by adding one more director on the board as its nominee, and the other party can do this by buying one additional share, but with no change in the joint sharing of the control. Therefore, though the arrangement effectively is unchanged; a small structuring can provide a vastly different accounting result.

Bad standards also prevent good accounting
A company takes a US$ loan from a bank which is to be repaid in thirty six equal installments in the next three years. The company does not stand exposed to exchange rate volatility, as the loan installments will be paid out of highly probable and matching future $ revenues. Typically, the hedging standard would allow the company to use hedge accounting for natural hedges and thereby avoid volatility in the income statement because of exchange rate swings. Unfortunately, under Indian GAAP, hedge accounting is not permitted when they contradict a standard that is notified under the Companies Act. Under Indian GAAP, such exchange gains and losses are recognised in the income statement creating an unnecessary volatility in the income statement, though the company has a 100% natural hedge.

Too many cooks spoil the broth
Consider this – a listed parent entity grants stock option to the employees of its subsidiary. Accounting for stock options is covered under both SEBI’s Guidelines and ICAI’s Guidance Note. ICAI’s guidance note requires the subsidiary company to recognise the expense on share based options irrespective of whether the subsidiary has any settlement obligation towards the parent. As per SEBI Guidelines applicable to listed entities, the parent records the compensation cost. These conflicting requirements create confusion and provide arbitrage to entities, and results in inconsistent application of the principles.

A duck will quack even if you call it a cat
Yes, a duck is a duck. Consider this. Many loans with a defined term and a guaranteed interest rate are structured as preference capital issued under the Companies Act, so that they are classified as share capital under the Indian GAAP. This vitiates the true debt equity ratio of the company. Further, the interest payments are treated as dividends to be appropriated from the P&L account rather than a charge to the P&L account. This is possible because Indian GAAP takes a view that when preparing financial statements, the Companies Act requirements will override accounting requirement of ‘substance over form’. The author believes that accounting should reflect the substance of a transaction. This should not be seen as overriding the legislation, which has been drafted for a different purpose and objective.

Remember the world is changing rapidly
Though the world has changed and is changing rapidly, Indian GAAP remains in the medieval ages. Consider this. Though financial instruments are rampant, the accounting standards relating to financial instruments are not yet notified under the Companies Act. As a result, there has been a lot of confusion, inconsistency and misuse of accounting principles. Under Indian GAAP, a company can structure a loan received from a bank on the pledge of the shares of its subsidiary as a sale of shares, with a right to buy back the same in the future at an agreed price. Typically, this is a financing transaction, but under Indian GAAP one could recognise the sale of the investment and recognise the buy back of the investment in the future. This practice could lead to recognising profit on sale of the investments, not recognising the loan and the corresponding interest expense on the books and obtaining deconsolidation and consolidation at convenience.

Fitting a square peg in a round hole
Financial statements have many uses, but the real objective of any general purpose framework is to provide investors and capital providers with information that is useful for taking decisions. An investor in an investment property company wants to know the fair value of the investment property portfolio, for decision making. The tax authorities are not concerned with the fair values, as they would typically tax rentals or realised capital gains. Standard setters should draft standards for capital providers. Drafting standards that will meet requirements of both capital providers and tax authorities, is like fitting a square peg in a round hole.

There are many travesties under Indian GAAP. The role of robust accounting standards should not be underestimated, in creating a climate of trust for investment. Only when nations create trust, they can raise capital locally and globally. It’s key to providing energy, food, water, education, employment, health and alleviating poverty. Having a variety of accounting standards across the world creates confusion, encourages errors and facilitates frauds. Having a single set of high standards, like IFRS, creates clarity, enhances confidence in financial statements and results in reduced costs of capital.

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Convergence to Ind AS 16 – Property, Plant & Equipment

Introduction

India has principally agreed to converge to IFRS by implementing Revised Schedule VI, being the first constructive step in the journey. Let us appreciate the requirements of accounting for fixed assets, in specific under Ind AS (ie IFRS), in the light of the existing governing principles under Indian GAAP.

Ind AS 16, corresponding to International Accounting Standard (IAS), 16 governs the accounting, measurement and reporting for fixed assets. This means that it also governs the accounting for depreciation. Presently, two standards namely, AS 6 – Depreciation Accounting and AS 10 – Accounting for Fixed Assets govern the subject.

Following are the major points of differences between the two GAAPs that have wider industry impact:

a. Component approach for accounting of fixed assets

b. Depreciation provision

c. Revaluation of fixed assets

This article brings out the major differentiating characteristics under Indian GAAP including relevant governing provisions under the Statute and Ind AS, for accounting of fixed assets on above points. We later discuss the industry impact analysis and way forward.

Existing Governing Literature in India on Fixed Assets

AS 10 – Accounting for Fixed Assets

This standard governs the treatment of capital expenditure related to acquisition and construction of fixed assets. It introduces broad categories of assets as observed in many entities. These include land, buildings, plant and machinery, vehicles, furniture and fittings, goodwill, patents, trademarks and designs. The standard requires management to apply judgment to use the aggregation rule for individually insignificant items.

It encourages an improved accounting for an item of fixed asset, where the total expenditure thereon is allocated to its component parts, provided they are in practice separable, and estimate is made of the useful lives of these components. For example, rather than treat an aircraft and its engines as one unit, it may be better to treat the engines as a separate unit if it is likely that their useful life is shorter than that of the aircraft as a whole.

However, the entry in fixed asset register is made at a class of asset. For example, aircraft is capitalised as a single asset. This is because Schedule XIV prescribes a common rate for aeroplanes, aero engines, simulators, visual system and quick engine change equipment at 16.2% (WDV) and 5.6% (SLM). In such a case, often, if the engine is replaced before it is fully depreciated, the balance WDV is charged off to Profit and Loss Account and the new engine is capitalised for being depreciated till the maximum life of its parent asset. This approach may lead to deferment of charge till the year of replacement. Indian Companies Act, 1956 Schedule XIV plays a critical role in accounting for fixed assets under Indian GAAP, in recording of assets and depreciating it over its useful life.

Recording of assets: There are about 20 different rates of depreciation under Schedule XIV under single shift usage, which drive the allocation of cost of assets. The broad categories or class of assets include Land, Building, Plant & Machinery, Furniture & Fitting and Ships. Plant & Machinery is further subdivided into various sub-asset classes considering business specific allocations.

Consider ‘mines and quarries’ being one of the groups under ‘Plant & Machinery’ that attracts 13.91% rate of depreciation. It includes Surface and underground machinery, Head gears, Shafts, Tramways, etc. and all being depreciated at the same rate. In practical terms, all of them may have a different useful life. Companies (Auditor’s Report) Order (2003) (CARO) requires every company to maintain proper records showing full particulars, including quantitative details and situation of fixed assets under para 4.1(a). Companies maintain minimum quantitative records for fixed assets that can be physically verified on an overall basis, in order to comply with CARO.

Depreciation: Section 205(2) of the Companies Act, 1956 (Act) provides that a company can declare or pay dividend only out of its profits. The profits for this purpose are to be arrived at after providing for depreciation as per section 350. If dividend is to be declared out of the profits of any earlier year or years, it is necessary that such profits should be arrived at after providing for depreciation for the respective years.

Section 350 of the Act requires a company to provide depreciation at the rates specified in Schedule XIV of the Act for arriving at net profit of the company for the purposes of section 205(2) and section 349 of the Act. There is no direct reference to useful life in the Act, but has indirect reference to it by prescribing depreciation rates for all types of assets for depreciation under the said Schedule. The rates prescribed under Schedule XIV are minimum rates (Circular No. 2/89, dated March 7, 1989 issued by Department of Company affairs).These are applicable for all the companies.

Thus, entities cannot depreciate the assets at a lower rate even if the technically established useful life of the asset is more than that derived from the rates specified under Schedule XIV, if they are governed by Companies Act. (In case of electricity companies, it is the Electricity Act that governs the minimum depreciation rates). There is also no provision of revisiting the rates at every year end.

AS 6 Depreciation Accounting

Para 5 of AS 6 requires assessment of depreciation based on historical or substituted historical cost, estimated useful life and residual value. U/s. 350 read with Circular. No. 2/89 as mentioned above, companies cannot estimate a useful life longer than that prescribed under Schedule XIV.

Companies exercise their judgement of useful life in the light of technical, commercial, accounting and legal requirements. It may periodically review the estimate and if it is considered that the original estimate of useful life of an asset requires any revision, the unamortised depreciable amount of the asset is charged to revenue over the revised remaining useful life.

Companies can use a shorter useful life based on parameters stated above and disclose the fact by way of a note. However, there is no requirement to review residual value at periodic intervals. AS 6 prescribes two methods of depreciation, namely, Straight line method (SLM) and Written down value method (WDV). The method of depreciation is applied consistently to provide comparability of the results of the operations of the enterprise from period to period. A change from one method of providing depreciation to another is considered as a change in policy and is made only if the adoption of the new method is required by statute or for compliance with an accounting standard or for more appropriate presentation of financial statements. Change in accounting policy requires retrospective recomputation of depreciation as per the new policy i.e. new method of depreciation and adjustment in the accounts in the year of such change. Thus, the depreciation charge in subsequent years is not impacted with the change adjustment.

Ind AS 16: Property, plant and equipment (i.e. IAS 16)

Ind AS brings in a more stringent requirement to maintain component details of fixed assets, in terms of its Component Approach. Hence, it may increase the line items in fixed asset register and work of physical verification for each identifiable component.

The Standard does not prescribe the unit of measure for recognition. However, judgement is required in applying the recognition criteria to an entity’s specific circumstances. It may be appropriate to aggregate individually insignificant items, such as moulds, tools and dies, and to apply the criteria to the aggregate value. We will discuss the component approach is a separate section below.

Under AS 16, major overhauling expenses are capitalised with the asset line item and are depreciated till the next scheduled maintenance date unlike AS 10 that requires such costs to be expensed as incurred, unless it increases the future benefits from the existing asset beyond its previously assessed standard of performance and is included in the gross book value.

Elements of cost also include an initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period. The value of such provisions is done based on discounted cash flow approach and depreciated over the useful life of the asset. Any change in estimate on account of principal amount would get adjusted in the cost of asset and any change on account of discount rate would be accounted in finance cost.

The major driving factor for component approach comes from the requirement to depreciate the asset over its own useful life. Though the useful life approach exists under Indian GAAP, the Companies Act has been considered more prominent since it forms part of the Statute.

As a convergence step towards IFRS, Revised Schedule VI has been helpful in addressing the conflict between erstwhile hierarchy of application between Schedule VI and Accounting Standards, by giving an upper hand to Accounting Stan-dards. Ministry of Corporate Affairs (MCA) has so far notified Ind ASs, for which implementation date is still to be notified. One may look forward for similar clarification or convergence of Schedule XIV and/or of section 350 of the Act, with Ind AS 16 useful life approach, so that entities can in true spirit converge to Ind AS 16.

It is practically observed that steel plants of SAIL and Tata Steel are more than 30 to 40 years old. These plants require a regular maintenance and can continue longer. Similarly, many refineries in Europe and US are more than 30 years old as against the derived depreciation rates under Schedule XIV that work out to 18-20 years on SLM basis.

As a point of reference, British Petroleum Plc depreciates its refinery and petroleum assets over a period of upto 30 years. Corus Plc depreciates its steel making facilities upto 25 years under IFRS and Arcelor Mittal Plc has attributed upto 30 years of useful life for its plant & machinery. Both of them have a life more than what is prescribed under the Indian GAAP.

As a reverse impact, items where the useful life under Schedule XIV is likely to be more that its actual useable life, may include electrical machinery, X-ray and electrothera-peutic apparatus and its accessories, medical, diagnostic equipments, namely, cat-scan, ultrasound machines, ECG moni-tors, etc. that have 20% rate under WDV method and 7.07% under SLM for depreciation. This works out to around 13 years keeping 5% residual value. The actual life of these electronic equipments could be less considering the technology advances and consequential obsolescence.

Assuming Ind AS 16 will get an upper hand in terms of accounting of Fixed assets, it may be expected that the entities could benefit from lower provision for depreciation based on more realistic estimate of useful life of the assets such as power plants, refineries, smelters, etc.

Another point of difference comes from para 51 and para 61 of Ind AS 16, which provide that the residual value, useful life of an asset as well as the depreciation method shall be reviewed at least at each financial year-end. Such changes are to be accounted for as a change in an accounting estimate in accordance with Ind AS 8 Accounting Policies, Changes in Accounting Estimates and Errors. Ind AS 8 requires such changes in estimates to be accounted prospectively.

Point to note that change in method and rates of depreciation are a change in estimate with prospective application under Ind AS 16 whereas, under AS 6 it is a change in policy that needs retrospective application.

Ind AS 16 is self contained, in the sense that it also prescribes the depreciation guidelines on fixed assets unlike the current environment where it is governed by AS 10, AS 6, Schedule XIV and Guidance notes. One may note that, exposure draft of AS 10 (Revised) issued by ICAI before notifying Ind ASs, was also in line with Ind AS 16, and included component approach and provided for calculating depreciation based on estimated useful life.

Component approach

Is component approach of assets required?

Yes, when it is significant. Ind AS 16 does not prescribe a unit measure. However, it requires that each part of an item of property, plant and equipment which has a probability of future economic benefits associated with the item will flow to the entity and the cost of the item can be measured reliably and is significant in relation to the cost of the item shall be depreciated separately. Implicitly, component approach is required under para 43 of Ind AS 16 which requires each significant part of the total asset to be depreciated separately.

How to determine components?

The determination of whether an item is significant requires a careful assessment of the facts and circumstances.

These assessments would include, at a minimum:

i. comparison of the cost allocated to the component to the total cost of the property, plant and equipment; and

ii. effect on depreciation expense between component approach and clubbing approach.

Following factors may broadly assist in arriving at component identification:

Shut down or major repairs and maintenance.

Shutdown costs are made of replacement of an item and labour cost. Thus, items that require replacement on a regular basis can be identified as separate components. For example, a furnace may require relining after a specified number of hours of use, or aircraft interiors such as seats and galleys may require replacement several times during the life of the airframe.

Useful life estimates of major components at the acquisition date. Example; it may be appropriate to depreciate separately the airframe and engines of an aircraft.

Technical knowhow and obsolescence may be considered in case of information technology (IT) and electronic equipment. With respect to IT, hardware has a different useful life as compared to software.

Revaluation model

Under Ind AS 16, there are two models of accounting fixed assets, namely ‘Historical Cost’ model and ‘Revaluation’ model.

Under AS 10, revaluation of fixed assets is considered as substitution for historical costs and depreciation is calculated accordingly. However, under Ind AS, it is a separate model of accounting. Once an entity chooses ‘Revaluation model’, it will be considered as its accounting policy to an entire class of property, plant and equipment. Revaluation is required to be made with sufficient regularity to ensure that the carrying amount does not differ materially from that which would be determined using fair value at the balance sheet date.

The base fundamental of Ind AS 16 and AS 10 remain the same, i.e. revaluation does not affect the Income Statement, and valuation difference is recognised in reserves, unless the revaluation adjustment decreases the value of asset below its original cost. In such a situation, it would result in a change in profit and loss account which is indirectly an impairment of asset.

However, there is a difference in amortisation impact when it comes to Ind AS 16. The depreciation is calculated on the fair value of the asset and is amortised over the useful life by debiting profit & loss account without taking any credit from the revaluation reserve. It is pertinent to note that, under the present Indian GAAP, the entities plough back the reserves in income statement to the extent of additional depreciation and balance if any, at the time of disposal in line with paragraph 11 of the Guidance note as stated below; and thus the debit in profit & loss account is reduced to that extent.

“The Revaluation Reserve is not available for payment of dividends. This view is also supported by the Companies (Declaration of Dividend out of Reserves) Rules, 1975. Similarly, accumulated losses or arrears of depreciation should not be set off against Revaluation Reserve. However, the revaluation reserve can be utilised for adjustment of the additional depreciation on the increased amount due to revaluation from year to year or on the retirement of the relevant fixed assets.”(Paragraph 11 from Guidance note on treatment of reserve created on revaluation of fixed assets, issued 1982)

This guidance note will not be applicable once Ind AS is implemented and thus the depreciation charge will increase for the entities that follow Revaluation approach. Additionally, the existing unutilised reserve will get transferred directly to retained earnings instead of being routed through the profit and loss account.

Note: Under Ind AS 12, deferred tax is calculated on all temporary differences. The revaluation adjustment will be considered as a temporary difference and hence the amount that will flow to equity will be net of deferred tax.

Industry Impact Analysis – Ind AS 16 Property Plant & Equipment:

Industry will be impacted due to Component Approach in Ind AS 16. Since the Schedule XIV rates are not split into various parts of heavy duty machinery, companies will have to go through a detailed exercise of breaking down its fixed asset line item into various components and assess each item’s independent useful life.

Mining and Construction

Assets in Mining and Construction industry include heavy duty trucks, vehicles, dozers, excavators, loaders & unloaders, tunnelling machinery, etc. These heavy duty machineries are made up of various assembled parts which are high in value and also have a different useful life as compared to the other parts such as chassis, rollers, body, electrical systems, etc. These items will have to be broken in to their components.

Entities will also have to estimate mine restoration liabilities and capitalise with the initial cost of the mine.

Excerpts from Mining major, Xstrata Plc’s Annual Report 2011:

“Where parts of an asset have different useful lives, depreciation is calculated on each separate part. Each asset or part’s estimated useful life has due regard to both its own physical life limitations and the present assessment of economically recoverable reserves of the mine property at which the item is located, and to possible future variations in those assessments. Plant & equipment have useful lives from 4-30 years.”

“Provision is made for close down, restoration and environmental rehabilitation costs.. ….At the time of establishing the provision, a corresponding asset is capitalised, where it gives rise to a future benefit, and depreciated over future production from the operations to which it relates”.

Commodity manufacturing Industry – Crude, Ore, Power

These industries include oil and ore refineries, smelters that are used to melt the ore, and power plants among others. These plants carry huge investments with complex designs and take years to build. They are made of various facilities that can be identified as first level components such as Water treatment, Gas tapping, Conveyors, Turbines, Rooters, Shafts, Grids, Tankages, Ovens, Casters, Moulds, Furnaces, Rolling mills, etc.. More often one component that is left out in the analysis is the Pipelines, which have material value and dif-ferent useful life.

Second level components will need a detailed analysis of each identified first level component with their individually assessed useful lives. Each unit will need separate line items for identification.

Entities will need to estimate its asset retirement obligations at the time of initial capitalisation.

A Nuclear Power Plant will have to estimate its related decommissioning liabilities and capitalise with power plants.

Another impact will be on account of capital repairs that are incurred during shut down, cell realignment, etc. This will be capitalised under fixed assets and amortised till the next overhauling date.

By virtue of assessment of useful life, entities get a chance to increase the useful life for depreciating the assets to its true useful lives.

Shipping

Main parts of a ship include hull and engine. Further, hull is made up of deck, chassis, propeller, funnel, stern and super structure. A modern ship includes a fair component of electronic and automatic control systems. Entities will have to carry out a detailed exercise and use its judgement for capitalising each component.

Dry dock expenses in shipping industry which carried out periodically will need capitalisation and amortisation.

Similar to the commodity industry, entities will get a chance to increase the useful life for depreciating the assets to its true useful lives. International peers such as B+H Ocean Carrier Plc have estimated useful life of 30 years for its vessels from the date of construction and capital improvements are amortised over a period of five years.

Major differences between AS and Ind AS on Accounting of Fixed Assets:

Hotel Industry

A restaurant maintains a minimum stock of silverware and dishes. Some entities treat cutlery, crockery, linen, etc, as stores and spares and group them under inventory. Any increase or decrease is accounted as consumption in profit and loss ac-count. Moreover, Schedule XIV does not lay down any rate for depreciating such items and hence companies in India adopt inventory and consumption approach to account these items.

For a restaurant, cutlery is similar to a plant, without which it cannot operate. Under Ind AS 6, these items fall into the definition of tangible assets and hence need to be capitalised as such and depreciated based on its useful life. Considering the nature of these assets, the estimation of their useful life may involve a significant amount of judgment. The management should consider factors such as physical wear and tear, commercial obsolescence, asset management policy of an entity that may involve replacement of such assets after a specified period, etc for such assessment. John Keels Hotels Plc, depreciates its Cutlery, Crockery, Glassware & Linen in a period of three years, as per its 2010 annual report.

Way forward:

(i) It is advisable to start updating the fixed as-set records in SAP or any other ERP with major component details. This can be done by opening various sub group codes for the master asset.

(ii) Any new capitalisation should be based on component approach assessing specific use-ful life of each component and then applying the aggregate rule.

(iii) Expect changes or clarifications for section 350 or Schedule XIV or both to avoid conflict with depreciation principles under Ind AS 16.

(iv) Assessment of useful life and residual value will have to be done by the management on a regular basis.

(v) Estimate dismantling, decommissioning, restoration liabilities valued at discounted cash flow basis at the beginning and continue to reassess on a regular basis.

(vi) Entities following revaluation approach for accounting fixed assets, will be impacted more, as Ind AS 16 does not allow an entity to plough back the reserve in profit and loss account to match the additional depreciation on revaluation. Ind AS 16 will come with first time exemptions under Ind AS 101 and hence entities may decide an appropriate policy when they adopt Ind AS, for the first time.

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Understanding the business before understanding the audit

Introduction:

One of the objectives of an audit is to identify and assess the risk of material misstatement within the financial statements, together with an assessment of the internal control environment within which an entity operates, to provide a basis for designing and implementing audit procedures to respond to the assessed risks of material misstatement. One of the best ways to identify and assess the risk of material misstatements to the financial statements is through understanding the entity and its environment, which is nothing but having an understanding of the business of the entity which is ultimately to be audited.

Obtaining an understanding of the entity’s business helps to undertake an effective and efficient audit, by tailoring audit procedures to suit the individual facts and circumstances of each client and to undertake the audit procedures and evaluate the audit findings in an informed manner. Knowledge of the entity’s business also helps to develop and maintain a positive professional relationship with the client. Accordingly, business relevance is becoming a key consideration in an audit. In view of the hectic pace at which changes are taking place, auditees have less time and they would prefer to listen to auditors who can demonstrate that they have business knowledge which would make them more credible and relevant. Accordingly, auditing is now a skill which cannot be applied in a business vacuum. Understanding the entity is an iterative and continuous process from the pre-engagement stage to the reporting stage.

The purpose of this article is to identify the professional responsibilities of auditors in dealing with various aspects of the entity’s business environment, which need to be considered by the auditor and evaluating their impact during an audit of the financial statements, duly supplemented by various practical scenarios.

Relevant Auditing Pronouncements:

The following Standards of Auditing (SAs) deal with various aspects of understanding of the entity and its environment during an audit of the financial statements: l SA-315 on Identifying and Assessing the Risks of Material Misstatements Through Understanding the Entity l SA-250 on Consideration of Laws and Regulations in an Audit of Financial Statements l SA-402 on Audit Considerations Relating to an Entity Using a Service Organisation l SA-550 on Related Parties Professional Responsibilities of Auditors: Various professional responsibilities of auditors under each of the above SAs, to the extent they deal with various aspects of understanding of the entity and its environment in an audit of financial statements, are briefly discussed below. SA-315 on Identifying and Assessing the Risks of Material Misstatements Through Understanding the Entity: SA-315 is the primary standard which deals with the various aspects of understanding an entity and its environment, keeping in mind the following two objectives:

Identifying and assessing the risk of material misstatements within the financial statements.
Understanding the Entity and its Internal Control environment.

Risk Assessment Procedures: The auditor should obtain an understanding of the entity’s strategies and related business risks that may result in material misstatement of the financial statements. Business risk is primarily concerned with external factors that could affect the entity, which may result in material misstatement within the financial statements. It arises as a result of significant conditions, events, circumstances or actions that could adversely affect the entity’s ability to achieve its objectives and strategies. Risk assessment can be undertaken by a combination of one or more of the following procedures:

Inquiries with the Management, operating personnel, those charged with governance, legal counsel etc. which could provide an insight into the industry developments, new products and services, extent of IT support, nature and extent of ongoing litigation and claims etc. Based on the results of the inquiries, the auditor is able to assess the impact of the following possible risks, which could have an impact on the financial statements:

1. Nature and extent of management override of controls especially in small and promoter driven entities. In such cases, the auditor should specifically inquire as to whether the transactions are undertaken on an arms length basis.

2. The risk of technological obsolescence of certain products which may necessitate provisioning for items lying in inventory.

3. The controls over the preparation and generation of financial information and reporting.

Analytical review of financial and non-financial information to identify any unusual trends or characteristics which will help in identifying risks of material misstatements, especially in relation to fraud. This will help the auditor in identifying any aspects which he is not aware of. Based on the results of the analytical review, the auditor is able to assess the impact of the following possible risks, which could have an impact on the financial statements.
Observation and inspection to enable gathering of evidence concerning assertions made by the management and others through one or more of the following procedures:

1. Observation of the entity’s activities and operations which would give an insight into the revenue streams, materials used etc.

2. Inspection of various documents like Minutes of meetings, MIS reports, Procedural Manuals etc. which would give an insight into future trends, investments, acquisitions, financial reporting mechanisms etc.

3. Performing walk through tests (i.e observing evidence of controls which are documented in the procedure manuals for a sample of transactions of each type) on various controls which would help identify any procedural inadequacies vis-a-vis the documented controls in the key business cycles like purchasing, revenue, payroll, fixed assets etc. which could result in possible risks and material misstatements.

Discussion amongst the engagement team members especially for recurring engagements. This enables the experienced team members to share their insights and learning with the junior and new staff members. Considering the global diversification of many entities, discussion is an effective way of communicating with the engagement teams located in different countries/jurisdictions.
Understanding the Entity and its Internal Control Environment: The auditor must understand the entity, the environment in which it operates and its internal control structure, so as to enable him to undertake an effective and efficient audit. This involves an understanding of the following aspects:

External factors
Nature of the entity
Internal Controls

External Factors:

There are various external factors as indicated below which the auditor needs to evaluate to ascertain the impact thereof during the course of the audit:

Industry and Economic Developments – These include a consideration of the following aspects:

1. Seasonality or cyclicality of the products or services which would help in applying appropriate analytical procedures.

2. Technological advances or obsolescence of the entity’s products or service offerings, which could have an impact on the demand and also whether any provision for impairment or obsolescence is warranted.

3. Economic conditions like interest rates, exchange rates etc. which could impact the ability to raise and service borrowings.

Specific Operational Issues – A large part of gaining an understanding of an entity and its environment, involves looking at the specific factors attached to the entity. The following are certain specific factors which an auditor should consider, when gaining an understanding of the entity and the environment in which it operates:

1. The entity’s business operations which encompass various matters such as revenue streams, nature of products and services, geographic dispersion, key customers and suppliers, legal and regulatory issues, research and development activities and initiatives etc.

2. Investments and investment activities including any planned or recently executed acquisitions, investments in various securities
and special purpose entities.

3. Financing and financing activities including those pertaining to subsidiaries and associated entities, consolidated and non consolidated structures, debt matters and use of derivatives and hedging instruments and structures.

4. Financial reporting issues such as the use of industry specific accounting policies (e.g. financial services, software, media and entertainment etc.), revenue recognition practices (e.g. fertilisers, telecom etc.), fair value accounting (e.g. investments, brand acquisitions etc.) and other complex transactions which could give rise to “substance over form” issues.

Nature of the Entity:

It is of prime importance for an auditor to gain a thorough understanding of the nature and structure of the entity, its owners and other parties who purport to control the entity in substance. This is particularly important for identification of any related party transactions in accordance with the applicable financial reporting and regulatory framework. In case of complex entities operating in various jurisdictions, this can be a complicated and long winding process.

The understanding of the ownership and control structure is particularly important and relevant for new entities, whose audit is accepted for the first time and must be performed prior to acceptance of the audit as part of the KYC procedures, which the ICAI has recently recommended vide its announcement dated 4th August, 2011. In terms of the said announcement, for all attest engagements, the Council has recommended that certain details be obtained by every member before accepting any attest function. Though the above guidelines are recommendatory, it is in the best interest of the auditor to adhere to them.

Internal Controls:
This is the single most important factor which determines the course of the audit, since it helps to identify factors that affect the risk of material misstatements within the financial statements. An ineffective internal control environment is more likely to give rise to material misstatements. However, a robust internal control environment is not a fool proof guarantee of success but merely an enabler to reduce the risk of material misstatements.

Internal controls represent processes designed and implemented by the management, those charged with the governance and other personnel to provide reasonable assurance about the achievement of the entity’s objectives and to address the business risks identified by the management. The nature and complexity of the internal controls is directly proportional to the size of the entity.

For the purposes of determining which internal controls are relevant to the audit, the following five components as laid down in the COSO framework, are useful to ascertain the different aspects of an entity’s internal controls:

The Control Environment

The Entity’s Risk Assessment Process

The Information System, including Related Busi-ness Processes relevant for Financial Reporting and Communication

Control Activities

Monitoring of Controls

The Control Environment:
An entity’s Control Environment is a crucial aspect. More than any tangible factors, it represents the intangibles which define an entity and its culture, values and ethics which the management and employees imbibe through a code of conduct or other similar means. The quality of the entity’s human resources plays a vital role in ensuring the effectiveness of the control environment. The following are some of the matters which an auditor needs to consider, whilst evaluating the adequacy of the control environment and the degree and extent of reliance which he needs to place thereon to determine the nature, timing and extent of further audit procedures:

Board and Committee Structure – The nature and composition of the Board and its various committees and the degree and extent of their involvement is the single most important factor that determines the effectiveness of the control environment. There is no better substitute than the “tone at the top” which determines the success or failure of the control environment. This can be determined based on a review of the minutes and the information which is furnished to the Board as part of the agenda.

Organisation Structure- A simple structure may work for smaller entities, whereas for larger and more complex entities, it is important to ascertain the authority and responsibility matrix and the lines of reporting.

HR Policies – Human resources play a vital role in the entity’s control environment. This can be evidenced by the selection of appropriately trained individuals for various roles and having appropriate KYC procedures prior to their selection, coupled with appropriate training and continued professional development activities.

Entity’s Risk Assessment Process:
The entity should have risk assessment processes in place to deal with the various business risks relevant to the preparation of the financial statements, which would encompass estimating the level of such risks as well as identifying the likelihood of their occurrence. The following are examples of certain factors which need to be considered by the auditor, to ascertain the impact of changes in circumstances due to which either new risks could arise or the existing risks could change:

Changes in the regulatory and operating environment can result in changes in competitive pressures leading to significantly different risks. A recent example is the power sector, which is impacted by the availability of coal both domestically and internationally.

Significant and rapid expansion of operations can strain controls and increase the risks of breakdowns in internal control.

Information System, including Related Business Processes, Relevant for Financial Reporting and Communication:

In today’s age, most entities deal with reporting and communication of financial issues through the use of IT. It is imperative for an auditor to obtain an understanding of the various general and application controls for various business cycles, to enable him to ensure that all assertions for the generation of financial statements can be tested to enable him to issue an opinion thereon:

Identifying and recording all valid transactions.

Obtaining sufficient details of all transactions on a timely basis to enable proper classification thereof.

Measuring the value of transactions in a manner that permits recording thereof at the proper value.

Determining the time period in which the transactions occurred, to permit the recording thereof in the proper accounting period.

The controls for capturing of data especially the master data is of prime importance, to determine the quality of the system generated reports and information, which not only affects the management’s ability to take appropriate decisions, but also enables preparation of reliable financial reports.

Control Activities:

An auditor must obtain a sufficient understanding of the control activities of the various business cycles, to assess the risk of material misstatement at the assertion level and to design further audit procedures in response to the levels of assessed risks. Control activities encompass a combination of one or more of the following procedures, which the auditor needs to review as deemed appropriate:

Authorisation procedures

Performance reviews

Information processing

Physical controls

Segregation of duties

Monitoring of Controls:
This is an all encompassing activity which covers each of the above components and is primarily performed by the management. It represents the major type of activities that the management uses to monitor internal controls over financial reporting, including those related to control activities relevant to an audit and how corrective actions are initiated. The Audit Committee and Internal Audit are the key facilitators in this process. There are various external and regulatory agencies which also monitor specific aspects of the controls relevant to them like tax authorities, RBI inspectors, factory inspectors etc. One of the most common methods of monitoring controls, is the preparation of the bank reconciliation statement on a monthly or more frequent basis and its regular review and followup.

Other Standards:

The requirements of other SA’s which deal with the audit considerations pertaining to the understanding of the entity and its environment are summarised below:

SA-250 casts a responsibility on the auditor to obtain an understanding of the various laws and regulations impacting the entity which is a key element of the environment in which the entity operates. The SA broadly envisages the following two situations:

1. Laws and regulations which have a direct effect on the financial statements and issuance of audit reports and other certificates in respect of the reporting entity.

2. Laws and regulations which do not have a direct effect on the financial statements of the reporting entity, but compliance with which may have a fundamental effect on the operating aspects of the business, non-compliance with which may result in material penalties being levied by the concerned regulatory authorities.

SA-402 casts a responsibility on the auditor to understand the nature of services provided to a user entity by a service organisation which is defined as a third party organisation or a segment thereof that provides services to user entities that are part of those entities’ information systems relevant to financial reporting since such service organisations are nothing but an extension of the environment in which the entity operates in accordance with the provisions of SA-315. The most common examples of service organisations are payroll processing agencies, registrars and transfer agents, custodians, accounting and tax compliance service entities etc. The following are some of the matters which the auditor needs to consider relating to the service organisation:

1. The nature of services provided.

2. The contractual terms.

3. The extent to which the internal controls of the entity interact with those of the service organisation.

4. Information available on the relevant internal controls of the service organisation.

5. Types of transactions processed.

The aforesaid information can be obtained in either of the following ways:

1. Visiting the service organisation.

2. Obtaining an independent auditors report on the design, implementation and operating effectiveness of the internal controls of the service organisation, commonly referred to a Type 1 and Type 2 reports.

3. Using another auditor to perform procedures to obtain an understanding of relevant controls at the service organisation.

SA-550 casts a responsibility on the auditor to ensure that the management has correctly identified the related party transactions and made sufficient disclosures thereof in the financial statements, which is part of the broader framework of understanding the entity and its environment in terms of SA-315. The following are examples of procedures to identify related parties:

1. Review of the declarations from directors in Form 24AA under the Companies Act, 1956.

2. Review of the minutes of board meetings.

3. Reviewing the audited accounts of known related parties to identify any step-down relationships.

4. Review of bank confirmation for existence of guarantees given to related parties.

Illustrative Scenarios On Understanding Certain Aspects of Business/Environment in which an Entity Operates:

An attempt here is made to give an illustrative understanding in respect of certain aspects of the business/environment in which an entity is operating which could have an impact on financial reporting.

Business Model/Supply Chain:

An understanding of the business model is the primary driver of the revenue streams and cash flows of an entity. It covers the entire supply chain right from the co-ordination with the suppliers for sourcing of raw materials, the production to be undertaken in line with the demand from the customers, the extent of inventory to be maintained, the various stocking points and the distribution chain. It is imperative to gain an appropriate understanding of the business model and assess its utility in the light of the changes in the business dynamics and competitive environment in which the entity is operating. This would help to assess whether the entity would be able to sustain its existence on a going concern basis, which is one of the fundamental assumptions for the preparation of the financial statements. Understanding the business model/ supply chain gives the auditor an insight into the following matters, amongst others:

The extent, level and type of inventory to be maintained and its valuation methodology.

The nature and type of customers and accordingly the extent of provisioning for any non recoveries.

The normal margin and cost structure.

Brand/Intellectual Property:

An understanding of the brands/intellectual properties owned/acquired by the entity is imperative to gain an understanding of the sustainability of the business model of the enterprise vis-a-vis the competition. This would help the auditor to assess the value at which it is to be recognised and whether any impairment needs to be considered.

Insurance Coverage

The nature and extent of the risk coverage is an important indicator of the risk management and risk philosophy of the entity. It also helps to assess the extent of loss, both qualitative and quantitative, in times of damages or other stresses that the business might have to undergo. It is imperative that the auditor is able to assess the adequacy of the nature and extent of insurance coverage, to enable the entity to sustain its existence on a going concern basis.

Properties:

The policy of the entity with regard to the type and nature of properties to be acquired needs to be understood, keeping in mind the business model and the cash flows of the entity. This would consequentially determine special accounting requirements, especially with respect to lease transactions and other similar matters.

Conclusion:

Understanding the business environment during the audit is a continuous activity which an auditor needs to undertake for an effective and efficient audit. To conclude, effective auditing requires not just good technical skills, but also a willingness to venture outside the box to gain a better understanding of the entity.

Reference Material:

Indian Auditing Standards

Wiley’s Interpretation and Application of International Standards on Auditing by Steven Collings

Various Research Reports on Audit Process available for general public.

shailesh.kwebmaker

Debt v. Equity — Case studies

In this article we cover a simple, but an extremely important aspect of classification i.e., debt or equity in the balance sheet. This aspect has significant implication on the financial results, particularly the net worth reported by companies.

A financial instrument is any contract that gives rise to both a financial asset of one entity and a financial liability or equity instrument of another entity. Financial instruments include a broad range of financial assets and liabilities. They include both primary financial instruments (such as cash, receivables, debt and shares in another entity) and derivative financial instruments (e.g., options, forwards, futures, interest rate swaps and currency swaps). An instrument, or its component, is classified on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the respective definition of a financial liability, a financial asset and an equity instrument.

An instrument is classified as a financial liability if it contains a contractual obligation to transfer cash or other financial asset, or if it will or may be settled in a variable number of the entity’s own equity instruments.

An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

Classification as equity or financial liability:

As per the currently effective Accounting Standards in India, there is no specific accounting guidance on classification of an instrument in the books of the issuer as an equity or debt i.e., financial liability. Currently the classification and presentation in the financial statements is based on the legal form of the instrument, rather than its substance. For example, redeemable preference shares are currently presented as a part of ‘share capital’ based on their legal form under the Companies Act, 1956. However, under Ind AS, the emphasis is on the substance of the contract as against the legal form for the purpose of classification of an instrument into debt or equity. It is important to analyse whether the issuer has a contractual obligation to deliver cash or another financial asset to the holder of the instrument. The existence of such an obligation would result in an instrument being classified as a financial liability. On the other hand, instruments that allow the issuer to unconditionally avoid making any payment are considered to be equity instruments.

Example 1:
A company issues a perpetual bond (a bond that contains no maturity date) that pays 5% interest per annum. The definition of financial liability states that an instrument shall be classified as a financial liability if it contains a contractual obligation to deliver cash or other financial asset. Accordingly, this perpetual bond shall be classified as a financial liability as it contains an obligation to pay interest annually.

However in this case, if there was no liability to pay interest, the instrument would have been classified as an equity.

Example 2:
A company issues a share that is redeemable for a fixed amount of cash at the option of the holder. In this case, the entity cannot avoid the settlement of this share through delivery of cash should the holder demand repayment. Accordingly, the share meets the definition of a financial liability.

Preference shares:

Under the currently effective accounting standards, preference shares have been classified as equity based on the requirements of the Companies Act, 1956. However, under Ind AS, the terms under which the preference shares have been issued shall determine the classification — financial liability or equity. Preference shares shall be classified as a financial liability unless all the following conditions are met —

They are not redeemable on a specific date

They are not redeemable at the option of the holder

Dividend payments are discretionary.

Consequently, distributions on such instruments that were previously recognised as dividend expense (including dividend distribution tax) would now be recognised as an interest expense under Ind AS.

Example 3:
A company issues redeemable preference shares, with a mandatory dividend of 8% each year. These preference shares are redeemable at the option of the holder.

As per the term of these preference shares, it contains a mandatory dividend payment of 8% and the principal amount is repayable. The holder of the instrument has the right to redeem the preference shares obliging the issuer to transfer cash or other financial asset. According to the definition of a financial liability, these preference shares shall be classified as a financial liability in the balance sheet of the issuer, although the legal form of the instrument is that of shares.

Example 4:
A company issues non-redeemable preference shares with a dividend payable at the discretion of the issuer.

As per the terms of the preference shares, dividend payments are discretionary and the issuer is not obliged to pay cash. Accordingly, the preference shares shall be classified as equity.

Compound financial instruments:

Instruments that have both — equity as well as liability features are considered compound instruments and are required to be split into their respective equity and liability components. Each component would then be presented separately in the financial statements. Ind AS provides guidance on bifurcation of the instrument into components, the liability being valued first based on the discount rate applicable to a comparable instrument with similar terms/tenure, but without the conversion feature. The residual amount is the value for the equity component. Therefore under Ind AS, instruments such as optionally convertible debentures would be considered a compound instrument for the issuer.

Debt instruments that have equity conversion features are currently presented as borrowings since there is no accounting guidance relating to instruments that have the features of both equity and a financial liability. These instruments are therefore recognised as one instrument, classified on the basis of their legal form. On conversion, the amounts relating to these instruments are then reclassified from borrowings to equity (for the par value) and reserves (for any premium on conversion).

Example 5:
Optionally Convertible Bond: Company A has issued 2,000 6% optionally convertible bonds with a 3-year term and a face value of Rs.1,000 per bond. Each bond is optionally convertible at any time until maturity into 250 equity shares. Assume that cost of debenture issue is zero. Market interest rate for similar instrument but without conversion option is 9%.

Under currently effective accounting standards, a liability will be recognised at Rs.2,000,000.

Accounting under Ind AS 32

Financial liability component will be recognised at present value calculated using a discount rate of 9%

Remaining amount recognised as equity § Unwinding of discount accounted as interest expense.

Present value of financial liability component (principal and interest) recognised using a discount rate of 9%

On conversion of a convertible instrument, which is a compound instrument, the entity derecognises the liability component that is extinguished when the conversion feature is exercised, and recognises the same amount as equity. The original equity component remains as equity, although it may be transferred within equity. No gain or loss is recognised in the profit and loss account.

Example 6: Compulsorily Convertible Bond

If in the previous example, the principal amount of bonds, instead of being optionally convertible, were compulsorily convertible into 2 equity shares each i.e., fixed number of shares will be delivered in exchange for a fixed amount of the bond —

PV of interest payable contractually (Rs.120,000 as per the contractual rate of 6%) every year for 3 years, calculated at the market rate of interest of 9% p.a. will be treated as liability (this comes to Rs.303,755, similar to example 5).

The balance (Rs.2,000,000 minus Rs.303,755, i.e., Rs.1,696,245) will be treated as equity (due to the fixed for fixed criteria).

Example 7: Foreign Currency Convertible Bond

Under Ind AS, a foreign currency convertible instrument that can be settled by issuing a fixed number of equity instruments for an amount that is fixed in any currency is classified as equity. Equity is measured at cost and hence the convertible option will be carried at cost and will not result in any volatility in the profit and loss account.

A company with INR functional currency issues 200 convertible bonds denominated in US Dollars with a face value of USD 1000 per bond. The bond carries a 1% rate of interest and is convertible at the end of 10 years, at the option of the holder, into fully paid equity shares with a par value of INR 1 of the issuer at an initial conversion price of Rs. 47.00 per share with a fixed rate of exchange on conversion of INR 44.24 to USD 1.

The conversion option is an obligation for the issuer to issue a fixed number of shares [(200,000*44.24)/47] in exchange for a financial asset (principal amount of the bond — USD 200,000) that represents a right to receive an amount of cash that is fixed in US Dollar terms but variable in INR terms, depending on the exchange rate prevailing on the date of conversion.

Accordingly, under Ind AS, the convertible option shall be considered as equity as it is convertible for a fixed number of equity shares for an amount that is fixed in US Dollar. The option will be measured at cost and will not result in profit or loss. This instrument hence will be treated as a compound financial instrument, the bond being classified as liability and the conversion option being treated as equity. The accounting will be similar to that in example 6.

Under IFRS, the conversion feature in a foreign currency convertible bond is considered to be an embedded derivative and is classified as a financial liability since the conversion feature involves issuing a fixed number of equity instruments for a variable amount of cash in INR terms. Since the redemption of the bond is denominated in a foreign currency and not in the functional currency of the issuer, the financial liability derivative will be measured at fair value and the gain or loss will be taken to profit or loss account.

Accordingly, under IFRS, the convertible option is considered an embedded derivative and would have been classified as a financial liability as it is convertible for a fixed number of shares for a variable principal amount in INR terms (functional currency) (200,000 * exchange rate on the date of conversion). The convertible option will accordingly be measured at fair value with gains or losses taken to profit or loss.

As is evident, from the aforesaid examples, the impact of reclassification of debt and equity has a significant impact on the financial results. Application of these principles become challenging based on the complexity of financial instruments being issued.

shailesh.kwebmaker

Power Finance Corporation Ltd. (31-3-2011)

Revenue recognition: Income under the head carbon credit, upfront fees, lead manager fees, facility agent fees, security agent fee and service charges, etc. on loans is accounted for in the year in which it is received by the company.

levitra

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Deepak Fertilisers & Petrochemical Corporation Ltd. (31-3-2011)

Revenue recognition:

Sales include product subsidy and claims, if any, for reimbursement of cost escalation receivable from FICC/Ministry of Agriculture/Ministry of Fertilisers.

Grants and subsidies from the Government are recognised when there is reasonable assurance of the receipt thereof on the fulfilment of the applicable conditions.

Revenue in respect of Interest other than on deposits, insurance claims, subsidy and reimbursement of cost escalation claimed from FICC/Ministry of Agriculture/Ministry of Fertilisers beyond the notified Retention Price and Price Concession on fertilisers, pending acceptance of claims by the concerned parties is recognised to the extent the company is reasonably certain of their ultimate realisation.

l Clean Development Mechanism (CDM) benefits known as carbon credit for wind energy units generated and N2O reduction in its nitric acid plant are recognised as revenue on the actual receipts of the applicable credits and estimated at prevailing realisable values.

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Gujarat Fluorochemicals Ltd. (31-3-2011)

Revenue recognition: The company recognises sales when the significant risks and rewards of ownership of the goods have passed to the customers, which is generally at the point of dispatch of goods. Gross sales includes excise duty but are exclusive of sales tax. Revenue from carbon credits is recognised on delivery thereof or sale of rights therein, as the case may be, in terms of the contract with the respective buyer and is net of payment towards cancellation of contracts.

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Navin Fluorine International Ltd. (31-3-2011)

Revenue recognition: Revenue (income) is recognised when no significant uncertainty as to its determination or realisation exists. Turnover includes carbon credits which are recognised on delivery thereof or sale of rights therein as the case may be, in terms of the contracts with the respective buyers.

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Chemplast Sanmar Ltd. (31-3-2011)

Revenue recognition: Montreal Protocol compensation: The company is eligible to receive compensation from Multilateral Fund under the Montreal Protocol for phasing out the production of Chlorofluorocarbons and supply of Carbon Tetra Chloride to non-feedstock sector. The aforesaid compensation is received in periodic instalments, subject to meeting certain conditions stipulated in the Protocol and accordingly the compensation is accounted only after complying with such conditions and ensuring that there is no uncertainty in this regard. Following this practice compensation received during the year alone has been accounted and shown under Other Income.

Income from Certified Emission Reduction (CER): The company is entitled to receive Carbon Credits towards CER from United Nations Framework Convention for Climate Change (UNFCCC). Income from CER is reckoned when the company is entitled to such credits, which occurs

— on incineration of HFC 23 at Mettur
— on production of steam from waste heat recovery boiler at Karaikal.

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Accounting standards – GAPS in GAP

The pre-revised Schedule VI specifically required proposed dividend to be disclosed under the head ‘Provisions.’ The revised Schedule VI requires separate disclosure of the amount of dividends proposed to be distributed to equity and preference shareholders for the period and the related amount per share. It also requires separate disclosure of the arrears of fixed cumulative dividends on preference shares. Thus, under the revised Schedule VI, dividend proposed needs to be disclosed in the notes. Hence, a question that arises is whether this means that proposed dividend is not required to be provided for when applying the revised Schedule VI?

There are two views on this matter.

View 1 View 1 is based on paragraph 8.8.7.7 of the ‘Guidance Note on the Revised Schedule VI to the Companies Act, 1956’ and paragraph 14 of AS-4 (see below). It states that AS-4 ‘Contingencies and Events Occurring After the Balance Sheet Date’ require that dividends stated to be in respect of the period covered by the Financial Statements, which are proposed or declared by the enterprise after the balance sheet date but before approval of the financial statements, should be adjusted. Keeping this in view and the fact that the Accounting Standards override the revised Schedule VI, companies will have to continue to create a provision for dividends in respect of the period covered by the financial statements and disclose the same as a provision in the balance sheet, unless AS-4 is revised.

Thus as per the Guidance Note a provision for proposed dividend is required, though there is no present obligation at the balance sheet to pay dividends. This is because of the specific requirement of paragraph 14 of AS-4.

View 2 The following two paragraphs deal with proposed dividends under AS-4.

8.5 There are events which, although they take place after the balance sheet date, are sometimes reflected in the financial statements because of statutory requirements or because of their special nature. Such items include the amount of dividend proposed or declared by the enterprise after the balance sheet date in respect of the period covered by the financial statements.

14. Dividends stated to be in respect of the period covered by the financial statements, which are proposed or declared by the enterprise after the balance sheet date but before approval of the financial statements, should be adjusted.

The requirement to provide for proposed dividend established in paragraph 14 should be read along with paragraph 8.5. When read together, some argue that the requirement to provide for proposed dividend exists in AS-4 only because of a statutory requirement (pre-revised Schedule VI). Hence, proposed dividends not required to be provided for under revised Schedule VI, should not be provided for even if paragraph 14 of AS-4 is not withdrawn or amended.

Author’s view The author believes that the requirement to provide for proposed dividend is expressly required under paragraph 14 of AS-4 and hence proposed dividend should be provided for. Nonetheless, view 2 has some merits and reflects the intention of the standard-setters. Thus view 2 may be an acceptable view, subject to clarification by the ICAI. In any case, the ICAI should take immediate steps to amend paragraph 14, to state that proposed dividends are not required to be provided for at the balance sheet date. This will also bring us in line with International Financial Reporting Standards.

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IMPACT OF LAWS AND REGULATIONS DURING AN AUDIT OF FINANCIAL STATEMENTS

Introduction:
The objective of an audit is to provide an assurance that the financial statements are prepared in accordance with the Generally Accepted Accounting Principles (GAAP) and that they comply with specific laws, regulations, policies and procedures. Hence an audit of the financial statements is a combination of both financial and compliance audit. In this context, auditing is a systematic process of adequately obtaining and evaluating evidence regarding assertions about economic actions to ascertain the linkage between these assertions and the established criteria and communicating the results to intended users of the financial statements. Hence, in all cases, the economic actions and financial results of an entity and the reporting responsibilities are determined to a significant extent by the applicable legal and regulatory framework.

The purpose of this article is to identify the professional responsibilities of the auditors in dealing with the legal and regulatory framework, various components of the legal and regulatory framework which need to be considered by the auditors and evaluating their impact during an audit of the financial statements, duly supplemented by certain practical scenarios.

Relevant auditing pronouncements:

The following Standards of Auditing (SAs) deal with the impact of and considerations of laws and regulations in an audit of the financial statements:

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

SA-260 on Communication to those charged with Governance ?

SA-265 on Communicating Deficiencies in Internal Control

SA-315 on Identifying and Assessing the Risks of Material Misstatements Through Understanding the Entity.

Professional responsibilities of auditors: The various professional responsibilities of auditors under each of the above SAs to the extent they deal with the impact of and consideration of laws and regulations in an audit of the financial statements are briefly discussed below.

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

SA-250 is the primary Auditing Standard which deals with the auditor’s responsibilities to consider laws and responsibilities which are relevant to an entity in an audit of its financial statements. It envisages the following two situations:

Laws and regulations which have a direct effect on the financial statements and issuance of audit reports and other certificates in respect of the reporting entity.

Laws and regulations which have an indirect effect on the financial statements of the reporting entity, but compliance with which may have a fundamental effect on the operating aspects of a business, non-compliance with which may result in material penalties being levied by the concerned regulatory authorities.

Accordingly, the laws and regulations which are most likely to materially affect the financial statements and with which an auditor is primarily concerned can be broadly categorised as under:

Form and content of the financial statements, including amounts to be reflected and disclosures to be made. These include the following:

(1) Specific format of the financial statements and the related disclosure requirements under Schedule VI to the Companies Act, 1956 (‘the Act’) and other disclosure requirements under the Act, such as transfer to Capital Redemption Reserve on buy-back of shares u/s.77A of the Act, amounts contributed to any political party or for any political purpose u/s.293A of the Act, amounts contributed to the National Defence Fund u/s.293B of the Act.

(2) Reporting requirements under the Companies (Auditor’s Report) Order, 1988 (CARO).

(3) Specific format of the financial statements and related disclosure requirements under the Third Schedule to the Banking Regulation Act, 1949 for banking companies and disclosures in the financial statements in terms of various Circulars issued by the Reserve Bank of India (RBI) from time to time.

(4) Issue of Long Form Audit Report in the case of banks.

(5) Certificate for Capital Adequacy, net worth, etc. in case of certain entities like banks, stockbrokers, etc.

(6) Specific format of the financial statements and the related disclosure requirements issued by the Insurance Regulatory and Development Authority (IRDA) for insurance companies and disclosures in the financial statements in terms of the various Circulars issued by the IRDA from time to time.

(7) Specific format of the financial statements and the related disclosure requirements issued by the Securities and Exchange Board of India (SEBI) for mutual funds and disclosures in the financial statements in terms of the various Circulars issued by SEBI from time to time.

(8) Disclosures under Clause 32 of the Listing Agreement mandated by SEBI.

(9) Disclosures under the Micro Small and Medium Enterprises Act, 2006.

Conducting the business of the entity including licensing, registration and health and safety requirements for entities like banks, NBFCs, mutual funds, pharmaceutical companies, hotels, etc., non-compliance of which could lead to Going Concern issues as well as financial consequences like penalties, fines, etc.

Operating aspects of the business like provisioning for banks and NBFCs, valuation of investments for banks and mutual funds, contributions to employee retirement benefit funds, taxation issues, etc. which could have a direct impact on the financial statements.

Responsibilities of management and those charged with governance:

SA-250 also clearly articulates that the primary responsibility for ensuring that an entity complies with laws and regulations rests with the management and those charged with governance.

The responsibilities of the management and those charged with governance in this regard can cover the following broad aspects:

Laying down appropriate operating procedures and systems, including internal controls in general for all business areas and operating cycles and specifically with regard to the various legal and regulatory aspects like capturing the data for provisioning requirements for banks and NBFCs, calculating various taxes and other statutory dues, valuation of investments, determination of subsidies for fertiliser companies, etc.

Developing an appropriate code of conduct for employees and other stakeholders for dealing with various aspects like insider trading, conflict of interest, etc.

Maintaining a log/register of the various laws and regulations applicable together with a compliance check-list for the same and laying down systems and procedures for monitoring and reporting compliance therewith with the ultimate objective of periodically preparing a Compliance Certificate for submission to the Board of Directors or other equivalent authority.

Establishing a legal department depending upon the complexity, size and nature of business of the entity and hiring/availing the services of legal advisors and consultants.

Ensuring that various statutory committees as required in terms of various statutes and regulations have been duly constituted with the appropriate constitution and terms of reference e.g., audit committee, asset-liability management committee, investment committee, risk management committee, etc. In this case, care should be taken to ensure that the conflicting requirements under different statutes/regulations are appropriately married e.g., the requirements for constitution of an audit committee for a listed NBFC would have to comply with the requirements of section 292A of the Act, Clause 49 of the Listing Agreement and the RBI guidelines. In this case, since the requirements under Clause 49 of the Listing Agreement are more stringent, especially with regard to the composition of and the matters to be disclosed to/discussed at the Audit Committee, the same should be adhered to.

Responsibilities of auditors:

SA-250 recognises that it is not the primary responsibility of the auditor to detect non-compliance with laws and regulations since these are matters for the courts to decide. SA-250 requires the auditor to gather sufficient appropriate evidence to obtain reasonable assurance that the entity is complying with the laws and regulations applicable to it. For this purpose, he should perform the following audit procedures to help identify any acts of non-compliance with the relevant laws and regulations:

Making inquiries of the management and those charged with governance to identify whether the entity is complying with the laws and regulations.

Inspecting correspondence with the relevant licensing and regulatory authorities.

These procedures can be performed both at the planning and the execution stage.

The procedures which could be performed at the planning stage are outlined below:

Obtaining a general understanding of the applicable legal and regulatory framework, including identification of those laws and regulations which would have a fundamental effect on the operations or the entity or affect its going concern status. For this purpose, the auditor should use his knowledge of the business and industry in which the entity is operating.

Reading of the minutes of various meetings.

Making inquiries with the management and those charged with governance regarding policies and procedures for compliance with the applicable legal and regulatory framework keeping in mind the matters discussed earlier as well as identifying, evaluating, disclosing and accounting for litigations and claims in terms of the applicable financial re-porting framework.

Identifying whether any specific reporting is required under certain laws and regulations e.g., PF, ESIC, income-tax, etc. under CARO, compliance with various RBI/SEBI requirements, etc.

The procedures which could be performed at the execution stage are outlined below:

Following up on the inquiries made with the management and those charged with governance during the planning stage.

Inspecting correspondence with and inspection reports of the relevant regulatory authorities.

Reviewing the nature of payments made to various legal consultants to identify any hidden claims and possible non-compliances.

Performing appropriate control and substantive procedures to take care of any business/industry-specific requirements like provisioning, valuation, accrual of employee and retirement benefit expenses, duties, subsidies, incentives, etc.

Based on the above procedures, the following are certain types of non-compliances the auditor could encounter, the impact of which would need to be dealt with in terms of the relevant legal, regulatory and financial reporting framework:

Non-payment or delayed payment of statutory dues necessitating reporting under CARO.

Non-compliance with certain statutory and procedural requirements under various laws and regulations in respect of specific types of transactions e.g., non-compliance with the provisions of section 372A of the Act, in respect of loans and investments, granting of loans by banks to directors in violation of the provisions of the Banking Regulation Act, 1949, inadequate provisioning for advances under the RBI guidelines, incorrect computation of royalty payable to the government in respect of mining and oil exploration activities, etc.

Non-compliance with the relevant licensing/regulatory requirements or transactions which are ultra vires.

Payments/transactions undertaken in violation of exchange control guidelines.

The above and any other possible non-compliances would need to be carefully evaluated by the auditor to understand the nature and circumstances thereof and obtain sufficient other information to evaluate its impact on the financial statements as under:

Whether there would be any financial consequences in the form of fines, penalties, damages, etc.?

Whether the entity would be embroiled in litigation and the consequential disclosure towards contingent liabilities, if any?

Whether the entity would be forced to discontinue operations and whether there are any going concern issues?

Whether the financial consequences are serious enough to impact the true and fair view?

The auditor should discuss the above aspects with the management and those charged with governance and where he is not satisfied with the outcome, he may seek independent legal advice.

Other Standards:

The requirements of other SAs which deal with the audit considerations pertaining to the implications arising from the impact of laws and regulations are summarised below:

SA-260 which deals with the auditor’s responsibility to communicate audit-related matters to those charged with governance recognises the fact that in certain situations there are obligations imposed by statutory and legal requirements to communicate certain matters to those charged with governance. This would include certain matters which are mandatorily required to be communicated to/discussed by the Audit Committee in terms of section 292A of the Act and Clause 49 of the Listing Agreement with the Stock Exchanges, mandatory communication to the Chief Executive Officers of banks and NBFCs, as mandated by the RBI, of any serious irregularities and frauds which are noted during the course of the audit.

Similarly, SA-265 which deals with the auditor’s responsibility to communicate deficiencies in internal control recognises the fact that in certain situations there are obligations imposed by legal and regulatory requirements to communicate deficiencies in internal control to regulatory authorities. Examples thereof include the direct communication to the RBI of any non-compliance with the RBI guidelines in respect of NBFCs and reporting any serious irregularities and frauds in respect of banks directly to the RBI.

SA-315 which requires the auditor to obtain an understanding of the entity and its environment includes an understanding of the entity’s legal and regulatory framework and how the entity is complying with that framework.

Components/Elements of the legal and regulatory framework:

The various components/elements of the legal and regulatory framework which need to be considered by the auditor can be broadly classified as follows:

Principal acts and legislations which regulate the financial reporting and operating aspects of the entity.

Regulations, notifications and guidelines issued pursuant to the above.

Sector/industry specific policies notified by the government or other regulators.

Legal and judicial pronouncements issued by the Supreme Court, High Courts and other judicial authorities.

Each of these elements is briefly discussed hereunder:

Principal Acts and legislations:

It is imperative that the auditor identifies the principal Acts and legislations governing the entity which deal with the incorporation of the entity as well as lay down its financial reporting, taxation, tariff fixation and operating framework amongst others. The primary legislation which deals with the incorporation of most entities is the Companies Act, 1956 which lays down the financial reporting framework as well as other operating requirements for certain types of transactions like borrowings, investments, advances, managerial remuneration and donations, compliance with which is essential or else the transactions could be illegal or ultra vires thereby exposing the entity to penalties, fines or other forms of prosecution. There are other legislations which lay down the registration/licensing requirements for certain specific types of entities like banks, insurance companies, broking companies, etc. The continued compliance with the minimum capitalisation and other requirements for licensing and registration of such entities is of utmost importance and any failure to comply with the same could lead to penalties and fines as well as going-concern issues.

Apart from the above, there are various legislations which deal with various operating aspects of the business like cess and levies, taxation, labour and employment, environmental protection, health and safety, etc. which need to be continuously monitored and assessed since any failure to adhere to the same could either result in material misstatements (in the form of non-accrual or under accrual of cess, duties, taxes or employee/retirement benefits, environmental remediation and legal costs) or expose the entity to potential litigation and penalties/ fines which could be sizeable and also impact the going concern assumption.

With the ever increasing globalisation, many entities are setting up branches and subsidiaries/joint ventures abroad, thereby exposing them to international laws and regulations. A case in point is the UK Bribery Act, 2010 which applies to all entities which are registered in the UK or who have some connection with entities registered in the UK. Accordingly, if an entity in India is a holding company, subsidiary or associate of an entity which is registered in the UK, it would have to comply with the provisions laid down therein.

Regulations, Notifications, Guidelines and Circulars:

In many cases, the principal Acts governing the entity provide enabling powers to various statutory authorities to issue regulations, Notifications, Guidelines and Circulars which would lay down the financial reporting, taxation, tariff fixation, licensing, registration and operating framework amongst others for an entity. Examples of such statutory authorities include RBI, SEBI, IRDA, Central Electricity Regulatory Authority, Telecom Regulatory Authority. As is the case with the principal Acts and legislations, it is imperative that the auditor identifies these so as to determine their impact on the financial statements and reporting requirements.

Sector/Industry-specific policies:
The auditor should also keep in mind any sector/ industry-specific requirements since any deviations from the same could result in the entity not being able to undertake its activities and also expose it to litigation. Examples include the Tourism Policy, Exchange Control Policy, Telecom Policy, Oil exploration and Licensing Policy, Foreign Direct Investment policy.

Legal and judicial pronouncements:
Whilst the Legislature may frame various laws and the statutory authorities may issue various guidelines, notifications, etc., it is the judiciary which ultimately interprets certain contentious issues. Accordingly, it is imperative that the auditor is aware of the various judicial pronouncements which could have an impact on the financial condi-tions and operating results of an entity. These mainly include judicial pronouncements relating to tax matters and other statutory payments. However, in certain situations, the impact of certain judicial pronouncements can even lead to the discontinuance of the business or going concern issues like the recent order by the Supreme Court in the matter pertaining to the allocation of telecom licences.

Some of the recent judicial pronouncements which could have implications on the financial and operating aspects of certain entities are as follows:

Recently, the High Courts of Judicature at Madras and Madhya Pradesh had passed an order dealing with the issue of whether various employee allowances paid by employers would get covered within the definition of ‘Basic Wages’ under the Employees’ Provident Fund and Miscellaneous Provisions Act, 1952 (the Provident Fund Act). Pursuant to the same, the Employees Provident Fund Organisation has issued a clarification to various Officers/Commissioners asking them to take note of these judgments and utilise the same as per merits of the case as and when similar situation arises in the field offices. In both the above judgments, it has been held that allowances like conveyance/transportation/special allowance/education/food concession/medical/city compensatory, etc. are to be treated as part of ‘Basic Wages’ under the Provident Fund Act for the purpose of determination of the Provident Fund (PF) liabilities if the same are being uniformly, necessarily and ordinarily paid to all employees. This could result in additional liabilities, if any demands are raised by the authorities.

The recent judgment of the Supreme Court banning mining activities in the State of Karnataka could have an impact on the operations of the affected entities.

Practical scenarios:

Before concluding, let us briefly evaluate the impact which the following recent changes in regulations will have on the financial and reporting aspects of a significant number of entities so as to gain a better perspective.

Service tax and Cenvat credit:

With effect from 1st July, 2011 service tax is payable on accrual basis based on ‘Point of Taxation Rules’ (POTR) as compared to receipt basis for most of the taxable services. This would have an impact on CARO Reporting as the due date of payment of service tax would consequently change.

In respect of CENVAT credit, the fol-lowing are some of the important changes which are relevant to the audit of financial statements:

(1) With effect from 1st July, 2011, banking companies and financial institutions including NBFCs will be required to pay 50% of the CENVAT credit availed on inputs and input services every month. Accordingly, the balance 50% should be immediately charged off under the respective expenses.

(2) With effect from 1st July, 2011, providers of life insurance services and management of investment in ULIPs will be required to pay 20% of the CENVAT credit availed on inputs and input services every month.

(3) With effect from 1st July, 2011, input credit in case of a pure service provider will be allowed in proportion of the taxable and exempt services rendered during the year. Input credit in case of an entity involved in trading as well as providing other services will be allowed in proportion of the gross profit on trading activity (which is exempt) and the taxable service rendered during the year. Accordingly, the balance should be immediately charged off under the respective expenses. It is imperative that the ratio of nature of trading activities and services provided by the client are identified at an early stage.

The Companies (Cost Accounting Records) Rules, 2011: The Ministry of Corporate Affairs has issued a Notification dated 3rd June, 2011 prescribing the Companies (Cost Accounting) Rules, 2011 (‘Rules’). Hitherto, the prevailing practice was for the Central Government to prescribe the Cost Accounting Rules applicable to specific products or industries and reference to such products or industry was being made by the auditors in their report under CARO. However, under the Rules now prescribed, the same would apply to the entity as a whole if it engaged in manufacturing, processing and mining activities and not to specific products, except those which are prescribed under the Rules like bulk drugs, sugar, fertilisers, etc. This would necessitate a change in the manner of our reporting under CARO as well as reviewing the prescribed records and their reconciliation with the financial records, which is specifically prescribed in the Rules.

Conclusion:

An auditor needs to continuously evaluate the impact of laws and regulations in respect of each entity. For this purpose, he needs to make inquiries with the management and those charged with governance, who are primary responsible to ensure such compliance, to identify that there is a proper framework to monitor any such non-compliances.

Reference material:

Indian Auditing Standards

Wiley’s Interpretation and Application of International Standards on Auditing by Steven Collings

Various Research Reports on Audit Process available for general public.

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Larsen & Toubro Ltd (31-3-2012)

Operating Cycle for current and non-current classification

Operating Cycle for the business activities of the company covers the duration of the specific project/contract/product line/service including the defect liability period, wherever applicable and extends upto the realization of receivables (including retention monies) within the agreed credit period normally applicable to the respective lines of business.

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Mahindra & Mahindra Financial Services Ltd (31-3-2012)

Basis for Preparation of Accounts

All assets & liabilities have been classified as current & non – current as per the Company’s normal operating cycle and other criteria set out in the Schedule VI of the Companies Act, 1956. Based on the nature of services and their realisation in cash and cash equivalents, the Company has ascertained its operating cycle as 12 months for the purpose of current and non-current classification of assets & liabilities.

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Hindustan Unilever Ltd (31-3-2012)

Basis for preparation of accounts

All assets and liabilities have been classified as current or non-current as per the Company’s normal operating cycle and other criteria set out in Revised Schedule VI to the Companies Act, 1956. Based on the nature of products and the time between acquisition of assets for processing and their realisation in cash and cash equivalents, the Company has ascertained its operating cycle as 12 months for the purpose of current/non-current classification of assets and liabilities

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GRASIM Industries Ltd (31-3-2012)

Classification of Assets and Liabilities as Current and Non-Current

All assets and liabilities are classified as current or non-current as per the Company’s normal operating cycle and other criteria set out in Schedule VI to the Companies Act, 1956. Based on the nature of products and the time between the acquisition of assets for processing and their realisation in cash and cash equivalents, 12 months has been considered by the Company for the purpose of current – noncurrent classification of assets and liabilities.

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Bajaj Electricals Ltd (31-3-2012)

Basis of Preparation
All assets and liabilities have been classified as current or non-current as per the Company’s normal operating cycle and other criteria set out in the Revised Schedule VI to the Companies Act, 1956. Based on the nature of products and the time between the acquisition of assets for processing and their realisation in cash and cash equivalents, the Company has ascertained its operating cycle as 12 months for the purpose of current or noncurrent classification of assets and liabilities.

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GAPS in GAAP – Borrowing costs – PAra 4(e) of as 16

The Genesis
Paragraph 4(e) of AS-16 Borrowing Costs has caused a lot of agony to Indian entities and is a highly debated and contentious issue, as exchange volatility shows no sign of cooling in India. In this article, we will try and understand the genesis of the problem, the theory of Interest Rate Parity (IRP), global interpretation on 4(e), linkage with paragraph 46 and 46A and analyse issues and provide author’s view on those issues. This article deliberately avoids the issue of derivatives which are used as hedges against the foreign currency (FC) borrowings, because it would have made the article unduly long and complex.

AS 16 requires borrowing costs incurred on construction of qualifying assets to be capitalised. Paragraph 4 of AS 16 contains an inclusive list of what borrowing costs may include. Sub-clause (e) of Paragraph 4 states: “exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs”. This requirement is explained in the Standard with the help of an illustration which is also reproduced below.

Illustration in AS-16 on exchange differences that are regarded as an adjustment to interest cost

XYZ Ltd. has taken a loan of $ 10,000 on 1st April, 20X3, for a specific project at an interest rate of 5% p.a., payable annually. On 1st April, 20X3, the exchange rate between the currencies was Rs. 45 per $. The exchange rate, as at 31st March, 20X4, is Rs 48 per $. The corresponding amount could have been borrowed by XYZ Ltd. in local currency at an interest rate of 11 % per annum as on 1st April, 20X3.

The following computation would be made, to determine the amount of borrowing costs for the purposes of paragraph 4(e) of AS 16:

i. Interest for the period = $ 10,000 × 5% × Rs. 48 $= Rs. 24,000.
ii. Increase in the liability towards the principal amount = $ 10,000 × (48-45) = Rs. 30,000.
iii. Interest that would have resulted if the loan was taken in Indian currency = $ 10000 × 45 × 11% = Rs. 49,500
iv. Difference between interest on local currency borrowing and foreign currency borrowing = Rs. 49,500 – Rs. 24,000 = Rs. 25,500

Therefore, out of Rs. 30,000 increase in the liability towards principal amount, only Rs. 25,500 will be considered as the borrowing cost. Thus, total borrowing cost would be Rs. 49,500 being the aggregate of interest of Rs. 24,000 on foreign currency borrowings [covered by paragraph 4(a) of AS 16] plus the exchange difference to the extent of difference between interest on local currency borrowing and interest on foreign currency borrowing of Rs. 25,500. Thus, Rs.49,500 would be considered as the borrowing cost to be accounted for as per AS 16 and the remaining Rs. 4,500 would be considered as the exchange difference to be accounted for as per Accounting Standard (AS) 11, The Effects of Changes in Foreign Exchange Rates.

In the above example, if the interest rate on local currency borrowings is assumed to be 13% instead of 11%, the entire exchange difference of Rs. 30,000 would be considered as borrowing costs, since in that case the difference between the interest on local currency borrowings and foreign currency borrowings [i.e., Rs. 34,500 (Rs. 58,500 – Rs. 24,000)] is more than the exchange difference of Rs. 30,000. Therefore, in such a case, the total borrowing cost would be Rs. 54,000 (Rs. 24,000 + Rs. 30,000) which would be accounted for under AS 16 and there would be no exchange difference to be accounted for under AS 11.

Author’s Note: As can be seen, the illustration is oversimplified and does not provide adequate guidance; for example, there is no guidance with respect to:

1. Whether an entity has a choice to assess the interest rate differential when the loan is drawn or at each reporting date? From the illustration, it appears that the interest rate differential is based on the date when the loan is drawn and not at each reporting date.
2. How is interest rate differential determined in the case of a floating rate loan?
3. Are exchange gains required to be considered as an adjustment to borrowing costs?
4. How to deal with exchange gains that follow a period of exchange losses? In such cases, should the exchange gains be treated as an adjustment to exchange losses or should it be fully recognised in the P&L?
5. Consider an example, where the interest rate differential at inception of borrowing is Rs. 1,000 and at the end of the reporting period there is exchange gain of Rs. 5,000. In this scenario, the author believes that it would be appropriate to conclude that there is no interest rate differential; rather than considering borrowing cost of Rs. 1,000 and notionally increasing the exchange gain by Rs. 1,000 to Rs. 6,000.

Why is para 4(e) a problem?
The idea of including paragraph 4(e) in AS-16 was a simple one. Indian companies borrowing in $ borrow at a much lower interest rate than borrowing in Indian Rupee. However, correspondingly because of the exchange rate movement, the $ loan liability increases, and results in the savings on account of low $ interest rates, being eroded. In a very simple world, and if IRP theory worked perfectly, then there would be a 100% offset. In other words, it is logical to see the exchange difference, as an interest cost to borrow the funds. Such 4(e) interest costs are allowed to be capitalised if they were incurred on the construction of a qualifying asset. 4(e) interest costs that are not incurred for the purposes of constructing a qualifying asset are to be charged off to the P&L account.

Companies that were constructing a qualifying asset and had borrowed in foreign currency are required to determine the 4(e) component, so that the same can be capitalised in accordance with AS 16 (4(e) component is capitalised only during the period of construction of a qualifying asset). Computing 4(e) was a problem, but was limited to situations where a qualifying asset was being constructed for which a foreign currency borrowing was used. 4(e) is now a much bigger problem, for two additional reasons.

1. AS-11 was amended to include paragraph 46 and 46A, which allowed an option of not charging foreign exchange differences on long term borrowings to the P&L a/c. The exchange differences could be amortised over the loan period, and if related to a loan for acquiring a capital asset, then the same should be capitalised as cost of the capital asset, even after the asset was put to use. The Institute of Chartered Accountants of India issued “Frequently Asked Questions on AS 11 notification – Companies (Accounting Standards) Amendment Rules, 2009 (G.S.R. 225 (E) dt. 31.3.09) issued by Ministry of Corporate Affairs”. In the said guidance, it was clarified that 4(e) interest should not be treated as foreign exchange difference. Consequently, 4(e) component is to be (a) capitalised only during the period of construction of a qualifying asset in accordance with AS-16 (b) charged to the P&L in all other cases.

2. The Ministry of Corporate Affairs issued circular no 25/2012 dated 9th August, 2012 clarifying that paragraph 4(e) of AS-16 shall not apply to a company which is applying paragraph 46A of AS-11. The circular has withdrawn 4(e) with respect to paragraph 46A, but not with respect to paragraph 46 of AS-11. There are a number of questions with respect to the circular. For example, does it have a prospective or retrospective application? Is it a clarification or a substantive amendment? Will 4(e) continue to apply to companies that were in paragraph 46?

3. Revised Schedule VI requires 4(e) component to the extent not capitalised to be separately disclosed in the P&L a/c as part of borrowing costs.

IRP Theory

The IRP theory states that interest rate differentials between two different currencies will be reflected in the premium or discount for the forward exchange rate on the foreign currency if there is no arbitrage. The theory further that states the size of the forward premium or discount on a foreign currency should be equal to the interest rate differentials between the countries in comparison. This is explained with the help of an illustration below.

How well does IRP predict Exchange Rate Movements in India?

Not so well, is the short answer. Menzie Chinn says, “Uncovered interest parity (UIP) has been almost universally rejected in studies of exchange rate movements.” Paul Krugman says, “Like stock prices, exchange rates respond strongly to ‘news’, that is to unexpected economic and political events, and like stock prices, they therefore are very difficult to forecast.”

As per the IRP theory, in countries which have higher interest rates, their currencies should depreciate. If this does not happen, there will be cases for arbitrage for foreign investors till the arbitrage opportunity disappears from the market. The reality is sometimes exactly the opposite; as higher interest rates could actually bring in higher capital inflows further appreciating the currency. In such a scenario, foreign investors earn both higher interest rates and also gain on the appreciating currency.

In reality, predicting currency movement is crystal gazing as it is affected by numerous variables, other than interest rate differential. These variables are discussed below.

Balance of Payments (BOP): BOP play’s a critical role in determining the movement of the currency. It is the aggregate of current account and capital account of a country like an external account of a country with other countries. Current account surplus means exports are more than imports and current account deficit means imports are more than exports. Eventually, import/export prices find equilibrium. Hence, the currency of a current account surplus country should appreciate. Likewise for current account deficit countries, the currency should depreciate. Growing Indian economy has led to widening of current account deficit, as imports of both oil and non-oil have risen. Gold imports have also added to the problem in India. Capital flows also play a crucial role in the BOP situation of India. Currency appreciates when there are huge capital inflows and depreciates when the capital inflows dry up and the current account deficit is also high. During the Lehman crisis, capital flows shrunk sharply from a high of $106.6 billion in 2007-8 to just $6.8 billion in 2008-09 and led to sharp depreciation of the rupee from around Rs. 39.9 per $ to Rs. 51.9 per $.

Inflation: Higher inflation leads to central banks keeping interest rates high, which invites foreign capital on account of interest rate arbitrages. This could lead to further appreciation of the currency. However, one needs to make a distinction between high inflation over a short term versus a long term. If inflation is short-term, foreign investors see inflation as a temporary problem and continue to invest in that economy. If inflation is sticky, it leads to overall worsening of the economy, capital flows and exchange rate. For almost two years now, inflation in India has been very high and persistent, resulting in a highly depreciating rupee. The present situation is different from the situation in 2007-08 when despite high inflation and high interest rates, capital inflows were abundant. This was because markets believed that inflation was not a structural problem.

Fiscal Deficit: Fiscal deficits play a key role in the determination of exchange rates. Higher deficits imply that government might resort to using foreign exchange reserves to fund its deficit. This leads to lowering of the reserves followed by speculation on the currency. If the government does not have adequate reserves, fall in the currency is imminent. In India, higher fiscal deficits have also played a role in shaping expectations over the currency rate. When the fiscal deficits are high, investors become nervous, reducing the capital inflows into the country.

Global economic conditions: In times of high uncertainty as seen lately, most currencies usually depreciate against US Dollar as it is seen as a safe haven currency. The South East Asian crisis and the recent Euro crisis stand evidence to that. Currently, the markets believe that the dollar is safer than the euro, given the economic problems of the euro zone. Global economic conditions have significantly impacted exchange rates in India.

Lack of reforms: This has further made investors negative over the Indian economy and coupled with global uncertainty, has put pressure on the Indian Rupee.

Speculation: There has been a fall of 22.7 % (in value of rupee against dollar) in four months – from Rs. 44.35 in end July 2011 to Rs. 54.4 on 31st December, 2011. Importers, having been lulled into complacency by the rupee’s appreciation earlier, rush to cover their exposures, thus driving up dollar demand. Exporters hold on to their earnings in foreign currency in the hope of a further fall in the rupee.

Measures by RBI : They have also made marginal impact in terms of arresting a downslide on the rupee. However, this is a short term measure.

Hence, even over a longer term, multiple factors determine an exchange rate with each one playing an important role over time. In a calm and stable world, IRP theory may work. Unfortunately, this is never the case. Exchanges rates behave erratically, and are caused by numerous factors other than interest rate differentials. Consequentially, exchange losses may represent more or less matching interest rate differential in a few cases only. In India, experience is that, exchange losses may be far more than the interest rate differential when rupee is sliding down and in other cases, there may be a huge exchange gain in which case, the interest rate differential would have had little or no impact on the exchange rate. Much would depend on when the borrowings took place and the exchange rate movement from thereon till redemption of the loan.

Author Sarbapriya Ray in the paper “Testing the Validity of Uncovered IRP in India” concludes as follows – “One vital potential issue determining the exchange rate is the uncovered interest rate parity (UIP). Uncovered interest parity (UIP) is a typical subject of international finance, a critical building block of most theoretical models, and a miserable empirical failure. Uncovered interest rate parity (UIP) states that the nominal interest rate differential between two countries must be equal to expected change in the exchange rate. In other words, if UIP condition holds, then high yield currencies should be expected to depreciate. The article attempts to test the validity of uncovered interest rate parity based on a theoretical formulation in line with economic theory. Although KPSS test suggests that excess return series are in stationary process, excess return curve shows erratic behaviour during some months of our study period (showing negative trend) which automatically excludes the possibility for the UIP to hold. The UIP regression estimate indicates that there is no statistically significant evidence that suggests the uncovered interest rate parity to hold during January, 2006 –July, 2010 for domestic interest rate (weighted average call money rate).This indicates that interest rate spread is a very poor predictor of exchange rate yields. Thus, the UIP hypothesis fails in India.”

Position on para 4(e) under IFRS taken by global firms

Under IFRS, paragraph 6(e) of IAS 23 Borrowing Costs, has the same requirement as 4(e) of AS-16. However, the illustration contained in 4(e) and reproduced in this article is not contained in IAS 23. The global big accounting firms have different interpretation on 6(e). Interestingly, the IASB is seized of this matter but has decided not to provide guidance. The International Financial Reporting Interpretation Committee (IFRIC) acknowledges that judgment will be required in its application.

Ernst & Young¹

Borrowings in one currency may have been used to finance a development the costs of which are incurred primarily in another currency, e.g. a US dollar loan financing a Russian rouble development. This may have been done on the basis that, over the period of the development, the cost, after allowing for exchange differences, was expected to be less than the interest cost of an equivalent rouble loan.

We, however, consider that, as exchange rate movements are largely a function of differential interest rates, in most circumstances, the foreign exchange differences on directly attributable borrowings will be an adjustment to interest costs that can meet the definition of borrowing costs. Care will have to be taken if there is a sudden fluctuation in exchange rates that cannot be attributed to changes in interest rates. In such cases we believe that a practical approach is to cap the exchange differences taken as borrowing costs at the amount of borrowing costs on functional currency equivalent borrowings.

In theory, foreign exchange rates and interest rates are related and, as such, it is fair to assume that any changes in foreign exchange rates reflect changes in the interest rate. On this basis, all of the foreign exchange gain or loss on foreign currency borrowings would be considered as part of the borrowing costs on the borrowing. But recently, this argument has not been holding true, with many other factors impacting the relationship between foreign exchange rates and interest rates. Accordingly, it is not necessarily safe to assume that all of the foreign exchange gains or losses on foreign currency borrowings are an adjustment to income. Take the following two examples Entity A’s functional currency is euro, and it borrows £1,000 on 1st January 2009 for one year at a fixed interest rate of 5% to fund the construction of an asset. The spot exchange rate at this date is € 1.5:£1. At 31st December 2009, the exchange rate is €1.1:£1. The entity has incurred a foreign currency gain of €400, while interest costs (assuming they were paid throughout the year at the then spot rate) amount to €65. How much of the foreign exchange gain is included in the borrowing costs eligible for capitalisation?

Entity B’s functional currency is euro, and it borrows US$1,000 on 1st January 2009 for one year at a fixed interest rate of 3% to fund the construction of an asset. The spot exchange rate at this date is €1: US£1. On 31st December 2009, the exchange rate is €1.4: US$1. The entity has incurred a foreign currency loss of €400, while interest costs (assuming they were paid throughout the year at the then spot rate) amount to €36. How much of the foreign exchange loss is included in the borrowing costs eligible for capitalisation?

A number of possible approaches exist:

1. Determine, at the date of entering into the loan, the equivalent interest rate on a local currency borrowing and use this as the borrowing cost to be capitalised. Let’s assume that, for both of the above examples, the interest rate on a €1,500 borrowing on 1st January 2009 is 7% (entity A), and the interest rate on a € 1,000 borrowing on 1st January 2009 is 4% (entity B). The amount of borrowing costs eligible to be capitalised by entity A would be €105, regardless of the movement in the foreign exchange rate. Entity B would be eligible to capitalise € 40 as borrowing costs. However, this ignores the reason for entities borrowing in a foreign currency i.e., that they expect it to be less expensive. In this case, the movement in the exchange rates has effectively generated an additional gain for entity A, which is also counter-intuitive.

2. Establish a ‘cap and floor’ for the amount of foreign exchange gains or losses to be included in borrowing costs. The floor may be up to the amount that reduces the borrowing cost to nil. We do not believe that a net gain can be capitalised. In the above example, entity A would include €65 of foreign currency gains as an element of borrowing costs, resulting in a net nil borrowing cost. The cap may be the interest on a local currency borrowing at inception, as this reflects the relationship between foreign currency and interest at that time. In the above example, entity B would therefore include € 4 of the foreign currency losses as borrowing costs, resulting in a net borrowing cost of € 40.

3. Determine a forward foreign exchange rate at the date of entering into the borrowing and use this to determine the amount of foreign exchange gains or losses that are eligible for capitalisation. Let’s assume in the above examples, the one year forward foreign exchange rates as on 1st January 2009 are €1.4:£1 and €1.1:US$1. The amount of foreign currency gains on the borrowing that entity A includes as borrowing costs is €10, regardless of the movement in the foreign exchange rate. Entity B includes €10 of foreign currency losses on the borrowings as borrowing costs. While this approach provides a consistent assessment of the relationship between foreign exchange rates and interest rates, it is by no means a perfect approach. There are many factors affecting the relationship between foreign exchanges rates and interest rates that cannot be adequately measured.

Management will need to carefully consider which approach they apply, to best reflect the relationship between foreign exchange rates and interest rates. However, the approach selected needs to be applied consistently and disclosed within the financial statements. Each approach also requires an appropriate information system to be in place to collect the relevant information.

PWC²

16.96 Capitalisation of borrowing costs includes capitalising foreign exchange differences relating to borrowings to the extent, that they are regarded as an adjustment to interest costs. The gains and losses that are an adjustment to interest costs include the interest rate differential between borrowing costs that would be incurred if the entity borrowed funds in its functional currency, and borrowing costs actually incurred on foreign currency borrowings. Other differences that are not adjustments to interest cost may include, for example, changes in foreign currency rates as a result of changes in other economic indicators, such as employment or productivity, or a change in government.

16.97 IAS 23 does not prescribe which method should be used to estimate the amount of foreign exchange differences that may be included in borrowing costs. IFRIC has considered this issue, but has not issued any guidance. There were two methods considered by the IFRIC:

The portion of the foreign exchange movement may be estimated based on forward currency rates at the inception of the loan.

The portion of the foreign exchange movement may be estimated based on interest rates on similar borrowings in the entity’s functional currency.

Other methods might be possible. Management has to use judgment to assess which foreign exchange differences can be capitalised. The method used to determine the amount that is an adjustment to borrowings costs is an accounting policy choice. The method should be applied consistently to foreign exchange differences whether they are gains or losses.

Deloitte³

2.1 Exchange differences to be included in borrowing costs.

IAS 23 includes no further clarification as to what is meant by the inclusion of exchange differences ‘to the extent that they are regarded as an adjustment to interest costs’.

It is clear that, not all exchange differences arising from foreign currency borrowings can be regarded as an adjustment to interest costs; otherwise, there would be no requirement for the qualifying terminology used in IAS 23:6(e). The extent to which exchange differences can be so considered depends on the terms and conditions of the foreign currency borrowing.

Qualifying interest costs denominated in the foreign currency, translated at the actual exchange rate on the date on which the expense is incurred, should be classified as borrowing costs. Although exchange rate fluctuations may mean that this amount is substantially higher or lower than the interest costs contemplated when the original financing decision was made, the full amount is appropriately treated as borrowing costs.

Some exchange differences relating to the principal may be regarded as an adjustment to interest costs (and, therefore, taken into account in determining the amount of borrowing costs capitalised) but only to the extent that the adjustment does not decrease or increase the interest costs to an amount below or above a notional borrowing cost, based on commercial interest rates prevailing in the functional currency at the date of initial recognition of the borrowing. In other words, the amount of borrowing costs that may be capitalised should lie between the following two amounts:

(1) actual interest costs denominated in the foreign currency, translated at the actual exchange rate on the date on which the expense is incurred; and

(2) notional borrowing costs based on commercial interest rates prevailing in the functional currency at the date of initial recognition of the borrowing.

Whether any adjustments for exchange differences are made to the amount determined under (1) above is an accounting policy choice and should be applied consistently.

KPMG⁴

4.6.420 Foreign exchange difference.

4.6.420.10 Borrowing costs may include foreign exchange differences to the extent that these differences are regarded as an adjustment to interest costs. There is no further guidance on the conditions under which foreign exchange difference may be capitalised and in practice, there are different views about what is acceptable.

4.6.420.20 In our view, foreign exchange differences on borrowings can be regarded as an adjustment to interest costs only in very limited circumstances. Exchange differences should not be capitalised, if a borrowing in a foreign currency is entered into to offset another currency exposure. Interest determined in a foreign currency already reflects the exposure to that currency. Therefore, the foreign exchange differences to be capitalised should be limited to the difference between interest accrued at the contractual rate and the interest that would apply to borrowing with identical terms in the entity’s functional currency. Any foreign exchange differences arising from the notional amount of the loan should be recognised in profit or loss.

4.6.420.30 When exchange differences qualify for capitalisation, in our view both exchange gains and losses should be considered in determining the amount to capitalise.

GT⁵

Exchange differences.
If an entity has foreign currency borrowings, to what extent are foreign exchange gains and losses eligible for capitalisation?

IAS 23.6(e) states that borrowing costs may include exchange differences arising from foreign currency borrowings to the extent that they are regarded as an adjustment to interest costs. The standard offers no detailed guidance on how to interpret this. Accordingly, entities should develop their own detailed policy. As with any other accounting policy, the chosen method should be applied consistently and disclosed if significant.

Is it appropriate to treat all exchange differences on foreign currency borrowings as an adjustment to interest costs?

No. In our view, not all such exchange differences are adjustments to interest costs. Exchange rate movements depend in part on current and expected differences in local currency and foreign currency interest rates (the interest rate differential). However, other factors also contribute to exchange rate changes: a currency will tend to lose value relative to other currencies if a country’s level of inflation is higher, or if the country’s level of output is expected to decline or if a country is troubled by political uncertainty (for example).

Moreover, although exchange gains and losses relate to an entity’s foreign currency borrowings, such gains and losses are different in character to interest costs on those borrowings. In particular, it is difficult to argue that exchange gains and losses on the principal amount of a loan is an adjustment to interest costs. Exchange gains and losses on the accrued interest portion of the loan’s carrying value may more readily be considered an adjustment to interest costs (see below).

What is an appropriate accounting policy for exchange differences?

One acceptable and straightforward approach is not to include any exchange differences as adjustments to interest costs. IAS 23.6(e) states that borrowing costs may include exchange differences to the extent they are regarded as an adjustment to interest costs – it does not therefore require such an adjustment. Applying this approach, interest costs on foreign currency borrowings include only the foreign currency interest expense converted into the entity’s functional currency in accordance with IAS 21 The Effects of Changes in Foreign Currency Exchange Rates.

Should an entity wish to take account of exchange differences, the challenge is to identify the portion of overall exchange differences that are adjustments to interest costs. A reasonable and practical approach is to treat only exchange differences arising on current period accrued interest as an adjustment to interest costs. This approach considers the adjustment to interest costs as the difference between:

the amount of interest cost initially recognised in the entity’s functional currency using the spot exchange rate at the date of the transaction; and

the amount the entity has to pay on settlement translated into the entity’s functional currency using the spot exchange rate at the date of payment.

Using this approach, exchange differences on the principal amount of the loan are not included in the calculation of borrowing costs to capitalise.

Are any other methods available?
Yes, an entity might develop other models and techniques to determine the exchange differences to include in the calculation of borrowing costs to capitalise. However, in our view any such method should:

• be consistent with the objective of IAS 23 to include borrowing costs that are directly attributable to a qualifying asset. Borrowing costs are considered to be directly attributable, if they would have been avoided had the expenditure on the qualifying asset not been made (IAS 23.10);

• not result in negative interest costs; and

• be consistently applied.

In our view it is not acceptable to:

• include exchange gains in excess of the interest expenses incurred (i.e. to capitalise a negative amount); or

• Capitalise only exchange losses, but credit all exchange gains to the income statement.

One alternative approach is to determine a notional borrowing cost based on the interest cost that would have been incurred, had the entity borrowed an equivalent amount in its functional currency. In effect, this approach treats a foreign currency loan as a functional currency loan with an embedded foreign currency exchange contract. The IAS 23 calculation is based on the notional functional currency loan.

Applicability of para 4(e) in different scenarios under AS 16

It would be fair to comment that the global practices being followed with respect to 4(e) are disparate. Even the guidance provided by the large firms is not consistent. A few of the large firms have debunked the theory of IRP, but most others show sympathy towards the determination of 4(e) component. Though sometimes the same terminology used by the large firms such as a “cap” and “floor”, have been used in different contexts and can be confusing. Fortunately or unfortunately, a large part of the debate in the large firms may be purely academic under AS-16, since unlike IAS-23 an illustration is included in AS-16. This resolves a lot of issues. Nonetheless, the illustration in paragraph 4(e) of AS 16 deals with computation of 4(e) adjustment in a scenario where the company takes foreign currency (FC) loan at a lower interest rate and incurs exchange loss on the FC borrowing. However, it does not deal with many other scenarios which the author has described in the foot note under the illustration.

Consider the following example. The company takes a FC loan at a lower interest rate and has exchange gain on restatement on FC loan. In this scenario, theoretically there should have been an exchange loss, but because the IRP theory does not work because of unusual factors, there is an exchange gain in certain periods. The question is whether one would notionally increase exchange gain so that a 4(e) component can be artificially determined. In this situation, the author believes that it may not be appropriate to further increase the exchange gain to consider a notional 4(e) charge. This is explained in the illustration below.

Entity A’s reporting currency is rupees, and it borrows US$100 million on 16th December 2011 for one year at a fixed interest rate of 2% to fund the construction of an asset. The spot exchange rate at this date is $1: Rs. 53.65. On 31st March 2012, the exchange rate is $1: Rs. 50.87. The entity has incurred a foreign currency gain of Rs. 278 million, while interest costs (translated using the average rate) amount to Rs. 30.48 million (Rs. 100 million

* 2% * 52.26 * 3.5/ 12). How much of the foreign exchange gain is included in the borrowing costs eligible for capitalisation?

A number of possible approaches exist:
1. Determine, at the date of entering into the loan, the equivalent interest rate on a local currency borrowing and use this as the borrowing cost to be capitalised, regardless of the movement in the foreign exchange rate. Let’s assume that, the interest rate on a Rs. 5,365 million borrowing on 16th December 2011 is 9%. Hence, the amount of borrowing costs eligible to be capitalised by entity A would be Rs. 140.83 million (Rs. 5,365 million * 9% * 3.5/ 12). In this approach, the movement in the exchange rates has effectively generated an additional exchange gain of Rs. 110.35 million (i.e., interest capitalised of Rs. 140.83 million minus actual interest of Rs. 30.48 million) for entity A, which is counter-intuitive.

2. To recognise interest cost of Rs. 30.48 million and FC gain of Rs. 278 million. The FC gain is not notionally increased by Rs. 110.35 million to determine the 4(e) component.

3. Establish a ‘cap and floor’ for the amount of foreign exchange gains or losses to be included in borrowing costs. The floor may be up to the amount that reduces the borrowing cost to nil because borrowing costs cannot be negative. It may not be appropriate to capitalise a net gain. In the above example, entity A would include Rs. 30.48 million of foreign currency gains as an element of borrowing costs, resulting in a net nil borrowing cost. The FC gain would be Rs. 247.52 million (Rs. 278 million – Rs. 30.48 million).

4. There are other acceptable methods which are not discussed here.

The conclusion on the above illustration can be summarised as below.

Rs million

Method

Actual

4(e)

Exchange

Interest

component

gain

30.48

110.35

388.35

30.48

–

278.00

–

247.52

Discrete vs. Cumulative Approach

Paragraph 4(e) of AS 16 and explanation thereto explains computation of 4(e) adjustment for one year. However, it does not deal with a scenario where FC loan extends for more than one year and there is loss/gain in one accounting period and gain/ loss in the subsequent periods. Two methods seem possible for dealing with this issue.

Method A – The discrete period approach

4(e) adjustment is determined for each period separately. FC gains/losses that did not meet the criteria for treatment as borrowing cost in the previous year cannot be treated as 4(e) adjustment in the subsequent years and vice versa.

Method B – The cumulative approach
4(e) adjustment are assessed/identified on a cumulative basis, after considering the cumulative amount of interest expense that is likely to have been incurred, had the company borrowed in local currency. The amount of 4(e) adjustment cannot exceed the amount of FC losses incurred on a cumulative basis at the end of the reporting period. The cumulative approach looks at the project as a whole as the unit of account, ignoring the occurrence of reporting dates. Consequently, the amount of the FC differences eligible for identification as 4(e) adjustment in the period is an estimate, which can change as the exchange rates changes over periods.

Example
An illustrative calculation of the amount of FC differences that may be regarded as borrowing cost under method A and method B is set out below.

Particulars

Year
1

Year
2

Total

Interest expense in FC (A)

25,000

50,000

Hypothetical interest in

30,000

60,000

LC (B)

FC loss (C)

6,000

3,000

9,000

Method
A – Discrete Approach

Particulars

Year
1

Year
2

Total

4(e) adjustment – lower

5,000

3,000

8,000

of C and (B minus A)

FC loss (net)

1,000

Nil

1,000

FC loss (C)

6,000

3,000

9,000

Method
B – Cumulative Approach

Particulars

Year 1

Year
2

Total

4(e) adjustment

5,0006

4,0007

9,000

Foreign exchange loss

1,000

(1,000)

Nil

(net)

If a company is also preparing quarterly financial information, a related issue will arise regarding the approach that should be adopted while preparing quarterly financial statements.

Ind-AS 23 provides additional guidance on this subject as follows.

“6A. With regard to exchange difference required to be treated as borrowing costs in accordance with paragraph 6(e), the manner of arriving at the adjustments stated therein shall be as follows:

(i) the adjustment should be of an amount which is equivalent to the extent to which the exchange loss does not exceed the difference between the cost of borrowing in functional currency when compared to the cost of borrowing in a foreign currency.

(ii) where there is an unrealised exchange loss which is treated as an adjustment to interest and subsequently there is a realised or unrealised gain in respect of the settlement or translation of the same borrowing, the gain to the extent of the loss previously recognised as an adjustment should also be recognised as an adjustment to interest.”

Ind-AS seems to be taking a cumulative approach when exchange gain follows exchange loss that were treated as an adjustment to interest cost. However, Ind-AS provides no guidance when there is a reverse situation, ie exchange gains precede exchange losses. In the latter situation, it is possible to recognise the exchange gain in the P&L account and the exchange loss could be split into a 4(e) component; the remaining being accounted as a pure exchange loss. It may be noted that, Ind-AS cannot be applied mandatorily with respect to interpreting Indian GAAP, though in the author’s view it could be applied voluntarily.

To cut the long story short

• The present AS-16 standard includes a clear illustration of how the interest rate differential will be determined. Therefore, entities will need to follow the same. However, as discussed in this article, the illustration does not deal with numerous situations, which are causing the problem.

• Consider an example, where the interest rate differential at inception of borrowing is Rs. 1,000 and the exchange loss in scenario 1 is Rs. 5,000 and in scenario 2 is Rs. 800. There should not be a debate that interest rate differential in scenario 1 is Rs. 1,000 and in scenario 2 is Rs. 800. Given that 4(e) is clearly explained in the standard by way of an illustration, it seems highly inappropriate not to consider Rs. 1,000 in scenario 1 and Rs. 800 in scenario 2 as interest rate differential (4(e) component).

• Consider a third scenario where at the first year end after taking the FC loan there is exchange gain of Rs. 5,000 (but the interest rate differential at inception of borrowing is Rs. 1,000). In this scenario, the author believes that it would be appropriate to conclude that there is no interest rate differential; rather than considering an interest rate differential of Rs. 1,000 and notionally increasing the exchange gain by Rs. 1,000 to Rs. 6,000.

• In the reporting period after the first reporting period, there seems to be a choice of either using the discrete approach or the cumulative approach. For example, the exchange loss in one period is followed by exchange gain in the following period. In the absence of any guidance under AS-16, either the discrete or cumulative approach is valid. Ind-AS seems to be suggesting a cumulative approach in some situations. That guidance is not mandatory with respect to interpretation of 4(e), but could be applied voluntarily.

• All companies should disclose in the financial statements the policy followed to determine the 4(e) component, and this policy should be applied consistently.

Should para 4(e) under Indian GAAP be withdrawn because IRP theory does not hold good?

• Para 4(e) is an issue of significance to India because of large volume of FC borrowings and high exchange rate volatility.

• It is quite clear from the many research papers that the uncovered IRP theory does not hold good.

• The global guidance and practices followed are inconsistent and disparate and many have debunked the IRP theory. IFRIC has refused to provide any guidance, citing that it is a judgmental matter.

• Capitalisation of borrowing cost on qualifying asset itself is not a good idea, because it is a consequence of how the asset is funded (whether from equity or borrowing?) and therefore provides an unnecessary arbitrage.
By adding 4(e) component to the definition of borrowing cost, is like adding one disputed theory on top of another disputed theory. That makes matters worse.

• Paragraph 46 and 46A of AS-11 were founded on the belief that exchange rates will either revert back to the original or will, in the medium to long term, reflect interest rate differential (stable forward points reflecting interest differences between two countries). By allowing amortisation of exchange differences, what is achieved is a smoothing of the exchange differences that would be similar to recognising interest rate differentials over the period of the FC loan.

• On account of various arguments made in this paper, the author believes that 4(e) should be withdrawn. Along with 4(e); paragraph 46 & 46A of AS-11 should also be withdrawn, as they are founded on similar belief. The belief that exchange rates will either revert back to the original or will reflect the interest rate differential for the medium to long term, is a preposterous assumption and unproven by empirical evidence. If one were to do a backward testing, the assumption may hold good in a few cases, as a matter of co-incidence, rather than on the basis of a proven theory. The world nor India, is or ever will be calm and stable. If we agree to this then we should withdraw 4(e) and paragraph 46 and 46A of AS-11.

• The Ministry of Corporate Affairs has issued has Circular No 25/2012 dated 9th August 2012 with-drawing 4(e) with respect to paragraph 46A, but not with respect to paragraph 46. The author’s suggestion is that 4(e) should be fully withdrawn along with paragraph 46 and 46A of AS-11.

shailesh.kwebmaker

Oberoi Realty Ltd (31-3-2012)

Other Notes

The Company’s normal operating cycle in respect of operations relating to under-construction real estate projects may vary from project to project depending upon the size of the project, type of development, project complexities and related approvals. Operating cycle for all completed projects and hospitality business is based on 12 months period. Assets and liabilities have been classified into current and non-current, based on the operating cycle of respective businesses.

Mahindra Lifespace Developers Ltd (31-3-2012)

Presentation and Disclosure of Financial Statements

During the year ended 31st March, 2012, the Revised Schedule VI notified under the Companies Act, 1956 has become applicable to the company, for preparation and presentation of its financial statements. The adoption of Revised Schedule VI does not impact recognition and measurement principles followed for preparation of financial statements. However, it has significant impact on presentation and disclosures made in the financial statements. Assets & liabilities have been classified as Current & Non – Current as per the Company’s normal operating cycle and other criteria set out in the Schedule VI of the Companies Act, 1956. Based on the nature of activity carried out by the company and the period between the procurement and realisation in cash and cash equivalents, the Company has ascertained its operating cycle as five years for the purpose of Current and Non-Current classification of assets & liabilities.

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Accounting for fair value hedge s and hedge s of net in vestment in foreign operations

In our previous
article, we discussed the need for hedge accounting by companies as well
as the basic principles of hedge accounting and criteria required to
qualify for hedge accounting. We gave an example of a cash flow hedge of
a highly probable forecast purchase transaction and illustrated the
impact of hedge accounting on a companies’ profit or loss account
through the term of the hedging instrument. In this article, we shall
elucidate the accounting using fair value hedges and the hedge of a net
investment in a foreign operation and illustrate the accounting
treatment through examples.

Fair value hedges:

A fair value hedge is a
hedge of changes in the fair value of a recognised asset or liability,
an unrecognised firm commitment, or an identified portion of such an
asset, liability or firm commitment, that is attributable to a
particular risk and could affect profit or loss. The following are
examples of fair value hedges: a hedge of interest rate risk associated
with a fixed rate interest-bearing asset or liability (e.g. converting a
fixed rate instrument to a floating rate instrument using an interest
rate swap); a hedge of a firm commitment to purchase an asset or to
incur a liability; or a hedge of interest rate risk on a portfolio basis
(a portfolio fair value hedge).

Accounting for a fair value hedge:

l
Hedging instruments that are derivatives – Fair value changes are
recognised in the profit or loss account.
Hedging instruments that are
non derivatives – Foreign currency components of their carrying amounts
measured in accordance with Ind-AS 21 are recognised in the profit or
loss account.
Hedged item otherwise measured at amortised cost (Eg.
fixed rate borrowing) or through other comprehensive income (Eg.
available for sale financial asset) – Adjustment to the carrying amount
of the hedged item related to the hedged risk are recognised in the
profit or loss account.
The categorisation of the fair value hedge
adjustment as either a monetary or a non-monetary item, under Ind-AS 21,
should be consistent with the categorisation of the hedged item under
Ind-AS 21.
In a fair value hedge, any ineffectiveness automatically is
reported in profit or loss through the accounting process, unlike in a
cash flow hedge, in which the ineffectiveness has to be calculated and
recognised separately.

If the fair value hedge is fully effective, the
gain or loss on the hedging instrument would fully offset the gain or
loss on the hedged item attributable to the risk being hedged.
Accordingly, there would be no net impact to the profit or loss account.

The qualifying criteria for hedge accounting remain the same across
types of hedges, i.e. cash flow hedges, fair value hedges or net
investment in foreign operation.

Let us look into fair value hedges in
more detail by way of the following example.

Example 1: Fair Value
Hedges

RV International Limited (RVIL) is a manufacturer with an Indian
Rupees (Rs.) functional currency with trade transactions with several
countries. The company has the maximum number of trade transactions with
companies in the United States of America. RVIL’s reporting dates are
30th September and 31st March.

On 15th July 20X1, RVIL enters into a
contract to sell its manufactured units to a company in the United
States. As per the contract, RVIL is committed to deliver 1,000 units at
a price of INRNaN per unit on 30th June 20X2. The contract contains
several specifications of the units to be delivered and also contains a
penalty clause that states that if RVIL fails to adhere to its time and
quality commitment, as per the specifications of the contracts, it shall
be liable to a penalty of INRNaN million. The invoice is payable on
31st August 20X2. RVIL expects that is shall incur costs of Rs. 67.5
million in manufacturing and packing the units. All such costs are
denominated in its functional currency, Rs.

On the date that RVIL enters
into the contract of sale, its management decides to hedge the
resulting foreign currency risk and enters into a forward contract to
sell INRNaN million against Rs. The terms of the sale transactions and
of the forward contract are as shown in Table 1 and Table 2

RVIL
accordingly adopts a risk management strategy to hedge its firm
commitment denominated in $ as a fair value hedge. The management of the
company designates the spot component of the forward contract as a
hedge of the change in the fair value of the contracted firm commitment
attributable to movements in spot rates. All critical terms of the
hedged item and hedging instruments match, on the date of inception –
15th July 20X1. The hedge is determined to be 100% effective on a
prospective basis considering that all the critical terms match. The
fair value of the forward contract (hedging instrument) is Nil as on the
date of inception. Fair value is calculated as the difference between
the discounted fair value of the forward contract at the forward rate on
inception (18,000,000 * 45.9420 * discount factor at 10.6500% = Rs.
749,959,475) with the discounted fair value of the forward contract on
testing date (18,000,000 *45.9420 * discount factor at 10.6500% = Rs.
749,959,475). On 30th September the fair value shall be Rs. 37,707,866
[(18,000,000 * discount factor at 10.8600 * (48.2040 – 45.9420)]. Hedge
accounting principles also require retrospective effectiveness testing
at each date which is determined to be 100% in this example for each
testing date.

In this example, the designated hedged risk is the spot
component i.e. hedge effectiveness is measured on the basis of changes
in spot component of the forward rates. The change in the fair value of
the derivative attributable to the forward points is excluded from the
hedge relationship. This forward points component does not therefore
give rise to any ineffectiveness. It is recognised in profit or loss as
‘other operating income and expense’. Alternatively, the forward points
can be recognised as ‘interest income and expense’.

Also important to
note is that in a fair value hedge, the full fair value of the hedging
instrument is recognised in the profit and loss account. Hence,
ineffectiveness is not measured separately. The journal entries for the
transaction are as shown in Table 3.

Hence the revenue is recognised, at
a net amount of Rs. 810,000,000, which is equivalent to the value at
the hedged rate i.e. the spot rate on the date of inception (18,000,000 *
45.000).

Net Investment in a Foreign Operation: Ind-AS 39 does
not override the principles of Ind- AS 21, but it does provide the hedge
accounting model for hedging an entity’s foreign exchange exposure
arising from net investments in foreign operations.

A net investment
hedge is a hedge of the foreign currency exposure, arising from a net
investment in a foreign operation, using a derivative and/or a
non-derivative monetary item as the hedging instrument.

The hedged risk is the foreign currency exposure arising from a net investment in a foreign operation when the net assets of that foreign operation are included in the financial statements. The application of hedge accounting for a net investment in foreign operation is relevant only for the consolidated financial statements of a group of companies.

Accounting for net investment hedges:

If the hedging instrument in a net investment hedge is a derivative, then it is measured at fair value. The effective portion of the change in fair value of the hedging instrument is computed by reference to the functional currency of the parent entity against whose functional currency the hedged risk is measured.

This effective portion is recognised in other comprehensive income and presented within equity in the foreign currency translation reserve. The ineffective portion of the gain or loss on the hedging instrument is immediately recognised in profit or loss.

If the hedging instrument is a non-derivative, e.g. a foreign currency borrowing, then the effective portion of the foreign exchange gain or loss, arising on translation of the hedging instrument into the functional currency of the hedging entity, is recognised in Foreign Currency Translation Reserve.

The effective portion is computed by reference to the functional currency of the parent entity, against whose functional currency the hedged risk is measured. Effectiveness is usually achieved if currency matches and notional amount of invest-ment is unlikely to go below notional amount of derivative, for e.g., due to losses incurred.

Hence, cumulative amounts are recognised in the other comprehensive income – changes on foreign currency translation of the foreign operation and effective portion of the gains or loss on the hedging instrument.

When a net investment in a foreign operation is disposed of, the cumulative amounts recognised previously in other comprehensive income, are re-classified to profit or loss. However, it is necessary for an entity to keep track of the amount recognised in other comprehensive income separately in respect of each foreign operation, in order to identify the amounts to be reclassified to profit or loss on disposal or partial disposal.

Let us look into net investment in foreign operations hedges in more detail by way of the following example.

Example 2: Hedges of net investment in a foreign operation

Company P is an Indian company with an Rs. functional currency. It has a subsidiary in the US, Company S, whose functional currency is $. The net investment of Company P in Company S is $ 10 million. The reporting dates of Company P for its consolidated financial statements are 30th September and 31st March. The group’s presentation currency is Rs.

On 1st April 20×1, Company P takes a two-year $ 10 million floating rate (Six month LIBOR) loan. Interest payment dates are 30th September and 31st March of the respective years. The loan matures on 31st March 20X3. It is assumed that no transaction costs are incurred relating to the loan issuance.

The management of Company P has decided to hedge its net investment in Company S by designating the $ denominated loan, in order to reduce the volatility in its consolidated balance sheet on account of foreign currency translation of its net investment in Company S. The net investment of Company P is not expected to fall below $ 10 million as company S is a profitable entity and has a profit forecast for future years as approved by the board of directors of Company P. However, on 30th September 20X2, the net investment of Company P in Company S decreases to $ 9.8 million on account of unexpected losses incurred by Company S.

As per hedge effectiveness testing, the hedge is 100% effective upto the time when losses are incurred by Company S which leads to a certain amount of ineffectiveness. Relevant details of the exchange and interest rates are as shown in Table 4 and Table 5 on page 90.

The journal entries for the transaction are as under:

At each period, following the process of consolidation of a foreign subsidiary’s net assets, Company P records a Foreign Currency Translation Reserve (FCTR) which is presented in Column C above. Journal entries relating to the loan are given in Table 6:

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Section B: I. Scheme of amalgamation accounted as per Purchase Method Nagarjuna Fertilizers and Chemicals Ltd (31-3-2012)

From Notes to Financial Statements

1. CORPORATE OVERVIEW

a. Nagarjuna Fertilizers and Chemicals Limited (Erstwhile NFCL) has during the year undertaken restructuring of its businesses. Accordingly, a Composite Scheme of Arrangement and Amalgamation (“Scheme”) was prepared, which was duly consented by the shareholders at the Court Convened Meeting held on 15th April, 2011 and also received the approval of jurisdictional High Courts of Andhra Pradesh at Hyderabad and Bombay at Mumbai. The restructuring envisaged de-merger of the Oil business undertaking to a separate company, Nagarjuna Oil Refinery Limited (“NORL”). The scheme also provide for merger of residual business of Erstwhile NFCL into its wholly owned subsidiary viz., Kakinada Fertilizers Limited (“KFL”) along with the business operation of iKisan Limited (iKisan). The entire scheme is made effective from 30th July, 2011 but operative from 1st April, 2011, being the Appointed Date.

b. Pursuant to the Scheme:

i. Oil Business Undertaking of erstwhile NFCL was demerged into NORL and residual NFCL and iKisan are merged in to KFL.

ii. The Effective Date of the Scheme is 30th July, 2011 but shall be operative from the Appointed Date i.e. 1st April, 2011. The Record Date of determining shareholders eligible to receive shares of KFL and NORL was fixed as 1st September, 2011.

iii. Equity Shares were allotted to the shareholders of erstwhile NFCL and iKisan on 1st October, 2011 and the account of the respective of shares, the existing pre-arrangement issued capital of Rs. 5 lakh stood cancelled.

iv. The name of KFL stands changed to Nagarjuna Fertilizers and Chemicals Limited w.e.f. 19th August, 2011

c. The Financial Statement for the year have been drawn-up incorporating necessary adjustments as envisaged in the Scheme and in compliance with purchase method of accounting under AS 14 (Accounting for Amalgamations). In accordance with the Scheme:

i. the assets and liabilities of residual business of erstwhile NFCL and iKisan have been recorded in the books of KFL at Fair Values as on 1st April, 2011

ii. the fair values were determined by the Board of Directors based on the report obtained from a reputed firm of valuers.

iii. the difference between the fair value of equity shares and face value of equity shares is considered as Securities Premium.

iv. the difference between the value of net assets transferred to KFL over the fair value of Equity shares, and Preference shares allotted is credited to Capital Reserve Account. shareholders were credited in electronic mode or share certificates issued, as the case may be. Consequent to the allotment

v. on and from effective date, the Authorised shares capital of NFCL stands increased to Rs.
801,00,00,000/- comprising of 621,00,00,000 equity shares of Rs. 1/- each and 2,00,00,000 preference shares of Rs. 90/- each.

vi. 59,80,65,003 equity shares of Rs. 1/- each aggregating to Rs. 59,80,65,003/- have been allotted to the shareholders of erstwhile NFCL and iKisan on 1st October, 2011 without payment being received in cash.

d. Amalgamation expenses incurred Rs. 500.16 lakh have been adjusted to capital reserve.

e. The Bombay Stock Exchange vide letter dated 14th December, 2011 approved the application of the company for listing of the equity shares and the National Stock Exchange vide letter dated 13th January, 2012 accorded in-principle approval for listing of the equity shares subject to relaxation by Securities and Exchange Board of India from the fulfilment of requirement under Rule 19(2)(b) of Securities Contracts (Regulation) Rules, 1957.

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Hedge accounting in a volatile environment

Entities generally enter into certain derivative transactions to protect or hedge themselves from risk of fluctuation in certain key variables (such as currency exchange rates, interest rates or commodity prices) that may have a detrimental impact on their profit and loss accounts. In a hedging transaction, there is usually a hedged item and a hedging instrument such that the hedging instrument protects an entity from fluctuations in the value of the hedged item. In order to reflect the impact of hedging activities in the profit or loss account, an entity may elect to apply the hedge accounting principles under IFRS (or Ind AS). These principles provide guidance on designating hedge relationships by identifying qualifying hedged items, hedging instruments and hedged risks.

Qualifying hedged items can be recognised assets, liabilities, unrecognised firm commitments, highly probable forecast transactions or net investments in foreign operations. In general, only derivative instruments entered into with an external party qualify as hedging instruments. However, for hedges of foreign exchange risk only, non-derivative financial instruments (for example, loans) may qualify as hedging instruments.

Hedge accounting allows an entity to either :
• measure assets, liabilities and firm commitments selectively on a basis different from that otherwise stipulated in IFRS or Ind AS (“fair value hegde accounting model”); or

• defer the recognition in profit or loss of gains or losses on derivatives (“cash flow hedge accounting model” or “net investment hedging”).

Hedge accounting is voluntary; however, it is permitted only when strict documentation and effectiveness requirements, as stated in IAS 39 are met. The Ind AS criteria are similar to the IFRS criteria. These criteria are:

• There is formal designation and written documentation at the inception of the hedge.

• The effectiveness of the hedging relationship can be measured reliably. This requires the fair value of the hedging instrument, and the fair value (or cash flows) of the hedged item with respect to the risk being hedged, to be reliably measurable.

• The hedge is expected to be highly effective in achieving fair value or cash flow offsets in accordance with the original documented risk management strategy.

• The hedge is assessed and determined to be highly effective on an ongoing basis throughout the hedge relationship. A hedge is highly effective if changes in the fair value of the hedging instrument, and changes in the fair value or expected cash flows of the hedged item attributable to the hedged risk, offset within the range of 80-125 percent.

• For a cash flow hedge of a forecast transaction, the transaction is highly probable and creates an exposure to variability in cash flows that ultimately could affect profit or loss.

One of the more common hedging transactions entered into by entities is a hedge of highly probable forecast transactions (purchases or sales), considered a cash flow hedge. A cash flow hedge is a hedge of the exposure to variability in cash flows that is attributable to a particular risk associated with a recognised asset or liability, or a highly probable forecast transaction that could affect profit or loss. In the case of hedges of highly probable forecast purchase or sale transactions in foreign currency, the hedged risk would be currency risk, the hedged items are the forecast purchases/sales and the hedging instruments typically used are currency forwards.

Given below is an example of applying hedge accounting to the cash flow hedge of a highly probable forecast purchase.

Example:
Company R is an Indian company with Indian Rupees (INR) as the functional currency. The reporting dates of Company R are 30th June and 31st December.

On 1st January 20X0, Company R expects to purchase a significant amount of raw materials in future for its production activities. A Company based in the US will supply the raw materials. Company R’s management forecasts 100,000 units of raw material will be received and invoiced on 31st July 20X1 at a price of USD 75 per unit. For convenience, it is assumed that the invoice will also be paid on 31st July 20X1.

The Company’s management decides to hedge the foreign currency risk arising from this highly probable forecast purchase. R enters into a forward contract to buy USD and sell INR. The negotiations with the US Company are in advanced stages and the board of Company R has approved the transaction.

On 1st January 20X0, the Company enters into a US Dollar forward contract, to purchase USD 7,500,000 at a forward rate of INR/USD 46.245, by selling an equivalent INR sum of INR 346,837,500 on 31st July 20X1.

Exchange Rates on various dates are as shown in Table 1 :

Annualised interest rates applicable for discounting cash flows on 31 July 20X1 at various dates of the hedge are as shown in Table 2:

The fair value of the foreign currency forward contract at each measurement date is computed as the present value of the expected settlement amount, which is the difference between the contractually set forward rate and the actual forward rate on the date of measurement, multiplied by the discount factor.

On 1st January 20X0, which is the start date of the forward contract, the fair value of the derivative will be nil, as the difference between the contractually set forward rate and the actual forward rate (7,500,000 * (46.2450 – 46.2450)) is Nil.

On 30th June 20X0, the actual forward rate is 45.9732 and discount factor of 0.9138. Accordingly, the fair value of the currency forward contract is Rs. (1,862,774) i.e. [(7,500,000 * (45.9732 – 46.2450)) * 0.9138].

The fair value of the currency forward contract at each measurement date is computed in the same manner. Accordingly, the fair values at each measurement date are shown in Table 3.

The company designates this hedge relationship on 1st January 20X0.

Hedge effectiveness testing needs to be performed on a prospective as well as on a retrospective basis. A common way to measure hedge effectiveness is the cumulative dollar offset method which is a quantitative method that consists of comparing the change in fair value or cash flows of the hedging instrument with the change in fair value or cash flows of the hedged item attributable to the hedged risk.

Prospective testing will consider the expected variability in cash flows based on possible movements in exchange rates using dollar offset/hypothetical derivative method. Retrospective testing will consider actual variability in value/cash flows based on actual changes in forward rates.

In the given case, hedge effectiveness has been assessed prospectively and retrospectively using the cumulative dollar offset method and a hypothetical derivative for the notional amount of hedged purchases to demonstrate a relationship between the change in fair value of the hedging instrument and the change in fair value of the hedged item. The hypothetical derivative method is used to measure hedge effectiveness and ineffectiveness and is based on the comparison of the change in the fair value of the actual contracts designated as the hedging instrument and the change in the fair value of a hypothetical hedging instrument for purchases in the month of payment (considering that payment is the designated hedged item). In the given case, the hypothetical derivative that models the hedged cash flows would be a forward contract to pay $ 7,500,000 in return for INR.

The effectiveness of the relationship will be demonstrated by the following ratio:
Cumulative change in the fair value of the forward contract(s) by designated expiry.

Cumulative change in the fair value of the Hypo-thetical Derivative.

If the ratio of the change is within the range of 80% to 125%, the hedge will be determined to both continue to be, and to have been highly effective.

In this example, using the cumulative dollar offset method and a hypothetical derivative, the hedge effectiveness has been assessed as 100% effective at each measurement date. This is primarily because the date of maturity of the currency forward contract and date of the forecasted purchase payment, and the notional amount being hedged is the same. Hence, the ratio of fair value of the forward contract undertaken (hedging instrument) and the hypothetical derivative is 100% in each case. In practice, ineffectiveness often arises due to any changes in the expected timing of the purchase/ collection and the maturity date of the derivative. For example, though the derivative matures at the end of the month, the payment may occur at any time during the month.

Journal Entries (ignoring the impact of taxes) for the transaction using hedge accounting:

Date

Particulars

Dr/ Cr

Amount

(INR)

1-Jan-X0

No entry as the fair value of the currency
forward contract is nil

30-Jun-X0

Hedging reserve (OCI)W

1,862,774

To Derivative (liability)

1,862,774

(Being, change in the effective portion of
the fair value of the cur-

rency forward
contract)

31-Dec-X0

Derivative (asset)

2,141,046

Derivative (liability)

1,862,774

To Hedging reserve (OCI)

4,003,820

(Being, change in the effective portion of
the fair value of the cur-

rency forward
contract – difference between the fair value between

measurement dates 31
December 20X0 and 30 June 20X0 (-1,862,774

– 2,141,046))

30-Jun-X1

Derivative (asset)

2,519,448

To Hedging reserve (OCI)

2,519,448

(Being, change in the effective portion of
the fair value of the currency

forward contract –
(4,446,495 – 2,141,046))

31-Jul-X1

Derivative (asset)

4,002,005

To Hedging reserve (OCI)

4,002,005

(Being, change in the effective portion of
the fair value of the cur-

rency forward
contract)

31-Jul-X1

Inventory

355,500,000

To Trade Payable

355,500,000

(Being,
recognition of purchase
of inventory at
spot rates

i.e.7,500,000*47.4)

31-Jul-X1

Hedging reserve (OCI)

8,662,500

To Inventory

8,662,500

(Being, recognition of gains recognised in
equity into the carrying

amount of the
inventory acquired by Company R. The
net impact

of this adjustment is
that the inventory is ultimately recognised at

the forward rate of
46.245; alternatively this could have been carried

in OCI and released
to the P&L account directly when the inventory

would have been
booked in the P&L account)

31-Jul-X1

Cash

8,662,500

To Derivative (asset)

8,662,500

(Being, settlement of derivative in cash)

31-Jul-X1

Trade Payable

355,500,000

To Cash

355,500,000

(Being, settlement of trade payable)

In this example, since the hedge is 100% effective. the fair value of the currency forward contract has been taken to Hedging Reserve at each period end.

Conclusion:

By adopting hedge accounting, a company is able to align its risk management policy with its accounting treatment and better represent the transaction in its financial statements. It also reduces the volatility in the profit and loss account by deferring the unrealised gains or losses on the hedging instruments to other comprehensive income. In the future articles, we shall discuss examples on the other two type of hedges i.e. fair value hedge and hedge of a net investment in a foreign operations.

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Ind-AS impact on retail industry and summary of the carve-outs

The final Indian Accounting Standards (Ind-ASs) have been notified by the Ministry of Corporate Affairs (MCA) vide its announcement dated 25th February 2011. With the announcement, the final position of Ind-ASs, including key carveouts, has become clear. However, the MCA announcement does not convey the effective dates for the application of the Ind-ASs, giving an impression to industry that the implementation of Ind-AS is deferred. However, such an interpretation may be made with caution, as the final notified date of transition may not be too far.

The adoption of Ind-AS will have an impact on financial reporting of many entities, some of which are sector-specific, while some may be entityspecific. This article attempts to analyse some of the key impact areas on transition to Ind-AS for the retail industry and summarises the carve-outs vis-à-vis the IFRS.

Revenue recognition:
Principal v. Agent: Many a time, the retailer permits another entity to operate from its retail outlet. Under such cases, the retailer should closely evaluate its risks emanating from the arrangement to determine whether the retailer is ultimately selling the goods to the customer in his own capacity or the retailer is only facilitating the sale of goods in his capacity as an agent.

Under the current practice, a retailer invariably recognises the gross value of sales proceeds as revenue in the absence of clear guidance in distinguishing a principal from an agent.

Ind-AS provides more elaborate guidance on classification between a principal and an agent. It clarifies that if the retailer carries significant risks (such as inventory risk and price risk) and determines the price of goods, it is considered a principal, or else an agent. If the retailer is acting as the agent, then only the commission earned should be booked as revenues.

Customer loyalty programmes: Most retailers use consumer promotional schemes to increase business opportunities. These promotions typically include offers such as award credits or points through a loyalty scheme or the provision of a future discount through vouchers or coupons. Award credits may be linked to individual purchases or group of purchases. The customer may redeem the award credits for free or discounted goods or services.

Under current practice, there is no specific guidance on accounting for customer loyalty programmes. Certain entities recognise the cost of discounted/ free goods along with cost of sales, while certain entities present such costs as sales promotion expense. Further certain entities recognise the cost upfront based on estimates, while certain entities recognise the cost on incurrence.

Under Ind-AS, the revenue transactions under customer loyalty programmes are considered to have multiple elements, where the revenue attributable to the sale of goods either free of cost or at discounted price in future is recognised separately from the current sale transaction. The principles of recognition of customer loyalty programmes are as under:

An entity recognises the award credits as a separately identifiable component of revenue and defers the recognition of revenue related to the award credits until its utilisation.

The revenue attributed to the award credits takes into account the expected level of redemption.

The consideration received or receivable from the customer is allocated between the current sales transaction and the award credits by reference to their fair values.

The fair value is determined based on relative fair value method (where the benefit under the award is charged proportionately to each component).

The above guidance shall lead to initial deferral of revenue attributable to the award credits.

Product warranties: In the retail industry, the retailers often provide warranty on sale of products of its own brand. Currently such warranty obligations are accounted for through full recognition of revenue and an accrual of estimated costs, irrespective of the duration of the warranty period. Under Ind-AS, where the normal warranty offered by entities is for a duration of more than a year, the warranty provision would be recognised at its discounted value. The provisions would accrete over the expected term of the provision leading to an interest expense.

Thus the warranty costs to the extent of time value of money would be recognised as interest cost.

Leases:
Often the lease arrangements involve an initial fit-out period before commencement of the retail store’s operation, during which the retailer may be offered a rent-free right to use the leased premise. The rent would commence on the commencement of the operations. In the absence of elaborate guidance on such arrangements, currently the lease rent is usually recognised based on the commencement of the lease payments.

The Ind-ASs provide specific guidance on treatment of such lease incentives as part of the net consideration agreed for the use of the leased asset, irrespective of the incentive’s nature or form or timing of payments. As such, the retailer (lessee) shall recognise the incentives as a reduction of rental expense over the lease term on a straightline basis, unless another systematic basis is representative of the time pattern of the lessee’s benefit from the use of the leased asset.

Thus, the lease rent shall be recognised even for the period when there were no lease rentals payable, leading to a higher lease rental during the initial rent-free period. However, the subsequent lease rental charge would decline on account of the lease incentives being recognised as a reduction of lease rent expense over the lease term.

Interest-free lease deposits: The retail outlets are invariably taken on a noncancellable operating lease with an interest-free lease deposit. Under the current practice, the interest-free deposits are recognised as such at their transaction values.

Under the Ind-ASs, such interest-free deposits are classified as financial assets, which are required to be recognised at its fair value on initial recognition and at its amortised cost subsequently. These interest-free deposits are recognised at their discounted values and the difference between the contractual amount and discounted values represent the prepaid lease rent. The lease deposits would accrete over the lease term to match the undiscounted amount, leading to interest income, while the prepaid lease rent would be amortised as lease rent over the lease term on a straight-line basis.

As such, the accounting treatment under Ind- AS would lead to grossing up of lease rent and interest income. However, as the lease rents would be charged on straight-line basis and the interest income on effective interest rate basis, the higher lease rents may not exactly offset the interest income for the intervening reporting periods, though they would exactly offset when the entire lease term is considered together.

Asset retirement obligations: The retailers that acquire their stores on lease invariably are obligated to return the leased premises to the lessor on completion of the lease term on an ‘as-is’ basis. The retailer is obligated to remove its fixed assets, especially the leasehold improvements, on completion of the lease term.

Ind-ASs, in line with the current practice, require the creation of a provision for asset retirement obligations when there is an obligation for outflow of economic resources that is probable and can is reliably measurable. However, it is not common to find entities, other than exploration companies, that recognise the asset retirement obligations under the current practice on account of lack of elaborate guidance under the current GAAP.

Ind-AS requires a provision (and a corresponding asset) to be created at the initial stage by discounting the eventual estimated liability to its present value. The discount is unwound by way of recognising an interest expense over the life of the asset. Further, the provision is required to be re-estimated every reporting date. Apart from re-estimating the amount and timing of the outflow of economic resources, even the discounting factor is also re-estimated at each reporting period and is accounted as a change of estimates.

Application of Ind-AS will lead to an increase in the depreciation charge related to the cost capitalised and higher finance costs on account of unwinding the discount over the life of the asset.

Key carve-outs:

The final Ind AS includes several ‘carve-outs’ (deviations) from IFRS as issued by the International Accounting Standards Board (IASB). The Indian standard-setters have examined individual IFRS and modified the requirements where deemed necessary to suit Indian conditions. ‘Carve-outs’ are generally perceived as non-desirable, since they would dilute the key purpose of converging with IFRS (i.e., to have a common set of accounting standards across countries; provide seamless access to international capital markets; provide comfort to investors).

An analysis of the Ind AS carve-outs reveal that while some of the carve-outs are mandatory and represent clear deviations from IFRS, several of the carve-outs represent removal of policy choices under IFRS in certain areas or conversely provide alternate policy choices under Ind AS for certain other areas.

Let us start with the first category of carve-outs (mandatory deviations). The significant mandatory deviations from IFRS that an Indian company cannot avoid are a handful. These include revenue recognition for real estate sales on the basis of percentage completion method (IFRS requires revenue recognition when the final possession is given to the customer) and accounting for the equity conversion option of a foreign currency convertible bond (FCCB) as an equity component (IFRS requires the equity conversion option to be periodically marked-to-market). Our experience indicates that these carve-outs are not expected to impact a wide cross-section of companies. There are some other, less substantive, mandatory deviations (for example, use of a government bond rate for discounting employee benefit obligations as opposed to corporate bond rates required by IFRS or excluding own credit risk in fair valuation of certain financial liabilities).

Let us now examine the second category of carve-outs (removal of policy choices). There are several areas where IFRS offers multiple policy choices, while Ind AS prescribes one of these policy choices. Such carve-outs include (1) Single statement presentation of the income statement (IFRS permits the statement of comprehensive income to be presented separately) (2) Classification of expenses in the profit and loss account by their nature (IFRS permits classification by function) (3) Classification of interest and dividend as financing/ investing cash flows (IFRS permits operating classification) (4) No choice to carry investment property at fair value (IFRS permits this) (5) Recognition of actuarial gains and losses directly in reserves (IFRS permits alternatives including recognition in the profit and loss account) and Recomputation of borrowing costs capitalisable (IFRS permits prospective application).

This category of carve -outs does not result in deviations from IFRS, as they represent permitted policy choices. These could pose a challenge for Indian companies, if global peers follow other alternative policies; 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.

The third category of carve-outs (additional policy choices) represent an area where a company can either elect to follow policies aligned to IFRS, or alternate policies that diverge from IFRS. Such carve-outs include (1) Choice to defer exchange differences on long-term foreign currency assets and liabilities, and recognise such differences over the period of the underlying asset/liability (IFRS requires all such differences to be immediately charged to the profit and loss account) (2) Choice to consider Indian GAAP carrying values as ‘deemed cost’ for fixed assets acquired prior to transition date (IFRS offers no such choice on transition — retrospective IFRS values or ‘fair values’ are the two choices on transition; Ind-AS offers a third choice). This category of carve-outs represents an area where each individual company needs to apply careful thought and consideration. While assessing these policy choices, companies need to evaluate not just their current environment, but future plans (for example, plans for a future overseas listing).

The notified converged standards have also deferred the applicability of guidance on accounting for embedded leases and service concession arrangements.

These carve-outs could have been avoided, but the Government has adopted a practical approach to implement a significant and complex change in the accounting framework. It is now up to each company to choose whether they want to fully converge with IFRS (subject to the mandatory deviations discussed above) or take a simpler way out to manage the transition.

Ind-AS financial statements for subsequent periods can be made compliant with IFRS if a company chooses optimal accounting policies and does not adopt the prescribed alternatives available under Ind AS (other than those impacted by mandatory deviations).

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Tata Motors Ltd. (31-3-2010)

From Accounting Policies: Product Warranty Expenses: The estimated liability for product warranties is recorded when products are sold. These estimates are established using historical information on the nature, frequency and average cost of warranty claims and management estimates regarding possible future incidence based on corrective actions on product failures. The timing of outflows will vary as and when warranty claim will arise —being typically up to three years.

From Notes to Accounts: Other provisions include [Schedule 12(e), page 72]:

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Siemens Ltd. (30-9-2010)

From Accounting Policies:

Provision: Provisions comprise liabilities of uncertain timing or amount. Provisions are recognised when the Company recognises it has a present obligation as a result of past events, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation and a reliable estimate can be made of the amount of the obligation.

Provisions are not discounted to its present value and are determined based on best estimate required to settle the obligation at the balance sheet date. These are reviewed at each balance sheet date and adjusted to reflect current best estimates.

Disclosures for contingent liability are made when there is a possible or present obligation for which it is not probable that there will be an outflow of resources. When there is a possible obligation or a present obligation in respect of which the likelihood of outflow of resources is remote, no disclosure is made.

Loss contingencies arising from claims, litigation, assessment, fines, penalties, etc. are recorded when it is probable that a liability has been incurred and the amount can be reasonably estimated.

Contingent assets are neither recognised, nor disclosed in the financial statements.

From Notes to Accounts:

Disclosure relating to provisions:
Provision for warranty: Warranty costs are provided based on a technical estimate of the costs required to be incurred for repairs, replacement, material cost, servicing and past experience in respect of warranty costs. It is expected that this expenditure will be incurred over the contractual warranty period.

Provision for liquidated damages:
Liquidated damages are provided based on contractual terms when the delivery/commissioning dates of an individual project have exceeded or are likely to exceed the delivery/commissioning dates as per the respective contracts. This expenditure is expected to be incurred over the respective contractual terms up to closure of the contract (including warranty period).

Provision for loss orders:
A provision for expected loss on construction contracts is recognised when it is probable that the contract costs will exceed total contract revenue. For all other contracts loss order provisions are made when the unavoidable costs of meeting the obligation under the contract exceed the currently estimated economic benefits.

Contingencies:
The Company has made provisions for known contractual risks, litigation cases and pending assessments in respect of taxes, duties and other levies, the outflow of which would depend on the cessation of the respective events.

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Jet Airways (India) Ltd. (31-3-2010)

From Accounting Policies: Provisions, contingent liabilities and contingent assets:

Provisions involving a substantial degree of estimation in measurement are recognised when there is a present obligation as a result of past events and it is probable that there will be an outflow of resources. Contingent Liabilities are not recognised but are disclosed in the notes. Contingent Assets are neither recognised, nor disclosed in the financial statements.

From Notes to Accounts:

As per Accounting Standard-29, Provisions, Contingent Liabilities and Contingent Assets, given below are movements in provision for Frequent Flyer Programme, Redelivery of Aircraft, Aircraft Maintenance Costs and Engine Repairs Costs.

(a) Frequent Flyer Programme: The Company has a Frequent Flyer Programme named ‘Jet Privilege’, wherein the passengers who frequently use the services of the Airline become members of ‘Jet Privilege’ and accumulate miles to their credit. Subject to certain terms and conditions of ‘Jet Privilege’, the passenger is eligible to redeem such miles lying to their credit in the form of free tickets.

The cost of allowing free travel to members as contractually agreed under the Frequent Flyer Programme is accounted considering the members’ accumulated mileage on an incremental cost basis. The movement in the provision during the year is as under:

Particulars	2009-10	2008-09
Opening balance	3,344	2,949
Add :
Additional provisions during the year	1,346	1 ,446
Less :
Amounts used during the year	(1,053)	(1,0 51)
Less :
Unused amounts reversed
during the year	(416)	—
Closing balance	3,221	3,344

(b) Redelivery of aircraft:

The Company has in its fleet aircraft on operating lease. As contractually agreed under the lease agreements, the aircraft have to be redelivered to the lessors at the end of the lease term in the stipulated technical condition. Such redelivery conditions would entail costs for technical inspection, maintenance checks, repainting costs prior to its redelivery and cost of ferrying the aircraft to the location as stipulated under the lease agreement.

The Company therefore provides for such redelivery expenses, as contractually agreed, in proportion to the expired lease period.

Particulars Opening Balance	2009-10 3,031	2008-09 2,115
Add : Additional provisions during the year*	315	1,441
Less : Amounts used during the year	753	525
Less : Un-used amounts reversed during the year	—	—
Closing balance	2,593	3,031

The cash outflow out of the above provisions as per the current terms under the lease agreements are as under:

Year

2009-10

2008-09

Aircraft

Amount

Aircraft

Amount

(Rs. in lakhs)

(Rs.
in lakhs)

2010-11

256

394

2011-12

205

2012-13

1,493

1,286

2014-15

130

106

2015-16

425

269

2017-18

—

2018-19

2019-20

—

Total

2,593

2,154

Aircraft maintenance costs:

Certain heavy maintenance checks including over-haul of auxiliary power units need to be performed at specified intervals as enforced by the Director General of Civil Aviation in accordance with the Maintenance Programme Document laid down by the manufacturers. The movements in the provisions for such costs are as under:

Particulars

2009-10

2008-09

Opening balance

3,433

2,115

Add/(Less)
:

Adjustments during the year*

(268)

1,441

Less
:

Amounts used during the year

(1,230)

525

Less
:

Unused amounts reversed

during the year

(166)

—

Closing balance

1,769

3,031

Adjustments during the year represent exchange fluctuation impact consequent to restatement of liabilities denominated in foreign currency.

(d) Engine repairs cost:

The aircraft engines have to undergo shop visits for overhaul and maintenance at specified intervals as per the Maintenance Programme Document. The same was provided for on the basis of hours flown at a pre-determined rate.

Amount (Rs. in lakhs)

Particulars

2009-10

2008-09

Opening balance

333

657

Add/(Less)
:

Adjustments during the year*

(6)

164

Less
:

Amounts used during the year

327

372

Less
:

Unused amounts reversed

during the year

—

116

Closing balance

—

333

*Adjustments during the year represent exchange fluctuation impact consequent to restatement of liabilities denominated in foreign currency.

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GAPs in GAAP — Presentation of Comparatives under Ind-AS

The Institute of Chartered Accountants of India (ICAI) recently submitted a set of near-final Indian IFRS standards (known as ‘Ind-AS’) to the National Advisory Committee on Accounting Standards (NACAS). Subsequently, the Ministry of Corporate Affairs (MCA) notified the Ind-AS standards. These notified standards contain many changes from the IFRS as issued by the International Accounting Standard Board (IASB). Some of the changes are resulting in internal inconsistencies or may give rise to practical challenges (generally referred to as ‘GAP in GAAP’ by the author). This article highlights one such key issue. Whilst all the previous articles have focussed on Indian GAAP, henceforth this series will also additionally bring out the GAP in GAAP on the new Ind-AS’s.

IFRS 1 First-time adoption requires a company to transit from a previous GAAP (say, Indian GAAP) to IFRS at the beginning of the comparative period. Therefore an Indian company that has to prepare IFRS accounts for 2011-12 financial year, will transit to IFRS on 1st April 2010 (transition date or start date). This approach results in the company having both the current year (2011-12) and the comparable year (2010-11) prepared under IFRS with one transition date. By providing comparable numbers under the same IFRS framework, investors and analysts will have a better understanding of those financial statements.

A somewhat different approach is followed in Ind- AS 101 First-time Adoption of Ind-AS. Under this standard there is no mandatory requirement to prepare comparable numbers under the same Ind-AS framework. So typically an Indian company would have current year numbers under Ind-AS 101 prepared with the transition date of 1st April 2011 and comparable numbers as per Indian GAAP. Under this approach, the investors and analysts may face difficulties in understanding the financial statements that do not contain comparable numbers prepared under the same reporting framework.

There is another alternative approach that is allowed under Ind-AS 101, so that companies can provide comparative information under Ind-AS. Ind-AS 101 defines the ‘transition date’ as the beginning of the current period, i.e., 1st April 2011. Thus, a company cannot adopt Ind-AS from the beginning of the comparative period. If it desires to give comparative information as per Ind-AS in its first Ind-AS financial statements, it can do so on memorandum basis only. For the purposes of preparing comparative information on a memorandum basis, the company will have a deemed transition date, i.e., 1st April 2010. This gives rise to the following issue.

If a company decides to give Ind-AS comparatives in the first year of adoption, it will use two transition dates : actual transition date and memoranda/ deemed transition date. For example, if a company covered in phase 1 of the IFRS conversion roadmap and having 31st March year decides to give one year comparative, its actual transition date will be 1st April 2011. In addition, it will use 1st April 2010 as memoranda/deemed transition date to prepare memoranda comparatives. It may be noted that the memorandum balance sheet prepared at the end of 31st March 2011, will not be carried forward and a new balance sheet will be prepared at 1st April 2011, by applying Ind-AS 101 all over again. Though the intention is to provide comparability between two years under Ind-AS, the approach in Ind-AS 101 will end up doing exactly the opposite. Given below are few examples that explain the point.

(a) A company acquires a new business whose acquisition date falls within the memoranda comparable period (2010-11 in the above example). In preparing its memoranda information as at and for the year ended 31st March 2011, the company will apply acquisition accounting as per Ind-AS 103 Business Combinations. However, in preparing Ind-AS opening balance sheet at 1st April 2011, it can still use Ind-AS 101 exemption and continue with previous GAAP accounting under Indian GAAP, after making certain specific adjustments. The 2010-11 numbers will have the impact of acquisition accounting, but the 2011-12 numbers will be based on Indian GAAP accounting.

(b) A company decides to use fair value as deemed cost exemption for property, plant and equipment (PPE). For its memoranda transition, it will determine the fair value as at 1st April 2010. For actual transition, fair valuation as at 1st April 2011 will be needed. Other than having to do fair valuation for two transition dates, the value of the PPE and the resultant depreciation for the two years will not be comparable.

Paragraph 21(b)(ii) of Ind-AS 101 actually acknowledges this fact and states that “For example, the first-time adopter for whom the first reporting period is financial statements for the year ending 31st March, 2012 would apply the exceptions and exceptions as at 1st April, 2010 and 1st April, 2011; accordingly the balance sheet as at end of 31st March, 2011 may not be equivalent to the opening balance sheet as at 1st April, 2011.”

Requiring IFRS conversion on two transition dates (i.e., 1st April 2010 and 1st April 2011), so as to enable a company to prepare comparative numbers under Ind-AS seems rather unique, unnecessary cost and burden and self-defeating. The approach results in nonmatching of the balance sheets and in many cases may actually distort comparability. It is therefore likely that many companies may provide comparable numbers only under Indian GAAP rather than under Ind-AS.

For the standards-setters a better strategy would have been to accept IFRS 1, as it is. This standard would require transitioning to IFRS on 1st April 2010 as a starting point. Comparable and current year numbers would be prepared on that basis and the issue of noncomparability or non-matching balance sheets would not arise. Moreover investors would have found it easy to understand and useful for decision-making purposes. Global investors too would have preferred it, as being compliant with IASB IFRS.

It may be noted that this article assumes that the transition date is as suggested in the original roadmap issued by the MCA. However, MCA has clarified on the notified standards that the implementation date will be intimated later. Therefore it cannot be said with any certainty whether the dates mentioned in the roadmap will be met.

levitra

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Revised Schedule VI — An Analysis

Introduction

Section 211(1) of the Companies Act, 1956 requires all companies to draw up the Balance Sheet and Statement of Profit and Loss account as per the form set out in Schedule VI. The pre-revised Schedule VI was introduced in 1976.

As mentioned in the Foreword of the ICAI Guidance Note on Revised Schedule VI to the Companies Act, 1956 (ICAI GN), “to make Indian business and companies competitive and globally recognisable, a need was felt that format of Financial Statements of Indian corporates should be comparable with international format. Since most of the Indian Accounting Standards are being made at par with the international Accounting Standards, the changes to format of Financial Statements to align with the Accounting Standards will make Indian companies competitive on the global financial world. Taking cognisance of imperative situation and need, the Ministry of Corporate Affairs revised the existing Schedule VI to the Companies Act, 1956”.

The Ministry of Company Affairs (MCA) vide Notification dated 28th February 2011 notified the format of Revised Schedule VI. Further vide Notification dated 30th March 2011, it was clarified that the “The new format shall come into force for the Balance Sheet and Profit and Loss Account to be prepared for the financial year commencing on or after 1st April 2011”.

The ICAI GN issued in December 2011 gives detailed guidance on the Revised Schedule VI and the manner in which the various instructions contained in Revised Schedule VI are to be interpreted.

The structure of Revised Schedule VI is as under:

(a) General Instructions
(b) Part I — Form of Balance Sheet
(c) General Instructions for preparation of Balance Sheet
(d) Part II — Form of Statement of Profit and Loss
(e) General Instructions for preparation of Statement of Profit and Loss

It should be noted that besides the format for preparation of Balance Sheet and Profit and Loss statement as notified by the Revised Schedule VI, there are other disclosure requirements also. These disclosures are:

(a) Disclosures as per the notified Accounting Standards i.e., as per the Companies (Accounting Standards) Rules, 2006;

(b) Disclosures under the Companies Act, 1956 (e.g., on buyback of shares — section 77, political contributions — section 293, etc.);

(d) Disclosures as per other ICAI pronouncements (e.g., disclosure on MTM exposure for derivatives);

(e) In case of listed companies, disclosures under Clause 32 of the Listing Agreement (e.g., Loans to associate companies, etc.)

Applicability of the Revised Schedule

VI As mentioned in the Notification dated 30th March 2011, financial statements for all companies have to be prepared using the format given by Revised Schedule VI for financial years commencing on or after 1st April 2011.

A company having its financial year ending on, say, 30th June 2011, 30th September 2011 or 31st December 2011 cannot adopt the new format since their financial years have not commenced on or after 1st April 2011. Since the format of Revised Schedule VI is a statutory format, a company cannot decide to follow the same even on a voluntary basis. However, if a company decides to prepare its financial statements from 1st April 2011 to 31st December 2011 (i.e., for a period of 9 months), it will have to prepare the same using the format of Revised Schedule VI.

All companies registered under the Companies Act, 1956 have to prepare their financial statements using Revised Schedule VI. However, proviso to section 211 exempts banking companies, insurance companies and companies engaged in generation or supply of electricity from following the said format since these are governed by their respective statutes. However, since the Electricity Act 2003 and the Rules thereunder do not prescribe any format for preparing financial statements, such companies will have to follow the format laid down by the Revised Schedule VI till a separate format is prescribed.

Listed companies require to publish information on quarterly and annual basis in the prescribed format in terms of clauses 41(l)(ea) and 41(l)(eaa) of the Listing Agreement. These formats are inconsistent with formats under the Revised Schedule VI. However, since the formats are statutory formats as per the Listing Agreement, the same will have to be followed till the time a new format is prescribed under Clause 41 of the Listing Agreement.

Companies which are in the process of making an issue of shares (IPO/FPO) have to file ‘offer documents’ containing among other details, financial information of the last 5 years. The formats of Balance Sheet and Statement of Profit and Loss prescribed under the SEBI (Issue of Capital & Disclosure Requirements) Regulations, 2009 (‘ICDR Regulations’) are inconsistent with the format of the Balance Sheet/Statement of Profit and Loss in the Revised Schedule VI. However, since the formats of Balance Sheet and Statement of Profit and Loss under ICDR Regulations are only illustrative, to make the data comparable and meaningful for users, companies will be required to use the Revised Schedule VI format to present the restated financial information for inclusion in the offer document. It may also be noted that the MCA had vide General Circular No. 62/2011, dated 5th September 2011 has clarified that ‘the presentation of Financial Statements for the limited purpose of IPO/FPO during the financial year 2011-12 may be made in the format of the pre-revised Schedule VI under the Companies Act, 1956. However, for period beyond 31st March 2012, they would prepare only in the new format as prescribed by the present Schedule VI of the Companies Act, 1956’.

Revised Schedule VI requires that except in the case of the first financial statements (i.e., for the first year after incorporation), the corresponding amounts for the immediately preceding period are to be disclosed in the Financial Statements including the Notes to Accounts. Accordingly, corresponding information will have to be presented starting from the first year of application of the Revised Schedule VI. Thus, for the Financial Statements for the financial year 2011-12 corresponding amounts need to be given for the financial year 2010-11. This will require all companies to take an extra effort to compile the corresponding amounts for 2010-11 for disclosing in Revised Schedule VI prepared for the financial year 2011-12.

All companies whether private or public, whether listed or unlisted, and irrespective of their size in terms of turnover, assets, etc. (other than those mentioned in para 9 above) will have to adhere to the new format of financial statements from 2011-12 onwards. Many small or family-owned companies which are run as an extension of partnerships will have difficulties in adopting the new formats since they may not have the necessary trained manpower or infrastructure for such changeover.

Major principles as per Revised Schedule VI

Revised Schedule VI has eliminated the concept of ‘Schedules’. Such information will now have to be provided in the ‘Notes to accounts’. Accordingly, the manner of cross-referencing to various other information contained in financial statements will also be changed to ‘Note number’ as against ‘Schedule number’ in pre-revised Schedule VI.

As per general instructions contained in the Revised Schedule VI, the terms used shall carry the meanings as per the applicable Accounting Standards (AS). As per the ICAI GN, the applicable AS for this purpose shall mean the AS notified by the Companies (Accounting Standards) Rules, 2006.

Revised Schedule VI requires that if compliance with the requirements of the Companies Act, 1956 (Act) and/or AS requires a change in the treat-ment or disclosure in the financial statements, the requirements of the Act and/or AS will prevail over Revised Schedule VI.

As per preface to the AS issued by ICAI, if a par-ticular AS is not in conformity with law, the provi-sions of the said law or statute will prevail. Using this principle, disclosure requirements of existing Schedule VI were considered to prevail over AS. However, since the Revised Schedule VI gives specific overriding status to the requirements of AS notified by the Companies (Accounting Stan-dards) Rules, 2006, the same would prevail over the Revised Schedule VI.

There are several instances of conflict between provisions of the Revised Schedule VI and the notified AS e.g., definition of Current Investments as per the Revised Schedule VI and AS -11, definition of Cash and Cash Equivalents as per the Revised Schedule VI and AS-3, treatment of proposed dividend as per the Revised Schedule VI and AS- 4, etc. In all such cases, provisions of the AS will prevail over the Revised Schedule VI.

The nomenclature for the Profit and Loss account is now changed to ‘Statement of Profit and Loss’. Also, only the vertical format is prescribed for both Balance Sheet and the Statement of Profit and Loss.

The format of the Statement of Profit and Loss as per the Revised Schedule VI does not contain disclosure of appropriations like transfer to reserves, proposed dividend, etc. These are now to be disclosed in the Balance Sheet as part of adjustments in ‘Surplus in Statement of Profit and Loss’ contained in ‘Reserves and Surplus’. Further, debit balance of ‘profit and loss account’, if any, is to be disclosed as a reduction from ‘Reserves and Surplus’ (even if the final figure of Reserves and Surplus becomes negative).

It is clarified by the Revised Schedule VI that the requirements mentioned therein are minimum requirements. Thus, additional line items, sub-line items and sub-totals can be presented as an addition or substitution on

the face of the financial statements if the company finds them necessary or relevant for understanding of the company’s financial position. Also, in preparing the financial statements, a balance will have to be maintained between providing excessive detail that may not assist users of the financial statements and not providing important information as a result of too much aggregation.

Revised Schedule VI requires use of the same unit of measurement uniformly throughout the financial statements and ‘Notes to Accounts’. Rounding off requirements, if opted, are to be followed uniformly throughout the financial statements and ‘Notes to Accounts’. The rounding off requirements as per pre-revised Schedule VI and as per the Revised Schedule VI are summarised in the following table:

Some disclosures no longer required in the Revised Schedule VI

The disclosure requirements as per the Revised Schedule VI do not contain several disclosures which were required by pre-revised Schedule VI. Some of these are:

(a)   Disclosures relating to managerial remuneration and computation of net profits for calculation of commission;
(b)   Information relating to licensed capacity, installed capacity and production;
(c)   Information on investments purchased and sold during the year;
(d)   Investments, sundry debtors and loans & advances pertaining to companies under the same management;
(e)   Maximum amounts due on account of loans and advances from directors or officers of the company;
(f)   Commission, brokerage and non-trade discounts; and
(g)   Information as required under Part IV of pre-revised Schedule VI.

Major changes in the format of Balance Sheet
Equity and Liabilities

A new disclosure requirement regarding details of number of shares held by each shareholder holding more than 5% shares in the company is inserted by the Revised Schedule VI. The ICAI GN has clarified that in the absence of any specific indication of the date of holding, such information should be based on shares held as on the Balance Sheet date. For this disclosure, the names of the shareholders would be normally available from the Register of Members required to be maintained by every company.

Details pertaining to number of shares issued as bonus shares, shares bought back and those allot-ted for consideration other than cash needs to be disclosed only for a period of five years immediately preceding the Balance Sheet date including the current year. Under the pre-revised Schedule VI requirement is to disclose such items at all times.

In case of listed companies, share warrants are issued to promoters and others in terms of SEBI guidelines. Since such warrants are effectively and ultimately intended to become part of capital, Revised Schedule VI requires that the same be disclosed as part of the Shareholders’ funds as a separate line-item — ‘Money received against share warrants.’ In case the said warrants are forfeited, the amount already paid up would be transferred to ‘Capital Reserve’ and disclosed as part of ‘Reserves and Surplus’.

There are specific disclosures required by the Re-vised Schedule VI for ‘Share Application money pending allotment’. It has been also stated that share application money not exceeding the issued capital and only to the extent not refundable is to be included under ‘Equity’ and share application money to the extent refundable is to be separately shown under ‘Other current liabilities’. Disclosures required regarding share application, whether included under ‘Equity’ or under ‘Other current li-abilities’ are as under:

(a)   terms and conditions;
(b)   number of shares proposed to be issued;
(c)   the amount of premium, if any;
(d)   the period before which shares are to be allotted;
(e)   whether the company has sufficient authorised share capital to cover the share capital amount on allotment of shares out of share application money;
(f)   Interest accrued on amount due for refund;
(g)   The period for which the share application money has been pending beyond the period for allotment as mentioned in the share application form along with the reasons for such share application money being pending.

A major change in the format of balance sheet as per the Revised Schedule VI is the classification of all items of liabilities and assets into Current and Non-Current. The terms ‘Current’ and ‘Non-Current’ are defined by Revised Schedule VI as under:

(a)   A liability is classified as Current if it satisfies any of the following criteria:
(i)   it is expected to be settled in the company’s normal operating cycle;
(ii)   it is held primarily for the purpose of being traded;
(iii)   it is due to be settled within 12 months after the reporting date; or
(iv)   The company does not have an unconditional right to defer settlement of the liability for at least 12 months after the reporting date.

All other liabilities shall be classified as non-current.

(b) An asset shall be classified as current when it satisfies any of the following criteria:
(i) It is expected to be realised in, or is intended for sale or consumption in the company’s normal operating cycle;
(ii) It is held primarily for the purpose of being traded;
(iii) It is expected to be realised within 12 months after the reporting date; or
(iv) It is cash or cash equivalent unless it is restricted from being exchanged or used to settle a liability for at least 12 months after reporting period date.

All other assets shall be classified as non-current.

(c) ‘Operating Cycle’ is defined by Revised Schedule VI as “An operating cycle is the time between the acquisition of assets for processing and their realisation in cash or cash equivalents. Where the normal operating cycle cannot be identified, it is assumed to have duration of twelve months”.

(d) Thus, all companies will need to bifurcate balances in respect of all liabilities and assets into ‘current’ and ‘non-current’. The definitions contain four conditions out of which even if one is satisfied, the said liability or asset would be classified as ‘current’. If none of the conditions are satisfied the said liability or asset will be classified as ‘non-current’. The four conditions are quite subjective since they use phrases like ‘expected’, ‘held primarily’, ‘due to be settled’, etc.

(e) As per the definition, current liabilities would include items such as trade payables, employee salaries and other operating costs that are expected to be settled in the company’s normal operating cycle or due to be settled within twelve months from the reporting date. Thus, liabilities that are normally payable within the normal operating cycle of a company, are classified as current even if they are due to be settled more than twelve months after the end of the balance sheet date.

(f) Similarly, as per the definition, current assets would include assets like raw materials, stores, consumable tools, etc. which are intended for consumption or sale in the course of the company’s normal operating cycle. Such items of inventory are to be classified as current even if the same are not actually consumed or realised within twelve months after the balance sheet date. Current assets would also include inventory of finished goods since they are held primarily for the purpose of being traded. They would also include trade receivables which are expected to be realised within twelve months from the balance sheet date.

(g) A company can have multiple operating cycles in case they are manufacturing/dealing in different products. In such cases, the bifurcation into ‘current’ and ‘non-current’ can become difficult.

(h) Companies will also need to bifurcate all their borrowings into ‘current’ and ‘non-current’. It is possible that the same borrowing will be classified into two components depending on the portion repayable within/after twelve months from the balance sheet date. Other detai ls in respect of borrowings such as whether secured (with terms of security) or unsecured, whether guaranteed or not, details of repayment of loans, details of redemption in case of debentures, etc. are also required to be disclosed.

(i) Since the format of the balance sheet mentions Deferred Tax Liability (DTL)/Deferred Tax Asset (DTA) as a non-current liability/asset, the same is to be always classified as non-current and cannot be classified as ‘current’ even if the deferred tax liability/asset would become payable or receivable within twelve months of the balance sheet date. It should be also noted that such DTL/DTA is always disclosed on a net basis as required by AS-22.

(j) For several items of liabilities/assets, the aforesaid classification exercise can become quite cumbersome and time-consuming for companies especially since the same is also required to be done for 2010-11.

In case of loans taken by a company, Revised Schedule VI requires specific disclosure of period and amount of continuing default as on the balance sheet date in repayment of loans and interest to be specified separately in each case.

Revised Schedule VI requires disclosure of loans and advances taken from related parties. ‘Related Parties’ for this purpose would mean those parties as defined by AS-18.

Revised Schedule VI requires disclosure of ‘Trade Payables’ as part of ‘other non-current liabilities’ or ‘current liabilities’. A payable can be classified as ‘trade payable’ if it is in respect of amount due on account of goods purchased or services received in the normal course of business. As per the pre-revised Schedule VI, the term used was ‘Sundry Creditors’ which included amounts due in respect of goods purchased or services received as well as in respect of other contractual obligations. Since amounts due under contractual obligations can no longer be included within ‘trade payables’, items like dues payables in respect of statutory obligations like contribution to provident fund, purchase of fixed assets, contractu-ally reimbursable expenses, interest accrued on trade payables, etc. will need to be classified as ‘others’.

Assets

As per Revised Schedule VI, the disclosure for fixed assets is to be segregated into:

(a)   Tangible assets;
(b)   Intangible assets;
(c)   Capital work-in-progress; and
(d)   Intangible assets under development

The classification of tangible assets is similar to the one under pre-revised Schedule VI, but has a separate item for ‘Office Equipment’. Besides, ‘Plant and Machinery’ is now renamed as ‘Plant and Equipment’.

Classification of intangible assets as a separate item of Fixed Assets is introduced by Revised Schedule VI. It is also required to classify ‘Computer Software’ separately within ‘Intangible Assets’.

It is also necessary to separately disclose, a reconciliation of the gross and net carrying amounts of each class of assets at the beginning and end of the reporting period showing additions, disposals, acquisitions through business combinations (i.e., on account of amalgamations/demergers, etc.) and other adjustments (like capitalisation of borrowing costs as per AS-16) and the related depreciation/ amortisation and impairment losses/reversals.

Since Revised Schedule VI specifically requires capital advances to be included under long-term loans and advances, the same cannot be included under capital work-in-progress. The same also cannot be therefore included within current assets.

There is also a specific requirement to include ‘assets given/taken on lease’, both tangible and intangible under each of the items of fixed assets.

As per Revised Schedule VI, all Investments are to be bifurcated into ‘current’ and ‘non-current’. They also further need to be classified (as in the pre-revised Schedule VI) into trade/non-trade and
quoted/unquoted.

The classification of investments is to be done as under:

(a)   Investment property;
(b)   Investments in Equity Instruments;
(c)   Investments in preference shares;
(d)   Investments in Government or trust securities;
(e)   Investments in debentures or bonds;
(f)   Investments in Mutual Funds;
(g)   Investments in partnership firms; and
(h)   Other investments (specifying nature thereof).

Revised Schedule VI also requires that under each classification, details need to be given of names of bodies corporate indicating separately whether they are:
(a)   subsidiaries,
(b)   associates,
(c)   joint ventures, or
(d)   controlled special purpose entities.

In regard to investments in the capital of partnership firms, the names of the firms (with the names of all their partners, total capital and the shares of each partner) need to be given. It is possible that the partnership firm maintains both ‘capital’ and ‘current’ accounts of its partners. In that case, the bal-ance in ‘capital’ account will be clas-sified as a ‘non-current’ investment in the balance sheet of the company, whereas the balance in ‘current’ account is classified as ‘current’ investment.

In case the company has an investment in a ‘Limited Liability Partnership’ (LLP), the disclosure norms of ‘partnership firm’ (as discussed in para 41 above) will not apply since an LLP is considered as a ‘body corporate’.

As per Revised Schedule VI, all loans and deposits, deposits, etc. given by a company
are to be classified into ‘current’ and ‘non-current’.

Revised Schedule VI requires disclosure of loans and advances given to related parties. ‘Related Parties’ for this purpose would mean those parties as defined by AS-18.

Revised Schedule VI requires disclosure of ‘Trade Receivables’ as part of ‘other non-current assets’ or ‘current assets’. A receivable shall be classified as ‘trade receivable’ if it is in respect of the amount due on account of goods sold or services rendered in the normal course of business. As per the pre-revised Schedule VI, the term ‘sundry debtors’ included amounts due in respect of goods sold or services rendered or in respect of other contractual obligations as well. Since, amounts due under contractual obligations cannot be included within ‘Trade Receivables’, items like dues in respect of insurance claims, sale of fixed assets, contractually reimbursable expenses, interest accrued on trade receivables, etc. will need to be classified within ‘others’.

The pre-revised Schedule VI required separate presentation of debtors for those outstanding for a period exceeding six months (based on billing date) and ‘other debtors’. However, for the ‘current’ portion of ‘Trade Receivables’, the Revised Schedule VI requires separate disclosure of ‘Trade Receivables outstanding for a period exceeding six months from the date they became due for payment’. This requirement can result in a lot of work for companies since it would mean modifying their accounting systems to compile the amounts exceeding six months based on the due date. Giving corresponding data for 2010-11 would also result in added work for most companies.

The requirement for classifying ‘loans and advances’ and ‘trade receivables’ into secured/unsecured and good/doubtful also continues in Revised Schedule VI.

The Revised Schedule VI does not contain any specific disclosure requirement for the unamortised portion of expense items such as share issue expenses, ancillary borrowing costs and discount or premium relating to borrowings. These items were included under the head ‘Miscellaneous Expenditure’ as per the pre-revised Schedule VI. Though, Revised Schedule VI does not mention disclosure of any such item, since additional line items can be added on the face or in the notes, unamortised portion of such items can be disclosed (both ‘current’ as well as ‘non-current’ portion), under the head ‘other current/non-current assets’ depending on whether the amount will be amortised in the next 12 months or thereafter.

The term ‘cash and bank balances’ existing in the pre-revised Schedule VI is replaced under Revised Schedule VI by ‘Cash and Cash Equivalents’. These are to be classified into:

(a)   Balances with banks;
(b)   Cheques, drafts on hand;
(c)   Cash on hand; and
(d)   Others (specify nature).

For ‘Cash and Cash Equivalents’, disclosure is also separately required as per Revised Schedule VI for:

(a)   Earmarked balances with banks (for example, for unpaid dividend);
(b)   Balances with banks to the extent held as margin money or security against the borrowings, guarantees, other commitments;
(c)   Repatriation restrictions, if any, in respect of cash and bank balances shall be separately stated;
(d)   Bank deposits with more than twelve months maturity shall be disclosed separately.

Major changes in the format of Statement of Profit and Loss

Revised Schedule VI requires disclosure of ‘Revenue from Operations’ on the face of the statement of profit and loss. In the case of a company other than a finance company, such ‘Revenue from Operations’ is to be disclosed as:

(a)   Sale of products
(b)   Sale of services
(c)   Other operating revenues
(d)   Less: Excise duty

Though Revised Schedule VI specifically requires disclosure of Sale of Products on ‘gross of excise’ basis, there is no mention of whether Sales Tax/VAT and Service Tax is also to be included or not in sale of products or sale of services, respectively. Though not entirely free of doubt, the ICAI GN has stated that “Whether revenue should be presented gross or net of taxes should depend on whether the company is acting as a principal and hence responsible for paying tax on its own account or, whether it is acting as an agent i.e., simply collecting and paying tax on behalf of government authorities. In the former case, revenue should also be grossed up for the tax billed to the customer and the tax payable should be shown as an expense. However, in cases, where a company collects tax only as an intermediary, revenue should be presented net of taxes.” (Also refer BCAJ February 2012 ‘Gaps in GAAP’ for a discussion on whether taxes should be disclosed gross or net).

In addition to Revenue from Op-erations, Revised Schedule VI also requires disclosure of ‘Other Operating Revenue’ as well as ‘Other Income’. The term ‘Other Operating Revenue’ is not defined by Revised Schedule VI. The ICAI GN has how-ever clarified that “this would include revenue arising from a company’s operating activities, i.e., either its principal or ancillary revenue-generating activities, but which is not revenue arising from the sale of products or rendering of services. Whether a particular income constitutes ‘other operating revenue’ or ‘other income’ is to be decided based on the facts of each case and detailed understanding of the company’s activities. The classification of income would also depend on the purpose for which the particular asset is acquired or held”.

In respect of a finance company, Revised Schedule VI requires ‘Revenue from Operations’ to include revenue from:
(a) Interest and
(b) Other financial services.

Though the term ‘finance company’ is not defined by Revised Schedule VI, the ICAI GN states that “the same should be taken to include all companies carrying on activities which are in the nature of ‘business of non-banking financial institution’ as defined in section 45I(f) of the Reserve Bank of India Act, 1935”.

In case of all companies, Revised Schedule VI requires ‘Other income’ to be disclosed on the face of the statement of profit and loss. For this purpose ‘Other Income’ is to be classified as:

(a)   Interest Income (in case of a company other than a finance company);
(b)   Dividend Income;
(c)   Net gain/loss on sale of Investments;
(d)   Other non-operating income (net of expenses directly attributable to such income).

As can be seen from the above, in the case of all company (including a finance company) Dividend income and Net gain/loss on sale on investments will be always classified as ‘Other Income’.

‘Other Income’ will also include share of profits/ losses in a partnership firm. Though there is no specific requirement mentioned for the same in the Revised Schedule VI, the ICAI GN mentions that the same should be separately disclosed. The ICAI GN also requires that in case the financial statements of the partnership firm are not drawn up to the same date as that of the company, adjustments should be made for effects of significant transactions and events that occur between the two dates and in any case, the difference between the two reporting dates should not be more than six months.

Revised Schedule VI requires the aggregate of the following expenses to be disclosed on the face of the Statement of Profit and Loss:

(a)   Cost of materials consumed
(b)   Purchases of stock-in-trade
(c)   Changes in inventories of finished goods, work in progress and stock in trade
(d)   Employee benefits expense
(e)   Finance costs
(f)   Depreciation and amortisation expense
(g)   Other expenses.

The ICAI GN mentions that for the purpose of disclosure, ‘Cost of materials consumed’, should be based on ‘actual consumption’ rather than ‘derived consumption’. In such a case, excesses/shortages should be separately disclosed rather than included in the amount of ‘cost of materials consumed’. This requirement was also contained in the ICAI pronouncements on the pre-revised Schedule VI.

As per Revised Schedule VI separate disclosure is also required for the following items which are classified under ‘Other Expenses’:

(a)   Consumption of stores and spare parts;
(b)   Power and fuel;
(c)   Rent;
(d)   Repairs to buildings;
(e)   Repairs to machinery;
(f)   Insurance;
(g)   Rates and taxes, excluding taxes on income;
(h)   Miscellaneous expenses.

The threshold for disclosure of ‘Miscellaneous Expenses’ is changed to those that exceed ‘1% of revenue from operations or Rs.100,000 whichever is higher’ as against the requirement of pre-revised Schedule VI of ‘1% of total revenue or Rs.5,000 whichever is higher’.

The format of Statement of Profit and Loss in Revised Schedule VI also requires specific disclosures of ‘Exceptional’, ‘Extraordinary’, items and ‘Discontinuing Operations’. These terms are defined by AS -4, AS-5 and AS-24, respectively and disclosures should be done in accordance with these definitions.

Disclosures by way of Notes

Besides the above disclosures, Revised Schedule VI also requires disclosures by way of Notes attached to the financial statements. Some of the major requirements are as under:

(a)   For manufacturing companies: raw materials consumed and goods purchased under broad heads;
(b)   For trading companies: purchases of goods traded under broad heads;
(c)   For companies rendering services: gross income derived from services rendered under broad heads.

Revised Schedule VI does not require disclosure of quantitative details for any of the above categories of companies. The same is also clearly mentioned in para 10.7 of the ICAI GN.

The ICAI GN also mentions that ‘broad heads’ for the purpose of the disclosure in para 62 above are to be decided taking into account the concept of materiality and presentation of ‘True and Fair’ view of financial statements. The said GN also mentions that normally 10% of the total value of sales/services, purchases of trading goods and consumption of raw materials is considered as an acceptable threshold for determination of broad heads.

Revised Schedule VI requires disclosures of ‘Contingent liabilities and commitments’. For this purpose, besides others, ‘other commitments’ are also to be disclosed. Such disclosure of ‘other commitments’ was not required as per pre-revised Schedule VI.

There is no explanation of what would be covered as part of ‘other commitments’ in Revised Schedule VI. The ICAI GN has however clarified that disclosures required to be made for ‘other commitments’ should include ‘only those non-cancellable contractual commitments (cancellation of which will result in a penalty disproportionate to the benefits involved) based on the professional judgment of the management which are material and relevant in understanding the financial statements of the company and impact the decision making of the users of financial statements. Examples may include commitments in the nature of buyback arrangements, commitments to fund subsidiaries and associates, non-disposal of investments in subsidiaries and undertakings, derivative related commitments, etc.’ Most of the other disclosure requirements as per Revised Schedule VI in Notes are similar to the requirements of pre-revised Schedule VI.

Implementation of Revised Schedule VI
As can be seen from the above, disclosure requirements of Revised Schedule VI are quite different from those existing in the pre-revised Schedule VI. Many of these disclosures and concepts (like ‘current’, non-current’) are similar to terms and concepts used in IFRS. Unless, companies gear up well in time to adhere to these new requirements for 2011-12 (and corresponding figures for 2010-11), it will be difficult for them to meet the reporting deadlines of the Companies Act, 1956.

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.

Nirav Shah

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.

Nirav Shah

Tax Due Diligence — Direct Taxation

M&A

Introduction:

Devising an M&A strategy is the first critical step for any
business contemplating a transaction. Armed with a plan and knowledge of the
competitive marketplace, companies are ready to practise the art of the deal.
But the need for a speedy transaction and post-merger integration should not
entice companies to take short cuts along the way. Companies should follow
necessary steps to execute an M&A transaction in a way that drives shareholder
value. All transactions — whether mergers, acquisitions, joint ventures, private
equity investments, etc., are full of complex business and tax issues that
require an expert to get on top of the transaction process and to reach the best
solution that is tax-efficient and meets commercial and business expectations.

The Indian tax regime is as complicated as any other matured
regime. Over the years, the Indian regulations have provided sufficient leverage
to foreign investments and at the same time, have ensured a closely controlled
mechanism on these investments.

In the M&A world, some of the typical tax challenges faced
today include non-availability of interest deduction for funds borrowed for
investment in shares of Indian companies, restricted group relief on asset
transfers, restricted debt push down mechanism and existence of high tax
compliance.

Every deal is unique in itself. It brings with it a basket of
complexities and issues, be it accounting, regulatory or taxation. Given the
complexities, it has become incumbent upon a good service provider to have a
dedicated and experienced team to provide tax due diligence services.

This write-up seeks to provide an overview of the key
features of a tax due diligence; it touches upon the procedure to be followed;
and it provides some ground rules for reporting findings so as to meet the
expectations of all stakeholders to the transaction.

Scoping of work:

One of the initial steps to be undertaken is to formulate the
scope of the assignment. One’s drafting skills are tested to the core whilst
formulating the scope for the tax piece of the due diligence. An essential
aspect of this is to explicitly provide for areas which would not be covered as
part of the due diligence process (generally referred to as ‘scope
limitations’).

Given the complexity and the time required to resolve
disputes with the tax authorities, it is of utmost importance to clearly bring
out the period of coverage as part of the scope of work to be covered in a due
diligence assignment. As a general practice, the tax returns filed by the target
company in the last 2 to 3 years are reviewed. Further, the status of all
pending assessments, disputes is obtained and reviewed for the earlier years.
One of the reasons for reviewing the last 2 to 3 years tax returns is that the
audit by the tax authorities for these years is typically not complete on the
date of carrying out the due diligence exercise.

Apart from the coverage, the scope of the tax piece of the
due diligence process needs to be very case-specific i.e., it would
depend upon the Industry to which the target company pertains, the age of the
target company, the shareholding pattern, etc.

For example, in a transaction in the power sector, it would
be critical to examine the continuity of availability of tax holiday and
incentives claimed by the target entity. Further, in case the target is a
private limited company, it would be essential to review the movement in its
shareholding pattern with a view to assess the continuity of availability of
business losses.

Characteristics and key features:

The tax specialists who are part of the due diligence team need to work very closely with the financial and accounting
specialists.

Before discussing the methodology to be adopted to conduct a
tax due diligence, it is imperative to understand the characteristics and
features of conducting the tax due diligence. The main objectives can be
classified as under:

Understanding the target:

its legal structure, cash flow mechanism and its operational strategy.

Assessment of tax impact arising from ‘change in control’

carry forward of past tax losses, relevant exchange control regulations
(especially recent developments)

availability and continuity of tax holidays/concessions

Assessment of
historical tax exposures

pending tax litigations, aggressive tax positions adopted in the past (possible

consequences)

risk of disallowance of expenditure for tax purposes

interest and penal consequences

Assessment of current
tax position

possible disallowances

ramification of past tax audits.

Tax benefits

There are various direct and indirect tax benefits in India for
companies/businesses. The conditions attached to such benefits are
important.

Contingent liabilities — disputed tax demands

These are largely potential liabilities (i.e., tax demand + interest + penalty which could extend to 300% of the tax sought to be evaded) arising on account of disputes with tax authorities. Since it is difficult to predict the outcome of such disputed demands, it is likely that in some businesses, even genuine tax demands may not be provided on the ground that such liabilities are ‘contingent’ and are being disputed (depending upon the likelihood of the company succeeding in defending these disputes).

Tax litigation procedure:

The tax litigation procedure in India is cumber-some and time consuming (the average time frame for an appeal to attain finality is in the range of 10-15 years). Further, positions adopted by the tax authorities in the initial years are generally followed by them in the subsequent years as well, unless there is a strong reason or a judicial/appellate pro-nouncement to change the position earlier adopted. Accordingly, disallowances made in a particular year are likely to be a routine occurrence in future years as well and the only option in such a scenario is to litigate. Hence, it may be advisable to be cautious while evaluating targets which are engulfed in too many tax litigations involving sizeable tax demands.

Current assets:

These may include balances that may not be realisable in the short term — such as (i) tax refunds due (ii) deposits with various tax authorities, etc. — such deposits generally are not realised for a very long time. These would consequentially have an impact on the working capital financing needs of the target.

Various tax compliances (including withholding tax):

The Indian tax laws prescribe several tax compliances for Indian companies. Failure to comply with these could inter alia give rise to penal consequences. Especially, in case there is a default in withholding taxes on payments made, it could have several con-sequences for the payer, such as recovery of the tax not so with held/deposited, interest thereon, penalty (which could be equivalent to the tax amount) and disallowance of the expenditure in relation to which tax has not been withheld/deposited. Hence, one should ensure that the target is tax compliant (more importantly, the withholding tax compliant).

Typical areas prone to income-tax litigation: While there is surfeit of issues that is prevalent in the tax litigation environment in India, there are some issues that typically arise during a tax due diligence, viz.:

ramification of past tax audits.

Depreciation for income-tax purposes and its impact on the deferred tax calculations.

allowability of expenses which are quasi-capital in nature (e.g., non-compete fee payments).

computation of various tax deductions/exemptions available.

disallowances on account of failure to withhold tax on payments (especially in cases where payments are made to non-residents).

levy and computation of interest on tax demands and refunds.

income characterisation (say, business income v. income from house property).

carry forward and set-off of tax losses.

levy of penalty.

taxability under presumptive taxation provisions.

computation of tax liability as per ‘Minimum Alternate Tax’ provisions, etc.

Transfer pricing adjustments:

Given that the tax authorities have commenced reacting to the transfer pricing report, policy and documentation filed by the taxpayers, it is very important to consider the rationale and reasoning behind determining the arm’s-length price, level of compliances and filings as required by the regulations. These are particularly important in the context of the potential future impact of similar transactions.

Fringe Benefit Tax:

In the short span when Fringe Benefit Tax was applicable, there were emerging controversial issues, some of which were resolved by the circulars/clarifications issued by the tax authorities. Although this legislation does not exist today, there is litigation which is gradually surfacing on this count.

The mechanics:

Tax is a complicated subject and to carry out a tax review which involves an understanding of the tax disputes, challenges faced from the tax authorities by the target entity, tax positions taken by the target entity, and to formulate a view on the basis of the documents reviewed and analysis performed normally within a short span of time is an uphill task. This is the precise reason that the tax due diligence team members need to be experienced, and should be well equipped to dissect and digest the flow of information and documents provided to them in the data room within the stipulated time.

Success, in the backdrop of the above challenges can be achieved by following an appropriate methodology while conducting the tax review.

Activities to be performed while conducting a tax due diligence would mainly include?:

Examination of status of tax assessments — cur-rent tax position, open years and evaluation of past liabilities.

Review the income-tax/fringe benefit/wealth tax returns filed for the open years.

Study the disputes between the entity and the tax department.

Identify potential liabilities on account of pending assessments and disputes.

Discuss the various direct tax benefits availed and attached conditions for continuation of the same with the target management and tax advisors.

Analyse the withholding tax compliance.

Examine the applicability of the double taxation avoidance agreements entered into by India while reviewing the tax treatment given to various transactions entered into by the target and analyse the implications arising thereof.

Read opinions obtained by the target management from external counsel and stands taken by the target/target’s advisors during assessment.

Peruse transfer pricing policy adopted.

Examine the various tax balances (particularly the deferred tax asset/liability) reflected in the financial statements.

The procedure to be followed while conducting tax due diligence has to be very discreet and well planned. There is an expectation of providing comments on the tax position adopted by the target entity. Given the areas to be covered in the tax due diligence, one is saddled with a large number of tax documents, records in relation to tax matters of the target. The tasks to be performed in the above context would include carrying out a review and check of the following:

Correspondence with the tax authorities.

Current and deferred tax calculations — reconciliations with the amounts disclosed in accounts.

All tax payments made within due dates — if not, check interest/penalties arising on account of the same.

Calculations supporting advance tax payments made.

Carry forward losses schedule — both as returned and also as assessed — also confirm the expiry dates/restrictions on utilisation of the same.

Details of transactions with related parties (interacting with the team carrying out the financial due diligence on this aspect should be useful as at times identification of all ‘related parties’ itself raises challenges).

Transactions with related parties from the transfer pricing perspective and confirm the pricing method/documentation maintained.

Details of permanent establishments in other countries.

Whether withholding tax provisions are being adhered to — also examine as to whether the withholding tax returns are filed in time.

Tax findings of non-India jurisdictions, if any, in which the target company operates — this may require liaising with local tax experts.

Potential implications of the existing tax position for future years considering the proposed Direct Taxes Code Bill, 2010, which has been recently introduced.

Years
subject to statute of

Limitation

Outside
scope (entities,

years, taxes)

Controlling

tax due

Materiality

diligence
risk

External
advice

Low
risk areas

Applicability of Wealth-tax.

Like any other due diligence process, the tax due diligence is also prone to risk. Con-trolling the tax due diligence risk therefore becomes a key aspect of the process. The elements of a tax due diligence risk can be addressed by considering the aspects shown in the diagram?:

Submission of findings and reporting:

It is always easy to document a detailed analysis arising out of the due diligence process. However, this may not serve the purpose of the report and the investor’s expectations. It is therefore advisable to articulate and document the findings in a reader- friendly manner. In addition to the complexities and the volume involved whilst carrying out the tax due diligence process, some ground rules which need to be followed include?:

Anticipate problems and opportunities

Early identification of and discussion of preliminary issues with client.

Measure exposures and seek solutions

Quantify estimated amounts and likelihood of exposures resulting in future cash outflows (range/sensitivity analysis).

Interpret findings in ways clients can use

Focus on material issues.

Use plain English — many of the decision-makers may not understand or appreciate a detailed technical tax answer to a question.

Timely communication of findings:

In order to generate a report which meets the expectations of all stake-holders, certain ground rules need to be followed as under:

One needs to

be clear and concise.

focus on key issues.

classify tax exposures into high/medium/low risk category and estimate the quantum.

consider additional verbal feedback.

issue a draft for comment and discussion prior to finalising the report.

add additional information as appendix.

be mindful of other readers e.g., financiers.

An integral part of the tax due diligence process is to identify issues and more importantly discuss the same with the target management, their advisor, as the case may be. This ensures that the tax findings given in the due diligence report do not give rise to surprises when these are discussed with the target management.

Tax Issues could primarily be classified as:

Deal breakers — Those issues which would impediment the consummation of the proposed transaction. For example, sizeable risk on account of various tax disputes, some of which may be quite material, could act as a ‘Deal Breaker’.

Negotiation points — Those issues which would be necessary to consider in the valuation of business/negotiation of bid price.

Issues for agreements — Those issues which would warrant indemnities and identify conditions precedent for happening of the transaction

Commercial override — Those risks and issues which are knowingly taken over as a calculated commercial decision.

In summary:

The due diligence exercise maps the way forward for transaction closure. Tax-related findings would form the bases of valuation of the target and aid in negotiating for a better price. These are also relevant for consideration in some of the key areas of the transaction documents. Tax indemnities and conditions precedents incorporated in the agreements are based on the due diligence exercise. Some of the observations and areas falling out in a tax due diligence report could also be relevant whilst structuring the transaction.

Studies suggest that tax factors are of significant magnitude in less than 10% of merger transactions. Be that as it may, there have been some large transactions which have fallen apart primarily due to adverse tax findings as a result of the due diligence exercise.

Therefore, the onus is on the tax specialist to identify the potential tax risks and exposures and to document them appropriately in order to provide adequate visibility to the investor.

Nirav Shah

Financial and Accounting Due Diligence — Some Aspects

M&A

Part-IV

Conducting a financial due diligence — A well-planned
approach

This is the fourth part of the article on ‘Financial and
accounting due diligence — Some aspects’. The first three parts highlighted the
various forms of due diligence, the process of carrying out an FDD exercise and
some of the key focus areas in an FDD exercise. This part continues and
concludes the discussion on the key focus areas.

Loans & Net Debt :

Analysis of the debt position is important and significantly
depends upon the transaction structure and valuation mechanism. As mentioned
earlier, the transactions are generally valued based on a debt-free, cash-free
mechanism. In view of the same, it is critical to define the components of debt
and quantify the same. The elements of trapped cash (i.e., cash that is not
freely usable, such as deposits with government authorities, margin monies,
etc.) need to be highlighted to allow for computation of equity value.

In most situations, particularly in the case of distressed
assets, the analysis of debt and related covenants assumes the most important
aspect of the transaction. Typically, the loan documents, including the
documents approving the restructuring, provide for conditions attached to the
loan including repayment terms, interest rates, stipulation of minimum financial
ratios, security mechanism and prepayment terms and each such provision would
need to be carefully assessed to identify its impact on the transaction.

Key elements to be analysed while reviewing loans are :

• Negative covenants in loan agreements/sanction letters (change of control) : a very common covenant is the need for prior approval of lenders for the transaction including release of charge on the assets;

• Compliance with terms of debt restructuring schemes : with a need to assess the level of promoter contribution required as per the scheme approved.

• Debt-like items (pension underfunding, severance and other non-operating liabilities) to be considered in valuation : identification of non-operating liabilities (capital creditors, etc.) reported as part of current liabilities under working capital that should be identified as debt-like items.

Potential liabilities and commitments :

This area is particularly important in the case of a complete
acquisition of a target with no future involvement of the existing promoters.
The extent of availability of representations and warranties and indemnities in
this area, although considered as a must in any transaction, should at best
provide only limited comfort. This is primarily considering the ability of the
acquirer to enforce such claims in the courts of law in India and the time value
of such claims. The identification/estimation of such liabilities therefore has
a direct valuation impact.

It is equally difficult to analyse this area since the
procedures are expected to identify liabilities that are not accounted for in
the books of account and may or may not have come to the notice of the existing
management and they may not have a basis to provide reasonable estimates.

The areas to be covered in the analysis and identification of
liabilities are summarised below :

• Provisioning policy : assessing the general approach towards cut-off and provisioning policies adopted by the management; (for example in the financial sector when the target management tries to postpone provisioning for non-performing assets or in the manufacturing sector when provisions for warranties tend to get accounted for only on cash basis or in the mining sector when future costs for rehabilitation under environmental regulations are currently ignored and provided for only when incurred);

• Contingent liabilities and off balance sheet items : (where aggressive tax opinions enable a target not to provide against matters in litigation); assessing guarantees/off balance sheet obligations in respect of related parties;

• Change of control matters : potential payments arising out of change of control/additional costs; severance/retention pay upon the occurrence of transaction;

• Pension and related obligations : assessing the provisioning and funding of liabilities; this is particularly important in cross-border transactions — there is a need to take the help from specialised local resources to assess the liabilities;

• Earn-outs/contingent consideration from prior business combinations : for e.g., an acquisition in the past that may have contingent payments to be taken into consideration or where receivables are securitised with a bank with recourse i.e., the target has an obligation to buy back delinquent receivables.

Separation, structuring and integration issues :

Typically, these issues are relevant for a strategic investor
engaged in a similar line of activity. The FDD exercise would focus on
identifying areas that may result in changes in the cost structure post
transaction, requirement of additional infrastructure to be created by the
client or potential utilisation of the existing infrastructure of the client or
additional cost of integration.

The areas that may be covered from a financial viewpoint
would typically cover :

• Identification of broad synergies : due diligence process should identify different kinds of synergies, and then an estimate of their potential value, likelihood, time and cost to achieve the synergies.

• Accounting policy conformity : extent of differences between the accounting policies of the buyer and the seller and its impact post the transaction. This assumes significant importance particularly in the case of a transaction where the buyer and the seller are from different countries — foreign buyer following a local GAAP — IFRS, USGAAP, etc. and the Indian seller following Indian GAAP. The differences in accounting may have a significant impact on the reported profitability/value of assets post the transaction. This may also create significant challenges in upgrading the existing systems and procedures of the target to be able to support the reporting requirements of the buyer.

• Transition services agreement : the target may have dependencies on the parent entity (the seller) and would thus require an agreement for continuity in the availability of goods or services in future (utilisation of common utilities, distribution network, etc.).

• Stand-alone considerations (impact of economies of scale, support functions) : it is essential to understand the dependencies on the parent entity and enter into the transition services agreement as mentioned above. However, it is also important to understand the impact on costs on a go-forward basis considering potential stand-alone operations.

Other matters :
During an FDD exercise, apart from the aforesaid broad areas that are directly linked to accounting matters, there are other aspects relating to the business that may have an impact on the financial position of the business and are thus important to consider during an FDD exercise. These are discussed below.

Related-party transactions :
Related-party transactions could have a significant impact on the reported historical earnings/margins of the business. Further, these transactions may also create significant dependencies and have a material impact on the continuity of the operations on the business. In such situations, it is important to identify the nature of transactions, the level of existing charges recovered from the target business, the availability of such services/facilities in future and the charges thereof. The arrangements that would need to be agreed during the transition period should be identified and provided for in the transaction documents. Further, any impact on the valuation model would also need to be considered for any revisions in the current costs.

Generally, ‘related parties’ are defined by law and the transactions are required to be reported in the financial statements. However, it is important to identify the related parties that are not covered by the definition as per law, but that are de facto related parties in common business parlance. This identification is generally achieved based on discussions with the management of the target and analysis of the key transactions in respect of purchase and sales relating to the terms and conditions.

Key aspects while reviewing related party transactions would involve an assessment of :

• Financial appropriateness of transactions within family-run businesses (arm’s-length pricing);

• Level of dependency of the target operating within a ‘group’ (assets used by the target entity but that are actually owned by a related party; e.g., office premises, the IT infrastructure or even the title to the corporate/product brand);

• Extent of sharing of resources and the allocation of common costs;

• Details of financing arrangements with related parties;

• Arrangements that are based on oral under-standings and/or are on a ‘no-cost’ basis.

Human resources :
Analysis of human resources is a multifaceted task and is generally covered by the legal due diligence, HR due diligence with defined inputs from the FDD exercise. The key focus areas of the FDD exercise in relation to human resource matters are to establish the total cost to the company (CTC) of all human resources, to assess the extent of accumulated unprovided/unfunded for liabilities in relation to employee benefits and to also understand the level of current charge of such costs and any underprovisioning thereof.

Identification of the total employee strength and total CTC of the target company may become an issue where there is a high level of contracted employees (like in the media advertising sector) or when there is high level of casual labour that is ‘permanently temporary’ !

In certain instances such as relocation of facilities post acquisition, the analysis may need to be extended to understand the implication of severance of employees not willing to transfer to the proposed new location and also additional facilities/ benefits that may need to be incurred to ensure transfer of necessary employees to the new location besides addressing the issues relating to availability of skilled resources in the new location.

It is important to analyse the movements in the level of staff in the recent period with specific emphasis on understanding if there have been attrition in respect of key staff. Particularly, in a distress situation, the current staff may not be adequate and may not represent the true requirement for the business and would need to be replenished. The costs relating to such optimum level of requirements of the staff would need to be assessed and considered in the valuation model.

In case of a strategic acquisition, matters relating to integrating the two businesses assume importance. The compensation levels and structure may be significantly different across the buyer and the seller and may have material implications for the buyer post acquisition. Thus a careful analysis is required in relation to the current staff cost of the target and potential changes post the transaction.

Conclusion :
In today’s environment, as a key input during the decision-making process and also as a part of general corporate governance, financial due diligence is considered as a must. It is not just checking of facts and summarising them, but it is about evaluation, interpretation and communication that require a proficient understanding of the business and of the transaction besides exercising strong financial and accounting skills.

Companies making acquisitions typically look for answers to four basic questions :

• What is being acquired ? (customers, competition, costs, capabilities)

• What is the target’s stand-alone value ?

• Where are the synergies and skeletons ?

• What is the walk-away price ?

It is vital that the FDD team remembers the above and exercises a degree of prudence and professional skepticism when carrying out the assignment — deal making is glamorous, due diligence is not. The FDD team may focus on negative information and on identifying the risks and problems surrounding the transaction, but as a professional service provider, the FDD team must devise solutions to problems or mechanisms to reduce or manage the risks involved in the transaction. For every man-made problem there is a man-made solution — the skill is to find it !

Nirav Shah

Valuation of intangible assets

M & A

Unlike in accounting, where
the accounting for tangible assets and intangible assets is different, the same
is not the case in valuation. Whether an asset is a tangible asset or an
intangible asset, the concept of valuation does not change. However, globally
with the exchange of only intangible assets being infrequent and the market for
intangible assets not fully developed, the subjectivity involved in the
valuation of intangible assets is more than, say, for valuation of equity shares
or valuation of a business. In this article we will discuss the various methods
of valuation of intangible assets. We will not discuss the identification or
recognition of intangible assets here, but the valuation of an identified
intangible asset.

At the end of the discussion
we will also touch upon the recent acquisition of Cadbury by Kraft Foods.

Examples of intangible
assets :

Different industries have
different value drivers and thus different intangible assets. There is no
exhaustive list of intangible assets, but accounting guidance from US GAAP and
IFRS give us the following examples as given in the chart.

Approaches to valuation of
intangible assets :

Similar to valuation of any other asset,
there are three basic approaches to valuation of intangible assets viz. the cost
approach, the market approach and the income approach. Again as applicable to
valuation of any other asset, the use of any of the above approaches differs
from asset to asset and industry to industry. Also an intangible asset in one
industry may not be an intangible asset in another industry and the economic
benefit of the same intangible may differ from industry to industry and in the
same industry from company to company. The following are the generally accepted
methods that are used in valuation of intangible assets :

Cost approach :

l Valuation is based on the cost to reproduce or replace the asset and the
principle of substitution

l The valuation of an asset using the cost
approach is based upon the concept of replacement as an indicator of value

l The premise is that a prudent investor would pay no more for an asset than
the amount required to replace the asset afresh. Value is not the actual
historical cost of creating the subject intangible asset. It is also not the
sum of the costs for which the willing seller would like to be compensated

l The approach establishes value based on the cost of reproducing or
replacing the asset, less depreciation from physical deterioration and
functional obsolescence, if present and measurable

l Applications :

Reproduction cost

Replacement cost

Market approach :

l Valuation is based on transactions involving the sale or licence of
similar intangible assets in the market place and the principles of
competition and equilibrium

l Value is derived by analysing similar intangible assets that have recently
been sold or licensed and then comparing these transactions to the subject
intangible asset

l Applications :

Transaction multiples derived from (the sale or
licensing) of the comparative intangible asset.

Income approach :

l Valuation is based on the present value of expected future cash flows to
be derived from ownership of the asset and the principle of future benefits

l Value of the subject intangible asset is the present value of the expected
economic income to be earned from the ownership of a particular intangible
asset

l Primary applications :

Relief from royalty

Excess earnings

l Other applications :

Discounted cash flow

Incremental cash flows/profits

Profit split

Valuation methodologies for intangible assets :

Replacement cost method under

the cost approach :

This method represents the hypothetical cost that would be
incurred to replace the subject asset by a new asset of similar utility.

Reproduction cost method under

the cost approach :

This method represents the hypothetical cost that would be
incurred to recreate or reproduce (either by constructing or by acquiring) the
subject asset by a new asset of similar utility.

After establishing the replacement/reproduction costs,
adjustments are made to represent any losses in value resulting from physical
deterioration and from functional and economic obsolescence. The above methods
are generally used when a substitute can be developed in-house and are normally
used in valuing intangible assets like assembled workforce, internally developed
software, etc.

Comparable transactions method under the market approach :

l The value of an asset under this method is measured through an analysis of sales and offering prices for the comparable asset. Such prices are then adjusted for differences, if any, between the comparable asset and the subject asset. This method is similar to the comparable transaction multiples approach used in business valuations.

-> The two requisites in this approach are an active public market and an exchange of comparable assets.

-> The key is to select the most appropriate/ relevant transaction multiples involving intangible assets. The difficulty however is in finding comparable assets and the adjustments required to make it comparable to the subject asset.

-> On account of the infrequent activity happening in intangible assets, generally this method can be made applicable to brands only.

Relief from royalty method under the income approach:

-> This method is based on the principle of opportunity cost.

-> The value of an asset under this method is the present value of the future savings that is available to the owner on account of his owning the subject asset.

l Had the owner not owned the asset, he/she would have had to license in the asset for which it would have had to pay a royalty. By owning the asset, the owner is thus saving these costs. This savings is generally quantified in terms of royalty savings on revenues.

l The general steps to implement this method are:

research licensing transactions with comparable assets to establish a range of market levels for royalty rates

select a royalty rate or range of royalty rates

apply the selected royalty rate to the future revenue stream attributable to the asset

use the appropriate marginal tax rate to arrive at an after-tax royalty rate

discount the resulting cash flow stream to the present using an appropriate risk-adjusted discount rate.

Excess earnings method under the income approach:

This method is based on the principle of elimination and residual value and is similar to the discounted cash flow method except that it does not take into account the cash flows but the earnings.

This method considers assets in isolation from all other assets. Assets do not generate cash flows in a vacuum — they also utilise contributory assets to generate earnings and hence to isolate the earnings attributable only to the subject asset, contributory charge on such assets are deducted.

The main steps under this method are:

estimate and forecast the earnings from the subject asset

deduct applicable tax charge on these earnings

deduct an appropriate required rate of return on all other assets (tangible and intangible) used in obtaining such earnings — the residual earnings thus obtained are ‘excess earnings’ arising from the use in the business of the subject asset being valued

assess an appropriate discount rate for the forecast after-tax excess earnings

discount the excess earnings to obtain the value of the subject asset.

In addition to the above, there are also various adaptations of the income approach like the

Discounted cash flows method

Incremental cash flows/profits method

Profits split method

There are also various valuation concepts applicable generally and some specifically to intangible asset valuations like

Tax amortisation benefit factor,

Residual life of the intangible asset

Return ‘on’ and return ‘off’

Market value of invested capital

Invested capital analysis

Weighted average return on assets.

All of the above we shall discuss in the next article where we shall start with the purchase price allocation process and by a case study cover all the above points including the valuation of intangible assets under each of the approaches.

Cadbury acquisition:

On February 2, 2010 Kraft Foods’ Cadbury acquisition was valued at $ 18,546 million ($ 17,485 million net of cash and cash equivalents). As part of that acquisition, Kraft Foods acquired the following assets and assumed the following liabilities:

The above goodwill of $ 9.1 billion was attributable to Cadbury’s workforce and the significant synergies that were expected from the acquisition. Also $ 10.1 billion of the intangible assets acquired were expected to be having an indefinite life.

If we analyse the above details, the following observations can be made:

74% of the asset value paid was attributable to intangibles and goodwill (which is nothing but unidentified intangible).

Though there is no official information available, Cadbury primarily being in the food and confectionery business, the intangible assets could primarily have been brands, trademarks, trade names, logos, marketing & distribution network, non-compete agreements and vendor relationships.

Brand Finance (R) Global 500 February 2010 summary report on the world’s most valuable brands ranks Cadbury brand at No. 274 with an enterprise value of USD 21,196 million and a brand value of USD 3,261 million which is about 15% of the enterprise value. The same report values Kraft at an enterprise value of USD 6,277 million and a brand value equivalent to USD 2,168 million which is 35% of the enterprise value. The Kraft brand has been ranked at No. 437.

Nirav Shah

LEGAL DUE DILIGENCE IN M&A TRANSACTION

Any responsible management will
require a comprehensive assessment of the possible legal risks related to the
corporate status, assets, contracts, securities, intellectual property, etc. of
the target company concerned before concluding any merger and acquisition
(‘M&A’) deal. Therefore, the process of legal due diligence assumes great
importance in a M&A transaction.

Meaning :

The expression ‘due diligence’
in a M&A transaction is used to refer to sort of an audit of a company’s legal,
financial, environmental and business affairs, and includes investigations into
the acquisition of the assets, risk analysis and general inquiries about the
company prior to entering into a contract. This process is undertaken by the
buyer before investing in a company, to ensure that the seller and the target
company have good title to assets proposed to be bought and also to know the
extent of the liabilities it will assume. Therefore, this data gathering process
forms an integral and critical part of the M&A process as it provides
information about the target’s business that enables the buyer to decide whether
the proposed acquisition represents a sound commercial investment.

Purpose :

Typically in an acquisition, the
purpose of legal due diligence is for the acquirer to check :

(i) the value of the assets
the seller is proposing to sell,

(ii) that the seller has
good title to the assets/shares free from all encumbrances,

(iii) that there are no
liabilities or risks that will reduce the value or use of the assets,
i.e., no third party has any right to use the assets,

(iv) applicable labour laws
and service contracts, etc.; and

(v) that there are no
existing or potential undisclosed liabilities that may adversely affect the
business of the target company and also evaluate disclosed liabilities.

The due diligence process helps
the buyer to properly evaluate the target company by investigating items that
either validate the offered price or items that diminish the company’s value and
its purchase price. The buyer may seek contractual protection from the seller in
the form of representations and warranties, but in practice, the protection
offered may be limited by disclosure and other contractual provisions. The
seller is required to disclose all relevant information relating to the target
to the buyer and often finds himself in a conflicting situation. On the one
hand, the seller wants to provide all relevant information to the buyer so as to
make the buyer comfortable with the seller’s offered price and on the other
hand, the seller does not want to reveal unnecessary information to the buyer,
for fear that should the deal not consummate, the prospective buyer may obtain
valuable commercial information and use to compete unfairly with the seller. In
the event of buyer’s breach, seller’s right to sue for damages and injunctive
relief may not be adequate protection or remedy, as such damages for breach may
be difficult to quantify and to enforce. Some prudent sellers require the buyer
and its advisers to enter into a confidentiality agreement.

Scope :

The scope of due diligence
review will depend on the purpose and nature of M&A transactions. For example,
acquisition of a company will demand extensive areas of inquiry than the
investigation made by a potential joint venture partner on the other joint
venture partners or inquiry made by a purchaser of shares in a company. The
extent of due diligence review is also likely to be governed by factors such as
available time, cost, the need to get the transaction done and the seller’s
sensitivity about the exercise.

In a due diligence process,
risks are identified and are borne by one or both parties and the parties will
negotiate the risks and the bargaining between the seller and the buyer will
relate to apportionment of the risks between them. The seller may give
warranties and indemnities with respect to risks that are identified, but more
often the seller is not aware of its problems until the buyer discovers it
during the due diligence process. However, representations, warranties and
indemnities from a seller covering a particular risk is not an adequate
substitute for carrying out the due diligence, because :

(i) warranties and
indemnities survive only for a few years by operation of law and contract,

(ii) warranties are often
qualified as to the materiality or the warrantor’s best knowledge,

(iii) indemnity claim have a
de minimis limit,

(iv) there is a time limit
in which the claim must be made usually within two to three years after
closing,

(v) sellers are more
cooperative prior to the closing as they need to close the transaction, but
are reluctant to address even the most valid warranty claims post closing,
and

(vi) by the time the
warranty claim is made, the warrantor may not be in existence or may not be
in a position to meet the claims.

The information obtained in the
due diligence review will place the buyer in a better position to assess the
risks and advantages of his investment and enable him to appropriately
renegotiate the terms of the acquisition. Therefore, a buyer not undertaking due
diligence would lose the opportunity to obtain more favourable terms of
purchase.

It must be noted that every due
diligence investigation depends on the quantity of data supplied by the seller.
The data may be sent to the buyer and its due diligence team to analyse at it
own offices or the buyer’s due diligence team is sent to the target’s office
where it is given access to the data room. It is necessary for the buyer to
support the data collection by securing representation, warranties an indemnity
from the seller, wherever possible, on those issues that are impossible for the
buyer to check and verify.The buyer usually requires that the seller warrants that the information supplied by the seller to the buyer’s due diligence team is complete and accurate. The seller more often would not war-rant those matters that would be known to the buyer during the course of due diligence process. In a situation where the due diligence exercise is limited, the buyer usually investigates key issues and may take the following precautionary steps to protect itself, such as:

i) secure appropriate representations, warranties and indemnities;

ii) consider negotiating a retention of the purchase price to cover potential claims;

iii) propose a price adjustment, if required;

iv) require compliance of certain conditions as a condition precedent to close of transaction, for example, obtaining of consents to the change of control from lender, etc.

Team conducting due diligence:

The legal due diligence team of a law firm usually consists of a partner, a senior associate, associates and paralegals (number of associates and para-legals will depend on the volume of documents to be reviewed). The senior associate is generally responsible for preparing the due diligence report for the client. The partner will be responsible for supervising the due diligence report and negotiating the acquisition agreements. The legal team prepares the legal due diligence questionnaire/ checklist and same is forwarded to the buyer’s personnel who after reviewing it will forward it to the seller. The legal team is constantly in touch with the buyer’s personnel to discuss issues arising out the due diligence review as the buyer’s personnel is the only person who will be able to make effective judgments as to the commercial importance and potential risk brought to light by the information revealed in the due diligence process.

Areas of legal due diligence:

The legal due diligence exercise will generally cover all of the areas listed below. This list is usually indicative and not conclusive and is tailored according to such factors as to whether the transaction is an asset purchase or share purchase and will also depend on the target’s industrial sector and size of the transaction:

i) Secretarial

ii) Real Estate

iii) Intellectual Property

iv) Litigation

v) Insurance

vi) Licences

vii) Employees

viii) Loans/Debts

ix) Material Contracts

x) Investments

xi) Environmental

xii) Competition

xiii) Other Laws

Gist of what the due diligence team investigates under the following heads are given below?:

Secretarial:

The investigation of corporate secretarial focus on the incorporation particulars, memorandum of association containing details about its objects, paid up capital, authorised capital, the number of shares issued, and the articles of association of the target containing provisions as to the directors, restrictions on shares, if any, shareholding pattern, etc. Under corporate secretarial, the register of members and directors and the minutes of meetings of the target are examined as well. Every company under the provisions of the Companies Act, 1956 is liable to maintain a register of members, register of charges and a register of directors to record and maintain minutes of all meetings of shareholders and of the board of directors held in the course of transacting business of the company. The target company is required to file records pertaining to their balance sheet and profit & loss account, annual return, consent of persons to act as directors, in case of increase of share capital/members, registration of resolution, creation/modification of charges, return of allotment, share transfer form, etc. with the registrar of companies. The due diligence team reviews all filings made with the registrar of companies. In case a company commits default in maintaining the said registers, or do not file their records with the registrar of companies in time, penal action may be initiated against the target company. The due diligence team besides examining compliance under the general provisions of the Companies Act, 1956, also gives particular attention to review compliances with provisions requiring government sanction.

Real Estate:

Investigation of real estate should delineate the immovable property held by the target, to whether it is leased, licensed or owned. If it is an owned property, the title of the target to such property must be ascertained. The due diligence team examines covenants attached to the transfer deed which may prohibit certain activities or may reserve easement rights and also assesses if there is a situation where the target may not have fully paid up the consideration or certain installments may be pending. In some cases, the target may not have obtained final deed of conveyance/sale deed in respect of the owned immovable property and there could also be outstanding dues pertaining to such property, namely, property tax, electricity and water charges, all of which needs to be checked. In case of leased and licensed property, one must check its capability to transfer the said property.

Intellectual property:

As regards the intellectual property, such as patents, designs, softwares, trade marks, careful assessment is required to ascertain whether they are owned and/or licensed by the target company and/ or licensed to the target company and whether they are registered or unregistered and whether they are in compliance with the relevant laws. The due diligence team examines whether there are any challenges, disputes or infringements of any registered and unregistered intellectual property rights licensed or owned by the target company. The due diligence team will also review pending applications related to intellectual property.

Litigation:

The due diligence team examines significant details of any disputes by or against the target company. Buyers may set a threshold in monetary terms to determine those litigation matters to be reviewed (for example, the buyer may not be interested in any claims for outstanding amounts from debtors below a certain figure). The diligence team may assess the contingent liability that the target may incur and examine the likely impact on the business of the target and details of any judgments given against the target and its assets as a result of litigation.

Insurance:

The investigation of documents relating to insurance would involve assessing the significant details of the insurance arrangements for the target company, such as whether there are any circumstances likely to give rise to a claim under insurance policies for the target company, whether insurance obtained by the target is valid, or whether the renewal of the policy is refused or premiums increased, whether there are any unusual terms in the insurance policies, and whether the target’s assets have been fully insured.

Licences:

The due diligence team must assess whether the licences or consents necessary to the operation of the target’s business, have been obtained, are valid and whether they are capable of being transferred/assigned to the buyer.

Employees:

With respect to employees and consultants of the target company, due diligence review would involve examination of service/employment contracts, letters of appointments, the executive and non-executive directors, consultants, key employees and managers have signed with the target company and the significant terms of those letters of appointments and contracts such as remuneration provisions, notice period for termination, any special payments on termination, term of contracts, absence of provisions on confidentiality, any restrictions during employment, restrictive covenants post-employment and confidentiality clause, etc.

The due diligence team inquires if there are any employees who have terminated or intend to terminate their employment in the period leading up to the transaction and examines the employee benefits such as share option schemes, bonus schemes, employee provident fund, gratuity, retirement benefits, etc. Investigation would also identify whether there are any trade unions / associations representing the personnel of the target company. The due diligence team makes inquiries about payment obligations to employees, whether relevant labour legislation has been complied with, whether there has been any strikes or litigation with respect to trade unions and employees or if there are any anticipated, industrial disputes or employment related litigation, involving the target company.

Loans:

Investigation with respect to loans would involve assessment of loans given by the target company to third parties and other members of the target group, whether there are any pending instalments or restrictive covenant in the loan documents that requires intimation to the lender in case of change in constitution of the target or whether the liability under the loan documents can be transferred to the buyer. The due diligence team also inquires if the seller has given any guarantees or indemnities in respect of the target and whether the target has provided any guarantees or indemnities for any other third party.

Material Contracts:

Evaluation of material contracts would include review of commercial agreements to which the target is party for example, any agency agreements, distribution agreements, share purchase agreements, licensing agreements and supply or purchase of goods agreements, hire-purchase agreements, etc. The due diligence team draws attention of the buyer to the relevant provisions in such agreements, such as obligations of the parties, termination provisions and effect of termination, change of control provisions, non-assignment provisions, representations and warranties, indemnities and guarantees, any other restrictive covenants.

Investments:

The due diligence team makes inquiries regarding any investments made by the target, including shares held in other companies, or fixed deposits or purchase of any other kind of instruments.

Environmental:

Environmental due diligence may be required in case of acquisition of a company which is a manufacturing company, or whose assets include land used for industrial processes. Environmental due diligence is conducted by lawyers or technical personnel who are experts in the field of environment. The environment due diligence team investigates potential responsibility for any clean-up and liability in relation to environmental damage. The investigation may range from a brief site visit to a more detailed survey involving detailed sampling of soil and ground water.

Competition:

The competition law is at a nascent stage in India, but the lawyer engaging in the diligence exercise is required to bear in mind the general competition law principles while reviewing the data of the target company. The due diligence team would need to seek information from the sellers to assess anti-competitive behavioural risks. Competition issues may have an effect on the acquisition value of the business or target, or may have an impact on the timelines for an M&A transaction. The analysis on competition issues is undertaken in consultation with lawyers specialising in competition law.

Other laws:

In case the target company is listed in any of the stock exchanges, the due diligence team would review all compliances the listed company is required to make under the Securities and Exchange Board of India Act, 1992, the Foreign Exchange Management Act, 1999 and other applicable laws.

Legal due diligence report:

The legal due diligence report is prepared by the buyer’s lawyers and addressed to the client-buyer, pursuant to the due diligence process of reviewing documents provided by the seller. The client may request for detailed form of report or just an executive summary summarising all the key findings of the legal due diligence review. The key findings in the executive summary will enable the buyer to consider issues for negotiations with the seller and help in deciding whether or not to proceed with the transaction. The description of key issues would include the change of control provisions in material contracts, prohibitions on assignment in material contracts, expiration of critical agreements, licences and registrations necessary for the operation of the target’s business, high-value on-going litigation matters, etc. Detailed reporting would include summary of all the documents reviewed in all areas of law.

Nirav Shah

Discounted Cash Flow

1 Introduction

Discounted Cash Flow (DCF) is a widely used method in the value analysis of any business. The value of an asset is the present value of expected cash flows from an asset. In this context, all the valuation methods including Net Asset Value (NAV),Profit Earning Capacity Value (PECV) and market price endeavour to determine the economic value of an asset but by using different approaches.

The relevance of Net Asset Value (NAV) derived from accounting books continues to diminish as self-generated intangible assets, which are key value drivers of modern corporations, are not recorded under accounting conventions. In PECV, profitability, sales and other relevant multiples derived from the market price of a comparable business is used as the metrics to arrive at the value of the subject business. It is assumed that market participants have paid for the expected future cash flows (FCF) from the asset when price under free market conditions is considered as indicative of value.

Though DCF is the application of the Net Present Value (NPV) rule, which in essence could be reduced to two variables – discount rate and cash flows, the application of DCF could be challenging as cash flows are impacted by several variables and the appropriate discounting rate is always a matter of debate. Several adjustments are also required to derive a finely calibrated value estimate. This article aims to provide an overview of the application of the DCF method in a practical context and the underlying theoretical concepts.

Description

The DCF method values a business based on the projected cash flows the subject business is expected to generate over a given period of time. The expected cash flows are discounted at an appropriate discount rate to determine its present value and thus the time value of money is provided for. A business is assumed to have a perpetual existence and DCF value is the summation of the present values of the cash flows expected in the projected horizon and estimated for perpetuity beyond the horizon.

Future cash flow (FCF) projections are the basic requirement for application of DCF. FCF usually forms part of the projected financial statements or may be derived from the projected income statements and the balance sheets. The FCF could be at the firm level available to the financiers of the business (both debt [D] and equity [E]) or to the equity holders. Generally the FCF to the Firm (FCFF), which represent business related cash flows available for distribution to both the owners (equity holders) of and the lenders to the business, is used in DCF . FCFF is equal to Profit before Interest, Tax, Depreciation and Amortisation (PBITDA) less Capital Expenditure (Capex), Taxes and adjustment for working capital changes. From the foregoing, it is evident that the FCFF is not impacted by the financing pattern of the enterprise. Conceptually, therefore, the value outcomes should not change whether the FCFF is used or Free Cash flow to equity (FCFE) is used.

Projections

The valuation estimate which is the output of a DCF model is only as good as the projections, which are built on subjective assumptions both at the macro level concerning the overall economy and business environment and at the micro level specific to the enterprise. In other words, integrity of the valuation output is largely determined by the thoroughness of the projections and its underlying assumptions. Projections review, therefore, entails a through understanding of the overall economy and the market in which the subject enterprise operates.

Common size statements, ratio analysis, peer group comparisons are analytical techniques employed in projections review. Inflationary expectations, currency movements, tariff levels are among the key macro assumptions. Business specific assumptions include pricing policy, salary levels and capital expenditure, which need to be consistent with the overall macro trends that are being projected. For example, it may not be realistic to assume a commodity would fetch prices higher than ruling market prices or to assume that raw material can be procured at lower than ruling market prices. In fact, it is likely that the prices may be influenced by the entry of other competitors prompting the incumbents to counter competition by reducing prices and influence the overall market.

At the micro level specific to the enterprise, working capital assumptions such as number of days of receivables and payables, inventories, trade advances and deposits will need to be estimated. Reasonableness of capex estimate may be ascertained through quotations/ orders placed for machinery and equipment. In this connection, it must be noted that maintenance capex should also be provided for in the projections. However, interest cost, if any, capitalized for accounting purposes is not be considered as capex for determining the FCFF.

Actual tax outflow must also to be projected with reference to the tax laws. Tax deduction on account of interest is to be ignored for computing the FCFF as the tax benefit on interest cost is captured in the discounting rate formula. Though the future FCF is derived from the accounting statements, it is the timing of the cash flows that is important and not the accounting distinction between revenue and balance sheet items. To illustrate- accounting of deferred tax does not impact cash flows but the actual outflow on payment of tax will affect the same.

2 A business entity under ordinary circumstances is expected to have a perpetual existence. But, projections are usually for a finite period. In a DCF model, the estimate of cash flows beyond the horizon is based on the cash flows generated in the last year of the horizon after appropriate adjustments. In order to fit the cash flow projections in a DCF model, the projections need to be at least up to the year in which the business is expected to achieve stable cash flows as the cash flows for perpetuity are based on the cash flows of the last year of the horizon after suitable adjustments. Conceptually the length of the forecast period should not impact value outcome.

It is important to note that it is not possible to forecast the behaviour variables with certainty and projected numbers may be considered as the outcome derived from various possibilities and the probability of their occurrence. In this context, a sensitivity analysis to assess the impact on cash flows by changes in the behaviour of variables is a necessary part of a value analysis exercise.

Theoretical Concepts

There are various theoretical concepts underlying the application of the DCF method. These are explained below:

Discount rate is the return expected by investors after taking into consideration the risk associated with the business. The investor raises return expectations when there appears to be an increase in risk.

Measurement of risk is at the heart of finance and we rely on theoretical insights and certain statistical concepts to arrive at the discount rate. In 1952, Harry Markowitz formulated the Portfolio Theory in a paper entitled “Portfolio Selection” wherein the principle of creation of the frontier of invest-ment portfolios is such that each of them had the highest expected return, given the level of risk that was set out and thus gave formal expression to the intuitive idea that diversification reduces risk. In Markwitz’s formula, Standard deviation (s) of the return on the security is considered as the risk. An investor is concerned with the risk of the portfolio which is the variance (s2) of the portfolio. A well diversified portfolio would encompass all securities in the market and would react to the general market movement and market risk.

Capital Asset Pricing Model (CAPM) is a theory about pricing assets in relation to the risks, which was independently formulated by John Lintner , Jan Mossin and William Sharpe in the 1960s. CAPM continues to be widely used although alternates such as Arbitrage Pricing Theory (APT) and Fama-French Three-Factor Model have been developed subsequently. Among other assumptions, CAPM assumes that all the investors employing Harry Markowitz theory are holding portfolios that are efficient and will maximize return at a given level of risk. An individual is concerned with the risk attached to the final portfolio and thus the risk of the individual asset will be assessed on the basis of the contribution to the variance of the portfolio.

Beta (b), which is the measure of sensitivity of a security in relation to the market as a whole, is the measure of risk. The statistical formula for Beta of a particular security is b = sim / s m2 where sim is the co-variance between the return of the particular security and the market return and s m2 is the variance of the market return.

Treasury bills/ government securities returns are assured and considered risk free thus assumed have a beta of 0. The aforementioned assumption is widely used although it is strictly not correct since only the nominal returns are assured while the real returns (inflation adjusted ) are not unless the security is inflation protected. An investor in a portfolio of well diversified stocks would require a premium for the market risk and this premium is the market risk premium.

Market risk premium = Market returns ( rm ) – Return from treasury/ government securities (rf).

A firm is exposed to business risk and financial risk. The value of a firm and business risk is dependent on its investment decisions and not by how the investments are funded. The theory that capital structure is irrelevant to the value of a firm is a proposition of Franco Modigliani and MH Miller. From a balance sheet perspective of an accountant, the value of the enterprise on the asset side is in-dependent of the ratios of debt and equity on the liability side. Leverage determines the financial risk. Cost of debt is lower than that of equity since debt holders claim ranks before that of equity holders. Increase in debt, however, increases the financial risk and thus the returns expectation of the equity holders (who are the residual claimants) would increase and the overall return expectations may not change. Equity holders have a limited liability and increase in debt may prompt the debt holder to demand a return closer to that of equity to cover the possibility of failure of debt repayment. In the real world, companies operating in sectors such as technology that have high degree of business risk and probability of failure do not have debt or have very low leverage so that the overall risk does not become unsustainable. In contrast utilities which have stable cash flows and thus lower business risks can afford to assume financial risk.

Usually the estimate of beta of the business that is valued is derived from the beta of a comparable company listed on the exchange. The leverage of the comparable company may be different from the leverage the target company has or intends to have. Under the circumstances the observed beta is to be unlevered to derive the asset beta and re-levered based on the firm’s targeted debt equity ratio. While the business risk exposure is reflected in the asset beta the financial risk element is captured on re-levering the beta. Levered beta increases as the proportion of debt increases to reflect the risk of volatility in earnings available to equity holders after providing for interest. It is assumed in practice that debt has a beta of 0. The equation bL = ba (1+(1-t)(D/E)) can be used for levering and re-levering the beta (wherein bL is the levered beta observed in the market, ba is the asset beta (unlevered beta), t is the tax rate and the tax shield on interest payments, D is the market value of debt and E is the market equity value).

Discount rate

It is important to link the discount rate to the as-sumptions underlying the FCF projections and also the expectations of the investor class who are the claimants of the cash flow. Real cash flows without inflation are to be discounted by the rate without inflation, while nominal cash flows, which have inflationary impact, are discounted using nominal rates. FCFE is to be discounted by the return expec-tations of equity holders while FCFF is discounted by the Weighted Average Cost of Capital (WACC). The WACC represents the returns required by the investors of both debt and equity weighted for their relative funding in the entity. WACC is de-rived based on the principles set out in the earlier paragraph.

WACC = Cost of equity (rE)* [E/ (D+E)] + Post tax cost of debt (rD)* [D / (E + D)]

rE = (rf )+ b * (market risk premium)

rD = Interest rate on debt* ( 1- tax rate)

The equity and debt ratios are based on the mar-ket values and not book values. In practice, book value of debt may be considered its market value if it can be retired with minimum cost or has been contracted recently or can be called on by the lender. Exceptions such as sales tax deferral loan (which does not carry interest) may need to be valued suitably. Equity value may need to be obtained by an iterative process because of the interdependence between cost of equity (due to leverage) and the resultant value.

Thus, the WACC formula clearly illustrates the relationship between return expectations and assumption of risk. Risk that can be diversified away is not rewarded while non-diversifiable risk is compensated in the formula. The minimum re-turn, which is the risk free rate, and market risk are common to all companies. A Beta of 1 means the firm is as risky as the market or a well diver-sified portfolio. Beta of 1.5 means the firms return expectation is 50% more volatile than the market and thus the risk premium increases by 50% over the market risk premium. A firm’s beta of 0.5 would reduce the return expectation to 50% of the market risk premium as the firm is less volatile than the market and its addition to the portfolio reduces the volatility of the portfolio. The building blocks of discounting rate are very clearly visible in the WACC formula.

The WACC formula also implies that unlisted shares, which do not have an exit mechanism that a listed security affords, may have a higher return expecta-tion from investors because of their lack of market-ability. similarly, in certain cases the project may not be complete and the asset beta of a completed project would not capture the project completion risk. The WACC may have to be appropriately adjusted up to compensate for the aforementioned factors.

The formula for discounting factor to be applied for each period is 1/( 1+WACC)n where n is the year in which the cash flow occurs. In a business, cash flows are distributed through the year and do not occur as a lump sum at the year end. Therefore n is corrected for midyear (on an average).

Perpetuity value

A business is expected to have perpetual life though it is usual to have a financial projection for a limited time horizon. The value of business beyond the horizon is captured in the perpetuity value. Perpetuity value usually accounts for a large part of the business value and needs to be estimated with care.

Usually the starting point for estimating the FCF

for perpetuity is PBITDA in the terminal year of the horizon period. Capex/ incremental working capital requirement for perpetuity are to be linked to assumed growth and depreciation. In case full plant utilization has already been achieved in the horizon, growth is not possible without capex invest-ment. Tax is a major outflow and is to be modeled carefully. Tax depreciation benefit is not available unless there is capex. The depreciation benefit may be equated to the capex though the tax benefit is spread over a longer period and its present value is usually lower.

Additional working capital requirement may be estimated by applying the growth percentage to the net working capital available at the end of the horizon. Year on year growth in cash flows for per-petuity is assumed after considering factors such as the competitive environment of the business, stage of growth of the overall economy, actual growth achieved and expected in the horizon etc. Typically companies in a mature economy grow at a lower rate as compared to entities in a developing economy. The cash flow is capitalized at the rate (WACC – g ) where g is the % growth assumed. The value is discounted for the present using the appropriate discount factor.

Other adjustments

The entity being valued may have non -operating assets on the valuation date, the income streams of which do not form part of the cash flows. The market value of such assets (net of taxes and expenses on realization ) is to be added to the business value. Treasury investments, land holdings (surplus) are examples of non- operating assets. Contingent li-abilities on the valuation date needs to be adjusted after considering the probability of materialisation and notional tax relief on the same. Arrears of divi-dend on cumulative preference shares not recoded in books are to be adjusted, if necessary.

Merits and Limitations of DCF

DCF explicitly uses forecast of cash flow genera-tion while other methods use proxies to get to the present value of cash flows. DCF unbundles key value drivers and the sources of risk with a great deal of clarity, thus facilitating value analysis and informed decision making much more effectively as compared to other methods. In an acquisition scenario, the synergy benefits and costs can be mapped in the model and its valuation implica-tions clearly understood through a DCF analysis. PECV, for example, captures the risk related return and growth in a single number. Given the forego-ing, DCF is indispensable as a tool to understand value drivers and facilitate value discovery from a corporate finance perspective. To value a finite life project, DCF may be the better alternate as multiples of comparable companies usually factor in perpetual existence.

The various data parameters used in building the WACC appears objective. On a closer examination, however, each of the parameters is open to chal-lenge and interpretation. Beta estimate of a traded company varies with the time period which is used to obtain the estimate. Risk free rate is strictly not risk free and impacted by several factors. There are theoretical issues with market risk premium. The parameters based on historical data are used to discount future cash flows and there is no assurance that the future will be a repetition of the past (extensive theoretical literature giving the dimensions of the issues involved is outside the scope of this overview).

In sum, DCF value is as good as the projections it is based on. Any bias in the projections would impact the value. The reasonableness of value and the projections necessarily needs to be tested with market prices of comparable companies. In case the value outcome under DCF is at significant variance with the value derived from market comparables, it would be necessary to inter alia reassess the reasonableness of the projections / market benchmarks applied to attempt to reconcile the values under both the approaches.

Considering the high level of subjectivity, DCF is seldom used in isolation and market benchmarks are important sanity checks to assess the reasonableness of the value outcome as the fair value is defined as the “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”. Under various accounting standards, the projections being unobservable inputs are lower in the hierarchy as compared to market based inputs such as multiples. Thus DCF may have a limited application for pure value measurement required for financial reporting, statutory purposes.

Practical application (in the Indian context)

As already discussed application of CAPM in its pure form may not be very challenging particularly in the Indian context. Apart from subscription based data services, stock exchange websites (NSE, BSE) are rich sources of data an d qualitative information and are freely available. The return on 10 year Government of India security may be considered as the rf. A well diversified index (in India– BSE 100, NIFTY, Sensex) is considered as a proxy for the market. The return from the index may be used to derive an estimate of market risk premium. The beta estimate of a particular security (used as a comparable) can be derived from the historical data of the prices and the indices by applying the statistical formula. Betas of the shares that are part of the index are readily available on the websites of the exchanges. An illustrative DCF computation is set out in the annexure.

Balance Sheet
Position as at 1Jan 2010	INR
Share capital	100.00

Reserves and surplus	200.00

Loans	400.00

Total funds employed	700.00

Fixed assets	400.00

Investments ( treasury)	100.00

Net current assets	200.00

Total application of funds	700.00

Notes:

Fixed assets include land not used for business which has book value of INR 100 and market value of INR 300.

The market value of Investments is INR 90 Excise duty claim of INR 25 is matter of legal dispute. Legal counsel has opined the probability of materialisation of the claim is ~ 25%.

Income Statements							INR

	Actual			Projected

Particulars for the year	2009	2010	2011	2012	2013	2014	2015
ended 31 December

Sales	500.00	550.00	600.00	650.00	700.00	750.00	800.00

Investment Income	10.00	12.00	12.00	12.00	12.00	12.00	12.00

Less:

Rawmaterials	200.00	220.00	240.00	260.00	280.00	300.00	320.00

Employee costs	100.00	104.00	108.16	112.49	116.99	121.67	126.53

Sales and administration	100.00	103.00	106.09	109.27	112.55	115.93	119.41

Profit before Interest,	110.00	135.00	157.75	180.24	202.46	224.41	246.06
Tax Depreciation and
Amortisation( PBITDA)

Depreciation	25.00	23.00	23.00	22.00	20.00	19.00	19.00

Profit before Interest)	85.00	112.00	134.75	158.24	182.46	205.41	227.06
and Tax (PBIT

Interest	45.00	40.00	40.00	30.00	20.00	10.00	8.00

Profit before Tax (PBT)	40.00	72.00	94.75	128.24	162.46	195.41	219.06

Tax	14.00	25.20	33.16	44.88	56.86	68.39	76.67

Profit after Tax (PAT)	26.00	46.80	61.59	83.36	105.60	127.01	142.39


IDCF Computation

Valuation Date : 1 Jan 2010							INR

PBITDA		135.00	157.75	180.24	202.46	224.41	246.06

Less

Investment income		12.00	12.00	12.00	12.00	12.00	12.00

Operational EBITDA		123.00	145.75	168.24	190.46	212.41	234.06

Taxes ( Refer Note 1)		35.00	42.96	51.18	59.66	67.69	75.27

Capex		10.00	15.00	15.00	15.00	15.00	15.00

Working capital requirements		12.00	12.00	12.00	12.00	12.00	12.00

FCFF		66.00	75.79	90.06	103.80	117.71	131.79

Discounting Factor ( Note 2)		0.9395	0.8292	0.7318	0.6459	0.5701	0.5031
Present Value of FCFF		62.00	62.84	65.91	67.05	67.11	66.31

Perpetuity value	INR	Remarks

PBITDA of terminal year	234.06

Less Depreciation	20.00	equalised to perpetuity capex

PBIT	214.06

Less : Taxes	74.92

Add: Depreciation	20.00

Less:

Capex	20.00	based on requirements conidering growth,
		depreciation etc.

Additional Working capital	5.44	2% ( growth rate) of NWC at the end of horizon

Net cash flow	133.70

Add Growth in cash flow	2.67

Cash flow for 2016	136.37

Capitalised at ( WACC- g)	11.30%

Capitalised value	1,206.64

Discount rate	0.5031

Perpetuity Value	607.12

Valuation Summary

Particulars	INR	Remarks
Present Value of free cashflows
– Horizon period (upto 2015 )	391.21
– Perpetuity( 2016 and beyond)	607.12
	998.33
Less:
Contingent Liabililities	4.06	after adjusting for probability of materialisation
		and net of taxes
Business Value of Enterprise	994.27	and net of taxes
Business Value of Enterprise	994.27
Add:
Investments	90.00	at realisable value
Land	230.00	net of tax on appreciation @35%

Enterprise Value	1,314.27

Borrowings	400.00

Equity value	914.27

Business WACC				Remarks
Debt weightage	40.0%			assuming book value equal to market value and
				debt is for funding business

Equity weightage	60.0%			based on equity value ( surplus assets and invest
				ments funded by equity )

Cost of Debt	7.8%			Post tax cost of debt after tax shield

Cost of debt	12.00%			Interest rate		contracted with lenders

Average Tax Rate	35.00%

Cost of Equity	17.0%

Risk Free Rate	7.87%			Yield on		10 year		Government of		India
				Security

Market Premium	7.00%			Estimate based on surveys and market returns

Beta	1.30			Unlevered		and relevered beta; asset beta
				obtained from market price of comparable
				and index movement

WACC	13.30%

Discount rate to be used	13.30%

Growth in perpetuity assumed	2%


Capex requirements			10		15		15	15	15	15

Additional working captal			12		12		12	12	12	12
requirements

NWC position	200		212		224		236	248	260	272

Taxes

PBT			72.00		94.75		128.24	162.46	195.41	219.06

Add: Interest			40.00		40.00		30.00	20.00	10.00	8.00

Less : Investment Income			12.00		12.00		12.00	12.00	12.00	12.00

PBT		100.00			122.75		146.24	170.46	193.41	215.06

Taxes	35%		35.00		42.96		51.18	59.66	67.69	75.27

Suggested Reading / References:

Damodaran on Valuation ( 2nd Edition) by Aswath Damodaran; Published by John Wiley and Sons, Inc.

Principles of Corporate Finance (6th Edition) by Richard Brearley and Stewart C Myers; Published by Tata McGraw- Hill Publishing Company Limited.

Valuation – Measuring and Managing the Value of Companies ( 4th Edition) by Tim Koeller, Mark Goedhart and David Wessels; Published by John Wiley and Sons, Inc.

Nirav Shah

Net Assets Method of Valuation

Background :

There are many methods of valuation of shares or businesses. One of the commonly used approaches of valuation is Net Assets Approach. Before we look into the finer aspects of this method, it may be important to note that each method of valuation proceeds on different fundamental assumptions. The data which is used for valuation has to be carefully chosen. In current times, when you have lots of data available at a click of the mouse, one needs to obtain and analyse only the relevant data. It is observed that lots of time is wasted in reviewing irrelevant information and at the end, time at disposal to review the relevant data is limited. One more factor which has materially changed in last couple of years is the time available to complete the valuation. There are times when the urgency is self-created or artificial. Only in few cases the urgency is justified.

Let us now look at some finer aspects of Net Assets Method.

1. The Net Assets Method represents the value of a share with reference to the historical cost of the assets owned by the company and the attached liabilities on the valuation date. Such value represents the support value of a share of a going concern. It is usual to ignore the market value of the operating assets under this method.

2. While the historical cost is adopted in respect of the assets that are to continue as a part of the going concern, it is necessary to adjust the market value of non-operating assets such as investments and any assets which are capable of being easily disposed of, without affecting the operations of the company.

3. The value as per Net Assets Method can also be arrived at by considering the replacement cost or the realisable value of the assets owned by the entity. This value generally represents the amount, which the company can fetch, if the assets are sold.

4. Under what situations Net Assets Method is adopted ?

The method to be adopted for a particular valuation must be judiciously chosen. Net Assets Method may be adopted in the following cases :

In case of start-up companies, where the commercial production has not yet started.

In case of manufacturing companies, where fixed assets have greater relevance for earning revenues. It would also be appropriate to use Net Assets Method for valuation in case of companies operating in the industry, which is capital intensive and is relevant to revenues in an industry, where norms are related to the capital cost per unit.

In case of companies where there is no reliable evidence of future profits due to significant fluctuations in the business or disruption of business.

In case of companies, where there is an intention to liquidate it and to realise the assets and distribute the net proceeds.

5. Methodology :

The value as per Net Assets Method is arrived at as follows :

Net Assets value represents equity value which is arrived at after reducing all external liabilities and preference shareholders’ claims, if any, from the aggregate value of all assets, as valued and stated in the balance sheet as on valuation date. It is very important that the valuer critically goes through the financial statements (Directors Report, Management Analysis and Discussions, Auditors Report, Accounts including notes). It is experienced that on review of all the above documents, chances of missing any important adjustments are very less.

The value so arrived at is further adjusted for contingent liabilities, if any, as on valuation date and increase in realisable value of surplus assets and investments on a net of tax basis to arrive at the value as per Net Assets Method.

6. Some issues and its treatment in valuation :

The following are some issues which one has to deal with in arriving at the Net Assets Valuation :

6.1 Contingent liabilities :

The amount of contingent liabilities as disclosed in the financial statements of the entity or otherwise needs to be given due consideration. The management’s perception of such liability materialising may also be considered. It is observed that certain items of contingent liabilities may involve a very peculiar technical or legal issue. It is not uncommon in such situations to seek some expert’s view in the matter. The valuer should mention in his report the adjustments made based on opinion of the expert. When an impact of contingent liabilities is captured in the valuation, if the item is tax deductible, the amount should be considered after taking into account the tax impact. For example if contingent liability on account of excise duty liability is, say, Rs.100. If the valuer has taken probability of 50% for such liability, the amount to be reduced from Net Assets of the company should be Rs.33 [Rs.100 X 50% X (100% — 33.99%)]. If the claim is in arbitration and the award is likely to take a long time, it is usual to take present value of such liability.

6.2 Investments :

If the entity which is being valued is holding shares in other companies, the same needs to be valued and captured in the overall valuation. Investment in shares and securities, which are regularly traded in a stock exchange, may be valued on the basis of the prices quoted on the stock exchange. It is usual to take either 3 months or 6 months average if the holding is large. For small lots a single day market price may be used. It must, however, be seen that there is regular trading in those securities. An isolated transaction may lead to erroneous results.

In case of quoted shares with isolated transactions and also in case of unquoted shares, if the amount is material, a secondary valuation of such shares may be necessary using accepted methodology of valuation.

In case of investment in subsidiary company, net asset value of the subsidiary may be considered instead of the cost.

The appreciation or diminution in the value of any investment needs to be taken after taking into account notional tax implications, as applicable.

6.3 Surplus assets :

There are many entities which are holding certain assets which are surplus in nature. They are not used for any operations of the entity. It could be a vacant flat, vacant land or a closed factory. It is generally observed that if such assets are disposed off, it will not affect the operations of the entity. The identification of surplus assets is an important task. Generally the valuer accepts management’s representation on the same. However it is always better to review the facts based on which a particular asset has been identified as surplus. In many cases it is observed that the assets identified as surplus were not surplus in nature. For example area vacant between two factory buildings was identified as surplus in one case. However it was not actually possible to dispose of that piece of land as it would have materially affected the operation of the plant. In such case it is not surplus asset.

It is usual to take the market value of the surplus assets based on a report of the technical valuer. The appreciation or depreciation in the value of surplus assets adjusted for the tax liability on such appreciation or depreciation would be added/deducted from the Net Assets Value.

6.4 Fixed assets :

While valuing the Shares/Business of a Company, the valuer takes into consideration the last audited financial statements and works out the net asset value. Following factors needs consideration in respect of fixed assets :

It has to be seen that book value is arrived at after charging adequate depreciation consistently. Any capital improvements in the past, which have been charged-off to revenue, should also be taken into account.

In taking the value of plant and machinery, the factor of obsolescence due to technological improvements, changes in designs, etc., should be given due consideration. If due to technical improvements, the present machinery is found to be so outdated that it has to be discarded, then the value which the plant and machinery would fetch, if sold piece-meal, should alone be taken account of.

At times, when a transaction is in the nature of transfer of asset from one entity to another, or when the intrinsic value of the assets is easily available, or when the projections of future profits cannot be made with reasonable accuracy or where there are losses or where the value of the entity is derived substantially from the value of its assets, the valuer can consider the intrinsic value of the underlying assets. For determining the intrinsic value of fixed assets, the valuers can place reliance on report from the approved Chartered Engineers or other approved valuers.

6.5 Inventory and debtors :

Due allowance should be made for any obsolete, unusable or unmarketable stocks held by the company. In case of debtors, bad debts and debts, which are doubtful of recovery need to be adjusted. If the valuation is carried after the Due Diligence Review, all adjustments arising on account of such review need to be captured in the valuation.

6.7 Contingent assets :

If the company has made escalation claims, insurance claims or other similar claims, then the possibility of their recovery should be carefully made, particularly having regard to the time frame in which they are likely to be recovered. The present value of such claims can be added to the valuation.

6.8 Qualifications & Notes to Accounts :

Qualifications in the Auditors Report and Notes to Accounts should also be given due consideration. If it calls for any adjustment, the same should be carried out while arriving at the Net Assets Value. Such items could be diminution in the value of long term investments not provided for, provision for gratuity and leave encashment not made, provision for doubtful debts not made, etc.

6.9 Liquidation :

Where the business of the company is being liquidated, its assets have to be valued as if they were individually sold and not on a going concern basis. In such cases, the total net realisable value will often be less than that on the basis of a going concern.

Regard should also be had to the tax consequences of liquidation. If fixed assets are to be sold at a price in excess of cost, the capital gains tax should be taken into account.

6.10 Brought forward losses :

Brought forward tax losses of a business should be considered if the buyer of the business would be entitled to take benefit of set off of such losses. Generally there is a practice to share the benefit of tax losses between both the parties.

6.11 Warrants :

If the Company has issued warrants which are yet to be exercised, the valuer has to take a call considering the current fair value and the amount to be paid on warrant conversion. If the fair value is higher, the warrant holder is likely to exercise his right. In such cases, amount receivable on warrant is added to the Net Assets Value. To arrive at the per share value, the current number of shares as well as the additional shares on exercise of warrants is considered.

Conclusion :

In many cases, Net Assets Method may not be relevant particularly where human capital or intangible are main assets used for generating revenues. In such cases, the Maintainable Profit Basis or the Discounted Cash Flow Method may be adopted.

For companies using tangible assets such as plant and machinery, building, etc, this method is relevant. Net Assets Method may sometimes be used as a backup to support the value arrived at as per other methods. In many cases, particularly valuation for mergers, Net Assets Method is used alongwith other methods but is given a lower weightage in arriving at final fair value. In many court cases where valuations were challenged, usage of Net Assets value as one of the methods of valuation was well accepted.

Following is an illustration of Valuation of Company PQR Ltd. as per the Net Assets Method :

Nirav Shah

Purchase Price Allocation (PPA)

M & A

Introduction :

As referred in my previous article on ‘Valuation of
Intangible Assets’, a purchase price allocation process is one exercise where
valuation of intangible assets plays an important part. Purchase Price
Allocation (PPA) is relatively new in India. However with the amount of mergers
and acquisitions (M&A) activity happening and with the roadmap for IFRS
convergence chalked out (beginning 2011), it cannot and should no longer remain
new.

PPA, very crudely put, can be defined as a process of
assigning values to acquired assets and liabilities. Unlike a normal valuation
exercise where ones efforts are driven towards finding and arriving at a value
of the target, in a PPA the value of the target is already known and where the
valuation of target ends, the process of PPA starts. The focus in a PPA exercise
is to allocate the total value paid for the target to individual assets and
liabilities acquired.

Rationale :

Just as a PPA is the reverse of a normal valuation, in order
to understand the full meaning of a PPA, the words have also to be read in
reverse. Purchase Price Allocation is ‘the process of ALLOCATION of the PRICE
paid for the PURCHASE of shares or of assets.’ The process is carried out to
ascertain the rationale behind paying a purchase price. The process identifies
the tangible and intangible assets/liabilities that have been purchased/taken
over, for which the purchase price has been paid. Most of us would be surprised
to know how much more a price has been paid if we compare the price paid for a
target to the book value of the target and that surprise element is the precise
reason why carrying out such a process is required by standards under US GAAP
and IFRS and with India’s planned convergence to IFRS, the knowledge of this
process along with its application is imperative. With this process, not only
would the shareholders of the acquirer understand why or why not a particular
purchase price was paid for a target but it would also bring to light the
inherent value of intangibles which may not get captured in the book value or in
the share price of a company. The following are the primary reasons why a PPA
would be carried out :

For transparency to shareholders

For the management to ascertain the reason for overpayment/underpayment

For
getting benefits of amortisation under revenue laws

Guiding Accounting Standards :

Currently the requirement of a PPA is mandatory only for
companies preparing financial statements under IFRS and US GAAP; however with
the much awaited convergence of Indian Accounting Standards with IFRS, the same
will be mandatory for companies preparing financial statements under Indian GAAP
as well.

Broad steps under the PPA process :

Business Enterprise Valuation to estimate the Internal Rate of Return (“IRR”)

Identification of Intangible Assets

Valuation Analysis of Intangible Assets

Reconciliation of Results

This is the first of the series of articles on PPA. Each
article in this series will explain the various steps in carrying out a PPA
process and how to value intangible assets forming part of a PPA. The series
will cover in detail the following aspects and the practical issues under each :

1. General Overview

2. Glossary of Business Terms and Definitions under a PPA

3. Computation of Purchase Price to be allocated

4. Calculation of IRR

5. Computation of Weighted Average Cost of Capital (‘WACC’)

6. Possible reasons for differences between the IRR and the WACC

7. Identification of Intangible Assets

8. Remaining Useful Life

9. Tax Amortisation Benefit Factor

10. Valuation Approaches and Methods

11. Tangible assets — Identification and

Valuation

12. Weighted Average Return on Assets

13. Reconciliation of Results

14. Non reconciliation of Results

15. Interpretation of Results

16. Negative Goodwill

17. Value additions

18. Case Study

19. Discussion of questions and answers received over the period of the series

20. Chartered Accountants as Valuers

21. Useful links and resources

levitra

Nirav Shah

Tax Due Diligence — Indirect Taxes

M & A

After reading the series of
articles of ‘Financial and accounting due diligence’ and Tax due diligence —
direct tax, readers would be clear about the circumstances under which due
diligence exercise is performed and its objectives. In the context of mergers
and acquisitions, due diligence is mandated either by a vendor who intends to
divest stake in a particular business/unit or by the potential acquirer who
intends to acquire the subject business/unit. The objective, in both the cases,
is common i.e., to avoid any post-transaction unpleasant surprises.

In terms of process of
performing indirect tax due diligence, it is no different from the manner in
which it has been discussed in the earlier articles on financial, accounting and
direct tax due diligence. In fact, the process should be so integrally linked
that it should appear seamless to the target and the client management.

Need for indirect tax due
diligence :

As the words ‘indirect tax’
suggest, these taxes are not a direct hit to the person who has the statutory
obligation to pay these taxes since these are recoverable in nature. However,
the indirect tax-related exposure, whether emerging from pending litigation or
from a potential exposure identified during the course of due diligence, remains
and/or travels with the subject-business.

This is one of the prominent
distinctions between direct tax and indirect tax i.e., the indirect
tax-related risks in terms of statutory liabilities and obligations are largely
associated with the business, irrespective of the manner in which the business
changes the ownership; say, by slump-sale or by transfer of equity or by sale of
merely the manufacturing unit or service centre or a particular branch, etc.
Thus, unlike income-tax where generally the statutory obligations remain with
the transferor entity, in the case of a business transfer, the indirect tax
obligations travel with the business. Hence, identifying and analysing indirect
tax obligations pertaining to the subject-business remain key focus areas as
discussed below.

Incidentally, it would be
important to also define in the scope of work with the client as to which
indirect taxes are being covered by the indirect tax diligence and which other
taxes/duties are excluded, say, that are expected to be covered by the legal due
diligence. Generally, custom duties, excise duties, sales tax, VAT and service
tax are covered in an indirect tax due diligence and taxes such as stamp duties
are picked up by the legal due diligence team.

Key focus areas :

One may broadly examine the
indirect tax diligence through eight key focus areas viz. :

1. Pending litigations and contingent liabilities :

This is one of the most common and traditional method of commencing the tax due diligence work. Here, the issues involved initially need to be studied from source documents, say, notices, demand orders and appeal papers made available along with interaction with the management and/or their tax advisors. The next step is to undertake research based on legal provisions, notifications, clarifications and judicial precedents found relevant. This leads to the third and important step involving merit analysis of the issue involved after considering the contentions of both the parties to the dispute and the result of indigenous research work along with tax positions adopted by industry members. Copies of legal opinion obtained should be reviewed with developments subsequent to the date of the opinion.

It is generally accepted that unlike tax advisors/advocates who are attending to the tax disputes, the diligence team does not have the luxury to take significant amount of time to analyse the issue. Needless to say, the expectations are always there for the diligence team to arrive at an independent and conclusive view on each of the issues involved. Hence, greater focus should be applied on providing ‘substance’ rather than ‘form’ in terms of detailed articulation of arguments of both sides before arriving at the view. For example, in media industry, specifically in production and distribution segment, one of the issues that is under litigation is VAT liability and the state in which such liability to pay VAT arises on transfer of distribution and various broadcasting rights in the content (say, film, television serial, event, etc.). Companies are known to take different positions, ranging from a conservative stand to execute the agreement in the state where the business of the media company resides and pay VAT as applicable in that state, to a more aggressive stand where the agreements are executed outside India or in any of the Indian states where VAT is not applicable or exempted.

Mere merit analysis of the disputed issues does not complete the exercise. What helps in achieving completion is understanding the accounting treatment in the books/financial statements i.e., the extent to which the amount is paid, provided as liability or disclosed as contingent liability. Even in case of payment, it would be relevant to ascertain the extent to which the amount paid under protest is accounted as a ‘receivable’ or charged to revenue. In case of industry engaged in export of services, say, IT and ITES industries, typically companies account for service tax and excise duty paid on input services, input and capital goods as a receivable, though the time the Tax Department generally takes in accepting the company’s contention, processing the refund claim and granting a refund is such that the possibility of receiving refund in the near future appears remote.

It is also important to note that the analysis should not be restricted to the disputed period. If the issue involved is ‘recurring’ in nature, the aggregate exposure needs to be quantified including the potential exposure for periods subsequent to the dispute if there is no change in the provision of law and adopted tax position. The two long-ranging disputes that come to mind are applicability of service tax and/or VAT on (i) construction and sale of residential/commercial premises, and (ii) licensing of software/copyrights. These issues are perennially being faced by the construction & real-estate and IT & media industries, respectively.

2. Observations in completed assessments and audits:

Completed assessment orders and audit memos provide opportunity to observe the acceptance or otherwise of the critical tax positions taken by the company. Tax positions include exemptions, abatements, incentives, reliefs, set-off claims, etc. claimed the company.

It may be noted that even though the assessments and/or audit memos finally do not result in any litigation, it is important to observe any disallowance or rejection of tax relief claimed which resulted into demand, which in turn have been accepted and paid by the company. These observations form the basis for analysing the tax positions in open assessments. At times, companies have been known to claim the benefit of inter-state sales at concessional tax rate against declarations in Form C, etc. in the return, but the collection and furnishing of these forms are not pursued aggressively until assessment (which generally takes after a period of three years or more) and results in some differential tax liability along with interest and penalty, when assessments are concluded. Hence, based on past trend of the company in completed assessments, the potential liability, if observed on this account, needs to be indicated.

3. Potential issues in open/unassessed periods:

The best way to tap the open assessment periods is to peruse the tax returns and filings including VAT Audit reports. However, it is not practical to peruse all the tax returns, payments and filings done say on monthly basis for excise, VAT and service tax for each of the locations where the indirect tax registration has been obtained. This needs to be done judiciously on sample basis.

The focus here should be applied on the tax claims and tax positions not yet tested in the assessments/audits. On a case-to-case basis, if the stake involved in adopted tax positions is significant, focussed interaction with management is desired to know the rationale and compliance to conditions for taking such positions. When found relevant, key customer contracts and/or vendor contracts may be perused on sample basis. This helps in gathering some comfort about tax positions adopted in the open assessment period which carries higher element of uncertain risk as compared to the risk in the matters already under litigation.

4. Positions vis-à-vis industry issues:

At times, it would be difficult to argue that merely because many/most players in the industry have adopted the same practice, the tax position would be acceptable. However, one cannot afford to ignore this altogether. It is because, there have been instances in the past where mere clarifications to the provisions of law (which otherwise is deemed to have been effective with retrospective effect) have been articulated in the Departmental circular or clarification so as to implement prospectively by providing relief for the past in indirect manner. The one example I recollect here is about clarifications on service tax liability in the case of international roaming under various scenarios of inbound and outbound roaming which provided some relief to telecom operators for the positions taken in historical period. This has happened generally when the issue involved is an ‘industry issue’ and contended on bonafideness. Thus, providing information on industry positions provides different level of business comfort.

5. Tax incentives — eligibility, admissibility, fulfilment of terms, conditions & obligations and continuity:

Tax incentives, specifically area-based tax incentives (say, available to manufacturing units in Uttaranchal, Himachal, Kutch, North Eastern States, etc. and/or to units in Special Economic Zone, Electronic Software/Hardware Technology Park and/ or to units in specified backward areas in States for VAT incentives, etc.) are subject to complying with specified terms and conditions. In this regard, it is important to gauge the continuity of tax incentives post transaction. This is because the quantum of unused tax incentives and its entitlement play a vital role in valuation of the transaction and hence its fate.

When the transaction structure is known at the time of due diligence, it is appreciated if the things found critical for continuation of tax benefits post transaction are briefly but appropriately communicated along with major concerns and listing of broader compliance steps for continuation.

6. Tax balances — perusal of reconciliation statement:

Understanding the quantum of tax balances accounted as ‘income’ (e.g., tax incentives/refunds), ‘expense’ (e.g., tax paid during audit observations), ‘assets’ (e.g., tax paid under protest and tax credit balance) and ‘liabilities’ (e.g., provision for periodical tax amount and for tax disputes) is important. It is because at the end of the due diligence exercise, one needs to identify the appropriateness of their accounting and the impact on profitability, net-worth and working capital.

After seeking reconciliation of tax balances, attention here needs to be paid on the rationale/ justification for each of the items forming part of the reconciliation statement. Post analysis, the resultant adjustments in terms of computation of profitability, net-worth, working capital, etc. should be identified and reported. The illustrative list of such adjustments includes (i) service tax refund for export of services, VAT refund for export, export incentives like duty drawbacks, etc. though entitled, not actually claimed before the appropriate authorities and accounted as ‘income’ and ‘receivable’, should be highlighted (ii) VAT/CST, etc. for March payable in April not accounted as ‘expense’ and ‘liability’ in the accounts for financial year, should be highlighted.

7. Related-party transactions:

Transactions with related party(ies) desire twofold attention i.e., (i) when the provision of law (say governing excise duty and VAT in some states), require transactions between related parties to be at fair market value, and (ii) when the provision of law is silent (say, service tax law or VAT in some states).

In the first scenario, the potential exposure should be identified. While in the second case, it needs to be understood that if the proposed transaction is structured in such a way that the benefit of ‘related party’ may not continue post transaction (say, where only one of the related entities is proposed to be acquired and hence the concessional transaction value regime shall come to an end in commercial terms). In such situations, the consequential tax implications need to be identified, analysed and discussed.

8. Important compliance procedures:

Verifying and reporting compliance matters is generally outside the work scope of due diligence as they generally do not give birth to any deal-breaker or significant valuation/risk issue. Besides, this requires greater amount of time and cost which always are constraints. However, understanding and providing broad flavour of tax compliance management (in terms of tax filings, tax payments, withholding tax on payment to works contract, etc.), tax team (in terms of qualification, level of competencies, etc.) and related systems (say, to undertake tax computations, to monitor collection of declaration forms, etc.) helps the client specifically in transactions envisaging change of management whether partially or completely.

In this regard, the indirect tax team would be well advised to clearly state the ‘exclusions’ from the scope of work of the indirect tax diligence so that there are no gaps in client expectations. Normally exclusions from an indirect tax diligence are review of tax compliance/procedural matters, providing tax advisory/planning services, etc.

Reporting:

Reporting is very critical to the entire exercise. Without adequate and smart reporting, the due diligence exercise may prove futile. While discussing the key issues, it needs to be ensured that though the approach and substance should suggest advisory role, the form in which the report is articulated should in no way appear as advisory deliverable like tax memo or opinion. The reason is obvious; the primary intention is not to repair the potential issue but to understand the worth and implications of the issues correctly.

For the foregoing reasons, the report is generally divided into three parts i.e.:

(i) Key issues (i.e., ‘must to know’ issues involving significant implications on the financial state-ments based on historical issue or from future perspective (say, continuity of tax incentives in special industrial areas, view on high-value litigation matters, etc.)

(ii) Other issues (involving non-key but ‘need to know’ issues) and

(iii) Informative issues (i.e., help in understanding overview of business from indirect tax perspective).

It is important to note that when the key issues could be in the nature of potential deal-breakers, there is no formal or structured way to communicate them for the first time during the diligence exercise. It means, such deal-breakers must be communicated ‘as and when’ they are observed without waiting for due date.

For each of the issues explained in the report, it must cover, inter alia, the exposure period, the quantum of exposure along with interest and mandatory penalty. When the penalty is not mandatory, a broad range should be indicated. Each issue needs to be analysed on merit by classifying risk as ‘probable’, ‘possible’ or ‘remote’ with agreed weightage for valuation adjustments, say for arriving normalised earnings, net-worth and/or working capital.

Lastly, reporting the issues without mitigation a strategy may leave the client clueless. Hence, it is equally important to provide a risk mitigation strat-egy in terms of obtaining warranty/indemnity, or in making a valuation adjustment, or deferring a part of the consideration in escrow account, etc. till a more definitive resolution of the issues concerned.

Conclusion:

It may be said that though there may not be a standard error-proof approach for carrying out a relatively subjective exercise of due diligence under different circumstances, the foregoing should help practitioners in carrying out an indirect tax due diligence exercise in a more structured manner to bring out the value to the client along with building efficiency and superior risk management to the whole diligence process.

A misperception at times amongst clients and their advisors is that indirect tax does not have the same flamboyance as a direct tax or a legal issue which then dangerously leads to a lack of adequate focus by the client on the unresolved indirect tax issues. We, indirect tax practitioners are well aware of the unending complexities of the indirect tax acts, rules, notifications and clarifications in our country and the multitude of judicial interpretations. And I humbly submit that a majority of my fellow direct and indirect tax practitioners would also acknowledge that more often than not, the potential tax liability arising from an indirect tax issue can be far more crippling than any other demand!

It remains the responsibility of the indirect tax team to correct any such misperceptions of the client or his advisors about ‘indirect tax’ and to ensure that the client has a true and fair appreciation of the indirect tax issues in the proposed M&A transaction.

Nirav Shah

Valuation — Market Approach

New Page 6

Oscar Wilde once described a cynic as “A man who knows the
price of everything and the value of nothing”. He was probably describing those
who believe in ‘survivor investing’ i.e., the theory of the value of an asset
being irrelevant as long as there is a ‘bigger fool’ willing to buy the asset at
a higher price.

A postulate of sound investing is that an investor does not
pay more for an asset than its worth. While this statement seems logical and
obvious, it is forgotten and rediscovered at some time in every generation and
in every market.

Every asset, financial as well as real, has a value. The key
to successfully investing in and managing these assets lies in understanding not
only what the value is but also the sources of the value.

Valuation is a process of determining a value. It’s a myth
that the value is nothing but a price. Price paid and the value determined can
sometimes be two ends of a pole. Valuation is subjective and may not provide any
precise or accurate estimate of value. Minimal skills sets required to carry out
a valuation include accounts and finance background, research and analytical
abilities, technology, communication and common sense.

Typically, there are three primary approaches to value the
business in practice. These approaches make very different assumptions but they
do share some common characteristics and can be classified as hereunder :

1. Market approach :

The market approach assumes that companies operating in the
same industry will share similar characteristics and the company values will
correlate to those characteristics. Therefore, a comparison of the subject
company to similar companies whose financial information is publicly available
may provide a reasonable basis to estimate the subject company’s value. There
are three forms of the Market Approach — the Comparable Companies approach (‘CoCos’),
the Comparable Transactions approach (‘CoTrans’) and the Market Price Method.
Market Approach is typically used to provide a market cross-check to the
conclusions reached under a theoretical Discounted Cash Flow approach.

2. Income approach :

The income approach recognises that the value of an
investment is premised on the receipt of future economic benefits. These
benefits can include earnings, cost savings, tax deductions and the proceeds
from disposition. There are several different income approaches, including
earnings capitalisation method (ECM), discounted cash flow (‘DCF’), and the
excess earnings method (which is a hybrid of asset and income approaches). ECM
considers company’s adjusted historical financial data for a single period,
whereas DCF and excess earnings require data for multiple future periods.

3. Cost approach :

The cost approach considers reproduction or replacement cost
as an indicator of value. The cost approach is based on the assumption that a
prudent investor would pay no more for an asset than the amount for which he
could replace or re-create it or an asset with similar utility. Historical costs
are often used to estimate the current cost of replacing the entity valued. When
using the cost approach to value a business enterprise, the equity value is
calculated as the appraised fair market value of the individual assets that
consists of the business less the fair market value of the liabilities that
encumber those assets.

Under a going-concern premise, the cost approach is normally
best suited for use in valuing asset-intensive companies, such as investment or
real estate holding companies, or companies with unstable or unpredictable
earnings.

Valuers generally use a combination of different approaches
to arrive at the fair value of an asset. In this issue we will discuss some
important aspects of the market approach.

Important definitions :

à Fair market value — fair market value means the amount at
which an asset or property would change hands between, a willing seller and
a willing buyer when neither is acting under compulsion and when both have
knowledge of reasonable facts.

à Enterprise value — market value of invested capital in the
business which includes all types of stocks and interest-bearing debts or a
measure of a business value calculated as market cap plus interest-bearing
debt, minority interest and preferred shares, minus total cash and cash
equivalents, non-operating assets and surplus assets.

à Equity value — Equity value is the value of a company
available to owners or equity shareholders.

à Book value — Book value is the value at which an asset is
carried on a balance sheet. In simple words, the book value is nothing but
an net worth of a company.

à Valuation multiple — Valuation multiple is computed by
dividing the price of the company’s stock as of the valuation date by some
relevant economic variable observed or calculated from the company’s
financial statements.

à EBITDA — Earnings before interest tax depreciation and
amortisation

à EBIT — Earnings before interest and tax

à PAT — Profit after tax

Market approach :

In the real estate sector, recent sale of comparable homes in
an area are used to establish the reasonable price range within which any home
is likely to sell. Similarly, market comparables are used as guidelines to value
a business, security or an intangible asset based on recent transactions in
comparable businesses, securities or intangible assets.

We will discuss in detail the following methods of valuation
under the market approach :

    a. Comparable companies
   b. Comparable transactions
   c. Market price

Comparable Company Method (CoCo) or Guideline Company Method :
Under the comparable company method, valuation multiples are computed based on prices at which stocks of similar companies are traded in a public market. The valuation multiples thus computed will be applied to the subject company’s fundamental data to arrive at an estimate of value for the company.

The value derived from CoCo method often represents a publicly traded equivalent value or freely traded value. In other words, it is a price at which the stock would be expected to trade if it were traded publicly. Thus, the value indication is appropriate for a marketable, minority ownership inter-est, using the premise of value in continued use, as a going-concern business. The method leads to fair market value, as it is a value at which an asset can be exchanged between willing buyer and willing seller with a full market knowledge and on an arm’s-length transaction.

We will use an example of AB Television Limited (‘ABTV’) to demonstrate practical application of market approach. ABTV is a general and business news channel with :

   Revenues of INR 5,000 million;
   EBITDA of Loss. INR 2,000 million; and
   EBIT of Loss. INR 2,500 million.

ABTV has around 6 news channels in its bouquet which includes 1 general English news channel, 1 general Hindi news channel, 1 English business news channel and 1 Hindi business news channel. It also has 2 regional language general news channels. It also has its general news Internet portal named www.abtv.com.

Identification of comparable companies :

Comparability of companies often becomes a central issue in litigated valuations. Companies can never be absolutely comparable to each other. The economics that drive the comparable companies should match those that drive the target company.

In order to determine the comparability factors such as product-mix, geographies, size, stages of business, market positioning, operating or EBITDA margins, dividend history, trading volumes, management, etc. should be considered.

Table 1 below shows list of broader comparables of ABTV.

The current portfolio of ABTV constitutes only news channels — business and general. It also includes its Internet business. Based on the business of ABTV and the above selection criteria, we selected com-panies like Zee News Limited, IBN 18 Broadcast Limited, TV Today Network, Television 18 Limited. NDTV has recently announced that it has sold off its 3 entertainment channels NDTV Imagine, NDTV Lumiere, NDTV Showbiz to Turner International. The TTM revenues of NDTV include revenues from the general entertainment business and hence, due to major restructuring of the businesses we have excluded NDTV Limited from the list of comparables. Though we have ignored the multiple of NDTV, we have tried to corroborate news channels’ multiples with the multiple of NDTV Limited.

Normalise the financial statements :

Normalising the financial statements is essential to remove the impacts of non-recurring and non-operating income or expenses, accounting differences, etc. from the financials, to arrive at maintainable or sustainable earnings and margins, operating revenues, etc.

Calculate multiples based on various financial parameters :

Multiples may take many forms. The numerator may be based on equity or enterprise value and the denominator may be based on a variety of normalised financial performance matrices on pretax or after tax basis.

If the numerator of a multiple is an equity value, then the denominator of the multiple should be an equity measure, such as PAT or net income or book value. Similarly, if it is enterprise value, then it should be operating parameter like operating revenue, EBIT-DA, EBIT, etc.

Company

Business

Country of

MCap

Net
worth

TTM sales

EBITDA

Trading

INR Millions

operation

margin

Zee News Ltd.

General and business

news channels

India

12,420

2,406

5,801

20%

52%

IBN 18 Broadcast Ltd.

News and general

entertainment
channels

India

18,978

2,787

4,826

-13%

NDTV Ltd.

General and business

news channel and

Internet

India

10,076

2,614

5,237

-66%

79%

Sun TV Network Ltd.

Regional entertainment

and news channels

India

124,165

17,016

12,790

82%

TV Today Network

Ltd.

General news channels

India

6,533

3,212

2,545

33%

23%

Zee Entertainment

Regional and

Enterprises Ltd.

entertainment
channels

India

96,749

33,995

20,611

34%

18%

Television Eighteen

News channels and

India Ltd.

business news and

Internet

India

11,570

4,442

4,853

-17%

81%

The time period used to calculate multiples is generally trailing twelve months (‘TTM’) or latest fiscal year. Sometimes the estimates of next year’s expected results also are considered.

Generally, TTM multiples display the latest information and the current state of operations, however they may not be readily available and need to be computed by using interim financial statements. Latest fiscal year multiples are directly available, but would not reflect the current state of operations. Forward multiples give a forward looking valuation, however they may not be accurate as they are estimates.

Valuation multiples computed from comparable company data for some time period (say, TTM), applied to the target company data for a different time period (say, last fiscal year) can result into consider-able distortions, especially if the industry conditions differ significantly between the time periods.

Either avoid comparable companies with recent corporate actions like mergers, acquisitions, etc., or make the adjustments to time period to arrive at real value. This is to make like to like comparisons and avoid speculative effect due to corporate announcements.

To calculate market capitalisation of the comparable companies, calculate 3 months’ or 6 months’ or 12 months’ volume-weighted average market price (‘VWAP’) to avoid daily fluctuations and speculative effect on the market prices.

In case of ABTV we have selected TTM revenue and TTM EBITDA to arrive at the enterprise value of the company. Further, we have considered 6 months’ VWAP for arriving at market capitalisation for the comparable companies.

Table 2 shows the range of multiples for ABTV Limited.

Notes : Market Cap. is Market Capitalisation; MI = Minority Interest; EV means Enterprise Value; TTM EBITDA numbers are adjusted for non-operat-ing and non-recurring items; NA is Not Applicable.

Select the type of multiple to be applied :

Selecting the type of multiple requires significant judgment. Industry practices are good indicators of the type of multiple that can be selected. In case of companies that are mature and generate stable cash flows, one must consider using earnings multiples.

In Table 2, we have not considered EBIT multiple or PAT multiple as most of the companies including ABTV Limited are making losses at EBITDA level. Ideally, EBITDA and EBIT multiple are best parameters to judge the business value. Hence, the key parameters for valuing ABTV Limited would be EV/Revenue. EV/EBITDA should also be ignored as EBITDA multiple is derived based on 2 companies’ parameters which may distort the valuation. To get the robust multiple, larger set of comparable should be adopted. But if the similarity of the businesses of the two companies is very similar, then one can consider even two companies as benchmark. In other words, more the disparity in the businesses of the comparable companies, the larger should be the group.

Further, while valuing ABTV Limited, EBITDA multiple will have to be multiplied with EBITDA number of ABTV which is a negative number. Therefore, for the purpose of this example, we have only considered revenue multiple which is also in range of multiple of NDTV Limited.

Selected comparable company multiple :

The median multiple is generally selected because the median provides a better measure of central tendency than the mean. Outliers would have a higher distorting effect on the mean than the median. The selected multiple needs to reflect the relative strengths and weaknesses of the subject company relative to comparable companies. If the outlook of the subject company is lower in terms of risk and/or more in terms of growth, then a multiple which is higher than the median may be selected.

In our illustration, the comparable companies are comparable in terms of risk and growth opportunities, as more or less all the companies are in business or general news channel except for IBN 18 broadcast which has various entertainment channels under its bouquet like MTV, Colours, Nick, and Vh1. It is also engaged in other businesses like film production, distribution of branded merchandise which though are in a start-up phase and are immaterial to its channel businesses. Therefore, if we remove it as an outlier, then median EV/Revenue is around 2.4x and average EV/Revenue is around 2.7x.

Apply adjustments for non-operating as sets and liabilities :

Excess cash and other non-operating assets need to be added and non-operating liabilities and inter-est-bearing debts should be subtracted from the enterprise value arrived at by applying the selected multiple to the financial performance matrices of the target company.

For example, ABTV has cash and cash equivalent of INR 1,200 million and Debt + Minority interest of INR 9,125 million which needs to be adjusted to its enterprise value. Enterprise Value of ABTV = EV/Rev-enue x TTM Revenue.

Types of multiples :

Price to earnings multiple :

Price to earnings (‘P/E’) multiple is calculated as follows :

Current Market Price

PE Multiple = ————————————————

Earnings per Share

Earning power of a company is one of the key drivers of its valuation. P/E ratio is one of the most widely accepted valuation parameters. Net profit after taxes, post adjustments for extraordinary and non-recurring income should be used to calculate the P/E ratio. The ratio cannot be used for companies with negative earnings. The P/E ratio is significantly influenced by the accounting decisions of the company. The guideline companies should have similar financing structures to compare their P/E ratio.

PEG ratio :

PEG ratio is calculated as follows :

PE Ratio
PEG ratio = _____________________________

Expected Growth Rate

Analysts compare PE ratios of a company with its growth rate to identify undervalued and overvalued stocks. PEG ratio of a firm must be compared with other firms operating within the same industry. A lower PEG ratio indicates undervaluation and a higher PEG ratio indicates overvaluation. The firm’s equity is considered fairly valued if PEG ratio reaches value of one. PEG ratio is useful to predict future growth of companies.

Price to book value multiple :

Price to book value multiple is calculated as follows :

Market price per share
Price to book value =_______________________________________

Book value of equity per share

The price to book (‘P/B’) multiple can be used for companies with negative earnings. The multiple is stable as the book value of a company does not change much from year to year. Book value of an asset is driven by the original price paid for the asset and accounting decisions of the company. As common sense would suggest that there is significant degree of correlation between return on equity and price to book value. Hence, while considering multiples of comparable companies also correlate the return on equities of the comparable companies and subject company.

Book value multiple is used in traditional manufacturing companies that derive their value from assets in place and high capital expenditure. The multiple is useful to value finance, investment, insurance and banking firms that hold significant liquid assets. P/B ratio can also be used for firms that are going out of business. The multiple is generally not used for valuation of companies in service industries primarily, because the multiple does not capture the potential of identifiable and unidentifiable intangible assets.

Revenue multiple :

Revenue multiple is calculated as follows :
Revenue Multiple = Enterprise Value/Revenue

Revenue multiple is another widely accepted valuation ratio because of several factors. Firstly, growth rate is a fundamental driver of valuation, which begins with sales. Secondly, sales information is subject to less manipulation than any other financial parameter. Besides, sales information is easily available for all types of firms including troubled and very young firms. Thirdly, revenue multiple is less volatile than the earnings multiple, therefore it can be used in cases where there are large fluctuations in earnings. A drawback of this ratio is that it does not capture the difference in cost structures and capital struc-tures between different companies. Further, it can be one of the best parameters for the companies in growth phase, or when company has launched new products and has not broke even.

Enterprise value to EBITDA/EBIT :

EBITDA multiple is calculated as follows :

Enterprise Value
EV/EBITDA or EBIT = _______________________

EBITDA or EBIT

EBITDA or EBIT multiple is one of the best param-eters to analyse the business value of the company. Since EBITDA or EBIT are operating margins of the business they are best to use for any industry. EBIT-DA or EBIT multiple can be used for comparing firms with different degrees of leverage. For these rea-sons, this multiple is particularly useful for valuation of companies in almost all industry. It may not be useful when the companies are in the growth phas-es or haven’t broke even. Best time to use these multiple is when the industry or subject company are in stable phase or mature phase.

Other multiples :

Analysts use other valuation multiples such as sec-tor specific ratios, for example price per hit ratio is used to value startup website companies, price per subscriber is used for valuation of cable and telecom companies, price per megawatt is used to value power generation companies, EV per tone can be used for cement or steel industry, etc.

Comparable Transaction Approach (‘Cotrans’) : One can derive indication of value from the price at which a company or an operating unit of a company has been sold or the price at which a significant in-terest in a company has changed hands. Such data is harder to find as compared to daily stock trading data. The steps followed by a valuer/analyst using the comparable transaction approach are similar to those of the comparable companies approach.

The primary difference between CoCos method and CoTrans method is that in CoTrans method the transaction price is the basis of calculating the multiple, whereas in CoCos method basis is the current market price of similar companies. Transactions in the target company’s industry or similar industry are analysed over a period of 3 to 5 years depending upon availability of set of transactions and changes in the industry.

This is because there are fewer transactions, and acquisition price multiples generally do not fluctuate a lot over time as compared to market price multiples. Characteristics of each transaction need to be analysed to decide which adjustments may be necessary in order to use the transaction price multiples. In case of ABTV we have considered the following as comparable transactions :

Valuer/Analysts should take into account the follow-ing aspects while using the CoTrans method :

Source of data :

Generally, the availability of data for comparable transactions is comparatively scarce v. stock price data for comparable companies. Data on the acqui-sitions of private companies are not subject to any regulations and vary tremendously in scope and format. If the subject company itself has changed control in the last few years, the transaction may be an excellent source of valuation multiples.

Date

Target

Bidder

Deal

Stake

EV/

P/E

value

acquired

Revenue

EBITDA

EGIT

USD million

31st Dec. 2009

NDTV imagine

Turner

92%

n.a.

International

29th Oct. 2009

Zee News Limited

Zee Entertainment

Enterprises Limited

252

N.A.

3.8

16.1

N.A.

22nd Dec. 2008

Broadcast

HDIL Infra

Initiatives Limited

Projects Pvt. Ltd.

N.A.

2.6

1.0

N.A.

27th Oct. 2008

UTV Software

The Walt Disney

Communications

Ltd.

302

N.A.

18.1

103.5

113.6

37.4

Ltd.

7th July 2008

New Delhi

Prannoy Roy,

Television Limited

Radhika Roy, RRPR

Holdings Pvt. Ltd.

140

N.A.

10.9

96.6

241.9

N.A.

28th Feb. 2007

Udaya TV Private

Limited

Sun TV Network

401

N.A.

19.7

36.5

N.A.

71.6

28th Feb. 2007

Gemini TV Pvt. Ltd.

Sun TV Network

603

N.A.

15.8

23.0

N.A.

59.8

Average-All

11.8

46.1

118.8

56.3

Median-All

13.3

29.8

113.6

59.8

Average-post
outliers

11.8

19.1

1.0

65.7

Median-post outliers

13.3

19.5

1.0

65.7

Average-recent
(2009)

3.2

8.5

1.0

N.A.

Median-recent (2009)

3.2

8.5

1.0

N.A.

Several databases are also available such as Bloomberg, Merger Market, Capital IQ, etc., which provide information on transactions across different sectors and different geographic locations. We have selected comparable transactions for ABTV from Merger Market.

Non-availability of data :

In case of most transactions, financial data is not available. In case of acquisitions of privately held companies, the data with respect to purchase price, revenue or earnings measures of the target company, percentage stake acquired, etc. are usually not available in the public domain. Therefore, analysts need to use appropriate judgment in case of trans-actions where data is not available.

Understanding the deal structure :

One must understand the rationale of each comparable transaction. For example, one must understand if the transaction was a strategic investment or financial investment, percentage of stake sold in the transaction, whether the sale was a distress sale, etc. Typically, due to different purposes of investments, transaction rationale and synergy benefits, different control premiums and minority discounts are embedded in the transaction values. Differences between the comparable transactions and the contemplated subject transaction should be noted and adjusted appropriately in developing valuation multiples. Due to lack of information on such parameters it would be difficult to really analyse these aspects of transactions and hence, comes the judgment of the Valuer.

Announcement versus closing date

The announcement and the closing date of a trans-action can be months apart. There may be a difference between the indicated deal values on the two dates. Generally, the date used does not make a material difference to the valuation. Most multiples are developed based on announcement date. This gives an indication of what the buyer and seller originally intended to pay or receive for the company based on the information available at the time when the deal was originally analysed and negotiated.

Rule of thumb :

Some industries have rules of thumb about how com-panies are valued for transfer of controlling ownership interests. If such rules of thumb are widely disseminated and referenced in the industry then, they should be used. Generally, there is no credible evidence on how these rules of thumb are developed. They fail to differentiate operating characteristics of one company to another and do not consider differences in the terms of the transactions.

Control premium :

The value of a majority stake in a company is always more than the value of a minority stake, because the majority shareholder gets control of the financial and operating decisions of the company. Therefore, if a transaction considers the acquisition a majority stake, then the price includes a control premium. The market price considered in calculation of multiples in CoCos method does not take into account any control premium. Therefore analysts should adjust the transaction multiples to remove the effect of the control premium while valuing a minority stake in a company.

Market Price Method :
Under the market price method, an asset is valued based on the price at which it is traded in the open market. This method gives a reliable indication of the value of an asset as the market price reflects the value that a buyer is willing pay to a seller for an asset in the free market. In case of shares of a company that is listed on a stock exchange, one can consider the market price of the company based on the last six-month VWAP on the stock exchange where the company’s shares are most frequently traded. It may happen that the equity market may not reflect the fair value of a stock, as the equity prices on a stock exchange get influenced by the market sentiments. It is important for a valuer/analyst to consider these market sentiments while using the market price method. At times the valuation practitioner may choose to ignore this method of valuation if market price is not a fair reflection of the company’s underlying assets or profitability.

Nirav Shah

Ind AS 102 – Share Based Payments

Background

Currently, the accounting guidance under Indian GAAP for Employee Share Based Payment Plans (ESOPs) is contained in the Guidance Note on Accounting for Employee Share-based Payments. In the case of listed companies, guidance is also provided in the Securities and Exchange Board of India (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999. There is no specific guidance currently under Indian GAAP for options granted to non-employees (for example, vendors or customers). Ind AS 102 deals with all types of share based payments, including share based payments made to non-employees.

Objective, scope and definitions

Ind AS 102 provides guidance with respect to the financial reporting by an entity, when it undertakes a share-based payment transaction. Ind AS 102 specifically excludes the below-mentioned share-based payment transactions from its scope, as the relevant guidance relating to these transactions are covered under other accounting standards:

• Share-based consideration paid in a business combination (Ind AS 103 – Business Combination)

• Certain contracts falling within the scope of Ind AS 32 “Financial Instruments: Presentation” or Ind AS 39 “Financial Instruments: Recognition and Measurement”.

Type of share based payment transactions

Under Ind AS 102, share based payment transactions are classified as follows:

Equity-settled share-based payment transactions. Under this the entity receives goods or services as Jamil Khatri Akeel Master Chartered Accountants IFRS consideration for equity instruments of the entity or another group entity. Cash-settled share-based payment transactions. Under this the entity acquires goods or services by incurring liabilities to the supplier of those goods or services for amounts that are based on the price (or value) of the entity’s shares or other equity instruments of the entity. Transactions with cash alternatives. Under this the entity receives or acquires goods or services and the terms of the arrangement, provide either the entity or the supplier of those goods or services with a choice of whether the entity settles the transaction in cash (or other assets) or by issuing equity instruments.

Measurement

Equity settled share based payment transactions Equity settled share based payment transactions are measured with reference to the fair value at the grant date (where options are granted to employees) or with reference to the fair value at the date at which the entity obtains the goods or receives the services (where options are granted to non-employees).

The measurement is at the fair value of the goods or services received, unless that fair value cannot be estimated reliably. If the fair value of the goods or services received cannot be estimated reliably, the entity shall measure the fair value by reference to the fair value of the equity instruments granted.

Typically, in the case of employees, fair value of equity instrument is considered since it is not possible to estimate reliably the fair value of the services received. However, in case of transactions with parties other than employees, there is a rebuttable presumption that the fair value of the goods or services can be estimated reliably.

The fair value of the instruments granted can generally be measured using the market prices (if available) or using a valuation technique (for example, option pricing models).

Example

Entity P grants 100 share options to each of its 200 employees which are conditional upon completing three years of service. Estimated fair value of each option on grant date is INR 10.

Year 1
Cumulative expense (100* 200* 10*1/3) = Rs. 66,667 Expense for the current period = Rs. 66,667 Entry – Expense Dr 66,667 To Equity 66,667

Year 2
Cumulative expense (100* 200* 10*2/3) = Rs. 133,333 Expense for the current period = Rs. 66,667 (133,333 – 66,667) Entry – Expense Dr 66,667 To Equity 66,667

Year 3

Cumulative expense (100* 200* 10*3/3) = Rs. 200,000 Expense for the current period = Rs. 66,667 (200,000-133,333) Entry – Expense Dr 66,667 To Equity 66,667

Cash settled transactions

Cash-settled share-based payment transactions are measured at the fair value of the liability. Further, at each reporting date, and ultimately at the settlement date, the fair value of the recognised liability is remeasured with any changes in the fair value recognised in the profit or loss account. It is to be noted that equity settled share based payment transactions are not required to be remeasured.

Example

Entity A granted 60 Share Appreciation Rights (SAR) to each of its 200 employees with three years service condition. The SAR will be ultimately settled by Entity A making cash payments to the employees based on the value of the SAR. Fair value of options at the end of: Year 1 – Rs. 15 Year 2 – Rs. 20 Year 3 – Rs. 22

At the end of Year 1

Cumulative expense (60* 200* 15*1/3) = Rs. 60,000 Expense for the current period = Rs. 60,000 Entry – Expense Dr 60,000 To Liability 60,000

At the end of Year 2

Cumulative expense (60* 200* 20*2/3) = Rs. 160,000 Expense for the current period = Rs. 100,000 (160,000 – 60,000) Entry – Expense Dr 100,000 To Liability 100,000

At the end of Year 3

Cumulative expense (60 * 200* 22 *3/3) = Rs. 264,000

Expense for the current period = Rs. 104,000 (264,000-160,000)

Entry – Expense Dr 104,000

To Liability 104,000

Conditions affecting the recognition and fair value

Conditions that determine whether the counterparty receives the share-based payment are separated into vesting conditions and non-vesting conditions.

Service conditions are those conditions which require counterparty to complete specified period of service, whereas performance conditions require the counterparty to meet specified performance targets in addition to service conditions. Performance conditions could either be market conditions where vesting is related to the market price of entity’s equity instruments or nonmarket performance conditions where vesting is related to specific performance targets unrelated to market price (for example, specified increase in sales, net profit or EPS).

Service conditions and non-market performance conditions are not reflected in the grant date fair valuation and a true up is required for failure to satisfy such condition. Market conditions and non-vesting conditions are reflected in grant date fair valuation and no true up is required subsequently for failure to satisfy such conditions.

Accordingly, no charge is recognised for goods or services received if the equity instruments granted do not vest because of failure to satisfy a service condition/non-market performance condition. On the other hand, in the case of grants of equity instruments with market conditions, the entity shall recognise the charge for goods or services received from a counterparty who satisfies all other vesting conditions (for example, services received from an employee who remains in service for the specified period of service), irrespective of whether that market condition is satisfied.

In other words, market conditions are reflected as an adjustment to the initial estimate of fair value at grant date of the instrument to be received and no adjustments are made as a result of differences between estimated and actual vesting due to market conditions.

Non-vesting conditions

Non-vesting conditions are similar to market conditions and are reflected in measuring the grant-date fair value of the share-based payment. No adjustment is made for any differences between expected and actual outcome of non-vesting conditions.

Therefore, if all service and non-market performance conditions are met, then the entity will recognise the share-based payment as a cost even if the counter-party does not receive the share-based payment due to a failure to meet a non-vesting condition.

In practice, most Indian ESOP plans have service vesting conditions, while some plans may contain performance conditions. Non-vesting conditions are rare.

Forfeiture

A grant is forfeited when the vesting conditions are not satisfied.

The amount recognised for goods or services received during the vesting period shall be based on the number of share options expected to vest considering options estimated to be forfeited.

When the goods or services received are recognised with a corresponding increase in equity, then entity shall not make any adjustment to total equity after the vesting date. An entity shall not subsequently reverse the amount recognised for services received from an employee if the vested equity instruments are later forfeited or, in the case of share options, the options are not exercised.

Estimated share-based payment cost is trued up for forfeitures or estimated forfeitures on account of an employee failing to provide the required service.

Group share-based payment arrangements

A share-based payment in which the receiving entity and the settling entity are in the same group from the perspective of the ultimate parent and which is settled either by an entity in that group or by an external shareholder of any entity in that group is a group share-based payment transaction from the perspective of the receiving and the settling entities.

In a group share -based payment transaction in which the parent grants a share-based payment to the employees of its subsidiary, the share-based payment is recognised in the consolidated financial statements of the parent, in the separate financial statements of the parent and in the financial statements of the subsidiary.

Examples

Parent P grants its own equity instruments or a cash payment based on its own equity instruments to the employees of Subsidiary S as a consideration for the services provided to S, wherein P has an obligation towards the employees of S; or

Subsidiary S grants equity instruments of Parent P or a cash payment based on the equity instruments to its own employees as a consideration for the services provided to S. Here S has an obligation towards its employees.

Let us understand the accounting treatment in case of group share based payment.

Accounting by subsidiary, when parent grants shares to the employees/counter party of its subsidiary

Here a subsidiary has no obligation to settle the transaction with the counterparty. However, subsidiary is receiving service/goods and hence recognises an expense/asset and an increase in its equity for the contribution received from the parent.

Accounting by a subsidiary who grants rights to equity instruments of its parent to its employees

The subsidiary shall account for the transaction with its employees as cash-settled. This requirement applies irrespective of how the subsidiary obtains the equity instruments to satisfy its obligations to its employees.

Accounting by parent that settles the share-based payment directly

When a parent grants rights to its equity instruments to employees of a subsidiary, the parent receives goods or services indirectly through the subsidiary in the form of an increased investment in the subsidiary, i.e. the subsidiary receives services from employees that are paid for by the parent, thereby increasing the value of the subsidiary.

Therefore, the parent should recognise in equity the equity-settled share-based payment with a correspond-ing increase in its investment in the subsidiary in its financial statements. The amount recognised as an additional investment is based on the grant-date fair value of the share-based payment. An increase in investment and corresponding increase in equity for the equity-settled share-based payment should be recognised by the parent over the vesting period of the share-based payment.

In consolidated financial statements, the investment in the subsidiary mentioned above would be eliminated against equity contribution recognised by subsidiary in its standalone financial statements and accordingly, employee compensation expense would be recognised with corresponding credit to either equity or liability.

Treasury shares

Under Ind AS, a trust formed for administering an employee stock option plan generally meets the definition of a Special Purpose Entity, and hence is consolidated with the entity. Under this approach, cost will be recognised for all grants through the trust; shares held by the Trust will be considered as treasury shares of the company; and any loan given by the company to the trust will be eliminated on consolidation. As a result of this accounting treatment, cost of any shares bought by the Trust from the open market will be reduced from the reserves of the company. Any subsequent sales by b the trust (either to the employee or third parties) will result in an increase in the reserves.

Exit Mechanism

Sometimes, an award requires an exit event (e.g. sale of the business) as either a vesting or exercise condition. The requirement for an exit event affects share-based payments in different ways, depending on how the condition is expressed. If the condition is required to occur during the service period, then it would be a performance condition.

For example, a grant of share options has a three-year service condition. However, the options cannot be exercised until an IPO occurs.

If employees leaving the entity after the service period but before the IPO retain the options, then the condition of an IPO is a non-vesting condition.

If employees leaving the entity before an exit event are required to surrender the ‘vested’ options (or sell them back at a nominal amount) then the exit condition is in substance a vesting condition.

Let us take another example. If the options do not vest until an IPO occurs and employees leaving before the IPO forfeit the options, then this is an award that contains both a service condition and a non-market performance condition, assuming that there is no minimum IPO price. Such an arrangement should be accounted for as a grant with a variable vesting period (i.e. the length of the vesting period) varies depending on when a performance condition is satisfied, based on a non-market performance condition. Because the IPO has no minimum price and therefore is not a market condition, the condition would not be reflected in the grant-date measurement of fair value and the cost would be recognised over the expected vesting period and trued up to the actual vesting period and the actual number of equity instruments granted.

Conclusion

The accounting for share based payment under Ind AS 102 is much wider in scope as compared to the existing guidance. The guidance on accounting for group share based payment should be carefully evaluated to determine the appropriate accounting treatment for group entities. Ind AS 102 provides guidance on accounting for share based payments and mandates use of fair value for recognition of share based payments (intrinsic method is permitted only in very rare circumstances). This is likely to impact the employee compensation expense of many Indian companies who have issued stock options to employees and currently use intrinsic value method to account for these options. The use of fair value method to recognise share based payment would provide a more accurate picture to all stakeholders with respect to the true compensation cost. However, this will also bring in challenges since compensation cost will be recorded, based on a calculated ‘fair value’ of the option on the grant date, which in most situations will be significantly different from the actual gain (or no gain) for the employee at the time of the vesting/exercise.

Nirav Shah

Ind AS 105 – Non-current assets held for sale and Discontinued Operations

Background

Current Indian GAAP does not prescribe comprehensive guidance on Non-current assets held for sale and discontinued operations. Under Indian Accounting Standards (Ind AS) that are converged to International Financial Reporting Standards (IFRS), Ind AS 105 has been aligned with IFRS 5 and there are no major differences between Ind AS and IFRS. Ind AS 105 also covers in an appendix the requirements specified in IFRIC 17 – Distribution of non-current assets to owners.

Scope and Definitions

Ind AS 105 provides guidance with respect to classification, measurement and presentation of all noncurrent assets/disposal groups held for sale and assets classified as held for distribution. The standard also covers classification and presentation requirements of Discontinued Operations.

Definitions

Non-current assets are assets which do not meet the definition of current assets as defined in Ind AS 1. In practical terms, non-current assets are assets which are not expected to be realised within a period of twelve months from the reporting period.

Disposal Group is a group of assets to be disposed of, by sale or otherwise, together as a group in a single transaction, and liabilities directly associated with those assets that will be transferred in the transaction. Thus, disposal group may contain assets or liabilities which are current in nature or assets which do not fall within the purview of this standard. Here, when an entity applies the measurement requirements of this standard it has to consider the Disposal group as a whole.

Discontinued Operation is a component of an entity that either has been disposed of or is classified as held for sale and:
• represents a separate major line of business or geographical area of operations;
• is part of a single co-ordinated plan to dispose of a separate major line of business or geographical area of operations; or
• is a subsidiary acquired exclusively with a view to resale.

Criteria for Classification as “Held for sale”

Under Ind AS 105, an entity shall classify a non-current asset (or disposal group) as held for sale if its carrying amount will be recovered principally through a sale transaction rather than through continuing use.

There are mainly two conditions which must be satisfied for an asset (or disposal group) to be classified as “Held for sale”.

1) An Asset must be Available for Immediate Sale in the Present Condition Subject to Terms that are Usual and Customary i.e. Common Practices which Exist for Sales of such Assets (or disposal groups) For example, an entity intends to sell second hand machinery and there is demand for second hand machinery in the market, however there are very few users of this particular machinery and usually it takes three to six months of time to close the sale transaction. In this case, the asset can be said to be available for immediate sale and can be considered as “held for sale” if other criteria is met.

2) Sale must be Highly Probable:

The Standard provides detailed guidance on this second condition about when can sale be said to be highly probable. The standard specified that for the sale to be highly probable:

• Appropriate level of management must be committed to a plan to sell the asset (or disposal group) and active programme to locate a buyer and complete the plan has been initiated.

• Assets (or disposal group) under consideration must be marketed at a price that is reasonable to its current fair value.

• The sale should be expected to qualify for recognition as a completed sale within one year from the date of such classification i.e. an entity expects to complete the sale transaction within one year from the date on which theses assets are classified as held for sale.

Measurement Principles

There are mainly three stages of measurement of assets (or disposal group) held for sale:

• Before initial classification as held for sale – Assets (or disposal group) held for sale before such classification are measured according to applicable Indian accounting standard e.g. Plant and machinery as per Ind AS 16.

• At the time of initial classification – Non-current asset (or disposal group) classified as held for sale is measured at the lower of its carrying amount and fair value less costs to sell.

• Subsequent measurement – After the classification of assets (or disposal group) as held for sale during subsequent reporting period, these assets (or disposal group) as a whole is measured at the lower of carrying amount and fair value less costs to sell.

Ind AS 105 also provides guidance on impairment testing of assets (or disposal group) classified as held for sale. Impairment testing is carried out on initial classification as well as during the subsequent measurement period. Write down of assets to fair value less cost to sell that has not been recognised as per the above mentioned criteria is recognised as impairment loss. For example, if carrying amount of non-current asset held for sale is 1,000 and fair value less cost to sell is 900, 100 will be included in profit and loss account as impairment loss.

Also, at the time of subsequent measurement, if there is any gain due to increase in fair value less cost to sell of an asset the same should be recognised to the extent of cumulative impairment loss recognised previously. For example, continuing above if there is gain of 120 based on re-measurement of non-current asset, gain to the extent of only 100 i.e. to the extent of impairment loss recognised earlier will recognised as gain in profit and loss.

Disposal group may contain assets or liabilities that are not non-current in nature or not within the scope of Ind AS 105. At the time of initial classification or during subsequent measurement, these assets or liabilities are measured or remeasured as per the standard applicable to such assets or liabilities. The measurement criteria i.e. amount lower of carrying amount and fair value less costs to sell is applied to disposal group as a whole i.e. for the disposal group itself.

For example, Disposal group contains PP&E (non-current asset) and also has inventories (current asset – not covered under Ind AS 105). Based on the individual assessment of assets applying relevant accounting standard value of disposal group let’s say is 20,000. If after applying the measurement criteria of Ind AS 105 to this disposal group as a whole value comes to 18,000 then 2,000 will be recognised as impairment loss. However, as per the standard this loss of 2,000 will be proportionately allocated only to non-current assets within the disposal group. Another important aspect that merits consideration is that the non-current assets held for sale shall not be depreciated (or amortised) individually or as a part of disposal group.

Changes to a Plan of Sale

If non-current asset (or disposal group) classified as held for sale, no longer meet the criteria specified, then such assets cease to be classified as held for sale.

In such a case, non-current asset (or disposal group) is measured at lower of:

• its carrying amount before the asset (or disposal group) was classified as held for sale, adjusted for any depreciation, amortisation or revaluations that would have been recognised had the asset (or disposal group) not been classified as held for sale, and

• its recoverable amount at the date of the subsequent decision not to sell.

The impact of the above change is recognised in profit and loss account.

There can be a case where some of the non-current assets of disposal group still meet the criteria of held for sale’ whereas disposal group as a whole does not meet the requirement. In such cases, these non-current assets shall be measured as per the measurement criteria of this standard in their individual capacity.

Disclosure in Financial Statements

There are mainly two disclosure requirements as per Ind AS 105 viz. disclosure requirements for:

• Non-current assets (or disposal group)
These are presented separately from other assets and liabilities (which are part of disposal group).

Also, an entity should not offset such assets and liabilities.
• Discontinued operations
There are mainly two disclosure required with respect to discontinued operations. These include (a) post-tax profit or loss and post-tax gain or loss recognised on the measurement to fair value less costs to sell or disposal group constituting discontinued operations. Both these can be presented as a single amount in the statement of profit or loss. (b) related income tax expenses as per Ind AS 12 on above.
Similarly, cash flows from discontinued operations will also form part of disclosure in cash flow statement. An entity has a choice of presenting above either in statement of profit or loss/cash flow or in notes to accounts.

Apart from above there are certain additional disclosures required by Ind AS 105 which mainly includes description of non-current assets (or disposal group), facts and circumstances leading to sale or disposal etc.

Distribution of Non-current Assets to Owners

The essence of the above guidance is that distribution of non-current assets to owners is akin to dividend distribution and hence should be accounted as such.

Appendix C of Ind AS 105 and Appendix A of Ind AS 10 contain this guidance.

This part of the standard mainly covers two types of transactions:

• Distribution of non-cash assets; and
• Distribution that give owners a choice of receiving either non-cash assets or a cash alternative.

The standard does not cover transactions where non-cash assets distributed are controlled by the same party or parties who controlled such assets before distribution or transactions where entity distributes ownership in a subsidiary but retains control.

Measurement and Presentation Requirements

As per the standard, when a company declares to distribute assets to its owners, the company should recognise liability for dividend payable when dividend is appropriately authorised and is not at the discretion of the entity.

Dividend payable liability will be measured by an entity at the fair value of the assets to be distributed where non-cash assets are distributed as dividend. Further, the standard specifies that when an entity settles the dividend payable, it shall recognise the difference, if any, between the carrying amounts of the assets distributed and the carrying amount of the dividend payable in profit or loss. The same is disclosed as a separate line item in profit or loss account.

An entity shall disclose carrying amount of the dividend payable at the beginning and end of the period and any changes in carrying amount of such liability due to changes in fair value which is reviewed at the end of each reporting period and necessary adjustments are made.

Conclusion

This accounting standard provides specific guidance on measurement and classification of Non-current assets held for sale, which does not exist under current Indian GAAP. The guidance requires measurement of such assets at lower of carrying amount and fair value less costs to sell.

Further, the standard also lays down criteria to be met for an operation to be classified as discontinuing operation.

The guidance on distribution of non-cash assets to owners requires accounting for such transactions as dividend.

The above guidance would change the accounting and disclosure requirements for the above transactions/events as compared to existing Indian GAAP.

Nirav Shah

Section A: Revision of Financial Statements since 31st March 2009 pursuant to approval obtained from the Ministry of Corporate Affairs (MCA)

Essar Oil Limited (31-3-2012)

From Directors’ Report Re-opening of books of accounts for financial years 2008-09, 2009-10 and 2010-11

As a consequence of the above-referred Supreme Court order, to reflect a true and fair view in the books of account for the three financial years ended on 31st March, 2009, 31st March, 2010 and 31st March, 2011 based on the permission received from the Ministry of Corporate Affairs, the Company proposes to re-open the books of accounts and financial statements for the said three financial years. Necessary resolution seeking approval of shareholders for re-opening of the said financial statements has been incorporated in the Notice convening the ensuing Annual General Meeting. Except for reflecting true and fair view of the sales tax incentives/liabilities etc. concerning the Government of Gujarat, there is no material change in the reopened and revised accounts of the Company.

Consequent to reopening of the books of account for the above three financial years, the financial statements for these years have been revised. The statement containing the salient features of the reopened and revised audited Balance Sheets, Statements of Profit and Loss, Cash Flow statements and auditors, reports on the abridged revised financial statements for the financial years 2008-09 to 2010-11 along with Auditors’ report on full revised financial statements and amendments to Directors’ Reports for respective financial years form part of the Annual Report. With amendment in the aforementioned financial statements, there are corresponding changes in the consolidated financial statements of the Company and its subsidiaries prepared in accordance with Accounting Standard AS 21 for the financial years ended on 31st March, 2009 and 31st March, 2010. Accordingly, statements containing the salient features of the reopened and revised audited Consolidated Balance Sheets, Statements of Profit and Loss, Cash flow statements and auditors’ reports on the abridged revised consolidated financial statements for the financial years 2008-09 and 2009-10 form part of the Annual Report.

From Auditors’ Report

2. We had previously audited the Balance Sheet of the Company as at 31st March, 2012, the Statement of Profit and Loss and the Cash Flow Statement for the year ended on that date, both annexed thereto (“the original financial statements”) which were approved by the Board of Directors of the Company in its meeting held on 12th May, 2012. Our report dated 12th May, 2012 on the original financial statements, expressed a modified opinion with respect to the matter described in paragraph 3(a)(ii) of the said report.

As explained in Note 38 to the attached revised financial statements, the original financial statements have been revised pursuant to revision of the financial statements for the years ended 31st March, 2009, 31st March, 2010 and 31st March, 2011 (“the prior years”) in accordance with the approval of the Ministry of Corporate Affairs (“the MCA”) obtained during the financial year 2012-13, subsequent to the approval of the original financial statements by the Board of Directors of the Company. The said note explains the effect of the revision of the financial year 2011-12. As explained in the Note, the effect of the revision of the financial statements of the prior years on the opening balances include decrease of opening balance of Reserves and Surplus as at 1st April, 2011 by Rs. 3,006.17 crore. In view of the above, our report dated 12th May, 2012 on the original financial statements stands replaced by this report. 4.

Attention is invited to:

(a) Note 38 of the revised financial statements wherein it is stated that, the Honorable Supreme Court of India has vide its order dated 17th January, 2012, set aside the order of the Honourable High Court of Gujarat dated 22nd April, 2008 which had earlier confirmed the Company’s eligibility to the ‘Capital Investment Incentive Premier/Prestigious Units Scheme 1995 – 2000’ of the State of Gujarat (“the Scheme”), making the Company liable to immediately pay Rs. 6,168.97 crore being the sales tax collected under the Scheme (“the sales tax dues”). The Company has deposited Rs. 1, 000 crore on account of the sales tax as per the directive of the Honourable Supreme Court on 26th July, 2012. In response to a Special Leave Petition filed by the Company with the Honourable Supreme Court seeking payment of the sales tax dues in installments and without interest, the Honorable Supreme Court has, on 13th September, 2012, passed an order allowing the payment of the balance sales tax dues in eight equal quarterly installments beginning 2nd January, 2013 with interest of 10% p.a. with effect from 17th January, 2012.

Consequent to the above and having regard to the revision of the financial statements for the prior years referred in paragraph 2 above, the Company has reversed income of Rs. 978.59 crore recognised during 1st April 1, 2011 to 31st December, 2011 by defeasance of the deferred sales tax liability under the Scheme, reversed liability of Rs. 45.21 crore recognised during the said period towards contribution to a Government Welfare Scheme for being eligible under the Scheme, recognised interest income of Rs. 155.13 crore (net of break up charges of Rs. 10.57 crore) on account of interest receivable from the assignee of the defeased sales tax liability and recognised interest of Rs. 83.39 crore (net of Rs. 43.33 crore capitalised as cost of qualifying fixed assets) on sales tax dues; and presented the same under ‘Exceptional Items’ in the Revised Statement of Profit and Loss.

(b) Note 7(ii)(c) of the revised financial statements detailing the recognition and measurement of the borrowings covered by the Corporate Debt Restructuring Scheme (“the CDR”) as per the accounting policy consistently followed by the Company in the absence of specific guidance available under the Accounting Standards referred to in s/s. (3C) of section 211 of the Companies Act, 1956 and consideration of the CDR exit proposal submitted by the Company which has been recommended for approval to the CDR Core Group by the CDR Empowered Group. (c) Note 7(ii)(a) of the revised financial statements describing the fact about accounting of interest on certain categories of debentures on a cash basis as per the Court order.

37. Exceptional items

38. Sales tax

The Company was granted a provisional registration for its Refinery at Vidinar, Gujarat under the Capital Investment Incentive to Premier/Prestigious Unit Scheme 1995-2000 of Gujarat State (“the Scheme”). As the commercial operations of the Refinery could not be commenced before the timeline under the Scheme due to reasons beyond the control of the Company viz, a severe cyclone which hit the Refinery Project site in June 1998 and a stay imposed by the Honourable Gujarat High Court on 20th August, 1999 based on a Public Interest Litigation which was lifted in January 2004 when the Honourable Supreme Court of India gave a ruling in favour of the Company, representations were made by the Company to the State Government for extension of the period beyond 15th August 15, 2003 for commencement of commercial operations of the Refinery to be eligible under the Scheme. As the State Government did not grant extension of the period as requested, the Company filed a writ petition in Honourable Gujarat High Court which vide its order dated 22nd April, 2008, directed the State Government to consider the Company’s application for granting benefits under the Scheme by excluding the period from 13th July, 2000 to 27th February, 2004 for determining the timeline of commencement of commercial production. Based on the order of the Honourable High Court, the Company started availing the benefits under the deferral option in the Scheme from May 2008 onwards and simulta-neously defeased the sales tax liability covered by the Scheme to a related party. An amount of Rs. 6,308.94 crore was collected on account of sales tax covered by the Scheme and defeased at an agreed present value of Rs. 1,892.82 crore resulting in a net defeasement income of Rs. 4,416.12 crore which was recognised during the period 1st May, 2008 to 31st December, 2011. The Company also recognised a cumulative liability of Rs. 189.27 crore towards contribution to a Government Wel-fare Scheme which was payable, being one of the conditions to be eligible under the Scheme.

The State Government had filed a petition on 14th July, 2008 in the Honourable Supreme Court of India against the order dated 22nd April, 2008 of the Honourable Gujarat High Court. The Honourable Supreme Court of India has vide its order dated 17th January, 2012, set aside the order of the Honourable High Court of Gujarat dated 22nd April, 2008 which had earlier confirmed the Company’s eligibility to the Scheme, making the Company liable to pay Rs. 6, 168.97 crore (net of payment of Rs. 236.82 crore) being the sales tax collected till 16th January, 2012 under the Scheme (“the sales tax dues”). Consequently, the Company had reversed the income of Rs. 4,416.12 crore recognised during 1st May, 2008 to 31st December, 2011, reversed the cumulative liability of Rs. 189.27 crore towards contribution to a Government Welfare Scheme and recognised income of Rs. 264.57 crore (net of breakup charges of Rs. 32.09 crore) on account of interest receivable from the assignee of the defeased sales tax liability, and had presented the same under ‘Exceptional Items’ in the Statement of Profit and Loss forming part of the financial statements for the year ended 31st March, 2012 which were approved by the Board of Directors in its meeting held on 12th May, 2012. These financial statements are hereinafter referred to as ‘the original financial statements’.

The Company has deposited Rs. 1,000 crore on account of the sales tax as per the directive of the Honourable Supreme Court of India on 26th July, 2012. In response to a Special Leave Petition filed by the Company with the Honourable Supreme Court of India seeking payment of the sales tax dues in installments and without interest, the Honorable Supreme Court has, on 13th September, 2012, passed an order allowing the payment of the balance sales tax dues in eight equal quarterly installments beginning 2nd Janu-ary, 2013 with interest of 10% p.a. with effect from 17th January, 2012.

The Company has since reopened its books of account for the financial years 2008-09 to 2010-11 (“the prior years”) in accordance with approval of the Ministry of Corporate Affairs (“the MCA”) obtained during the financial year 2012-13 subsequent to the approval of the original financial statement by the Board of Directors of the Company, for the limited purpose of reflecting true and fair view of the sales tax incentives/liabilities, etc. consequent to the order dated 17th January, 2012 of the Honourable Supreme Court of India. Accordingly, the income aggregating to Rs. 3,437.53 crore recognised during 1st May, 2008 to 31st March, 2011 by defeasance of the sales tax liability and the cumulative liability of Rs. 144.06 crore pertaining to the prior years towards contribution to a Government Welfare Scheme were reversed, and interest of Rs. 109.44 crore (net of breakup charges of Rs. 21.52 crore) recoverable from the assignee of the defeased sales tax liability was recognised and the net effect was presented as ‘Exceptional Items’ in the Revised Statement of Profit and Loss for the respective prior years.

The effects of the revisions have been explained in detail in the revised financial statements for the prior years.

In view of the above, the original financial statements for the year ended 31st March, 2012 have now been revised. Consequent to the said revision and having regard to the revision of the financial statements for the prior years described above, the Company has reversed income of Rs. 978.59 crore recognised during 1st April, 2011 to 31st December, 2011 by defeasance of the deferred sales tax liability under the Scheme, reversed liability of Rs. 45.21 crore recognised during the said period towards contribution to a Government Welfare Scheme for being eligible under the Scheme, recognised interest income of Rs. 155.13 crore (net of break-up charges of Rs. 10.57 crore) receivable from the assignee of the sales tax liability and recognised interest of Rs. 83.39 crore (net of Rs. 43.33 crore capitalised as cost of qualifying fixed assets) on the sales tax dues; and presented the same under ‘Exceptional Items’ in the Revised Statement of Profit and Loss.

The revised financial statements also consider the effect of subsequent events after the approval of the original financial statements in accordance with Accounting Standard 4, (AS 4), ‘Contingencies and Events Occurring after the Balance Sheet Date’.

The effects of the revisions of the financial statements for the prior years on the opening balances for 2011-12 have been summarised below:

The summary of changes in the original financial statements has been given below:

a) Statement of Profit and Loss:

Nirav Shah

GAP in GAAP? Virtual Certainty vs. Convincing Evidence

The principles of virtual certainty continue to remain challenging for many Indian enterprises. Paragraph 17 of AS-22 Accounting for Taxes on Income states as follows: “Where an enterprise has unabsorbed depreciation or carry forward of losses under tax laws, deferred tax assets should be recognised only to the extent that there is virtual certainty supported by convincing evidence that sufficient future taxable income will be available against which such deferred tax assets can be realised.”

Explanation to paragraph 17 states as follows: Determination of virtual certainty that sufficient future taxable income will be available is a matter of judgment based on convincing evidence and will have to be evaluated on a case to case basis. 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.

Author’s analysis of virtual certainty

Let us analyse the above requirements of virtual certainty.

1. Virtual certainty has to be supported by convincing evidence of future taxable income. The evidence has to be very strong, such as a non cancellable order, the cancellation of which will result in heavy penalty. The explanation provides non cancellable order as an example. There could be many other examples, which do not entail a non cancellable order, but nonetheless provide virtual certainty. For example, an oil well with proven oil reserves, or FDA approval of a blockbuster drug or a toll road between two very busy cities, for which there is no alternate commute (monopoly situation).

2. Virtual certainty is not a matter of perception, but judgment needs to be exercised. Judgment is based on detailed analysis of facts and circumstances; whereas perception is not based on a detailed analysis or evidence.

3. Mere projections will not suffice. There has to be virtual certainty of future taxable income. Projections would certainly be required to determine future taxable income. However, those projections would have to be supported by virtual certainty of future profits. The virtual certainty could come from non cancellable confirmed orders or other factors.

The Expert Advisory Committee (EAC) has also opined on several occasions on the concept of virtual certainty. Some of the key views of the EAC in addition to those already described above are set out below.

1. An unlimited period of carry forward in respect of unabsorbed depreciation is not a basis for recognising DTA and on its own does not demonstrate virtual certainty.

2. The fact that the company has made book profits (DTA is with respect to tax losses) does not on its own demonstrate virtual certainty.

3. Orders secured by the company, may be considered while creating deferred tax asset, provided these are binding on the other party and it can be demonstrated that they will result in future taxable income. However, mere projections made by the company indicating the earning of profits from future orders, or financial restructuring proposal under consideration or the fact that the books of account of the company are prepared on going concern, or the upward trend in the business or economy, may not be considered as convincing evidence of virtual certainty.

Apparently, the “virtual certainty” criteria laid down in AS 22 for the recognition of DTA is difficult to implement. Given below are the author’s perspectives on some of the key challenges:

(i) The explanation to paragraph 17 gives an example of a profitable binding order for the recognition of DTA and disallows recognition of DTA on the basis of mere projections of future profits based on capital expenditure/restructuring plans.

In practice, there will be many situations that fall between the two scenarios. Let us consider the following scenarios:

(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 set-up 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 stabilized 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 will absorb the entire accumulated tax loss of the entity.

(b) A battery manufacturer (Battery Co), which 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.

A perusal of both the aforementioned scenarios indicates that entities have significant additional evidence than mere projections of future profitability to support the recognition of DTA. However, since they do not have any binding orders in hand, or other concrete evidence, it may lead to the conclusion that the virtual certainty criterion laid down in AS 22 for recognition of DTA is not met.

(ii) There are certain sectors such as retail or building material, which generally do not have any binding sale orders. This indicates that these sectors, unless they are monopolies, cannot recognise DTA if they have unabsorbed depreciation and/or carry forward of tax losses. This may not be fair, as the principle of virtual certainty is tilted in favour of entities that work on binding orders such as construction, IT or engineering companies.

(iii) If the intention is that profits are to be virtually certain for the recognition of DTA in case of carry forward losses/unabsorbed depreciation, then it is not clear why the virtual certainty principles are applied only for revenue and not for input costs or availability of inputs.

The virtual certainty principle has a fatal flaw; nothing in this world is virtually certain. Even profitable binding orders could be cancelled without receiving any penalty as the buyer/seller could end up getting bankrupt. Interestingly, both Ind-AS 12 (Ind-AS are notified in the Companies Act, but are not yet applicable) and IAS 12 on Income Taxes lay down the criteria of “probability” to recognise DTA, including on unabsorbed depreciation and/or carry forward of tax losses. However, when an entity has a history of recent losses, it should recognise DTA only to the extent it has convincing evidence that sufficient taxable profit will be available. The principle of convincing evidence under Ind-AS and IAS is not only fair, but is also practical to apply, compared to the “virtual certainty” principle under AS 22. In the two examples referred to in this article, the principles of convincing evidence (under Ind-AS and IFRS) would probably result in recognition of DTA, but under Indian GAAP principles of virtual certainty, no DTA can be recognised.

The ICAI should look into the matter and align the requirement of Indian GAAP with Ind-AS.

Nirav Shah

Consolidated Financial Statements vs. Companies Bill

Currently, listing agreement mandates listed companies to prepare Consolidated Financial Statements (CFS). Neither the existing Companies Act nor AS 21 requires companies to prepare CFS. Under the Companies Bill, 2012 (Bill) all companies, including unlisted companies and private companies that have a subsidiary will need to prepare CFS.

Unlike IAS 27, the Bill does not exempt an intermediate unlisted parent company from preparing CFS. Under IAS 27 an unlisted intermediate parent is exempt from preparing CFS if and only if:

a)the parent is itself a wholly-owned subsidiary, or is a partially-owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the parent not presenting CFS;

b)the parent’s debt or equity instruments are not traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets);

c)the parent did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market; and

d)the ultimate or any intermediate parent of the parent produces CFS available for public use that comply with International Financial Reporting Standards.

Preparation of CFS at each intermediate parent level is likely to increase compliance cost. The Ministry of Corporate Affairs may look into the matter, and provide an exemption on the above similar lines. The said exemption may be incorporated in the rules.

For all companies, CFS should comply with notified Accounting Standards (AS) . Notified AS currently means the Indian GAAP. In the future, it may include Ind-AS for specified entities. This will impact companies that are currently preparing CFS according to IFRS, based on option given in the listing agreement. These companies will have to mandatorily prepare Indian GAAP CFS (Ind-AS in the future), and may choose to continue preparing IFRS CFS on a voluntary basis or stop preparing the same. The Ministry of Corporate Affairs may look into the matter and allow companies to continue preparing CFS using IASB IFRS instead of Indian GAAP or Ind-AS.

There seems to be some confusion with respect to associates and joint ventures. The explanation, to the section 129 of the Bill states that “the word subsidiary includes associate company and joint venture.” Apparently, the following two views seem possible:

(i)a company needs to consolidate associates and joint ventures in accordance with the notified AS using equity/proportionate consolidation method. In other words, CFS is prepared only when the group has at least one subsidiary para

(ii)a company needs to apply equity method/ proportionate consolidation to its associates and joint ventures even if it does not have any subsidiary. In other words, CFS will be prepared when the company has an associate or joint venture, even though it does not have any subsidiary.

The first view seems more aligned to the requirements of notified AS and the current practice. The second view can be supported if the intention of the lawmaker was to require a company to apply equity method/proportionate consolidation method to its associates and joint ventures even if it does not have any subsidiary. ICAI and MCA should provide clarification on this issue. It would be appropriate if the clarification maintains status quo with current requirement, which is essentially view (i).

The definition of control, subsidiary and significant influence as provided in the Bill and the accounting standards are quite different. If the companies to be consolidated under the Bill and the accounting standards are different, because of the differences in the definition, it would create a lot of confusion and difficulty. A comparison of the definitions is given in the Table.

Apparently, the definition of “control” given in the Bill is broader than the notion of “control” envisaged in the definition of the term “subsidiary.” In accordance with definition of “subsidiary,” only board control and control over share capital is considered. However, the definition of the “control”, suggests that a company may control other company through other mechanism also, say, management rights or voting agreements. Further, the definition of “subsidiary”, refers to control over more than one-half of the total share capital, without differ-entiating between voting and non -voting shares. This could lead to a situation where a company is a subsidiary under AS-21, but on which the parent has no control as defined in the Bill. Consider a simple example of a company, which has a share capital of Rs. 100, comprising 40% equity with voting rights held by A and 60% preference shares with no voting rights, held by B. In accordance with AS, A would consolidate the company but in accordance with the Bill, B would consolidate the company. The Bill seems to provide an unacceptable response, where the lender rather than the equity holder would consolidate the company.

There seems to be similar confusion with respect to associates. In accordance with the explanation in the Bill, the term “significant influence” means control over 20% of business decisions. Control over business decisions is an indicator of subsidiary, rather than associate. It appears that the definition in the Bill “controls 20% of business decisions” is wrongly described. The right way to describe it would have been “has significant influence over all critical business decisions”, and “significant influence is evidenced by 20% voting power, representation on the board, or through other means.” The other issue is that the 20% under the standard works as an indicative threshold. In other words, even a lesser percentage may give significant influence and a higher percentage need not necessarily give significant influence. However, under the Bill the 20% requirement works like a rule, rather than a rebuttable presumption.

To resolve all these anomalies, the MCA may clarify that the definitions in the Bill are relevant for legal/ regulatory purposes. For accounting purposes including preparation of CFS, definitions according to the notified AS should be used.

Nirav Shah

Section A: Financial Statements of an NGO

Section A: Financial Statements of an NGO Compiler’s Note:

Compiler’s Note:

The financial statements and annual report of ‘The Akshaya Patra Foundation’, an NGO based in Bangalore, India has won several awards in India and abroad for the best presented annual report. It is also one of the few NGOs in India who, besides Indian GAAP, also prepares its financial statements under IFRS principles.

The annual report for 2011-12 for Akshaya Patra makes a very interesting reading and can encourage several other NGOs to improve on their financial reporting. The entire annual report can be accessed on www.akshayapatra.org/sites/default/files/Annual- Report-2011-12.pdf. Given below are the significant accounting policies followed by the Foundation.

The Akshaya Patra Foundation (31-03-2012)

Significant Accounting Policies

1.1 Organisation overview

The Akshay Patra Foundation (‘the Trust or TAPF’) is registered under the Indian Trust Act 1882 as a Public Charitable Trust. It was formed on 1st July 2000 and was registered on 16th October 2001. The principal activity for the Trust is to implement the mid-day meal program of the Government of India through respective state governments for the children studying in government and municipal schools.

The Trust is also involved in various other charitable activities such as providing intensive coaching for eligible students after school hours under “Vidya Akshaya Patra Program”, providing subsidised meals to daily wage earners under various schemes like “Akshaya Kalewa program” and “Aap Ki Rasoi Program”, providing food for babies and mothers in Anganwadis and implementing various other programs for the relief of the poor.

1.2 Significant accounting policies

(i) Basis of preparation of financial statements The balance sheet and income and expenditure accounts are prepared under the historical cost convention and the accounting is on accrual basis. In the absence of any authoritatively established accounting principles for the specialised aspects related to charitable trusts which do not carry out any commercial activity, these statements have been prepared in accordance with the significant accounting policies as described below. There are no trusts or entities over which TAPF exercises controlling interest, thus there is no requirement of consolidating other entities into the TAPF’s financial statements.

(ii) Use of estimates The preparation of the financial statements in conformity with the significant accounting policies, requires that the Board of Trustees of the Trust (‘Trustees’) make estimates and assumptions that affect the reported amounts of income and expenditure of the year and reported balances of assets and liabilities. Actual results could differ from those estimates. Any revision to accounting estimates is recognised prospectively in current and future periods.

(iii) Fixed assets Fixed assets are stated at cost of acquisition or construction, less accumulated depreciation. The cost of fixed assets includes the purchase cost of fixed assets and any other directly attributable costs of brining the assets to their working condition for the intended use. Borrowing costs, if any, directly attributable to acquisition or construction of those fixed assets which necessarily take a substantial period of time to get ready for their intended use are capitalised.

Intangible assets are recorded at the consideration paid for acquisition of such assets and are carried at cost less accumulated amortisation. Fixed assets received as donation in kind are measured and recognised at fair value on the date of being ready for their intended use. Advances paid towards the acquisitions of fixed assets as at the balance sheet date are disclosed under long-term loans and advances.

(iv) Depreciation Depreciation on fixed assets is provided on a straight-line method basis over the estimated useful life as follows:

Class
of assets

Estimated

useful life

in years

Buildings

Kitchen and related
equipments

Office and other
equipments

Computer equipments

Furniture and fixtures

Vehicles

Distribution vessels

Intangible assets

Land is not depreciated. Depreciation on leasehold improvements is provided over the primary lease term or the useful life of assets, whichever is lower.

Depreciation is charged on a proportionate basis for all assets purchased and sold during the year.

Individual low cost assets, acquired for less than Rs.5,000 (other than distribution vessels), are depreciated fully in the year of acquisition.

(v) Inventory

Inventory comprises provisions and groceries which include food grains, dhal & pulses, oils and ghee and other items like spares and fuel. Inventory is valued at cost, determined under the First-In-First Out method.

In case of Government grants of rice and wheat, the inventory cost is determined at the lower of the market price of government regulated price.

Cost of inventory, other than those received as government grants, comprises purchase cost and all expenses incurred in bringing the inventory to its present location and condition.

Inventories received as donation in kind are measured at fair value on the date of receipt.

(vi) Revenue recognition

Donation received in cash, other than those received for depreciable fixed assets, are recognised as income when the donation is received, except where the terms and conditions require the donations to be utilised over a certain period.

Such donations are accordingly recognised rateably over the period of usage. The deferred income is disclosed as “Deferred donation – feeding” under other current liabilities in the balance sheet.

Donation received in kind, other than those received for depreciable fixed assets are measured at fair value on the date of receipt and recognised as income only upon their utilisation.

Unutilised donations are deferred and disclosed as kind donations or grain grants received in advance under other current liabilities in the balance sheet.

Donations made with a specific direction that they shall form part of the corpus fund or endowment fund of the Trust are classified as such, and are directly reflected as trust fund receipts in the balance sheet.

Government grants related to subsidy received in cash or in kind are recognised as income when the obligation associated with the grant is performed and right to receive money is established and reflected as receivables in the balance sheet. The value of subsidies and donations received in kind is determined based on the lower market price or government regulated price of those goods at the time of receipt.

Donations received in cash towards depreciable fixed assets, the ownership of which lies with the Trust, are treated as deferred donation income and recognised as donation income in the income and expenditure account on a systematic and rational basis over the useful life of the asset.

The deferred donations towards depreciable fixed assets (receive both in cash and in kind), being identified as funds which provide long term benefits to the Trust, are disclosed under the Designated Funds in the Balance Sheet.

Income from cultural events, if any, is recognised as and when such events are performed.

Income from receipts for other programs is recognised when the associated obligation is performed and right to receive money is established.

Interest on deployment of funds is recognised using the time-proportion method, based on underlying interest rates.

(vii) Income Tax

The Trust is registered u/s. 12A of the In-come tax Act, 1961 (‘the Act’). Under the provisions of the Act, the income of the Trust is exempt from tax, subject to the compliance of terms and conditions speci-fied in the Act.

Consequent to the insertion of tax liability on anonymous donations vide Finance Act 2006, the Trust provides for the tax liability in accordance with the provisions of Section 115 BBC of the Act, if at all there are any such anonymous donations.

(viii) Foreign exchange transactions

Transaction: Foreign exchange transactions are recorded at a rate that approximates the exchange rate prevailing on the date of the transaction. The difference between the rate at which foreign currency transactions are accounted and the rate at which they are realised, is recognised in the income and expenditure account.

Translation: Monetary foreign currency assets and liabilities at the year-end are restated at the closing rate. The difference arising from the restatement is recognised in the income and expenditure account.

(ix) Provisions and contingent liabilities

The provisions are recognised when, as a result of obligating events, there is a present obligation that probably requires an outflow of resources and a reliable estimate can be made of the amount of obligation.

The contingent liability disclosure is made when, as a result of obligating events, there is a possible obligation or a present obligation that may, but probably will not, require an outflow of resources.

No provision or disclosure is made when, as a result of obligating events, there is a possible obligation or a present obligation when the likelihood of an outflow of resources is remote.

(x) Impairment of assets

The Trust periodically assesses whether there is any indication that an asset may be impaired. If any such indication exists, the Trust estimates the recoverable amount of the asset. If such recoverable amount of the asset is less than its carrying amount, the carrying amount is reduced to its recoverable amount. The reduction is treated as an impairment loss and is recognised in the income and expenditure account. If at the balance sheet date there is an indication that if a previously assessed impairment loss no longer exists, the recoverable amount is reassessed and the asset is reflected at the recover-able amount subject to a maximum of depreciable historical cost.

(xi) Retirement benefits

Provident fund
All eligible employees receive benefit from provident fund, which is a defined contribution plan. Both the employee and the Trust make monthly contributions to the fund, which is equal to a specified percentage of the covered employee’s basic salary. The Trust has no further obligations under this plan, beyond its monthly contributions. Monthly contributions made by the Trust are charged to income and expenditure account.

Gratuity
The Trust provides gratuity, a defined benefit retirement plan, to its eligible employees. In accordance with the Payment of Gratuity Act, 1972, the gratuity plan provides a lumpsum payment of the eligible employees at retirement, death, incapacitation or termination of employment, of an amount based on the respective employee’s basic salary and tenure of employment with the Trust. The gratuity liability is accrued based on an actuarial valuation at the balance sheet date, carried out by an independent actuary.

Compensated absences
The employees of the Trust are entitled to compensated absences which are both accumulating and non-accumulating in nature. The expected cost of accumulating compensated absences is determined by actuarial valuation based on the additional amount expected to be paid as a result of the unused entitlement that has accumulated as at the Balance Sheet date. Expense on non-accumulating compensated absences is recognised in the period in which the absences occur.

(xii) Leases

Assets acquired under lease, where the Trust substantially has all the risk and rewards of ownership, are classified as finance lease. Such assets acquired are capitalised at the inception of lease at lower of the fair value or present value of minimum lease payments.

Assets acquired under lease where the significant portion of risks and rewards of ownership are retained by the lessor are classified as operating lease. Lease rentals are charged to income and expenditure account on a straight line basis over the lease term.

Nirav Shah

Related parties under Ind AS: Enhanced scope and disclosure requirements

Related party relationships and transactions with such parties are an integral part of day-to-day business for many groups. Users of financial statements are likely to be interested in the existence of these relationships and in transactions, along with their potential impact, between such parties when they assess the operations, financial performance and financial position of an entity.

The accounting definition of a related party under AS-18, which is a part of the present Indian GAAP, is not as far reaching in its scope as the international practice.

As part of convergence to IFRS, the Ind AS attempts to address the above and introduces certain additional disclosure requirements to enhance the quality of financial information to the users of financial statements.

In this article we shall consider some of the key differences in the identification of related parties for financial reporting purposes between Indian GAAP and Ind AS.

Definition of related party

AS-18 defines a related party as follows — ‘Parties are considered to be related if at any time during the reporting period one party has the ability to control the other party or exercise significant influence over the other party in making financial and/ or operating decisions’. It clarifies that AS-18 applies only to related party relationships described in the standard, which are as under:

(a) enterprises that directly, or indirectly through one or more intermediaries, control, or are controlled by, or are under common control with, the reporting enterprise (this includes holding companies, subsidiaries and fellow subsidiaries);

(b) associates and joint ventures of the reporting enterprise and the investing party or venturer in respect of which the reporting enterprise is an associate or a joint venture;

(c) individuals owning, directly or indirectly, an interest in the voting power of the reporting enterprise that gives them control or significant influence over the enterprise, and relatives of any such individual;

(d) key management personnel and relatives of such personnel; and

(e) enterprises over which any person described in (c) or (d) is able to exercise significant influence. This includes enterprises owned by directors or major shareholders of the reporting enterprise and enterprises that have a member of key management in common with the reporting enterprise.

Ind AS 24 states that a related party is a person or entity that is related to the entity that is preparing its financial statements referred to as the ‘reporting entity’.

(a) A person or a close member of that person’s family is related to a reporting entity if that person:

(i) has control or joint control over the reporting entity;

(ii) has significant influence over the reporting entity; or

(iii) is a member of the key management personnel of the reporting entity or of a parent of the reporting entity.

(b) An entity would be a related party if any of the following conditions apply:

(i) The entity and the reporting entity are members of the same group (which means that each parent, subsidiary and fellow subsidiary is related to the others).

(ii) One entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other entity is a member).

(iii) Both entities are joint ventures of the same third party.

(iv) One entity is a joint venture of a third entity and the other entity is an associate of the third entity.

(v) The entity is a post-employment benefit plan for the benefit of employees of either the reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a plan, the sponsoring employers are also related to the reporting entity.

(vi) The entity is controlled or jointly controlled by a person identified in (a). (vii) A person identified in (a) (i) has significant influence over the entity or is a member of the key management personnel of the entity (or of a parent of the entity).

Related party relationships included and excluded

For the purpose of this section, we shall analyse these relationships from the perspective of Reporting Entity (RE), and reference to Parent, Associates and Joint Ventures of the reporting enterprise shall be denoted as P, A and J, respectively. Further, to highlight indirect relations within a group structure, for instance, Parent company’s investment in its Joint venture is referred to as P-J, where the ‘P’ denotes RE’s Parent Company and the ‘J’ that follows ‘P’ denotes to another Joint venture of the Parent Company.

Parent’s investment in Joint Venture (i.e., P-J) and associates (i.e., P-A)

Under the present Indian GAAP, parent’s investment in another subsidiary (i.e., P-S) is a related party, as that subsidiary is reporting entity’s fellow subsidiary. However, from the drafting of the relationships stated above, the parent’s investment in its joint venture (i.e., P-J) is not considered as related party under current Indian GAAP. Similarly, the parent’s investment in its associate (i.e., P-A) is also not considered as a related party to RE.

Under Ind AS, two entities are related if one entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other entity is a member). Since the group is defined to include the parent company and each of entities under its direct and indirect control, the parent’s investment in its joint venture (i.e., P-J) is a related party to RE. Similarly, the parent’s investment in its associates (i.e., P-A) is also considered to be related party to RE.

Subsidiaries of joint ventures (i.e., J-S) and associates (i.e., A-S)

The present Indian GAAP does not specifically clarify whether a reference to the associates and joint ventures in AS-18 should be interpreted as those stand-alone entities or their entire group. As such, it is a common practice of not considering the subsidiaries of associates and joint ventures as related parties.

Under Ind AS, it is specifically stated that an associate includes subsidiaries of the associate and a joint venture includes subsidiaries of the joint venture. As such, for instance, an associate’s subsidiary (i.e., A-S) and the investor (i.e., RE) that has significant influence over the associate (A) are related to each other. Similarly, J-S is also considered to be a related party under Ind AS.

Key managerial personnel (KMP)

Under present Indian GAAP, a non-executive director of a company is not considered as a KMP by virtue of merely his being a director unless he has the authority and responsibility for planning, directing and controlling the activities of the reporting enterprise.

Under Ind AS, KMP are those persons having authority and responsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director (whether executive or otherwise) of that entity.

Classification of investees as subsidiaries, joint ventures and associates

It may be noted that the reference to the terms subsidiaries, joint ventures and associates as stated above are required from the perspective of the Ind AS principles in assessing control, joint control and significant influence, considering the rights to participate in the financial and operating policies of the investee. As such, unlike present Indian GAAP, the percentage ownership of the investee’s capital may not be the determinative factor in assessing the relationship with the investee.

As such, the related party relationships may undergo a change not only on account of changes to the identified related party relationships in the standard, but also on account of change in classification of the investees based on the degree to which the company can influence the operations of the investee.

State-controlled enterprise/Government-related entities

The present Indian GAAP defines a state-controlled enterprise as an enterprise which is under the control of the Central Government and/or any State Government(s). Under the definition of state-controlled enterprises, those enterprises that are under joint control or under significant influence of the Central and/or State Government(s) are not considered as state-controlled enterprises. As such, the disclosure exemptions provided under AS-18 do not extend to such enterprises under joint control/ significant influence of the government.

Under Ind AS, a government-related entity is an entity that is controlled, jointly controlled or significantly influenced by a government. As such, disclosure exemptions provided under Ind AS 24 extend to enterprises under joint control/significant influence of the same government. Further, it follows that the differences stated above (such as subsidiaries of associates i.e., A-S) may additionally be considered for this purpose.

Disclosure requirements
Duties of confidentiality

Like the present Indian GAAP, the Ind AS states that the related party disclosure requirements as laid down under Ind AS 24 do not apply in circumstances where providing such disclosures would conflict with the reporting entity’s duties of confidentiality as specifically required in terms of a statute or by any regulator or similar competent authority.

However, this is a departure from the IFRS as issued by IASB (commonly referred to as a carve-out). As such, IFRS does not prescribe any such exemption from disclosure requirements prescribed under IAS 24 on account of duties of confidentiality as specifically required in terms of a statute or by any regulator or similar competent authority.

Compensation to KMP

Under the present Indian GAAP, the employee compensation provided to KMP is required to be disclosed. However, there is no specific requirement to disclose the breakup of such compensation.

Under Ind AS, the employee compensation to KMP is required to be disclosed, along with its breakup into short-term employee benefits, post-employment benefits, other long-term benefits, termination benefits and share-based payments.

Disclosure of terms and conditions of transaction

The present Indian GAAP requires disclosure of, amongst other things, name of related party, description of related party relationship and the description of the transaction.

Ind AS additionally requires disclosure of terms and conditions of the related party transactions, including whether they are secured, and the nature of the consideration to be provided in settlement; and details of any guarantees given or received.

Disclosure exemptions for government-related entities

As per AS-18, no disclosure is required in the financial statements of state-controlled enterprises as regards related party relationships with other state-controlled enterprises and transactions with such enterprises.

As per Ind AS 24, the reporting entity is exempt from the disclosure requirements in relation to related party transactions and outstanding balances, including commitments, with:

a) a government that has control, joint control or significant influence over the reporting entity; and
b) another entity that is a related party because the same government has control, joint control or significant influence over both the reporting entity and the other entity.

If a reporting entity applies the exemption as stated above, it shall disclose the following about the transactions and related outstanding balances:

a) the name of the government and the nature of its relationship with the reporting entity (i.e., control, joint control or significant influence);

b) the following information in sufficient detail to enable users of the entity’s financial statements to understand the effect of related party transactions on its financial statements:

i) the nature and amount of each individually significant transaction; and
ii) for other transactions that are collectively, but not individually, significant, a qualitative or quantitative indication of their extent.

Summary
One of the key GAAP differences between present Indian GAAP and Ind AS is that of indirect relationships, whereby Ind AS considers the all group entities of an entity (instead of that separate legal entity) to be related if that entity is related to the reporting entity. Accordingly, for instance, if an entity is related to a reporting entity in the capacity of an associate or joint venture, all entities controlled by such associates and joint ventures are considered as related parties under Ind AS. Similar is the case with the associates and joint ventures of the reporting entity’s parent company.

Overall, the implementation of Ind AS will require identifying the additional related party relationships covered within the scope of the standard. Further, the related party relationships need to be identified after appropriately classifying all the entities concerned as subsidiaries, associates and joint ventures, in accordance with Ind AS (that could be different from its classification under present Indian GAAP) from the perspective of the investor i.e., the reporting entity or its investee within its group or its associates/joint ventures as the case may be. It may particularly be difficult at times to assess the appropriate classification of the investees of an associate into subsidiary/ associates/joint venture, on account of associate company not reporting under Ind AS and limited access to the financial information of the associate.

While the Ind AS is not mandatory as yet, it is expected that preparers will want to evaluate their involvement with related parties under the new standard soon, as the changes in the group structure from an accounting perspective under Ind AS will have additional implications.

Nirav Shah

Revision for dividend declaration

NHPC Ltd. (31-3-2011)

From Notes to Accounts

33. Subsequent to the approval of accounts for the year ended 31st March, 2011 by the Board of directors on 27th May, 2011, the members of the Board has recommended dividend @ Rs.0.60 per share [subject to rounding off to nearest Rupee in terms of Rule 23 of Companies (Central Government’s) General Rules & Forms, 1956] on the paid-up equity capital of the Company (as per Balance Sheet as at 31st March 2011) for the year ended as at 31st March 2011 in the meeting held on 30-6-2011. Accordingly the Company has reopened and revised its earlier finalised audited account for the year ended 31st March 2011 and a provision for dividend amounting to Rs.738.04 crore (subject to rounding off) @ 6% on the paid up equity capital amounting to Rs.12300.74 crore (divided into 1230,07,42,773 equity shares of Rs.10 each fully paid-up) and dividend distribution tax thereon, has been made.

From Auditors Report

1. We have audited the attached revised Balance Sheet of M/s. NHPC Limited as at March 31, 2011 and the revised Profit & Loss account, revised Statement of expenditure during construction and revised Cash Flow Statement of the Company for the year ended on that date annexed thereto. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

2. Reference is invited to Auditors’ Report dated 27-5-2011 given by us on the Financial Statements of NHPC Limited for the financial year ended as at 31-3-2011.

3. The Company has amended its aforesaid financial statements covered by the abovereferred Auditor’s Report so as to incorporate the provision for dividend and dividend distribution tax thereon in the books, which has been recommended by the Board of NHPC Limited. Accordingly, the Balance Sheet as at 31-3-2011 and Profit & Loss Account for the period ended on even date, audited by us (covered by our above-referred Auditors Report) has been amended by the Company (refer Note No. 33 of Schedule 24).

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Nirav Shah

Revision pursuant to merger

Tata Communications Ltd. (31-3-2011)

From Notes to Accounts

The Board of Directors of the Company at its meeting held on 31st January 2011 had approved the merger of the Company’s wholly owned subsidiary, Tata Communications Internet Services Limited (TCISL) with the Company with effect from 1st April 2010. The Company had obtained the consent of the shareholders for the merger at Extra Ordinary General Meeting held on 27th April 2011.

In accordance to the final order dated 20th August 2011 as pronounced by the Bombay High Court the financials have been revised to reflect the merger of TCISL with the Company effective 1st April 2010.

In accordance to the said Scheme, the Company has accounted for this amalgamation in the nature of merger under the pooling-of-interest method. Consequently:

(i) All the assets, debts, liabilities and obligations of TCISL have been vested in the Company with effect from 1st April 2010 and have been recorded at their respective book values.

(ii) The net asset value of TCISL as on the date of amalgamation was Rs.15.28crore as against the investment of the Company of Rs.384.47 crore. The excess of the cost of investment of Rs.369.19 crore is adjusted against the general reserve to the extent of Rs.78.24 crore, Rs.0.56 crore against capital reserve and Rs.291.51 crore against the opening profit and loss account.

(iii) Consequent to the merger there has been a reduction in the current tax expense of Rs.37.97 crore and increase in deferred tax benefit of Rs.39.65 crore.

From Auditors’ Report

(3) The financial statements for the year ended 31st March, 2011 were audited by us and our report dated 29th May, 2011 expressed an unqualified opinion on those financial statements. Consequent to order dated 20th August, 2011 of the High Court of Bombay sanctioning the merger of Tata Communications Internet Services Limited with the Company, the audited financial statements for year ended 31st March, 2011 were revised by the Company to give effect to the said merger, effective from 1st April, 2010. We have accordingly carried out audit procedures and amended the date of our audit report in respect of this subsequent event. (Refer Note B9 of Schedule 19 to the financial statements.)

(1) As required by the Companies (Auditor’s Report) Order, 2003 (CARO) issued by the Central Government in terms of section 227(4A) of the Companies Act, 1956, we enclose in the Annexure a statement on the matters specified in paragraphs 4 and 5 of the said Order.

(2) Further to our comments in paragraph 3 . . .

For ………………… & Co. Partner (M. No. . . . . . . .)

__________________________

Chartered Accountants

Mumbai 29th May 2011 (30th August 2011 as to give effect the amendment discussed in paragraph 3 above).

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Nirav Shah

GAPs IN GAAP — Amortisation of Leasehold Improvements

Over what period does a lessee depreciate leasehold improvements that it makes to a property under an operating lease that contains an option for the lessee to extend the lease?

Fact pattern
A lessee enters into an operating lease for an office property. The lease has a term of 5 years, and contains an option for the lessee to extend the lease for a further 5 years. The rentals for the period under the extension option (i.e., years 6-10) are at market rates. Upon commencement of the lease term, the lessee incurs CU100,000 constructing immoveable leasehold improvements specific to the property. The economic life of the leasehold improvements is 7 years. At commencement of the lease, the lessee expects to exercise the extension option, but is not reasonably certain it will do so.

Conclusion View 1: The useful life of the leasehold improvements is the shorter of the lease term or the assets’ economic life.

The lessee depreciates the leasehold improvements over the lease term of 5 years.

Reasons for View 1

AS-19.3 states:
“The lease term is the non-cancellable period for which the lessee has agreed to take on lease the asset together with any further periods for which the lessee has the option to continue the lease of the asset, with or without further payment, which at the inception of the lease it is reasonably certain that the lessee will exercise.”

In this fact pattern, at the inception of the lease, the lessee is not ‘reasonably certain’ that it will exercise the lease option, although renewal may be expected. For the purpose of AS-19, the lease term is thus 5 years. AS-6.20 requires “the depreciable amount of a depreciable asset shall be allocated on a systematic basis to each accounting period during the useful life of the asset”.

AS-6.3.3 defines ‘useful life’ as either: “
(a) The period over which a depreciable asset is expected to be used by the enterprise; or
(b) The number of production or similar units expected to be obtained from the use of the asset by the enterprise.”

In addition, AS-6.7 states that:

“The useful life of a depreciable asset is shorter than its physical life and is:

(i) Predetermined by legal or contractual limits, such as the expiry dates of related leases.
(ii) ……………. ” In the fact pattern, one of the factors in determining the useful life of the leasehold improvements is the expiry date of the related lease. The expected utility of the leasehold improvements should be consistent with the reasonably certain lease term as defined in AS-19. Therefore, the useful life of the leasehold improvements is 5 years.

View 2: The expected economic life of the leasehold improvements is used as the useful life.

In the fact pattern, the lessee depreciates the leasehold improvements over 7 years, since it expects to extend the lease to 10 years and utilise the leasehold improvements for 7 years.

Reasons for view 2

AS-6.20 requires “the depreciable amount of an asset shall be allocated on a systematic basis over its useful life”.

AS-6.3.3 defines ‘useful life’ as either:

(a) The period over which a depreciable asset is expected to be used by the enterprise; or

In addition, AS-6.7 states that:

“The useful life of a depreciable asset is shorter than its physical life and is:

(i) Predetermined by legal or contractual limits, such as the expiry dates of related leases.”

The useful life of the leasehold improvements is based on the ‘expected utility’ (AS-6.3.3). To determine the expected utility, the lessee would consider ‘all the factors’ in AS-6.7. While 6.7 should be considered, the factor regarding ‘expected usage of the asset’ in AS-6.3.3 is equally relevant in determining the useful life. The condition contained in AS-6.7 reflects the necessity to consider the existence of legal or other externally imposed limitations on an asset’s useful life. However, in the fact pattern, the ability to extend the lease term is within the control of the lessee and is at market rates so there are no significant costs or impediments to renewal.

The lease term as defined in AS-19 does not include the extension period because the lessee is not ‘reasonably certain’ of extending the lease. However, a different threshold is used in AS-6 for the determination of the useful life, which is the period over which the lessee expects to use the leasehold improvements. The term ‘expected usage of the asset’ for the determination of useful life of an asset indicates a lower threshold than the ‘reasonably certain’ of extending the lease threshold for including the extension period in the lease term for accounting purposes. As a result, although the accounting lease term is 5 years, the leasehold improvements is depreciated over the period over which the lessee expects to use the assets (as it expects to extend the lease to 10 years), which is 7 years.

In accordance with AS-6.23, if the assessment of useful life changes as a result of the lessee not expecting to exercise the lease renewal option, the unamortised depreciable amount should be charged over the revised remaining useful life.

The author believes that view 1 is conservative and fits into the concept of prudence enshrined in Indian GAAP framework. On the other hand view 2 is also justified on the basis of AS-6.

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Nirav Shah

FINDING FRAUDS IN FINANCIAL STATEMENTS — 10 COMANDMENTS FOR AUDITORS

Introduction

“Auditor is a Watch Dog But Not a Blood Hound” is the famous quote well known amongst the entire professional community; but the expectations of society from the auditors may not be exactly on these lines and it expects the auditors to play a role bigger than mere accountants confirming the numbers recorded in the financial statements. The gap in the expectation and the reality gets widened primarily because of the interpretations of the responsibility of the auditors in finding frauds through their audit of the financial statements. Though the fact remains that the auditor is not an investigator or a fraud specialist, he does have certain responsibilities in responding to the fraud risks in the financial statements subjected to the audit process. This article summarises the 10 important commandments for the auditors in responding to such fraud risks while discharging his professional responsibility.

Auditors responsibility towards frauds

The auditor should 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 the auditor’s belief about management’s honesty and integrity. In India there is an Auditing Standard (SA-240) which deals with the responsibilities of auditors to consider fraud and error in the audit of the financial statements. This auditing standard is generally consistent in all material respects with those set out in the International Standard on Auditing (ISA) 240 on The Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements.

According to this standard, the primary responsibility for the prevention and detection of fraud and error rests with both those charged with governance and the management of an entity. It also explains that the objective of an audit of financial statements, prepared within a framework of recognised accounting policies and practices and relevant statutory requirements, if any, is to enable an auditor to express an opinion on such financial statements. An audit conducted in accordance with the auditing standards generally accepted 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 auditor is not and cannot be held responsible for the prevention of fraud and error. An auditor cannot obtain absolute assurance that material misstatements in the financial statements will be detected. Owing to the inherent limitations of an audit, there is an unavoidable risk that some material misstatements of the financial statements will not be detected, even though the audit is properly planned and performed in accordance with the auditing standards generally accepted in India.

The critical principle arising out of this auditing standard is that an audit does not guarantee that all material misstatements will be detected because of factors such as the use of judgment, the use of testing, the inherent limitations of internal control and the fact that much of the evidence available to the auditor is persuasive rather than conclusive in nature. For these reasons, the auditor is able to obtain only a reasonable assurance that material misstatements in the financial statements will be detected.

Challenges and audit techniques

It is not always easy to find out a well-structured fraud if perpetuated by the management of the entity. The fact remains that irrespective of the audit procedures performed, the integrity and the honesty of those charged with governance and those running the operations of the entity and their corporate culture is very important and is the corner-stone for determining the content, quality and the transparency of the financial statements. Hence, due care needs to be taken while accepting a client. The auditor who has a tremendous responsibility of forming an opinion about these financial statements needs to perform his professional duty duly considering the fraud risks.

Dr. Steven Albrecht, the famous Professor in Accountancy who has done extensive studies and research on business frauds and ethics, wrote that fraud is seldom witnessed firsthand. Instead, only fraud symptoms (or ‘red flags’) exist to alert management or the auditors about the possible existence of fraud. He has identified six categories of fraud symptoms:

Accounting or document symptoms: Anything that is wrong with the accounting records or documents of the entity — either electronic or paper (e.g., a copy where there should be an original, a journal entry or G/L that does not balance, a missing invoice, etc.).

Analytical symptoms: Things that are too big, too small, unusual, wrong person, wrong time, out of the ordinary, unexpected, etc. (e.g., balances or ratios changing too quickly, new vendors with unusually high transactions/balance amounts, etc.).

Lifestyle symptoms: This symptom is better for misappropriation of assets than for financial statement fraud, but when people embezzle money, they rarely save what they steal. Rather, they spend the ill-gotten gains to meet whatever financial pressures they had and then they start to increase their lifestyles. Sudden increases in lifestyles are fraud symptoms.

Behavioural symptoms: When people commit fraud, they feel stress. Because they have to cope with this stress, they usually change their behaviour. Sudden changes in behaviours are fraud symptoms.

Internal control overrides: It takes the combination of pressure, opportunity and rationalisation for someone to commit fraud, especially first-time offenders. Overriding internal controls provides fraud opportunities and often completes the fraud triangle. Such overrides are excellent fraud symptoms.

Tips and complaints: While tips and complaints are often great fraud risk factors, it is often difficult to know what motivates them. Like the other five types of symptoms, they should be seriously considered, but their presence does not mean that fraud is definitely occurring.

Auditors have to identify these symptoms and then carry out the required procedures to form an opinion about the financial statements.

Commandment No. 1: Identification of fraud risk factors

While carrying out the audits, the auditors have to keep in mind that “If you were management, how could you manipulate an account balance AND conceal it from the auditors”. If they approach the audit with this mindset, there is every possibility of identifying the fraud risks affecting the financial statements.

In considering the risk of material misstatement resulting from fraud, the auditor should consider whether fraud risk factors are present that indicate the possibility of either fraudulent financial reporting or misappropriation of assets while identifying and responding to the fraud risks. The fact that fraud is usually concealed can make it very difficult to detect. However, using the auditor’s knowledge of the business, the auditor may identify events or conditions that provide an opportunity, a motive or a means to commit fraud, or indicate that fraud may already have occurred.

The presence of fraud risk factors may indicate that the auditor will be unable to assess control risk at less than high for certain financial statement assertions. On the other hand, the auditor may be able to identify internal controls designed to mitigate those fraud risk factors that the auditor can test to support a control risk assessment below high.

Commandment No. 2: Inquiries on fraud

Many times when you ask questions formally there is a tremendous pressure on the individual to tell you the truth. Hence, as part of the audit process, auditors should have formal inquiries on fraud not with the management but also with those in charge of governance. These formal inquiries should be adequately documented and minuted as part of the audit files. While structuring such inquiries, due care needs to be taken in choosing the number of persons to be inquired, their level in the hierarchy, representation across various divisions/departments, role/responsibilities etc. Further, such inquiries could focus on the following:

obtaining an understanding of:

i) Management’s assessment of the risk that the financial statements may be materially misstated as a result of fraud; and

ii) The accounting and internal control systems management has put in place to address such risk;

to obtain knowledge of management’s understanding regarding the accounting and internal control systems in place to prevent and detect error;

to determine whether management is aware of any known fraud that has affected the entity or suspected fraud that the entity is investigating; and

to determine whether management has discovered any material errors.

The auditor should also have formal discussions with those in charge of governance to have an understanding of their concerns, if any, affecting the financial environment, the adequacy of accounting and internal control systems in place to prevent and detect fraud and error, the risk of fraud and error, and the competence and integrity of management.

In addition to the formal inquiries, the auditor should also have informal discussions with the entity personnel. He should always keep his eyes and ears open. Many times, such informal discussions with the entity personnel may provide valuable information to the auditor, which can be evaluated for determining the extent/nature of further inquiries. At times, discussion discloses more information than documents. As the term auditor emanates from the word ‘audire’, which means ‘to hear’, he should keep listening to people and should have more and more discussions with people. He will get to know more about the entity he is auditing when he talks to people rather than by only going through the documents.

Commandment No. 3: Brainstorming amongst the audit team members

According to SAS 99, Consideration of Fraud (US Auditing Standard), brainstorming is a required procedure and should be applied with the same degree of due care as any other audit procedure, such as inventory observation or confirmation of accounts receivable. Brainstorming amongst the audit team members facilitates the following objectives:

Reinforce importance of professional skepticism;

Discuss external and internal fraud risk factors;

Consideration of frauds on or by the entity which occurred in the past;

Exchange ideas about how fraud could occur, including through management override;

Consider how management could conceal financial reporting fraud and how assets could be misappropriated; and

Consider audit procedures to address fraud risks — the nature, timing and extent of audit procedures.

The importance attached to such brainstorming sessions facilitates greater awareness about the responsibility on the part of the audit team and helps in gaining a better understanding of the potential for material misstatements in the financial statements resulting from fraud or error in the specific areas of the audit assigned to them, and how the results of the audit procedures that they perform may affect other aspects of the audit.

Commandment No. 4: Journal entry testing/ review of year-end entries

As part of the audit process, the auditors could perform Journal Entry Testing to address key fraud considerations. There is also a need to examine journal entries and other adjustments for evidence of possible material misstatement due to fraud, to mitigate the risk of management override of controls. The auditors are required to include procedures in their audits to test for management override of controls and to test manual journal entries.

Material misstatements of financial statements due to fraud often involve the manipulation of the financial reporting process by (a) recording inappropriate or unauthorised journal entries throughout the year or at period end, or (b) making adjustments to amounts reported in the financial statements that are not reflected in formal journal entries, such as through consolidating adjustments, report combinations, and reclassifications. Accordingly, the auditor should design procedures to test the appropriateness of journal entries recorded in the general ledger and other adjustments (for example, entries posted directly to financial statement drafts) made in the preparation of the financial statements. More specifically, the auditor should

obtain an understanding of the entity’s financial reporting process and the controls over journal entries and other adjustments;

identify and select journal entries and other adjustments for testing;

determine the timing of the testing; and

inquire of individuals involved in the financial reporting process about inappropriate or unusual activity relating to the processing of journal entries and other adjustments.

To identify and select journal entries and other adjustments for testing, the auditor should use professional judgment in determining the nature, timing, and extent of the testing of journal entries and other adjustments. For purposes of identifying and selecting specific entries and other adjustments for testing, and determining the appropriate method of examining the underlying support for the items selected, the auditor should consider

the auditor’s assessment of the risk of material misstatement due to fraud;

the effectiveness of controls that have been implemented over journal entries and other adjustments;

the entity’s financial reporting process and the nature of the evidence that can be examined;

the characteristics of fraudulent entries or adjustments;

the nature and complexity of the accounts; and

journal entries or other adjustments processed outside the normal course of business.

Inappropriate journal entries and other adjustments often have certain unique identifying characteristics. Such characteristics may include entries (a) made to unrelated, unusual, or seldom-used accounts, (b) made by individuals who typically do not make journal entries, (c) recorded at the end of the period or as post-closing entries that have little or no explanation or description, (d) made either before or during the preparation of the financial statements and do not have account numbers, or (e) containing round numbers or a consistent ending number.

Further, a detailed/specific review of the entries recorded at the end of the reporting period could also give critical inputs required for the auditors in drawing overall conclusions.

Commandment No. 5: Surprise elements in the audit

The auditor should incorporate an element of unpredictability with respect to the nature, timing, and extent of audit procedures. He should never allow the auditee to predict the exact procedures he is going to perform. Surprise verification of cash and inventory is a classic example of such surprise audit procedures. He could insist on obtaining certain new types of confirmations every year in addition to the past types of confirmations. Further, by way of introducing new audit procedures, every year, the auditor not only brings in robustness in the audit process, but also addresses the important fraud risk criteria through this process.

Many times, by following the approach of ‘Same As Last Year’ (SALY), there is a possibility of overlooking the fraud risks inherent in the control environment. The auditor should not only challenge the past practice, but also evaluate its applicability/relevance every time so as to make sure that the audit procedures do not become redundant/a formality, but always challenge the status quo and gives the required comfort to the auditor in discharging his duties.

Commandment No. 6: Audit is for the entity and not for the finance team

Invariably, the audit process is considered as an event that occurs once in a year and this has something to do with the finance department. This mindset and the approach needs to change totally and there should be awareness both on the part of the auditor and the auditee that the audit process is for the entity as a whole. This would imply that the auditor has to necessarily interact with business heads/other non-finance teams as well to have an understanding of the entity as a whole. Many times, such interactions with non-finance personnel will provide valuable insights and also throw light on the various red flags which need to be investigated further.

Further, the auditor while interacting with various personnel from the entity needs to observe closely, their behavioural pattern, their thought process, culture, etc.

Needless to insist that in all such interactions, the auditor needs to evaluate the responses by applying common sense. If he is not satisfied/clear about the explanations, he should challenge the same rather than accepting them without understanding the explanations totally. Many times, well -managed frauds are covered by way of providing confusing explanations/diverting from the core issues with some incidental/trivial matters, etc.

At times, dominating characters would like to push through some vague explanations/rosy presentations and the auditor should be watchful in dealing with such situations.

The client management and interaction skills are extremely important in the audit process and the auditor should sharpen his skills in those areas to effectively manage the audit engagements.

Commandment No. 7: Make your presence felt!

In the real sense, the process of audit is more to put a moral fear in the minds of the people to make sure that there is an oversight and if there are any issues, the same will be checked by someone else. By way of having an independent examination, the auditor brings in credibility to the financial statements and also is playing the role of providing important checks and balances to the financial reporting system.

Considering this in mind, the auditor has to make sure that his presence is felt by the system. This could be done by way of meeting up with various people, discussing with them, identifying and raising issues at the right forum, performing surprise audit procedures, etc. Interactions with the junior-most persons in the organisation could help him in getting a better understanding of ground level issues since the basic recording of transactions is done by them. Further, the auditor should talk about the importance of the audit process, consequences of false/ incorrect reporting, its repercussions, and statutory requirements, etc. so as to create awareness in the minds of the people. The moral fear created across the system will help in creating an atmosphere for preventing people from engaging in fraudulent activities.

Further, such an environment could also set the tone for having smooth/purposeful interactions and transparent discussions with the auditee.

Commandment No. 8: Sanctity to the audit processes

The auditor should never dilute the importance attached to any audit process. The audit procedures carried out in any form, such as physical verification of inventory, sending confirmation requests, investigating the differences arising on any reconciliation exercise, performing walkthroughs for the various business cycles, disposal of the issues raised by the audit team members, etc. should be given utmost sanctity and importance. The extent of importance provided by the auditor drives and dictates the importance attached to those processes/importance gained from the auditee. Further, the auditor should escalate the key issues arising out of the audit on a timely basis to the management and those in charge of governance.

Commandment No. 9: Corroboration of the information from more than one source

The information obtained as part of the audit process should always be corroborated with other information/other sources. This would help in ensuring appropriate checks and balances and provide a platform for validating/cross checking the information. Such an exercise would also help in mitigating the fraud risks.

Commandment No. 10: Trust but verify!

The auditor should be alert and should be looking out for circumstances/situations requiring detailed scrutiny. He should never take any information at face value and should follow the golden principle of ‘Trust but Verify’ which requires eloquent application of ‘professional skepticism’. There is a need for fine balancing of challenging everything vis-à-vis accepting the same at face value.

Conclusion

Professional skepticism is the backbone of the audit process and the auditor has to apply this diligently and carefully. While designing his audit procedures, he should always keep in mind that he should not miss the woods for trees. Considering the expectations of society and the professional responsibility, the auditor should pay more attention to identifying and responding to the fraud risks affecting the financial statements. The Ten Commandments explained above is a combination of procedures he should perform and the precautions he needs to take while discharging his duties. Further, based on the major accounting failures and the fraud stories all across the globe, the auditor should continuously learn and fine tune the audit process. As quoted by Russel Means, If you learn from an experience, that’s good — so nothing bad happened to you!

Nirav Shah

Tax Accounting Standards: A new way of computing taxable income

In our previous article, we had covered the approach for formulation of the Tax Accounting Standards by the CBDT Committee (the Committee), final recommendations of the Committee and some of the important implications of the TAS around areas such as accounting policies, inventories, prior period expenses, construction contracts, revenue recognition and fixed assets. In this article, we will cover some other important areas which would be impacted and lead to different taxable incomes under the proposed TAS regime.

The effects of changes in foreign exchange rates

• Unlike AS 11, under TAS all foreign currency transactions will have to be recorded at the exchange rate prevalent on the date of the transactions. TAS eliminates the option for entities to recognise foreign currency transactions at an average rate for a week or month when the exchange rate does not fluctuate significantly. This may lead to practical challenges with no significant benefits in reporting.

• Unlike AS 11 wherein exchange differences on translation of non-integral foreign operations are required to be recorded in reserves i.e. foreign currency translation reserve account, TAS requires these exchange differences to be recognised in the profit and loss account as income or expense. This treatment appears to be based on the analysis that the Income Tax Act, 1961 (‘the Act’) does not distinguish between the tax treatment of incorporating the results of branches that may qualify as non-integral from those that qualify as integral. However, as per TAS, there is a measurement difference in quantification of impact of exchange differences between integral and non-integral foreign operation.

For instance, fixed assets and other non-monetary assets of non-integral foreign operations are measured at closing rates whereas such assets are not re-measured in case of integral operations. Prior to the TAS, where the foreign currency exposures on existing monetary items were hedged through options, any exchange loss on the foreign currency monetary item was claimed as a deduction, but any corresponding unrecognised gain on the option contract may have been ignored, if the company determined that such contracts were not directly covered by AS 11.

However, the TAS now includes foreign currency option contracts and other similar contracts within the ambit of forward exchange contracts. When these contracts are entered into for hedging recognised assets or liabilities, the premium or discount is amortised over the life of the contract and the spot exchange differences are recognised in the computation of taxable income. Although this treatment may not be in line with current accounting and tax practices, it brings in uniformity in the treatment of foreign currency options and forward contracts to the extent that they seek to hedge a recognised asset or liability.

• The premium, discount or exchange differences on all foreign currency derivatives that are intended for trading or speculation purposes or that are entered into to hedge the foreign currency risk of a firm commitment or a highly probable forecast transaction are to be recognised only at the time of settlement of the contract. This is consistent with other provisions of the TAS to not recognise unrealised gains and losses.

• As per TAS, exchange differences on foreign currency borrowings, other than those specifically covered u/s. 43 A will be allowed as a deduction or will be taxed based on translation at the year-end spot rate.

Government grants

• As per AS 12, grants in the nature of promoters’ contribution are recorded directly in shareholders’ funds as a capital reserve. However, TAS does not permit the above capital approach for recording government grants.

• Under the 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.

• Under the TAS, grants related to non-depreciable assets such as land, shall be recognised as income over the same period over which the costs of meeting any underlying obligations are charged to income.

• AS 12 specifically provides that mere receipt of a grant is not necessarily conclusive evidence that conditions related to the grant will be fulfilled. Unlike AS 12, the TAS provides that the initial recognition of the grant cannot be postponed beyond the date of actual receipt.

Securities

• Unlike AS 13, the TAS covers securities held as stock–in-trade, but does not cover other securities.

• TAS provides that where an asset is acquired in exchange for another asset, shares or securities, its actual cost shall be the lower of the fair market value of the securities acquired or the assets/securities given up/issued. Unlike TAS, AS 13 requires that the actual cost in such cases shall be determined generally by reference to the fair market value of the consideration given.

• The TAS requires the comparison of cost and net realisable value for securities held as stock-in-trade to be assessed category-wise and not for each individual security. This may represent a significant change in practice for entities that currently do this comparison for each individual security.

• The TAS also provides that securities that are not quoted or are quoted irregularly shall be valued at cost. This could also represent a change in practice for some entities.

• Unlike AS 13 which allows the weighted average cost method for determination of cost for securities sold, TAS provides that the determination of such costs shall be made using the First in First Out method.

Borrowing costs

• Unlike AS 16, TAS requires capitalisation of borrowing costs for all covered assets irrespective of the period of construction. The only exception to this rule is for inventories, where the TAS requires capitalisation of borrowing costs to inventories that require more than 12 months to complete. In comparison, AS 16 defines a qualifying asset as an asset that necessarily takes a substantial period of time (generally understood as 12 months) to be ready for its intended use or sale. This could result in significant practical challenges to compute capitalisation of borrowing costs in all such cases. Under the TAS, the actual overall borrowing cost (other than borrowing costs on loans taken specifically for a qualifying asset) is allocated to qualifying asset (other than those funded through specific borrowings) based on the ratio of their average carrying value to the average total assets of the company. It should be noted that, while this allocation approach may be simple to apply, it may result in unintended consequences.

For example, assume that construction on a qualifying asset commences on 2nd April and the asset is put to use on 30th March of a previous year. Under the proposed approach, since the qualifying asset is not under construction either on the first day or the last day of the previous year, the average cost may be determined to be Nil. This could result in no allocation of borrowing costs to such an asset.

• Under TAS, in the case of loans borrowed specifically for acquisition of qualifying asset, capitalisation of borrowing costs commences from the date on which the funds are borrowed. Whereas under AS 16, capitalisation of borrowing cost commences only if all three conditions are satisfied (a) expenditure on qualifying asset is being incurred (b) borrowing costs are being incurred and (c) activities that are necessary to prepare the asset for its intended use or sale are in progress.

• Currently, there is inconsistency in treatment of income from temporary deployment of unutilised funds from specific loans (to be considered as an adjustment to borrowing costs incurred or considered as a separate income). The TAS now provides that in case of specific loans, any income from temporary deployment of unutilised funds shall be treated as income. Along with the provision relating to capitalisation of borrowing costs on specific loans even in period prior to the construction activity, this may have a significant impact on the practices currently followed.

• TAS requires capitalisation of borrowing costs even if the active development is interrupted. Under AS 16, the capitalisation of borrowing cost is suspended during extended periods in which active development is interrupted. However, this provision in the TAS seems to clarify the requirements that already exist in the Act.

Leases

• Under the TAS, the lessor would not be entitled to depreciation on assets that are given on finance lease. TAS now provides that assets covered by a finance lease shall be capitalised and depreciated by the lessee like any other owned asset. Presently, the Act permits depreciation only on those assets that are owned by the assessee. As such, for a finance lease arrangement, it is generally the lessor that is entitled to the depreciation deduction and the lease rentals are taxed as income in the hands of the lessor. Since the Act overrides the TAS, suitable amendments may be required to the Act to facilitate this provision of the TAS.

• Similarly, assets given on finance lease by the manufacturer lessor would be considered as sold by lessor with a corresponding recognition of revenues and profits. The finance income component of the lease rental would be recognised as income over the lease term.

• The consequential impact of the above changes under various other provisions such as Tax Deduction at Source and benefits under Double Taxation Avoidance Agreements would need to be considered prior to implementation of the TAS.

• Under the TAS, same lease classification shall be made by the lessor and lessee for the lease transaction. A joint confirmation to that extent will have to be executed in a timely manner, in the absence of which the lessee would not be entitled to a depreciation deduction on such assets. It is currently unclear on whether the lessor would be eligible for a depreciation deduction in such cases.

• AS 19 requires a lease to be classified as a finance lease, if there is a transfer of substantial risks and rewards relating to the ownership of the leased asset. AS 19 accordingly provides several indicators for finance lease classification that have to be considered in totality based on the substance of the arrangement. These indicators do not necessarily individually result in classification as a finance lease. However, the TAS considers the existence of any one of the specified indicators as sufficient evidence for finance lease classification. This may result in a change in lease classification as compared to current practice, with a greater number of lease arrangements meeting the finance lease classification criteria.

• Under the TAS, the definition of minimum lease payment does not include residual value guaranteed by any party other than the lessee. This is to ensure that there is a uniform lease classification. Whereas under AS 19, in case of a lessor, the definition of minimum lease payment (which affects the lease classification into operating or finance lease) includes residual value guaranteed by the lessee or any other party. However, in case of the lessee, the definition of minimum lease payment includes only the residual value guaranteed by the lessee. This difference may at times result in different lease classification for lessor and lessee under AS 19.

• Unlike AS 19 where initial direct costs incurred in negotiating and arranging a lease can be recognised upfront or over time, under TAS the upfront recognition of initial direct cost for the lessor is not permitted. Prior to TAS, in the absence of specific guidance under the Act, the tax treatment was in line with the requirements of the accounting standards.

Intangible assets

• TAS excludes goodwill from its scope, whereas AS 26 includes goodwill arising on acquisition of a group of assets that constitute a business (for example, slump sale). In the absence of specific provisions in the TAS, the current practice in this area (that has emerged based on judicial pronouncements) may prevail.

• For internally developed intangible assets, TAS does not provide any guidance on scenarios, where the development phase of a project cannot be distinguished from the research phase. Hence, the assessee would need to establish clearly whether the costs relate to the research phase or the development phase. Unlike TAS, AS 26 provides that in case the development phase of a project cannot be distinguished from the research phase, then the entire costs are recognised as part of research phase and consequently charged as expense.

• Under the TAS, development costs cannot be expensed merely on grounds of uncertainty around the commercial feasibility. If other criteria for capitalisation are met, the same should be capitalised. Unlike TAS, AS 26 requires companies to establish commercial feasibility of the project for determining capitalisation of development costs.

• Under the TAS, in the case of acquisition of an intangible asset in exchange for another asset, shares or other securities, the actual cost shall be the lower of the fair market value of the asset acquired or the fair value of the asset given up/securities issued. Unlike TAS, AS 26 provides that in such cases, the fair value of the asset/securities given up or fair value of the asset acquired, whichever is more clearly evident, should be recorded as actual cost.

Provisions, contingent liabilities and contingent assets

• AS 29 provides for recognising losses on onerous executory contracts, when the unavoidable costs of meeting the obligations under the contract exceed the economic benefits expected to be received under it. TAS excludes all executory contracts, including onerous contracts, from its scope. Accordingly, such unavoidable future losses cannot be currently recognised under the TAS. This is consistent with the general provisions under the TAS, which preclude recognition of unrealised gains and losses.

• Under the TAS, provision is required to be recognised if its existence is reasonably certain. In comparison, AS 29 requires the recognition of a provision if its existence is considered probable (more likely than not). This change from ‘probable’ to ‘reasonably certain’ may result in new interpretation issues.

• Under AS 29, contingent assets are not recognised unless the virtual certainty criteria is met. This is a very high threshold and generally such assets are not recognised until realised. However, under TAS, contingent assets are recognised when it is reasonably certain that an inflow of economic benefits will arise. Thus, the provisions of the TAS may accelerate the recognition of contingent assets and related income. This provision seems to have been inserted to bring in parity between the treatment of provisions for contingencies and treatment of contingent assets.

Summary

The final report of the Committee along with the draft TAS, represents a significant move towards providing a uniform basis for computation of tax-able income. Many of the differences between the TAS and the AS are intended to harmonise the basis for computation of taxable profits with the existing provisions of the Act. Companies would therefore have a comprehensive framework based on which adjustments may be made each year to their accounting profits to determine taxable income.

Some of the provisions of the TAS also represent a significant change or clarification in the tax position as compared to currently prevailing practices. These are broadly intended to cover aspects that have historically been a subject matter of litigation and diversity. Depending on the practices currently followed, a company may be affected significantly by these changes.

The report also indicates that additional guidance would be provided through TAS where there is currently no guidance, including areas such as real estate accounting, service concessions, financial instruments, share based payments and exploration activities. This will further strengthen the TAS framework in the future.

The draft TAS will also remove one of the significant impediments to adoption of Ind AS, since the TAS provides an independent framework for computation of taxable income, regardless of the accounting framework adopted by companies (Indian GAAP or Ind AS). However, an important consideration for adoption of Ind AS is the impact it will have on computation of the Minimum Alternate Tax (MAT), which is based on the accounting profits. The Committee did not address this issue in its Final Report. The main reasons cited were the uncertainty around the implementation date for Ind AS as well as the forthcoming changes in IFRS. The Committee has recommended that transition to Ind AS should be closely monitored and appropriate amendments relating to MAT should be considered in the future based on these developments.

The real benefit of providing a uniform framework for computing taxable income will only be achieved through a uniform and impartial implementation of TAS by the tax authorities and the judiciary. The tax authorities may consider issuance of internal implementation guidelines and training to ensure that the TAS are correctly applied and implemented at the field level.

Nirav Shah

Determination of Control- Now a Critical Judgement Area under IFRS

IFRS 10 – Consolidated Financial Statements is effective for annual periods beginning on or after 1st January 2013. It builds on the control guidance that existed in IAS 27 and SIC 12 and adds additional context, explanations and application guidance that is consistent with the definition of control. IFRS 10 applies a single control model to determine whether an investee should be consolidated. De-facto control is explicitly included in the model.

IFRS 10 states that ‘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’. IFRS 10 requires an investor to assess whether it has power over the relevant activities of the investee. Only substantive rights of the investor are relevant for this purpose and voting and other rights needs to be considered for this assessment. There are additional considerations for assessment of power in the instance of the investor holding less than a majority of the voting rights.

De-facto control is one such consideration. De-facto control is said to exist when an investor’s current voting rights may be sufficient to give it power even though it has less than half of the voting rights. Assessing whether an investor has de-facto control 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 vote holders. Even without potential voting rights or other contractual rights, when the investor holds significantly more voting rights than any other vote holder or organised group of vote holders, this may be sufficient evidence ofpower. In other situations, these factors may provide sufficient evidence that the investor does not have power – e.g. when there is a concentration of other voting interests among a small group of vote holders. In some cases, these factors may not be conclusive and the investor needs to proceed to 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. The investor also considers the factors normally used to assess power when the investee is controlled by rights other than voting rights.

An investor with less than a majority of the voting rights has rights that are sufficient to give it power when the investor has the practical ability to direct the relevant activities unilaterally. When assessing whether an investor’s voting rights are sufficient to give it power, an investor considers all facts and circumstances, including:

a) the size of the investor’s holding of voting rights relative to the size and dispersion of holdings of the other vote holders, noting that:

• the more voting rights an investor holds, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;

• the more voting rights an investor holds relative to other vote holders, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;

• the more parties that would need to act together to outvote the investor, the more likely the investor is to have existing rights that give it the current ability to direct the relevant activities;

b) potential voting rights held by the investor, other vote holders or other parties

c) rights arising from other contractual arrangements; and

d) any additional facts and circumstances that indicate the investor has, or does not have, the current ability to direct the relevant activities at the time that decisions need to be made, including voting patterns at previous shareholders’ meetings.

When the direction of relevant activities is determined by majority vote and an investor holds significantly more voting rights than any other vote holder or organised group of vote holders, and the other shareholdings are widely dispersed, it may be clear, after considering the factors listed above, that the investor has power over the investee.

Determining whether an investor has de-facto control over an investee is usually highly judgmental: it includes determining the point at which an investor’s shareholding in an investee is sufficient and the point at which other shareholdings’ interests are sufficiently dispersed. It would also be difficult for a dominant shareholder to know whether a voting agreement amongst other shareholders exists.

Applying the above principles poses various challenges. There may be situations in which the dominant shareholder does not know whether arrangements exist among other shareholders, or whether it is easy for other shareholders to consult with each other. The investor should have processes in place to allow it to capture publicly available information about other shareholder concentrations and agreements.

The smaller the size of the investor’s holding of voting rights and the less the dispersion of the holding of other vote holders, the more reliance is placed on the additional factors in Step 2 of the analysis; within these, a greater weighting is placed on the evidence of power.

The ‘voting patterns at previous shareholders’ meetings’ requires consideration of the number of shareholders that typically come to the meetings to vote (i.e. the usual quorum in shareholders’ meetings) and not how the other shareholders vote (i.e. whether they usually vote the same way as the investor). However, how far back should one look for assessing the past trend is a question of judgment. Also, for start-up companies this will particularly be a challenge.

Determining the date on which an investor has de-facto control over an investee may in practice be a challenging issue. In some situations, it may lead to a conclusion that control is obtained at some point after the initial acquisition of voting interests. At the date that an investor initially acquires less than a majority of voting rights in an investee, the investor may assess that it does not have de-facto control over the investee if it does not know how other shareholders are likely to behave. As time passes, the investor obtains more information about other shareholders, gains experience from shareholders’ meetings and may ultimately assess that it does have de-facto control over the investee. Determining the point at which this happens may require significant judgment.

In the backdrop of companies getting capital infusion from private equity investors the assessment of de-facto control will be very challenging. While the investors may not have majority voting rights, they do obtain various rights that include appointment of key managerial personnel, guaranteed return on their investments, right to approve the annual operating plans/ budgets, etc. Such cases will need to be closely looked into for determining whether the investor has a de-facto control on the investee.

Let us consider an example: Company A acquired 45% in Company B (which is a listed company and balance shareholding is widely dispersed). Company B has 6 directors who are appointed by shareholders in their general meeting based on simple majority. Whether Company A needs to consolidate Company B as a subsidiary.

Analysis under AS-21 under Indian GAAP: Under Indian GAAP an investor consolidates the investee company only if it ‘controls’ the investee. Control is defined as

(a) the ownership, directly or indirectly through subsidiary(ies), of more than one-half of the voting power of an enterprise; or

(b) control of the composition of the board of directors in the case of a company or of the composition of the corresponding governing body in case of any other enterprise so as to obtain economic benefits from its activities.

Based on the aforesaid definition of control, in this example Company A does not have control of Company B (either majority voting power or control composition of Board), thus it cannot consolidate Company B as a subsidiary.

Analysis under IFRS: Under IFRS 10, Company A will need to determine whether it has control over Company B. As discussed earlier, the control definition under IFRS is wider and includes de-facto control as well. In the instant case, Company A is the largest shareholder of Company B and it is given that the balance shareholding is widely dispersed. Company A will need to evaluate the following:

(a) Number of shareholders that own the next 45 % shareholding: The higher the number, the greater are the chances that Company A will need to consolidate Company B, for example if the next 45% is held by around 5 shareholders it will be difficult to demonstrate de-facto control as 5 shareholders can get together and vote against Company A. However if the next 45% shareholding is owned by 1,000 shareholders (widely dispersed public shareholding), it can be demonstrated that Company A in effect would control the functioning of Company B as the probability of 1,000 shareholders coming together and vote against Company A will be remote.

(b) History of voting in the past general meetings: Company A will need to evaluate the number of shareholders actively attending the general meetings and participating in the decisions of shareholders. It is important to assess the number of shareholders that attend general meetings and not how they vote. Thus, in case past history reflects that all 100% shareholders attend the general meeting and cast their votes it may be difficult to demonstrate de-facto control, no matter that the balance shareholders voted for decisions in favour of Company A. However, if the total number of shareholders casting their votes in the general meeting are always less than 80%, then it can be demonstrated that de-facto control exists, since Company A has more than 50% voting power of effective votes cast in the general meetings.

(c) Rights of other shareholders: Before concluding whether Company has de-facto control of Company B, it will need to be assessed in any special rights are available to other shareholders or shareholder groups such as their consent is required prior to approving annual business plan or appointment and removal of key managerial personnel. Presence of such rights will impact the ability of Company A to consolidate Company B as a subsidiary.

After considering the above factors, under IFRS Company A may need to consolidate Company B as a subsidiary though it only holds 45% of the voting power in Company B. Under the earlier consolidation standard under IFRS IAS 27- application of de-facto control approach was an accounting policy choice, however under IFRS 10, consideration of de -facto control is mandatory for assessing control.

The requirement to assess control is continuous. De-facto control relies, at least in part, on the actions or inactions of other investors. Therefore, the requirement to assess control on a continuous basis may mean that the investor who is assessing whether it has de-facto control may need to have processes in place that allow it to consider who the other investors are, what their interests are and what actions they may or may not take with respect to the investee on an ongoing basis.

This is an important change for companies, as currently under Indian GAAP, consolidation is more rule driven based on the definition of control under AS -21. Under IFRS 10, companies will need to closely monitor aforesaid factors on a regular basis to determine control over entities and preparation of its consolidated financial statements.

Nirav Shah

GAP in GAAP ESOP issued by parent to the employees of unlisted subsidiary

The accounting for employee share-based payments is determined by two authoritative pronouncements, namely, SEBI’s Employee Stock Option Scheme and Employee Stock Purchase Scheme Guidelines, 1999, and ICAI’s guidance note on Employee Share-based Payments. Clause 3 of the SEBI’s guidelines states as follows: “these Guidelines shall apply to any company whose shares are listed on any recognised stock exchange in India.” Unlike SEBI guidelines, ICAI’s guidance note applies to all reporting entities whether listed or unlisted.

Consider a scenario, where a parent company issues ESOP’s to employees of its subsidiary. The question is who records the ESOP cost; the parent, the subsidiary or no one. As per the SEBI guidelines (which are applicable to all listed entities) the parent recognises the ESOP compensation cost because under the SEBI guidelines, an employee of a subsidiary is treated as an employee of the parent company for this purpose. Thus, if the parent of a listed subsidiary issues ESOPs to the subsidiaries employees, the listed subsidiary should not recognise the ESOP expense. As per the SEBI guidelines, the parent company is required to record the compensation cost. Typically, the requirement with respect to the parent recognising the ESOP compensation cost can be enforced only when the parent itself is a listed entity in India within the jurisdiction of SEBI. However, it cannot be enforced when the parent is in a foreign jurisdiction or is in India but is an unlisted entity.

In contrast to the SEBI guidelines, the ICAI guidance note provides as follows:

“10. An enterprise should recognise as an expense (except where service received qualifies to be included as a part of the cost of an asset) the services received in an equity-settled employee share-based payment plan when it receives the services, with a corresponding credit to an appropriate equity account, say, ‘ Stock Options Outstanding Account’. This account is transitional in nature as it gets ultimately transferred to another equity account such as share capital, securities premium account and/or general reserve as recommended in the subsequent paragraphs of this Guidance Note.

The underlying principle of the ICAI guidance note is that the ESOP related compensation costs should be accounted for as expense in the books of the enterprise whose employees receive the ESOP’s.

Further, paragraph 4 of the ICAI’s guidance note states as below:

“For the purposes of this Guidance Note, a transfer of shares or stock options of an enterprise by its shareholders to its employees is also an employee share-based payment, unless the transfer is clearly for a purpose other than payment for services rendered to the enterprise. This also applies to transfers of shares or stock options of the parent of the enterprise, or shares or stock options of another enterprise in the same group as the enterprise, to the employees of the enterprise”.

It can be inferred from the basic principle discussed in paragraphs above, that the ICAI guidance note requires a subsidiary company to recognise share based options granted by the parent company to its employees, even if the subsidiary does not have to settle the cost by making a payment to the parent. This position is consistent with the requirements of International Financial Reporting Standards (IFRS). Under IFRS,the recipient of services will record the cost of those services or benefits.

What is the issue?

In India, legislation prevails over the requirements of the accounting standards and other accounting promulgations such as the guidance notes issued by ICAI. Thus, SEBI guidelines would prevail over the ICAI guidance notes. Therefore, a listed subsidiary will not record ESOP costs, if the ESOPs were issued by the parent company to the employees of the subsidiary company.

Now, in the above example, what happens if the subsidiary is not a listed company in India. In such a case, SEBI guidelines are not applicable to unlisted companies but ICAI guidance note would certainly apply. When the ESOPs are issued by the parent company to the employees of the subsidiary, is it fair to require expensing of ESOP compensation cost in the case of an unlisted subsidiary, but not in the case of a listed subsidiary?

Under the circumstances, the author’s view is that “what is good for the goose, should be good for the gander”. In other words, the author does not support different accounting consequences purely on the basis of the listing status of the reporting entity. Thus, the author believes that the unlisted subsidiary company may not record ESOP compensation cost. This view can also be supported by the fact that the unlisted subsidiary company does not have any settlement obligation with the parent company.

In practice, there is diversity and it is noticed that there are some unlisted subsidiary companies which have recognised the ESOP compensation costs whilst other unlisted subsidiary companies have not. One challenge faced by the subsidiary companies when they record the ESOP compensation cost is with respect to the utilisation of capital reserves. Since the shares issued under the ESOP are of the parent company, in the absence of a re-charge by the parent to the subsidiary, the corresponding credit will be given to the capital reserve (akin to an investment made by the parent company in the subsidiary). This reserve will accumulate over the years. However, the utilisation or remittance of this reserve back to its parent company in the future, would not be easy in the light of restrictions under Companies Act, 1956, the Income Tax Act, 1961, FEMA, etc.

Conclusion

At this juncture, there is an accounting arbitrage available to unlisted subsidiary companies because of different accounting rules under the SEBI guidelines and the ICAI guidance note. For the future, SEBI should withdraw its guidelines, so that the arbitrage is removed and the ICAI guidance note which is based on true and fair view principles and aligned to IFRS (in this case) should be given preference.

levitra

Nirav Shah

Section A: Illustration of an audit report giving ‘Disclaimer of Opinion’

Gujarat NRE Coking Coke Ltd (Australian Subsidiary of Gujarat NRE Coke Ltd, India) (31-3-2013)

From Summary of Accounting Policies

Going Concern

As at the reporting date the Consolidated Entity had a net loss for the period of INR4,744 million (March 2012: Net Profit of INR605 million). Included in the loss are impairment charges of INR5,189 million (refer note below on critical accounting estimate and judgment for further breakdown). The Net cash from operation for the year was INR2,405 million (March 2012 INR4,289 million). The Consolidated Entity has a net current asset deficiency of INR25,266 million (March 2012: INR5,040 million), which includes the current portion of borrowings of INR5,021 million (March 2012: INR2,267 million) and the balance INR14,362 million (March 2012: Nil) have be reclassified as Current liabilities in accordance with AASB101 on account of breach of financial covenants.

The Directors believe this in itself is not a cause of concern considering the nature of business where there are no raw materials, WIP or finished goods until such time as they are mined. Further-more once the coal is mined it is transported to nearby port for export, as such inventory holding is expected to be low. In addition to the above the current liabilities includes installments of loan payable in next 12 months and the creditors mainly comprises of capex creditors as the company continues to be in brown field expansion.

The following events in the current financial year have led to the current performance:

• Significant changes with the adverse effect on the entity have taken place during the period (i.e. a considerable decline in the prices of coking coal)

• Delays in production at both the mines

• Reduced production on account of delay in approvals

• Due to above reasons there was cash flow restraints with payment terms being of certain creditors being extended against normal terms of payment.

Notwithstanding the loss for the year and the Consolidated Entity’s deficiency in net current assets, the financial report has been prepared on the going concern basis.

The directors consider the entity to be a going concern on the basis of the following:

• An anticipated increase in production levels to around 2.3 million tonnes for the coming financial year based on detailed mine plans;

• NRE Wongawilli colliery has all the necessary approvals in place to continue mining upto 2015-2016, the company is in the process of lodging further applications to extend this for another 5-15 years.

• NRE No.1 currently has approval to extract coal from LW 5 upto September 2013 and anticipates receiving long-term approval to extract coal in December 2013.

• The necessary approvals, as described above, for Wongawilli and NRE 1 will be obtained to continue production through the 2014 FY and beyond;

• Increased revenue due to both mines being in production and the anticipated future profit-able position.

• The Company has agreed a term sheet for the introduction approximately A$66 million in new capital to the Company through a placement at 20 cents per share to Jindal Steel & Power Group (“Jindal”) subject to shareholders’ approval. As part of placement Jindal will receive 328.5 million ne shares as well as around 328.5 million unlisted transferable options which shall be exercisable for nil consideration within a period of 5 years from the date of issue of the option. In addition, the Company will make an offer to shareholders not associated with Jindal and Gujarat on a pro-rata basis one new share for every four shares held on the record date plus one attaching unlisted transferable option for every one share subscribed. The ordinary shares will be issued at the price of 20 cents per new shares and each option shall be exercisable for nil consideration within a period of 5 years from the date of issue of the option, subject to shareholders’ approval.

• Suppliers will be brought back into their credit terms and the Consolidated Entity will have ongoing support from its suppliers and creditors;

• The Company is also in an advance discussion with its existing bankers for further borrowing the $200 million:

o $140 million of the same shall held the Company in freeing up the funds utilized for capex incurred (from its own sources) in FY13 and H1FY14 which is proposed to be utilized to prepay the scheduled princi-pal repayments falling due in FY14 & FY15 under the Axis Bank syndicated facilities. The Company has received sanction for $66 million from some of the lenders; and

o $60 million would be used to part-financing the capex for Project in H1FY14 and meet-ing expenses in relation to this facility. The Company has received sanction for $10 mil-lion from one of the banks.

Sanctions from the remaining banks are expected to be in place in the next few weeks.

• The entity has prepared cash flow forecasts covering a period of more than 12 months from the date of approval of these financial statements. These indicate that the entity will meet its liabilities as they fall due.

• The entity continues to develop the two mines to secure production into the future.

In order to complete these projects the entity will have to continue to be able to sources funding by way of debt or equity. The di-rects are in the process of exploring funding opportunities and are confident of being able to secure sufficient funds to complete both mines.

Based on the above, the Directors consider the entity to be a going concern and able to meet its debts and obligations as they fall due.

Notwithstanding the above, if one or more of the planned measures doe not eventuate or are not resolved in the Entity’s favour, then in the opinion of the Directors, there will be significant uncertainty regarding the ability of the Entity to continue as a going concern and pay its debts and obligations as and when they become due and payable.

If the Entity is unable to continue as a going concern, it may be required to realise its assets and extinguish its liabilities other than in the normal course of business at amounts different from those states in the financial report.

No adjustments have been made to the financial report relating to the recoverability and classification of the recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Entity not continue as a going concern.

Trade and Other Receivables

Trade receivables are recognised at original invoice amounts less an allowance and impairment for uncollectible amounts. Collectability of trade receivables is assessed on an ongoing basis. Debts which are known to be uncollectible are written off. An allowance is made for doubtful debts where there is objective evidence (such as significant financial difficulties on the part of the counterparty of default or significant delay in payment) that the group will not be able to collect all amounts due according the original terms.

Impairment of Assets

At each reporting date, the Group reviews the carrying values of its tangible and intangible assets to determine whether there is any indication that those assets have been impaired. If such an indication exists, the recoverable amount of the asset, being the higher of the asset’s fair value less costs to sell and value in use, is compared to the asset’s carrying value. Any excess of the asset’s carrying value over its recoverable amount is expensed to profit or loss.

The Details of impairments that have been recog-nised during the financial year is as under:

1.Impairment of Land & Building in Gujarat NRE
Properties Pty Ltd.    $5.50 million
2. Impairment of Investments    $11.58 million
3. Impairment of Cethana    $5.25 million
4. Impairment of Mining Assets    $61.46 million

Impairment of Mining Assets – $61.46 Million

The Company undertook review of the carrying value of its assets to assess for impairment, if any, as there were the following indicators:

• the carrying amount of the net assets of the entity is more than its market capitalisation

• significant changes with an adverse effect on the entity have taken place during the period (i.e. a considerable decline in the prices of coking coal)

• Delays in production due to outstanding ap-provals

• Cash flow restraints.

The Company accordingly appointed Geos Mining (Geos) to carry out an independent valuation of the assets. Geos provided the valuation of the assets in the range of $398 million to $995 million with preferred value being $810 million. The preferred value was not considered appropriate due to the following factors:

1. The mine plan of the Company has been made by its executives who have a considerable experience of coal mining in the region and the mine plans have been duly assessed an independent technical review undertaken independently by Runge Pincock Minarco (Minarco). However the preferred value arrived by Geos was based on, amongst other assumption, on achieving 95% of the optimal Bulli mine plan.

2. Also Geos have considered the recommendation of Edwards Global Services as the High case for coking coal prices. There are coking coal price forecasts which were higher than those of Edwards. It was believed that the coking coal prices recommended by Edwards Global Services are in between the range of forecast and closer to higher long term prices forecast in the market and it was considered appropriate to adopt these prices for the valuation exercise.

The Company’s business operation i.e. coal mining, coal preparation and export of coal from two coal mines has been assessed as a single cash generating unit (CGU) considering the following justifications:

a) Mines are located in the same regional area.

b) Both the mines have only one product line, coal.

c) The performance of the cash inflow of one mine gets directly affected by the performance of the other mine.

d) The revenue from each mine is not independent of each other.

e) The management monitors the operations collectively and that the revenue from one mine is directly affected by the quantity exported by other mine.

Based on the assessment undertaken by the Company the preferred valuation of the CGU based on value in use has been arrived at $995 million considering the undernoted assumptions:

a) The company has done a valuation using a discount rate of 8.5% (based on WACC).

b) Long Term coking coal price of $197.

c) Long Term US$: AUS$ long-term exchange rate of 0.85.

d) Life of each mine should have in excess of 25 years.

e) The permitted rates of extraction will be up to 3.2 Mtpa for both mines, in line with current plans.

The Carrying value of the mining assets of the Company is $1,056.46 million & based on the above factors and assessments undertaken by the Company, the preferred valuation of the assets (CGU) has been arrived at $995 million, and an impairment of $61.46 million has been recognized in the books.

Impairment of Property Held in Gujarat NRE Properties Pty Ltd – $5.50 million

The Company owns a property located at Cliff Road, Wollongong, the carrying value of which was $9.25 million as at 31st March 2013. An independent valuation of said property was carried out and the property was valued at $3.75 million resulting in an impairment of $5.50 million. This impairment was on account of general downtrend in the real-estate market.

Impairment of Investment: – $11.58 million

The Company made investments in mutual funds anticipating better returns. However, the value of those investments have significantly diminished due to economic and financial crisis and impaired accordingly.

Impairment of Cethana Project: – $5.25 million

As a result of limited expenditure being incurred on the tenements over the past two years, the Board considered it was prudent to obtain a valuation of the Cethana project tenements. The Cethana project was valued using two approaches: attributable value of exploration expenditure and comparable market valuations, these resulted in a preferred valuation of $1.20 million for 100% of the project. Our share in JV, being 30% of the Cethana project has thereby been reduced to $0.36 million from a carrying value of $5.61 million. An impairment of $5.25 million has been recognised in profit and loss.

From Independent Auditor’s Report (dated 15th August 2013)

Basis for Disclaimer of Opinion

We have been unable to obtain sufficient appropriate audit evidence on the books and records and the basis of accounting of the consolidated entity. Specifically, we have been unable to satisfy ourselves on the following areas:

i. Valuation and impairment of assets – the consolidated entity obtained an independent valuation of its mining assets and mining licences. The independent valuation was based on certain assumptions which may no longer be valid. The directors have not obtained an updated independent valuation to determine the extent of the impairment to the carrying value of the mining assets and mining leases. We have been unable to obtain supporting evidence, based on updated assumptions, which would provide sufficient appropriate audit evidence as to the carrying value of the mining assets and mining leases.

ii. Going concern – the financial report has been prepared on a going concern basis, however the directors have not provided an update of their assessment of the consolidated entity’s ability to pay their debts as and when they fall due. The consolidated entity has reported a loss before income tax of $112,182,825 (including an impairment charge of $83,792,190) for the year ended 31st March 2013 and a working capital deficiency of $407,998,443. At the year end, the consolidated entity is in breach of loan covenants, has significant creditors in arrears and has been unable to provide evidence to support the full amount of the replacement loan facility which is required to pay existing facilities. As discussed in Note 1(c), the consolidated entity is in the process of renegotiating financing and has announced a share placement to the market, subject to shareholder approval, for additional equity funding.

We have been unable to obtain alternative evidence which would provide sufficient appropriate audit evidence as to whether the consolidated entity may be able to obtain such financing, and hence remove significant doubt of its ability to continue as a going concern for a period of 12 months from the date of this auditor’s report.

iii. Deferred Tax Assets – included in non-current assets are Deferred Tax Assets of $87,302,944. In accordance with AASB112 “Income Taxes”, the recognition of deferred tax assets when an entity has incurred tax losses requires convincing other evidence that sufficient taxable profit will be available against which the unutilised tax losses can be utilised by the Group. The directors have not provided sufficient appropriate audit evidence of the Group’s ability to recover these losses.

iv. Recoverability of Trade Receivable – included in Trade Receivables is an amount of $27,795,628 due from the consolidated entity’s ultimate parent company. We were unable to obtain sufficient appropriate audit evidence to determine the recoverability of this receivable. Consequently, we were unable to determine whether any adjustment to this receivable was necessary.

v. Completeness of Contingent Liabilities and Sub-sequent Events disclosures – we were unable to obtain sufficient appropriate audit evidence to determine the completeness of the contingent liabilities and subsequent events disclosures. Consequently, we were unable to determine whether any additional disclosures are required to the relevant notes.

vi. To the date of the directors approving the financial statements, we were not provided with sufficient appropriate audit evidence, or time, to finalise our procedures pertaining to various disclosures and transactions contained within the financial report. This constitutes a limitation of scope.

As a result of these matters, we were unable to determine whether any adjustments might have been found necessary in respect of the elements making up the consolidated statement of financial position, consolidated statement of profit and loss and other comprehensive income, consolidated statement of changes in equity and consolidated statement of cash flows, and related notes and disclosures thereto.

Disclaimer of Opinion

Because of the significance of the matters described in the Basis for Disclaimer of Opinion paragraphs, we have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion. Accordingly, we do not express an opinion on the financial report.

From Independent Auditors’ Report on Consolidated Financial Statements of Holding Company, Gujarat NRE Coke Ltd, India (dated 30th May 2013)

Other Matter

We have relied on the unaudited financial statements of all the Australian subsidiaries as referred in not no. 31 of the Consolidated Financial Statement, whose financial statements reflect total assets of Rs. 8.532.55 Crore as at 31st March, 2013 and total revenue of Rs. 1,394.86 Crore and net Cash outflows of Rs. 5.61 Crore for the year ended 31st March, 2013. These unaudited financial statements has been approved by the Management Committee of the respective subsidiaries and have been furnished to us by the management, and our report in so far as it relates to the amounts included in respect of these subsidiaries are based solely on such Management approved financial statements.

Nirav Shah

SA 560 (Revised) – Subsequent Events – Hindsight Better Than Foresight?

It is often said that hindsight provides new eyes. Reality looks much more obvious in hindsight than in foresight.

Events that occur post balance sheet date can provide hindsight on the conditions that existed as on the date of the financial statements. SA 560 (Revised) provides guiding principles to auditors in evaluating events that occur post the balance sheet date and the auditors’ responsibilities for facts which become known to the auditor post issuance of his report. The emphasis here is on ‘facts that become known to the auditor’ which would imply that the scope of subsequent events review transcends well beyond enquiries of management by the auditors. In the Indian context, we have observed how external investigations into the affairs of the auditee enterprises have lead auditors to withdraw their audit opinions (on account of newer facts becoming known which have resulted in the audit opinion being rendered inappropriate).

SA 560 (Revised) has been aligned with International Standards on Auditing (ISA) 560 on ‘Subsequent Events’. SA 560 (Revised) requires auditors to evaluate facts that become known to the auditor after the date of issuance of the auditor’s report, where such facts have a bearing on the financial statements covered by the audit report issued.

SA 560 (Revised) requires auditors to consider the following time periods over which facts need to be evaluated:
• from the date of the audit report but before the date when financial statements are issued
• after the date when financial statements are issued

Per SA 560 (Revised), the term ‘date when financial statements are issued’ is defined to be the date when financial statements are made available to third parties.

Financial statements may be impacted by events that occur after the date of the financial statements. Such events can be broadly classified into two categories:
(a) Those that provide evidence of conditions that existed at the date of the financial statements; and
(b) Those that provide evidence of conditions that arose after the date of the financial statements.

Adjustments to assets and liabilities are not appropriate for events occurring after the balance sheet date, if such events do not relate to conditions existing at the balance sheet date. The date of the audit report informs the reader that the auditor has considered the effect of all subsequent events and transactions which he became aware of and that occurred up to that date.

Let us understand the applicability of SA 560 (Revised) by considering an elementary case study involving an event that has occurred between the date of the financial statements and the date of the auditor’s report and the underlying responsibility of management and the auditors’ to respond to this event.

Case Study 1

XYZ Limited (‘the Company’) has a legal proceeding pending against it in a Court of Law for breach of a contract. As at the balance sheet date, 31st March 20XX, the Company represented to its auditors that it had not breached the contract and provided a legal opinion supporting its position as the most likely outcome. No provision towards damages for breach of contract was recognised in the draft financial statements for the year ended 31st March 20XX. A week prior to the board meeting (scheduled to be held on 1st June 20XX to approve the accounts for the year ended 31sts March 20XX), the Court delivered an adverse ruling and held the Company liable for damages of Rs. 10 crore. The Company does not have recourse to appeal before a higher judiciary.

In the given case, in light of the judgment which was delivered subsequent to the balance sheet date, management should adjust the financial statements by accounting for provision for damages of Rs 10 crores because the judgment provides sufficient evidence that an obligation existed at the balance sheet date. The auditor on his part would need to take cognisance of the adverse ruling and perform audit procedures to obtain sufficient appropriate audit evidence for provision of damages. These procedures would include:
• obtaining from the Company’s legal counsel, the updated status of pending litigation or the Court ruling,
• reading minutes of board meetings, if any,

• verifying that provision for damages made in the accounts is adequate,

• inquiry of management and, where appropriate, those charged with governance as to whether any other subsequent events have occurred which might require disclosure in or adjustment to the financial statements and

• obtaining written representation from management that subsequent events have been appropriately adjusted/disclosed.

Review of subsequent events essentially involves making enquiries of management about developments occurring post the balance sheet date such as those relating to recoverability of assets, measurement of estimates, updates in the litigation status, onerous commitments etc. More importantly, where events occurring post the balance sheet date cast a doubt on the ability of the enterprise to continue as a going concern, the auditor would need to weigh the appropriateness of the basis of accounting, i.e., whether the accounts should be prepared on a going concern basis or on liquidation basis.

It needs to be noted that the auditor has no obligation to perform any audit procedures regarding the financial statements after the date of the auditor’s report.

A. Auditors’ responsibilities for facts that he becomes aware of before the financial statements are issued

There could arise a situation where after the date of the auditor’s report but before the date the financial statements are issued, a fact becomes known to the auditor that, had it been known to the auditor as on the date of the audit report, the same would have caused the auditor to amend the audit report. In such a case, the auditor would need to make enquiries of the management or those charged with governance and determine whether the financial statements need amendment and, if so inquire how management intends to address the matter in the financial statements.

In a situation where management amends the financial statements, the auditor would need to perform necessary audit procedures and provide a new audit report dated no earlier than date of approval of amended financial statements.

In certain circumstances, management may not be restricted from amending the financial statements only to incorporate the effect of the subsequent events and such amended financial statements may be permitted to be approved by the approving authority to the extent of the amendment. In such cases, the auditor is permitted to restrict audit procedures to that amendment and amend the audit report by dual dating it for the specific subsequent event or provide new or amended report including an emphasis of matter (EOM) or other matter paragraph clearly conveying that the auditor’s procedures are restricted solely to the amendment of the financial statements as described in the relevant note to the financial statements.

Where amendment of financial statements is considered necessary and management refuses to do so, the auditor would need to issue a modified opinion, if the audit report is yet to be provided to the entity.

If the audit report has been provided to the entity, the auditor would need to notify management not to issue the financial statements and the auditor’s report thereon. If the financial statements are nevertheless issued by the entity, the auditor would need to take appropriate action to prevent reliance on the auditor’s report as released by the entity.

B. Auditors’ responsibilities for facts that he becomes aware of after the financial statements are issued

The auditor has no obligation to perform any audit procedures after the financial statements have been issued. Where a fact becomes known to the auditor that, had it been known to the auditor as on the date of the audit report, the same would have caused the auditor to amend the audit report, the auditor would need to perform the same procedures as explained in paragraph

(A) above. In addition, the auditor would need to review the steps taken by management to ensure that anyone in receipt of the previously issued financial statements together with the auditor’s report thereon is informed of the situation.

Case Study 2

The Board of Directors of ABC Limited (ABC) approved an equity dividend of Rs. 6 per share on the paid up equity capital of 1,000,000 equity shares of Rs. 10 each at the board meeting held on 28th May 20XX. The Company recorded proposed dividend of Rs. 6,000,000 which was subject to approval by the shareholders at the annual general meeting scheduled on 5th September 20XX. The audit opinion was signed by the auditors on 28th May 20XX. On the date of the AGM, the Board of Directors convened a board meeting to recommend an enhanced dividend of Rs. 9,000,000 (as against Rs. 6,000,000 which was recommended on 28th May 20XX). The shareholders approved the enhanced dividend of Rs. 9,000,000 in the AGM held on the same date. What would be the course of action in this case?

Consistent with the requirement of Accounting Standard 4 – Contingencies and Events Occurring after the Balance Sheet date, the recording of proposed divided at the time of approval of accounts by the board of directors of ABC was appropriate. As a usual practice, the dividend recommended by the board gets approved by the shareholders. However, in the instant case, the dividend proposed by the Board was enhanced by the Board subsequent to the approval of the accounts on 28th May 20XX. The enhanced dividend was approved by the shareholders. It is entirely within the competence of the Board of Directors to amend the accounts and resubmit them to the statutory auditors for report before the accounts are placed before the annual general meeting. Consequently, management could amend the accounts for the year ended 31st March 20XX to account for the enhanced proposed dividend (as well as dividend tax thereon). In such a case, the auditors would need to perform procedures to verify the increase and its corresponding effects on the result for the period and the net reserves. A detailed note in the financial statements explaining the facts of the case would need to be inserted. The auditor may amend the original report to include an additional date to inform users that the auditors’ procedures on subsequent events are restricted solely to the amendment of the financial statements to the extent these relate to proposed dividend (more simply known as dual dating). Alternatively, the auditor may provide a new or amended report that includes a statement in an Emphasis of Matter paragraph (EOM) or Other Matter paragraph clearly mentioning that the auditors’ procedures on subsequent events are restricted solely to the amendment of the financial statements in relation to reversal of proposed dividend.

Revision to the financial statements – a recent example

The original accounts of Essar Oil Limited (‘EOL’) for the year ended 31st March 2012 which were revised post issuance is a pertinent example of subsequent events resulting in amendment to the financial statements after these were issued. In January 2012, the Hon’ble Supreme Court of India ruled against EOL’s claim of eligibility for sales tax incentives for the financial years 2008-09 to 2010-11. The Company sought approval from the Ministry of Corporate Affairs (MCA) to reopen its books of account for the financial years 2008-09 to 2010-11 for the limited purpose of reflecting true and fair view of the sales tax incentives/ liabilities, etc. for the individual accounting years commencing 2008-09 and ending 2011-12. The MCA approval was received during the financial year 2012 -13. The original financial statements for the year ended 31st March 2012 which were approved by the board of directors and the auditors on 12th May 2012 were revised post receipt of MCA approval and approved by the shareholders in November 2012.

In the Indian context, there have also been cases where auditors have in accordance with SA 560 (Revised) informed management of the auditee enterprises that the audit reports issued should not be relied upon in view of purported crisis relating to the auditee’s business operations reported in public domain. Further, in a case where management admits to falsification of the accounts, the auditors would need to inform management as well as regulatory authorities that their opinion on the financial statements would be rendered inaccurate and unreliable.

Concluding remarks

If recent developments in India Inc. were to be diagnosed, withdrawal of audit opinions have had ramifications on reliability of financial information presented of the auditee enterprise, market capitalisation and more importantly maintenance of public trust and confidence.

With the changes in corporate regulation on the horizon and the availability of easy access to information and technology, auditors have the wherewithal to seek facts about the enterprises which they audit from sources other than the auditee. SA 560 (Revised) makes it incumbent upon auditors to assess whether based on the facts known, they have reasons to believe that the audit report which they have issued stands compromised. The standard also provides direction to auditors where management refuses to take cognisance of subsequent events that have an impact on the financial statements issued. The revised standard is in a way a welcome step in safeguarding interests of stakeholders.

Nirav Shah

GAP in GAAP— Deferred Tax Liability (DTL) on Special Reserves

Under section 36 (1)(viii) of the Income-tax Act, certain specified entities such as a banking company or a housing finance corporation carrying on the business of providing long term finance for industrial or agricultural development or development of infrastructure or housing in India are allowed a special deduction. The deduction shall not exceed 20% of the profits, computed under the head “Profits and gains of business or profession”. For claiming the deduction, an equivalent amount is transferred from the profits to special reserves. Where the aggregate of the amounts carried to such reserve account exceeds twice the amount of the paid up share capital and of the general reserves of the entity, no allowance will be available in respect of such excess.

Any amount subsequently withdrawn from the special reserves (mentioned above) created to claim deduction u/s. 36(1)(viii), shall be deemed to be the profits and gains of business or profession and chargeable to income-tax as the income of the previous year in which such amount is withdrawn.

The accounting debate is whether DTL needs to be created in respect of the special reserves created u/s. 36(1)(viii). This question has been asked frequently to the Expert Advisory Committee and the Institute of Chartered Accountants of India.

It may be noted that under AS 22 Accounting for Taxes on Income, “Timing differences are the differences between taxable income and accounting income for a period that originate in one period and are capable of reversal in one or more subsequent periods.”

The Expert Advisory Committee (EAC) has always held the view that creation of a special reserve creates difference between accounting income and taxable income in the period in which special reserve is created. Further, this difference is capable of reversal in the period in which the special reserve is utilised or withdrawn, since the amount utilised/ withdrawn would be treated as taxable income in that year under the Income-tax Act. In support of its position, the EAC states in its opinion that deferred taxes are measured either under full provision method or partial provision method. Under the full provision method, deferred taxes are recognised and measured for all timing differences without considering assumptions regarding future probability, future capital expenditure, etc, with the exception of applying the prudence principles for recognising deferred tax assets. Under the partial provision method, the tax effect of timing differences which will not reverse for some considerable period ahead are excluded. However, this involves considerable subjective judgment and therefore AS-22, has been worded based on the full provision method. In other words, the EAC feels that DTL should be created on the special reserves, as deferred taxes are required for all timing differences (subject to application of prudence in case of deferred tax assets) which are capable of reversal. Whether those timing differences actually reverse or not in the subsequent periods is not relevant for this assessment.

Most of the querists believe that creation of DTL on special reserves will not reflect a true and fair picture of the entity’s financial statements, as experience over many years is clearly indicative that the special reserves have not been utilised by most entities as there was no need and in view of the tax impact. In other words, the querists believe that creation of DTL on special reserves is merely a theoretical construct, and distorts the true and fair picture of the entity’s financial statements by putting in the financial statements a fictitious liability.

This is an impasse between the preparers of financial statements and the ICAI/regulators that has carried on for several years. The author has a different take on the subject, which is to look at the requirements of Ind-AS/IFRS on this issue, since those are the applicable standards in the near future. This may probably end the impasse.

First let’s look at Para 52A and 52B of Ind-AS. 52A:

In some jurisdictions, income taxes are payable at a higher or lower rate if part or all of the net profit or retained earnings is paid out as a dividend to shareholders of the entity. In some other jurisdictions, income taxes may be refundable or payable if part or all of the net profit or retained earnings is paid out as a dividend to shareholders of the entity.
In these circumstances, current and deferred tax assets and liabilities are measured at the tax rate applicable to undistributed profits.

52B: In the circumstances described in paragraph 52A, the income tax consequences of dividends are recognised when a liability to pay the dividend is recognised. The income tax consequences of dividends are more directly linked to past transactions or events than to distributions to owners.
Example illustrating paragraphs 52A and 52B
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.

Let’s convert the above example to the tax regime prevailing in India, where a company pays higher tax rate on distributed profits. The company has a 31st March year end. Assume that the tax rate for distributed profits is higher than that for undistributed profits; say 40% and 30% respectively. A dividend of Rs. 500 was declared in April 20X4, payable in May 20X4. Under Ind-AS, no liability will be recognised for the dividend at 31st March 20X4. The PBT is Rs. 3,000. The tax rate applicable to undistributed profits should be applied, because the tax rate for distributed profit is used only where the obligation to pay dividends has been recognised. So the current income tax expense for year end 31st March 20X4 is Rs. 900 (3,000 x 30%). For year 20X4- 20X5, a liability of Rs. 500 will be recognized for dividends payable. An additional tax liability of Rs. 50 (500 x 10%) is also recognised as a current tax liability.

The above examples are equally applicable in the case of distribution of special reserves created u/s. 36(1)(viii). In simple words, current tax liability is recognised for special reserves when they are distributed/ withdrawn, and no DTL is recognised when the special reserve is created.

In light of the above requirements of Ind -AS, the author believes that the issue of creating DTL on special reserves under AS-22 may be kept at abeyance. Rather the focus should be on understanding the right interpretation under Ind-AS 12. Even under Indian GAAP, the author believes that no DTL should be created on special reserves, in as much, no tax liability is provided under existing Indian GAAP, on general reserves or profit and loss surplus, that are subsequently distributed and on which dividend distribution tax is paid.

Nirav Shah

IFRS Exposure Draft on Leases – Sectoral Impact

The
International Accounting Standards Board (IASB) and the U.S. Financial
Accounting Standards Board (FASB) released a joint revised exposure draft on
lease accounting on 16th May 2013 (the ED). This ED proposes fundamental
changes to lease accounting which would bring most leases on the balance sheet
for lessees. Recognising leases on the balance sheet is a long stated goal of
the standard setters. These proposals would achieve that goal.

In addition to recognising most leases on the balance sheet for lessees, the
proposals would also introduce new lease classification tests resulting in a
‘dual model’ for both lessees and lessors. This would preserve straight-line
expense recognition for most leases of property, i.e. land and/or buildings,
similar to operating leases today. However, there would be recognition of
interest and amortisation expense for most other leases, similar to finance
leases today – i.e. lease expense would not be recognised on a straight-line
basis.

The previous article of this series discussed the proposals of the ED in
detail. To recap, the significant changes introduced by the ED include the
following:

• The biggest change proposed is the introduction of dual lease accounting
models – and a new lease classification test to assess whether a lease is a
Type A lease or a Type B lease. This does away with the concept of operating
and finance leases. The classification criteria would be based on the nature of
the underlying asset and the extent to which the asset is consumed over the
lease term.

The proposed lease classification tests are fundamentally different from the
current ‘risks and rewards’ approach in IAS 17. Also, they perform a different
role, for example, for lessees, the outcome of the classification tests would
no longer determine whether a lease is recognised on the balance sheet, but
instead, would affect the profile of lease expense recognised over the lease
term.

• The ED proposes to bring on the balance sheet of the lessee, a lease
liability and a right-to-use (ROU) asset for both Type A and Type B leases.
Lease expenses in a type A lease comprise of amortisation of the ROU asset and
interest accretion to lease liability (a finance expense). The lease expense
would be front loaded over the lease term. Whereas, the lease expense will be
straight lined over the lease term in the case of Type B with both the components
i.e amortisation and accretion to lease liability to be presented as an
operating expense.

• The ED now proposes to include within its ambit the concept contained in
IFRIC 4 Determining whether an arrangement contains a lease. A lease would
exist when both of the following conditions are met: fulfillment of a contract
depends on the use of an identifiable asset; and the contract conveys the right
to control the use of the identifiable asset for a period of time in exchange
for consideration. While at the first glance, the proposal appears to be
similar to IFRIC 4, there are examples and clarifications in the ED with regard
to the portion of assets, control, direction to use, derivation of benefits and
substitution of assets which may lead to different conclusions about whether or
not a lease exists.

• The ED requires a reassessment of the lease payment and consequently a
computation of the new carrying value for its lease liability when there is a
change in assessment of lease term, economic incentive to exercise purchase
option, residual value guarantees and an index or rate used to determine lease
payments during the reporting period.

• The ED introduces new requirements from the lessor perspective as well. A
concept of ‘residual asset’, representing the interest of the lessor in the
underlying asset at the end of the lease term, has been introduced. The lessor
recognises a lease receivable for Type A leases by de-recognising the
underlying asset. There are specific rules around computation and recognition
of profit/loss on such de-recognition.

The above propositions will have far reaching impacts not only on the
accounting policies of companies, but also on their business strategies,
processes and systems. Significant impact will be felt on account of the
additional effort involved in reviewing and identifying lease arrangements and
extracting lease data, new requirements for estimation and judgment, balance
sheet volatility on account of reassessment, and communication of the changes
in lease accounting to the stakeholders. The foremost financial impact across
sectors will be the recording of new asset and liability which will impact the
key financial metrics such as financial ratios, debt covenants, etc. A summary
that highlights the key impact that the ED may have on certain specific sectors
is given below:

Aviation:

The airline operators deploy aircrafts taken on operating and finance leases.
The ED will require recognition of most of the operating leases on the balance
sheet. Considering the high value of the underlying asset, this will
significantly impact the debt to be recorded on balance sheet. The p r o p o s
a l will also impact the income statement profile for many leases, accelerating
e x p e n s e recognition compared to current operating lease treatment.

Example –
Company A enters into a 4-year lease contract for an aircraft which has a
total economic life of 20 years. The lease does not contain any renewal,
purchase, or termination options. The lease payments of Rs. 2,000,000 per year
are made at the end of the period, their present value is calculated at Rs.
6,339,731 using a discount rate of 10%. The fair value of the aircraft is Rs.
35,000,000 at the date of inception of the lease.

This lease would be classified as a Type A lease since it is not property and
the lease term is considered more than an insignificant part of the total
economic life (20%) and the present value of lease payments is more than
insignificant relative to the fair value of the aircraft (18%).

This lease would have been classified as an operating lease under the existing
principles of IAS 17, and Rs. 2,000,000 would be the annual lease cost to be
accounted by the airline operator. However, the Type A classification will lead
to much different accounting under the ED proposals.

The lessee would recognise a lease liability and a ROU asset of Rs. 6,339,731. In year 1, the amortisation expense would be Rs. 1,584,933 (6,339,731/4) and interest expense of Rs. 633,973 (6,339,731*10%). In year 2, the amortisation expense would be Rs. 1,584,933 and interest expense of Rs. 497,370 [(6,339,731+633,973-2,000,000)*10%]. The cash outflow of Rs. 2,000,000 will be reduced from the lease liability. Thus, under the Type A model, the lessee would see a front loading of the lease expense.

Generally, lease payments for aircrafts are denominated in USD or EUR considering the concentration of suppliers of aircraft in the countries with USD and EUR as the functional currency. The requirement of reassessment of lease liability will significantly impact the reporting entities which do not have USD or EUR as their functional currency. The foreign currency lease liability recorded on Type A leases (erstwhile operating leases) will need to be restated and the effect taken to profit and loss account. This will have a significant impact on Indian companies, given the depreciation of the Indian Rupee.

The new judgments to be made with regard to classification of leases with regard to ‘insignificant’ portion of the economic useful life of the asset and present value of lease payment in relation to the fair value of the asset may risk different interpretations. This is further complicated with the existence of second-hand aircrafts in the market.

The ED does not discuss whether a lessee should identify components of the ROU asset as would be required for an item of property, plant and equipment. If the componentisation principles are to be applied to the aircrafts, there will be additional efforts involved.

Infrastructure:

While at first glance the proposals of the ED appear similar to that contained in IFRIC 4, different conclusions may be reached in the assessment of whether an arrangement contains a lease. For e.g. some power purchase agreements that are identified as leases under IFRIC 4 may not be leases under these proposals. This is because ED’s approach to control has a greater focus on the purchasers’ ability to direct the use of the underlying asset than IFRIC 4. Accordingly, an agreement under which an entity agrees to purchase all of the electricity from a power plant but does not control the operations of the power plant might be a lease under IFRIC 4 but not under ED.

Retail

One of the critical success factors of the companies in this industry is to have retail spaces throughout the country to increase the customer reach. In India many retail companies enter into long term lease arrangements (3-9 years) to ensure business continu-ity. This could have a significant impact on the balance sheets of retail companies ie., grossing up of asset and liability and in turn may impact debt covenants and ability to raise more funds

The following example illustrates the impact as discussed above:

Consider a property lease under which a retailer and landlord enter into a lease of a retail premise for a 5-year period. Assume that the lease payments are Rs. 4,120 per year (paid in arrears) and the discount rate is 4.12%. The lease agreement does not contain a renewal or purchase option.

Under the EDs’ proposed lease classification tests, this lease would be classified as a Type B lease by both Lessee and Lessor. This is because the asset is property (property is defined as land or a building, or part of a building, or both), the lease term is for less than a major part of the economic life of the underlying asset, the present value of the lease payments is less than substantially all of the fair value of the underlying asset, and the lease does not contain a purchase option.

Lessee would recognize a ROU asset and a lease liability for its obligation to make future lease payments. Lessee would initially measure the lease liability and ROU asset at the present value of Rs. 4,120 per year over 5 years discounted at 4.12% (Rs. 18, 280). The following table summarises the amounts arising in lessee’s balance sheet and profit and loss account.

It is important to note that amortization and interest would be combined as a single lease expense in the profit and loss account.

In this example, the ROU asset would be amortized each period by the straight-line lease expense amount minus interest on the lease liability for the period.

In this simple fact pattern, the ROU asset would equal the lease liability throughout the lease term because the lease payments are constant through-out the lease term. If a lease contains variable lease payments that are based on an index or rate, rent escalations, or a rent-free period, then the calculation of the amortization of the ROU asset each period increases in complexity and the ROU asset will not equal the lease liability after lease commencement.

Certain retail companies have arrangements for sub-contracting warehousing, distribution and re-packaging of goods on an exclusive basis. These arrangements mostly qualify as lease arrangements following the guidance in IFRIC 4 and particularly because of the complete off-take of the services/goods from the sub-contractor by the retailer. Considering the proposals of ED, such arrangements may not qualify as a lease because the retailer may not have ability to direct the use of the underlying assets as envisaged in the ED.

Banking and leasing businesses

The new proposal, for a lessor, will result in the de-recognition of underlying assets given on operating lease by leasing companies and recognition of residual asset and lease receivable, representing the interest of the lessor in the underlying asset at the end of the lease term. The new principles of computation and recognition of profit on commencement of leases will need to be applied. There will also be a significant change in the profile of lease income to be recognised. Further, the lease income will now have a component of finance income (being accretion of interest on residual asset and lease receivable). This will significantly impact the EBITDA of companies. Application of the principles of the proposal in practice will pose a significant challenge with IT systems as well.

While it is not yet known how convergence with IFRS in India interplay with the RBI’s capital adequacy framework, a key consideration of the new proposal’s impact on the financial services sector is likely to be in the area of regulatory supervision. As all leases would be brought onto the balance sheet in a grossed-up manner, the increase in liabilities could have significant adverse implications on the capital adequacy requirement, thereby reducing the amount of capital available for business.

Lending entities would need to determine the impact on debt covenants of their clients, as service coverage and leverage ratios as well as net worth calculations may be affected. It will also affect their own decisions of whether to lease or purchase assets, as well as the same decisions made by clients to whom they provide lease financing.

While the ED proposes significant changes, the local tax and regulatory regulations may or may not factor in the principles specified in the ED proposals. This will possibly result in different accounting policies being followed for tax computations. All the proposals in the ED will have a consequential impact on the deferred taxes to be recognised.

The proposals of the ED are complex and create a far reaching fundamental difference from the existing principles. While accounting professionals are getting their arms around the proposals, it will be a significant challenge to educate the users of the financial statements in terms of communicating the change in accounting policies and explaining the volatility and complexities that it brings from both an operational, as well as financial standpoint.

Given that India has not yet converged with IFRS, it will be important to watch out for the position that standard setters and regulators take in India for implementation of the new leases standard (i.e., will Ind AS be based on the old lease principles of IAS 17 or the new standard that may be issued pursuant to the ED).

Nirav Shah

GAP in GAAP— Acquisition of a Company with a Negative Net Worth

Consider Company X with assets of Rs. 120 and liabilities of Rs. 220, and consequently a negative net worth of Rs. 100, which comprises of accumulated losses of Rs. 120 and share capital of Rs. 20. Company Y acquires 51% shares of Company X, directly from promoters, for a consideration of Rs. 25. Accordingly, Company Y would recognize in the consolidated financial statements (CFS) a net liability of Rs100, goodwill of Rs. 76 and a negative minority interest (MI) of Rs. 49. The question is how does Company Y account for the negative MI of Rs. 49?

View 1: The negative MI of Rs. 49 is reduced againstthe parent’s reserves in the CFS.
The author believes that it may not be appropriate to record the unabsorbed losses on MI at the date of acquisition in the parent’s reserves in CFS. Recording unabsorbed minority losses in the parent’s reserves in CFS would carry a presumption that the parent always owned the entity. This presumption is obviously not correct and hence this view is not tenable.

View 2: The negative MI of Rs. 49 is included in goodwill on acquisition
In accordance with paragraph 13 of AS 21, goodwill is determined as follows

(a) the cost to the parent of its investment in each subsidiary and the parent’s portion of equity of each subsidiary, at the date on which investment in each subsidiary is made, should be eliminated;

(b) any excess of the cost to the parent of its investment in a subsidiary over the parent’s portion of equity of the subsidiary, at the date on which investment in the subsidiary is made, should be described as goodwill to be recognised as an asset in the consolidated financial statements;

The parent’s portion of the equity at the date of acquisition should also include the MI losses (since the minority does not absorb it the parent will have to absorb it). Thus on the basis of the above MI losses should also be included in goodwill. The total goodwill should therefore be Rs. 125. This view seems an acceptable alternative.

View 3: The negative MI of Rs. 49 is included in MI
Paragraph 26 of AS 21 Consolidated Financial Statements states: “The losses applicable to the minority in a consolidated subsidiary may exceed the minority interest in the equity of the subsidiary. The excess, and any further losses applicable to the minority, are adjusted against the majority interest except to the extent that the minority has a binding obligation to, and is able to, make good the losses. If the subsidiary subsequently reports profits, all such profits are allocated to the majority interest until the minority’s share of losses previously absorbed by the majority has been recovered.” Paragraph 13(e) states: Minority interests in the net assets consist of: (i) the amount of equity attributable to minorities at the date on which investment in a subsidiary is made; and (ii) the minorities’ share of movements in equity since the date the parent subsidiary relationship came in existence.

Paragraph 26, prohibits the recognition of negative MI, unless there is a binding obligation by the minority to make good the losses. Thus no negative MI can be recognised in the CFS. However a careful reading of paragraph 13(e) suggests that losses at the date of acquisition relating to minority are attributable to minority.

Thus a negative MI can be recorded at the date of acquisition. However, losses subsequent to the acquisition should not be attributed to the MI.

View 4: The negative MI of Rs. 49 is ignored
It is not possible to ignore the negative MI, as the balance sheet would not tally. Hence this view is ruled out.

The author’s opinion is that View 2 & View 3 are appropriate under the circumstances.

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Nirav Shah

Section B : Miscellaneous

The Company had initiated a voluntary recall of certain products as a precautionary measure against possible contamination due to the packaging integrity of such recalled products. The provision for loss due to products recalled is based on estimates made by the management by applying principles laid down in Accounting Standard – 29 ‘Provisions, Contingent Liabilities and Contingent Assets’. Further it is not possible to estimate the timing/uncertainty relating to the outflow. The movement in the provision during the period is as under:

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Nirav Shah

Day one fair valuation of financial instruments

This article
illustrates the accounting implications of day one fair valuation of assets and
liabilities on initial recognition and its subsequent measurement. When a
financial asset or financial liability is recognised initially in the balance
sheet, the asset or liability is measured at fair value (plus transaction costs
in some cases). Fair value is the amount for which an asset could be exchanged,
or a liability settled, between knowledgeable, willing parties in an
arm’s-length transaction.

In other words, fair value is an actual or estimated transaction price on the
reporting date for a transaction taking place between unrelated parties that
have adequate information about the asset or liability being measured.

The following are certain transactions where fair value on initial recognition
may be different than their transacted amounts.

1. Low-interest or interest-free loans Where a loan or a receivable is
transacted at market interest rates the fair value of the loan will equal the
transaction value. If a loan or a receivable is not based upon market terms,
then it is accounted for in accordance with IAS 39 which states that “the fair
value of a long-term loan or receivable that carries no interest can be
estimated as the present value of all future cash receipts discounted using the
prevailing market rate(s) of interest for a similar instrument (similar as to
currency, term, type of interest rate and other factors) with a similar credit
rating. Any additional amount lent is an expense or a reduction of income
unless it qualifies for recognition as some other type of asset.” In assessing
whether the interest charged on a loan is below market rates, consideration
should be given to the following factors:

Credit worthiness of the
counter-party
The terms and conditions of the
loan including whether there is any security
Local industry practice
Local market circumstances.

In particular, the entity would
consider the interest rates currently charged by the entity or by others for
loans with similar maturities, cash flow patterns, currency, credit risk,
collateral and interest basis.

Initial recognition

A. Repayable on demand: A loan repayable on demand is not required to be
discounted, as the fair value of the cash flows associated with the loan is the
face value of the loan (due to it being repayable on demand).

B. Repayable with fixed maturity: The fair value of the interest-free loan is
the present value of all future cash flows discounted using the market-related
rate over the term of the loan. The rate used to discount an interest-free loan
is the prevailing market interest rate of a similar loan. Any difference
between the cost and the fair value of the instrument upon initial recognition
is recognised as a gain or a loss, unless it qualifies to be recognised as an
asset or liability. Subsequent measurement If the loan is classified by the
lender as a ‘loan and receivable’, the loan is measured at amortised cost using
the effective interest rate method. The fair value of the loan will increase
over the term to the ultimate maturity amount. This accretion will be
recognised in the income statement as interest income.

For the borrower that measures the financial liability at amortised cost,
the liability will increase over the life of the loan to the ultimate maturity
amount. This accretion in the liability will be recognised in the income
statement as interest expense. Illustration — Nil interest loan between common
control parties When low-interest or interest-free loans are granted to
subsidiaries, in the separate financial statements of the investor, the
discount should be recognised as an additional investment in the subsidiary. In
the separate financial statements of the investee, the effect would be given in
the shareholders’ equity.

Illustrative examples

Assume the face value of the loan is Rs.100,000 and the fair value of the loan
is Rs.80,000 at the initial recognition date.

Case 1: Parent grants interest-free loan to the subsidiary

Case 2: Subsidiary grants an interest-free loan to its parent

Case3: Subsidiary grants an interest-free loan to another fellow subsidiary

Note: Deferred tax entries have been ignored

Accounting entries in the books of the

Parent in Case 3

Dr.

Cr.

Deemed Investment in
borrowing subsidiary

To deemed dividend
income from lending

subsidiary

(20)

2. Low-interest or interest-free loans to employees

Loans given to employees at lower than market interest rates generally are
short-term employee benefits. Loans granted to employees are financial
instruments within the scope of IAS 39 Financial Instruments. Therefore,
low-interest loans to employees should be measured at the present value of the
anticipated future cash flows discounted using a market interest rate. Any
difference between the fair value of the loan and the amount advanced is an
employee benefit. If the favourable loan terms are not dependent on continued
employment, then there should be a rebuttable presumption that the interest
benefit relates to past services, and the cost should be recognised in profit
or loss immediately. If the benefit relates to services to be rendered in
future periods (e.g., if the interest benefit will be forfeited if the employee
leaves, or is a bonus for future services), then the amount of the discount may
be treated as a prepayment and expensed in the period in which the services are
rendered. If the services will be rendered more than 12 months into the future,
then the entire benefit is a long-term benefit.

The above accounting treatment would not hold good if the loans are repayable on demand. This is because in absence of a fixed tenure and the feature of repayable on demand, the fair value of the loan would correspond with the amount of the loan.

3. Interest-free security/lease deposits

Initial recognition

In case of the provider of the deposit, the deposit should be recognised at fair value. The difference between the fair value and transaction amount would be considered as a prepaid rent under IAS 17 for the provider.

Subsequent measurement
The loan is classified by the provider of the deposit as a ‘loan and receivable’; the loan is measured at amortised cost using the effective interest rate method. The fair value of the deposit will increase over the term to the ultimate maturity amount. This accretion will be recognised in the income statement as interest income and prepaid rent will be amortised on a straight-line basis as rent expense under the principles enunciated in IAS 17.

For the receiver of the deposit, the deposit shall be classified as a financial liability at amortised cost; the liability will increase over the life of the loan to the ultimate maturity amount. This accretion in the liability will be recognised in the income statement as interest expense and advance rent received will be amortised on a straight-line basis as rent income. The amortisation would be similar to the prepaid salary as illustrated above.

Illustration

Assume Rs.1,000,000 lease deposit has been given — interest-free for a term of 5 years. Assuming market rate of borrowing is 10% for the lessee and market rate for investments is also 10% for the lessor. The fair value on the first day of the lease would be Rs.620,931 (i.e., fair value as discounted).

The accounting would be as follows:

Accounting
entries

Dr.

Cr.

In
the books of entity

giving
the deposit

Transaction
date —

Initial
recognition of

deposit
at fair value

and
difference treated

as
prepayment

Lease deposit receivable

620,921

Prepaid rent

379,079

To bank

1,000,000

End
of first period —

1. Accretion of interest

on
deposit using

original
discount rate

Lease deposit receivable

62,092

To Interest income on

deposit

62,092

Accounting
entries

Dr.

Cr.

2. Amortisation
of

notional
prepaid rent

Rent expense

(i.e., 379079/5 years)

75,816

To prepaid rent

75,816

In
the books of entity

receiving
the deposit

Bank

1,000,000

To lease deposit payable

620,921

To rent received in advance

379,079

End
of first period —

1. Accretion of interest on

deposit
using original

discount
rate

Interest expense on

deposit

62,092

To lease deposit payable

62,092

2. Recording
additional

notional
rental income

Rent received in advance

75,816

To rent income

75,816

The aforesaid accounting principles would not apply if the lease is a cancellable lease, since then the security deposit would be repayable on demand and as explained above would need to be accounted at the transaction value.

Nirav Shah

Section A : Accountin g Treatment for Share Issue and IPO-related expenses

Bajaj Corp. Ltd. (31-3-2011)
From Significant Accounting Policies:

Initial Public Offer (IPO) Expenses: All the IPO expenses amounting to Rs.1,896.25 lac are written off during the year and shown as exceptional item in the Profit & Loss Account.

IndoSolar Ltd. (31-3-2011)

From Significant Accounting Policies and Notes to Accounts:

Miscellaneous expenditure: Until 31st March 2010, the Company had an accounting policy to amortise share issue expenses over a period of 5 years. The share issue expenses amounting to Rs.308,863,060 incurred during the year and the balance of Rs.26,960,927 remaining unamortised as at 31st March 2010, has now been adjusted against the Securities Premium Account as permitted u/s.78 of the Companies Act, 1956, on account of a change in the accounting policy in the year ended 31st March 2011. Had the Company continued to follow the same accounting policy, the miscellaneous expenditure written off and the net loss would have been higher by Rs.34,778,485 for the year ended and miscellaneous expenditure would have been higher by Rs.301,045,502 as at 31st March 2011.

Subex Ltd. (31-3-2011)

From Significant Accounting Policies:

Preliminary and Share Issue Expenses: Expenses incurred during the Initial Public Offer, follow on offer and issue of Bonus Shares are amortised over 5 years. Other issue expenses are charged to the securities premium account.

Kingfisher Airlines Ltd. (31-3-2011)

Deferred revenue expenses: Share issue expenses are amortised over a period of three years on a straight-line basis following the year of incurring the expenses.

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Nirav Shah

GAPS in GAAP — Guidance Note on Accounting for Real Estate Transactions (Revised 2012) is in no-man’s land

Introduction

On account of the diverse practices, the ICAI felt it necessary to issue a revised Guidance Note titled Guidance Note on Accounting for Real Estate Transactions (Revised 2012) to harmonise the accounting practices followed by real estate companies in India. The revised Guidance Note should be applied to all projects in real estate which are commenced on or after April 1, 2012 and also to projects which have already commenced but where revenue is being recognised for the first time on or after April 1, 2012. An enterprise may choose to apply the revised Guidance Note from an earlier date, provided it applies it to all transactions which commenced or were entered into on or after such earlier date. The revised Guidance Note (2012) supersedes the Guidance Note on Recognition of Revenue by Real Estate Developers, issued by the ICAI in 2006, when this Guidance Note is applied as above. Though apparently the Guidance Note on accounting for real estate transactions is drafted in a simple and lucid manner, but when implemented, can throw a lot of implementation issues. Particularly, there are several requirements in the Guidance Note, which some may argue conflict with the accounting standards notified under the Companies (Accounting Standards) Rules.

Scope of the Guidance Note

One of the big challenges is with respect to scope of the Guidance Note, which is not very clear on several aspects. The Guidance Note scopes in development and sale of residential and commercial units. Would that mean that if a customer were to hire a real estate developer to construct a villa on the land owned by the customer and in accordance with the customer’s specification, that transaction would be covered under the Guidance Note? In the author’s view, this seems like a typical construction contract, to which AS-7 and not the Guidance Note would apply. The Guidance Note applies to construction-type contracts, for example, construction of a multi-unit apartment to be sold to many buyers. It is pertinent to note that though percentage of completion is applied under AS-7 and the Guidance Note, there are other significant differences which would give different accounting results. Consider another example. A real estate developer sells villas to customers. It enters into two agreements with each buyer: one for sale of land and other for construction of building. Can the company treat these two agreements separately and recognise revenue accordingly?

In a practical scenario, three possibilities may exist with regard to construction of villa. These possibilities and likely views are:

(1) Customer owns land and it hires real estate developer to do the construction according to its specifications. In this case, the arrangement seems like a typical construction contract to which AS-7 and not the Guidance Note will apply.

(2) Real estate developer sells land and constructed villa together as part of one arrangement in a manner that customer cannot get one without the other. In this case, it seems appropriate that the developer will apply Guidance Note to land and building together.

(3) Real estate developer sells land. The buyer has an option of getting construction done either from the developer or any other third party. Both the land sale and construction element are quoted/ sold at their independent fair values.

The Guidance Note does not specifically deal with this scenario. However, the author believes that the more appropriate view will be to treat the sale of land and construction of building as two separate contracts and apply revenue recognition principles accordingly. The Guidance Note applies to redevelopment of existing buildings and structures. This scope is very confusing. For example, very often existing housing societies may ask a developer to reconstruct a property, with detailed specification on structure and design and the right to change that specification before or during the construction. The developer (who is hired like any other contractor) in return is remunerated by a fixed amount or a part of the constructed property or land. The author’s view is that in these circumstances, AS-7 should apply, rather than the Guidance Note. This is because the said contract is a construction contract which is covered under AS-7 and not a construction-type contract which is covered under the Guidance Note. But consider another example of a SRA project in Mumbai. The real estate developer evacuates existing tenants, constructs a huge property to be sold to customers, and adjacently constructs a small building that will house the existing tenants. All through the builder acts as a principal. In such a scenario the Guidance Note will apply.

Can the Guidance Note be applied by analogy to construction and sale of elevators or windmills, etc.? Therefore, applying the guidance note by analogy, can entities manufacturing elevators or windmills, which are of a standardised nature, use the percentage of completion method? The scope of the Guidance Note is very narrow.

The Guidance Note should not be applied by analogy to any other activity other than real estate development. Depending on the facts and circumstances, either AS-7 or AS-9 should apply to construction and sale of elevators, aircraft, windmills or huge engineering equipments. The Guidance Note scopes in joint development agreements, but provides no further guidance on how joint development agreements are accounted for. Joint development agreements may take various forms. The accounting for joint development agreement will be driven by facts and circumstances. They could be joint venture agreements or they could represent the typical scenario where land development rights are transferred to the real estate developer by the land owner, and the legal transfers take place much later, for reasons of stamp duty or indirect taxes. Transfer of development rights on land is like effectively transferring the land itself. Where development rights are transferred, the author has seen mixed accounting practices. Some developers treat the transaction as a barter transaction and record the development rights acquired as land purchased with the corresponding obligation to pay the landowner at a future date. The payment to the landowner could either be in a fixed amount or a fixed percentage of revenue or a portion of the constructed property. Many developers do not account for the barter transaction.

A third option is to record the acquisition of the development rights at the cost of constructed property to be provided to the land owner. This option can be justified on the basis that the Guidance Note requires TDRs to be recorded at lower of net book value or fair value. Though there is no impact on the net profit on the overall contract, whichever method is followed, it would impact the grossing up of revenue and costs. It will also result in the grossing up of the balance sheet. Further though the overall profit is the same over the project construction period, due to the manner of computing POCM, year-to-year profit may vary under the three options. For better clarity the three options are enumerated below. (Figures in all tables are in CU=Currency Unit, unless otherwise stated)

Balance sheet

Particulars	Option 1		Option 2	Option3
Share capital		100	100	100

Reserves		500	500	500
Equity		600	600	600
Loan liability		2,000	2,000	2,000
Liability to landowners
(to be paid by way of
transfer of constructed
property — long term)		—	2,000	1,500
Total liabilities		2,000	4,000	3,500
Total funds		2,600	4,600	4,100
Land (acquired thru JDA)		—	2,000	1,500

Other assets		2,600	2,600	2,600
Total assets		2,600	4,600	4,100
Debt/equity ratio		3.33	6.66	5.83

Particulars	Option 1	Option 2 Option 3

Sale of flats to outsiders 8,000		8,000	8,000
Transfer of flat to
land owners	—	2,000	1,500
Total revenue	8,000	10,000	9,500
Land cost	—	2,000	1,500
Construction cost	7,500	7,500	7,500
Total cost	7,500	9,500	9,000
Profit	500	500	500

% profit on turnover	6.25%	5%	5.26%

Is the Guidance Note in conformity with the Companies (Accounting Standards) Rules?

AS-9, Revenue Recognition, applies to sale of goods and services. AS-7, Construction Contracts applies to construction contracts which are defined as “contracts specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose of use”. In respect of transactions of real estate which are in substance similar to delivery of goods, principles enunciated in Accounting Standard (AS) 9, Revenue Recognition, are applied. For example, sale of plots of land without any development would be covered by the principles of AS-9. These transactions are treated similar to delivery of goods and the revenues, costs and profits are recognised when the goods are delivered. In case of real estate sales, which are in substance construction-type contracts, a two-step approach is followed for accounting purposes.

Firstly, it is assessed whether significant risks and rewards are transferred to the buyer. The seller usually enters into an agreement for sale with the buyer at initial stages of construction. This agreement for sale is also considered to have the effect of transferring all significant risks and rewards of ownership to the buyer. After satisfaction of step one, the second step is applied, which involves the application of the POCM. Once the seller has transferred all the significant risks and rewards to the buyer, any acts on the real estate performed by the seller are, in substance, performed on behalf of the buyer in the manner similar to a contractor. Accordingly, revenue in such cases is recognised by applying the POCM. Once the revenue recognition conditions as per the Guidance Note are fulfilled, the POCM is to be applied mandatorily. In circumstances where the revenue recognition conditions are fulfilled, completed contract method is not permissible.

Accounting standards are notified under the Companies Accounting Standard Rules. The standards that deal with revenue recognition contract are AS-7 & AS-9. Accordingly the entire population of revenue contracts should either fall under AS -7 or AS-9. For example, a strict interpretation of a construction contract under AS-7 will lead one to the conclusion that a real estate sale is a product sale rather than a construction contract. By carving a new category in the Guidance Note, namely, in substance construction contract, for purposes of real estate development; some may argue that this Guidance Note falls in no -man’s-land and is not in accordance with the law. This line of thinking may be of particular interest to private companies that may find completed contract method more attractive for tax reasons.

Volatility in earnings

The Guidance Note imposes several conditions before a company can start applying the percentage of completion method on the real estate project. One of the conditions is that at least 25% of the construction and development costs should have been completed. One interesting aspect of the Guidance Note is that land cost is not included to determine if the 25% construction cost trigger is met. However, once the revenue recognition trigger is met, all costs including land cost is added to the project cost to determine percentage completion and the corresponding revenue and costs. This is likely to bring about a lot of volatility in the reported revenue and profit numbers. For example, let’s assume that land cost is 60% and development cost is 40%. As soon as 25% development cost is incurred, POCM commences. In this example, 70% of the costs (land cost of 60% and 25% of 40 on development), and corresponding revenue would be recognised at the point 25% development cost criterion is met. This would result in significant spike in the revenue and profit numbers. One of the main criticisms of the completed contract method is that it resulted in lumpy accounting. The manner in which POCM is applied as per the revised Guidance Note, it would fall into the same trap.

The examples below will explain more clearly how the revised Guidance Note results in volatility and how one could have avoided the volatility in the pre-revised Guidance Note.

RE Ltd. undertakes construction of a new real estate project having 20,000 square feet saleable area. The project will take 2 years to complete. Half the project is sold on day 1, and there are no further sales. All critical approvals are received upfront and all other POCM conditions are fulfilled at the end of Year 1. The construction and development cost is evenly spread in the two years at CU 150 million each. The total sale value of the units sold is Rs.400 million. Assume 50% amount is realised on all executed contracts and there are no defaults from customer side.

Particulars	Year 1	Year 2

Area sold (sq.ft)	10,000	10,000

Estimated land cost (a)	300	300

Estimated construction cost (b)	300	300

Total estimated cost (a+b)	600	600

Actual cost incurred on land (c)	300	NIL

Actual additional construction cost (d)	150	150

Actual cost incurred on cumulative
basis (c+d)	450	600

Total sale consideration as per
executed agreements	400	400

Revenue as per POCM under revised GN

Particulars	Year 1	Year 2
Particulars	Year 1	Year 2

Total estimated project cost	600	600

Actual cost incurred	450	600

Stage of completion (% completion)	75	100

Cumulative revenue to be recognised
(400 x % completion)	300	400

Revenue for the period (a)	300	100

Land cost charged to P&L (b)
(300 x 10,000/20,000)	150

Construction cost charged to P&L (c)
(Actual construction cost incurred x
10,000/20,000)	75	75

Particulars	Year 1	Year 2

Profit for the period (a-b-c)	75	25

Inventory — land cost	150	150
Inventory — construction cost of
unsold area	75	150
Total inventory	225	300

As stated earlier, consider that under the revised Guidance Note land cost is not included to determine the revenue trigger; but once the revenue trigger is achieved, land cost is included to determine percentage completion and the corresponding revenue and costs. As one can see in the above table this Guidance Note results in significant volatility in the revenue and profit recognised in Year 1 and Year 2, though the construction activity was evenly spread in the two years. This is because the land costs and the associated revenues get recognised in Year 1.

Revenue as per POCM under pre-revised GN

Particulars	Year 1	Year 2
Total estimated project cost
(excluding land)	300	300

Actual cost incurred (excluding land)	150	300

Stage of completion (% completion)	50%	100%

Cumulative revenue to be recognised
(400 x % completion)	200	400

Revenue for the period (a)	200	200

Land cost charged to P&L (b)
(300 x 10,000/20,000 x % completion)	75	75

Construction cost charged to P&L (c)
(Actual construction cost incurred x
10,000/20,000)	75	75

Profit for the period (a-b-c)	50	50

Inventory — Land cost	225	150

Inventory — construction cost of
unsold area	75	150

Inventory	300	300

In the pre-revised Guidance Note the practice many companies followed was to allocate the land cost and revenue proportionately over the development activity. As one can see in the above table, one of the practices under the pre-revised Guidance Note results in a more stable recognition of revenues and profits. This is because the land cost and corresponding revenues are recognised in proportion to the development activity.

Revenue as per POCM if only 24% construction is completed under revised GN

Particulars	Year 1	Year 2
Total estimated project cost	600	600
Actual cost incurred	372	600
Stage of completion for revenue
recognition threshold*	24%	100%

Stage of completion (% completion)	NIL	100%

Cumulative revenue to be recognised
(400 x % completion)	NIL	400

Revenue for the period (a)	NIL	400

Land cost charged to P&L (b)
(300 x 10,000/20,000)	NIL	150
Construction cost charged to P&L (c)
(Actual construction cost incurred x
10,000/20,000)	NIL	150

Profit for the period (a-b-c)	NIL	100

Inventory — land cost	300	150
Inventory — construction cost
(sold — no revenue recognised
+ unsold area)	72	150

Total inventory	372	300

Assumptions

Same facts as POCM example except actual construction cost incurred

Assume company has incurred CU72 million of construction cost in Year 1

* First year POC = 72/300 = 24% (actual construction cost/total estimated construction cost)

In a slightly tweaked example (as seen in the above table), assume in Year 1 that construction cost of CU 72 million is incurred. This works out to 24% of the total construction costs. Hence revenue recognition trigger is not satisfied in Year 1. All of the revenue and costs get recognised in Year 2. This example demonstrates two things. One is that the Guidance Note would result in significant volatility in the revenue and profit numbers. Secondly, this example demonstrates how a rule-based standard can be abused. For example, by incurring a little more cost and crossing the 25% threshold, the developer could have recognised significant revenue and profits in Year 1.

What is a project?

The application of the POCM under the Guidance Note is done at the project level. The Guidance Note defines project as the smallest group of units/plots/ saleable spaces which are linked with a common set of amenities in such a manner that unless the common amenities are made available and functional, these units/plots/saleable spaces cannot be put to their intended effective use. The definition of a project is very critical under the Guidance Note, because that determines when the threshold for recognising revenue is achieved and also the manner in which the POCM is applied. The definition of the term ‘project’ in the Guidance Note is somewhat nebulous. Firstly, it is defined as a smallest group of dependant units. This is followed by the following sentence in the Guidance Note “A larger venture can be split into smaller projects if the basic conditions as set out above are fulfilled. For example, a project may comprise a cluster of towers or each tower can also be designated as a project. Similarly a complete township can be a project or it can be broken down into smaller projects.” Once the term ‘project’ is defined as the smallest group of dependant units, it is not clear why the word ‘can’ is used instead of ‘should’. Does it mean that there is a limitation on how small a project can be, but no limitation on how big a project could be?

The definition is nebulous. Consider an example where two buildings are being constructed adjacent to each other. Both these buildings would have a common underground water tank that will supply water to the two buildings. As either of the building cannot be put to effective use without the water tank, the project would be the two buildings together (including the water tank). Consider another example, where each of those two buildings have their own underground water tank and other facilities and are not dependant on any common facilities. In this example, the two buildings would be treated as two different projects. Consider a third variation to the example, where each of those two buildings have their own facilities, and the only common facility is a swimming pool. In this example, judgment would be required, as to how critical the swimming pool is, to make the buildings ready for their intended use. If it is concluded that the swimming pool is not critical to the occupancy of either of those two buildings, then each of those two buildings would be separate projects. Where it is concluded that the swimming pool is critical to put the two buildings to its intended effective use, the two buildings together would constitute a project. In the example, where two buildings are being constructed adjacently, and each have their own independent facilities and are not dependant on common facilities, one may argue that there is a choice to cut this as either a project comprising two buildings or two projects comprising one building each. If this is indeed the case, the manner in which this choice is exercised is not a matter of an accounting policy choice, but rather a choice that is exercised on a project-by-project basis. In the author’s view, a company should exercise such choice at the beginning of each project and not change it subsequently.

Recognition criteria — Some practical issues

Query
For the purposes of applying the POCM risks and rewards should be transferred to the buyer. Real estate construction involves various types of risks, such as the price risks, construction risks, environmental risks, ability of the real estate developer to complete the project, political risks, etc. There could be situations where the political or environmental risks may be very significant and put to doubt the developers ability to complete the project. Clearly both under the 2006 Guidance Note and the 2012 Guidance Note revenue should not be recognised. But in normal scenario’s how much weightage one would provide to price risks in determining the transfer of risks and rewards?

Response

As per the 2006 Guidance Note, the important criteria were the legal enforceability of the contract, the transfer of price risks to the buyer and the buyer’s legal right to sell or transfer his interest in the property. In contrast paragraph 3.3 of the 2012 Guidance Note states as follows: “The point of time at which all significant risks and rewards of ownership can be considered as transferred, is required to be determined on the basis of the terms and conditions of the agreement for sale. In the case of real estate sales, the seller usually enters into an agreement for sale with the buyer at initial stages of construction. This agreement for sale is also considered to have the effect of transferring all significant risks and rewards of ownership to the buyer, provided the agreement is legally enforceable and subject to the satisfaction of conditions which signify transferring of significant risks and rewards even though the legal title is not transferred or the possession of the real estate is not given to the buyer.” As can be seen the 2012 Guidance Note is nebulous, and is not explicit like the 2006 Guidance Note which clearly sets out the price risk as being most critical to the transfer of significant risks and rewards. At this stage it is not clear how this difference will impact accounting of the real estate sales. For example, a company may decide the construction, environment and regulatory risk as being more critical than the price risk. In those circumstances, would the company apply the completed contract method instead of the POCM? Therefore this will be a significant area of judgment, and could lead to diversity in practice if companies interpret this term differently. However, if a project has become highly uncertain because of political and environmental issues, revenue should not be recognised under either Guidance Note.

Query

Is payment of stamp duty and registration of the real estate agreement necessary to start applying POCM?

Response

In certain jurisdictions, one needs registered docu-ments for the purposes of obtaining a bank loan. In other cases, a customer may decide to register the documents later at the time of possession to save on the interest element on the stamp duty amount. It is important to understand this. POCM can be applied only when there is a legally enforceable contract. It is a matter of legal interpretation and the applicable legislation, whether an unregistered document is legally enforceable. If the agreement is legally enforceable, POCM can be applied. If the agreement is not legally enforceable, POCM cannot be applied. The same also holds true in the case of MOU or letter of allotment given by the builder to the customer instead of a complete legal agreement. The question to be answered invariably is whether the arrangement is legally enforceable.

Query

Very often real estate companies to protect the valuation of the property impose a lock-in restriction on a buyer for a reasonable period, which generally does not extend beyond the project completion period. Would lock-in restrictions preclude the application of the POCM till such time the lock-in rights exist?

Response
In the author’s view, such reasonable restrictive provision does not materially affect the buyer’s legal right. Accordingly, it can be argued that in such instances risks and rewards are transferred to the buyer. Hence POCM can be applied.

Query
In rare cases, real estate developers provide price guards to customers as an incentive to buy properties. For example, a guarantee is provided that should the real estate developer sell the property to subsequent buyers at a rate lower than the previous buyer, the real estate developer would reimburse the previous buyer for the fall in price. Would this preclude application of the POCM?

Response

If these restrictions are substantive, then it may be argued that price risks are not transferred and hence POCM should not be applied. In some situations the price guards may not be substantive, for example, a guarantee by the developer that subsequent sales would not be made at a price lower than 40% charged to the previous buyer may be irrelevant in a rising property market. In such cases POCM can be applied. In the author’s view if there are repurchase agreements or commitments, or put-and- call options, between the developer and the customer, which are substantive in nature, POCM cannot be applied in those circumstances.

Query

One of the conditions for POCM is environment clearance and clear land title. In few cases, this could be a highly judgmental area. Auditors may have difficulty in auditing the same.

Response

Past experience has been that some major projects were stalled mid-way in India, because of lack of environmental clearance, or the land title was questionable. The problem is further compounded because of myriads of clearances and complicated legislations. As an auditor, one would look at seeking clarity from the in-house legal department or an external law firm. Banks generally conduct due diligence on these projects before approving loan to the developer and the customer. Clearance of the project by various banks may provide additional evidence.

Query

One of the conditions for POCM is the 25% completion of construction and development costs. Whether borrowing cost capitalised would be included to determine if this 25% threshold is achieved?

Response

There is some confusion on this. In paragraph 2.2 of the Guidance Note borrowing cost is treated as a distinct category separate from construction and development costs. But paragraph 2.5 lists down borrowing cost as construction and development costs. Based on paragraph 2.2 borrowing costs will not be included to determine the trigger. Based on paragraph 2.5 borrowing costs will be included to determine the trigger. The best way to resolve this anomaly is to include borrowing costs relating to construction and development costs and exclude proportionate borrowing costs on land to determine the trigger.

The other issues around borrowing cost relate to allocation of borrowing cost and which borrowing cost qualify for capitalisation for the purposes of determining project cost and corresponding revenue. The EAC had earlier opined that borrowing cost relating to security deposit for the purposes of acquiring land or other assets is not eligible for capitalisation, because security deposit is not a project cost. Another question that arises when determining project cost for calculating POCM is whether proportionate borrowing cost on land should be included. One view is that land is ready for its intended use when acquired and hence borrowing cost should not be capitalised. Another view is that land and building should be seen as part of a project. If the project is considered as a unit of account, borrowing cost should be capitalised on the project which includes the land component till the project is ready for its intended use. The author believes that the latter is more appropriate given the emphasis on project as the unit of account in the Guidance Note.

Query

Real estate developers enter into innovative schemes with customers. A customer may pay the entire consideration upfront of CU 100 and receive the possession of the property after 2 years of construction. Alternatively the customer pays CU 121 after 2 years on receiving the possession of the property. Would the real estate developer consider time value of money and recognise an interest expense of CU 21 and revenue of CU 121 in the former case?

Response

Well, generally interest imputation is not done under Indian GAAP.

Query

Real estate developers usually pay selling commission to various brokers for getting real estate booking. Can a real estate company include such commission in project cost to apply POCM?

Response

The Guidance Note does not explicitly deal with selling commission paid to brokers. According to paragraph 2.4 of the Guidance Note, selling costs are generally not included in construction and development cost. This suggests a company cannot include selling commission in the project cost and it will need to expense the same to P&L immediately. However, some real estate companies may argue that this view is not in accordance with paragraph 20 of AS-7. Since the Guidance Note refers to AS-7 for application of POCM, implication of its paragraph 20 should also be considered. According to this paragraph “costs that relate directly to a contract and which are incurred in securing the contract are also included as part of the contract costs if they can be separately identified and measured reliably and it is probable that the contract will be obtained.” This is one more instance where the Guidance Note conflicts notified accounting standards. The ICAI should clarify this issue.

Query

With respect to onerous contract, at what level would the developer evaluate onerous contract – is it at the individual contract level or project level?

Response

At the project level, the overall project may be profitable, as the profitable contracts may outnumber the loss -making contracts. If the unit of account was the individual contract, then all contracts that are loss making, will require a provision for onerous contract. The Guidance Note requires such evaluation to be done at the project level rather than on each individual contract. Some may argue that this requirement of the Guidance Note is in contravention of the requirements of the notified accounting standard, namely, AS-29 which requires the provision to be set up at the individual contract level.

Query

How is warranty costs accounted for?

Response

Warranty costs are included in project cost. In practice there are different ways in which warranty costs are treated in the application of the POCM. Warranty costs are unique in the sense that they are incurred after the project is completed and can only be estimated. Firstly warranty is not a separate multiple element or service or sale of good or service. Rather it is part of the obligation of the developer to hand over the constructed property to the buyer. The author has seen mixed accounting practices for warranties. Some companies recognise warranty costs and the corresponding revenue when the project is completed, because that is the time, the warranty period effectively starts. Other companies recognise warranty costs and corresponding revenue throughout the construction period, on the basis that a percentage of the cost incurred would need reworking.

Assume the same facts as POCM example. Consider that RE also gives a 5-year warranty from water leakage and other structural defects. Based on past experience, RE estimates that it will incur warranty cost equal to 5% of total construction cost. Hence, additional warranty cost is CU 15 million (i.e., 5% of CU 300 million construction cost).

Option 1 — Consider warranty cost only when tower is handed over

Particulars	Year 1	Year 2

Total estimated project cost
(excluding warranty) — (a)	600	600

Total estimated project cost
(including warranty) — (b)	615	615

Actual cost incurred
(excluding warranty provision) — (c)	450	600

Warranty provision — (d)	NIL	15
Total cost including

warranty — (c + d) (e)	450	615
Stage of completion

(% completion) — (e)/(b)	73.17%	100%

Cumulative revenue to be
recognised (400 x % completion)	293	400

Revenue for the period	293	107

In this case, the company recognises warranty cost and related revenue only when tower is handed over. Warranty cost is factored in total estimated construction cost. Since no provision for warranty is made in Year 1, stage of completion is lower resulting in lower revenue being recognised in Year 1 (i.e., CU 293 million vis-à-vis CU 300 million in earlier scenario when there was no warranty cost). Lower revenue recognised in Year 1 gets recognised in Year 2 on completion of the project.

Option 2 — Consider warranty cost as and when revenue is recognised

Particulars	Year 1	Year 2
Total estimated project cost
(excluding warranty) — (a)	600	600

Total estimated project cost
(including warranty) — (b)	615	615

Actual cost incurred (excluding
warranty provision) — (c)	450	600

Warranty provision (5% of actual
construction cost) — (d)	7.5	15

Total cost including warranty
(c + d) (e)	457.5	615

Stage of completion
(% completion) — (e)/(b)	74.39%	100%

Cumulative revenue to be recognised
(400 x % completion)	298	400

Revenue for the period	298	102

In this option, company follows a policy of recognising warranty as and when revenue is recognised. Hence company provides for warranty as and when work is carried out. In Year 1, company incurs actual construction cost of CU 150. Hence, it makes a warranty cost equal to 5% of actual construction cost incurred i.e., CU 7.5 in Year 1. Since warranty provision is made on an ongoing basis, stage of completion in Year 1 is higher vis -à-vis option 1. This results in higher revenue being recognised in Year 1.

Transfer of development rights

TDRs are recorded at the cost of acquisition; but interestingly in an exchange transaction, TDR is recorded either at fair market value or at the net book value of the portion of the asset given up, whichever is less. For this purpose, fair market value may be determined by reference either to the asset or portion thereof given up or to the fair market value of the rights acquired, whichever is more clearly evident. The principle of recording TDRs at lower of cost or fair value ensures that fair value gain on exchange of TDRs is not recognised in the financial statements but when fair value is lower than cost, it is recorded at fair value, so that impairment is captured upfront.

Typically under AS-26 and AS-10, recording of exchange transactions at fair market value is permitted. Under IFRS principles, exchanges that have substance are also recorded at fair market value. It is not clear why recording of exchanges with substance at fair market value is not permitted. By conjecture, the standard setters may be concerned about the possibility of abuse by recognising profits on exchanges that may not have substance.

Transactions with multiple elements

An enterprise may contract with a buyer to deliver goods or services in addition to the construction/ development of real estate. The Guidance Note gives example of property management services and rental in lieu of unoccupied premises as multiple elements. It further states that sale of decorative fittings is a separate element, but fittings which are an integral part of the unit to be delivered is not a separate element. Where there are multiple elements, the contract consideration should be split into separately identifiable components including one for the construction and delivery of real estate units. The consideration received or receivable for the contract should be allocated to each component on the basis of the fair market value of each component. For example, a real estate company in addition to the consideration on the flat, charges for property maintenance services for a period of two years, after occupancy. Such revenue is accounted for separately and over the two-year period of providing the maintenance services.

As already mentioned, the consideration received or receivable for the contract should be allocated to each component on the basis of the fair market value of each component. Such a split-up may or may not be available in the agreements, and even when available may or may not be at fair value. When the fair market value of all the components is greater than the total consideration on the contract, the Guidance Note does not specify how the discount is allocated to the various components. Under the proposed revenue recognition standard in IFRS, the allocation is done on a proportion of the relative market value. This in the author’s view is the preferred method. However, some may argue that the residual or reverse residual method may also be applied, in the absence of any prohibition in the Guidance Note. Under the residual method the entire discount is allocated on the first component and in the reverse residual method the entire discount is allocated to the last component.

Would one consider revenue on sale of parking slots as a multiple element? Unfortunately the Guidance Note does not elaborately define multiple elements. In the author’s view, parking slots are an extension of the construction and development of the real estate unit and hence should not be treated as a separate multiple element.

What about lifetime club membership fees? Will it be treated as a separate element? If the club is going to be transferred to the tenants or the housing society, then it should be treated as an extension of the real estate unit rather than a separate element. However, if the real estate developer will own and operate the club, it should be treated as a separate element.

Conclusion

As discussed at several places in this article, there are too many loose ends and too many matters of conflict between the notified accounting standards and this Guidance Note. Some may argue that the Guidance Note is ultra vires the law. These matters need to be appropriately addressed by the ICAI. In the author’s view, an appropriate response would have been to participate in the standard-setting process of the IASB; particularly with respect to the development of the new IFRS standard on revenue recognition, which requires the application of the POCM on real estate contracts.

Nirav Shah

Reality Check in Implementing the Revised Schedule VI

Introduction

The Revised Schedule VI is applicable for the financial statements prepared for the periods commencing on or after 1 April, 2011. Since the year end for the majority of the Indian companies happens to be 31 March, the real impact of the changes brought out in the format of financial reporting in the form of Revised Schedule VI is going to be felt by the corporate world only now! By way of introducing the changes in the reporting format of the financial statements which was prevailing for several years and introducing new concepts and disclosure requirements, the Regulator has posed an onerous obligation on the finance professionals serving the Indian corporates to understand the nuances of the reporting requirements and extract the information required to ensure appropriate reporting and compliance. Though the Revised Schedule VI itself contains several explanatory provisions for the various new reporting requirements at a macro level, there are several matters which need to be micro managed and addressed carefully. The Institute of Chartered Accountants of India (ICAI) has issued a Guidance Note on the Revised Schedule VI providing implementation guidance on various aspects of the Revised Schedule VI. In view of the extent of the changes and the complications involved in applying the changed concepts in practical business scenarios, the first year of reporting under the Revised Schedule VI will throw several questions/ implementation issues. This article is aimed at discussing some of the implementation issues that may arise in presenting the financial statements as per the Revised Schedule VI and the suggested approach for dealing with the same.

Backbone of the Revised Schedule VI

The essence of the changes brought out by the Revised Schedule VI could be broadly summarised as under from a macro perspective:Changing the presentation of the financial statements in line with the expectations of the international investor community. ? Bringing in clarity/standardisation in the formats.
Making explicit that the requirements of the Companies Act, 1956 and the Accounting Standards would override the reporting requirements.
Introducing the robust concept of current and non-current classification of assets and liabilities. In the light of the above, several new disclosure requirements have been introduced and similarly some of the redundant disclosures have been omitted. It is quite obvious that the extent of additions is comparatively more than the disclosures which have been discarded. A careful analysis of the Revised Schedule VI would also highlight that the disclosures required now do not imply a simple representation of the figures but also a careful compilation of the various information with sound business knowledge.

Implementation challenges

Various implementation challenges arising out of the Revised Schedule VI could be broadly summarised under the following categories:

Issues relating to Applicability
Issues relating to Presentation
Issues relating to Interpretation of Concepts/ Terms
Other Issues

The above classification is intended for analysing the practical problems logically so as to better understand the issue and deal with the same. Needless to add that the issues identified are not exhaustive but representative only.

Issues relating to applicability

The issues that arise with respect to the applicability of the Revised Schedule VI are discussed below:

Applicability for the consolidated financial statements

As regards the applicability of the Revised Schedule VI for the consolidated financial statements, the current requirement of AS-21 stipulates that the consolidated financial statements have to be prepared in accordance with the format closer to the stand-alone financial statements. In this regard, since the standalone financial statements are expected to be prepared as per the Revised Schedule VI, it is but natural to prepare the consolidated financial statements also in accordance with the Revised Schedule VI requirements. However, to the extent the information is not relevant for meeting the AS- 21 requirements, the same need not be included. It is worth noting that the information as stipulated under the Revised Schedule VI relating to various subsidiaries including foreign subsidiaries needs to be obtained well in advance to facilitate the preparation of the consolidated financial statements.

Applicability for tax purposes

If a company has a reporting period which is different from the tax financial year which is based on April-March, there is a need for preparing a set of separate financial statements for the financial year to meet the tax requirements. There is an issue regarding the format to be used for such reporting in view of the changes made in the reporting format for the statutory accounts prepared under the Companies Act, 1956. Since there is no format prescribed as per the provisions of the Income-tax Act, 1961, the financial statements specifically compiled for the tax financial year may be prepared using the Revised Schedule VI to the extent feasible.

Applicability for Clause 41 of the Listing Agreement As regards presentation of the information for meeting the Clause 41 requirements with respect to the statement of assets and liabilities, the SEBI, recently vide its Circular No. CIR/CFD/DIL/4/2012 dated 16 April 2012, has introduced a new format for reporting the results for listed companies which is in line with the Revised Schedule VI.

Issues relating to presentation

The various issues related to presentation aspects in the Revised Schedule VI could be summarised as under:

Data relating to previous year to be provided for comparative purposes

The Revised Schedule VI stipulates that the corresponding amounts have to be provided in the financial statements for the immediately preceding reporting period for all items shown in the financial statements including notes. This would result in representing the previous year financial data as per the Revised Schedule VI which has introduced several new concepts/requirements. With respect to certain requirements where the information is not readily available with the company, suitable disclosures have to be made in the financial statements explaining the same along with the reasons. Further, wherever the previous year audited numbers are represented in accordance with the Revised Schedule VI requirements, it would be better to provide a detailed reconciliation of the reclassifications carried out for making them comparable with the current year presentation.

Cash Flow Statement presentation

The Revised Schedule VI does not stipulate any format for the Cash Flow Statement similar to that for the Balance Sheet and the State of Profit and Loss. This would imply that the Cash Flow Statement needs to be prepared based on the guidance provided in AS-3. Since majority of the companies would present the cash flow statement using the indirect method involving the derived movements between two Balance Sheets, for the purpose of presenting the movements of the previous year, the Balance Sheet of the year preceding the previous year is the starting base. If the cash flow movements have to be presented using the terminologies/principles stipulated as per the Revised Schedule VI (such as Trade receivables, trade payables with current and non-current break-ups, etc.), the exercise of identification/ regrouping of the relevant Balance Sheet items in the year preceding the previous year also needs to be carried out using the Revised Schedule VI in addition to the representation required for the previous year Balance Sheet.

Since there is no stipulated format for the Cash flow statements in the Revised Schedule VI, the possibility of presenting the Cash flow statements as per the terminologies used in AS-3 which may not be in line with the Revised Schedule VI terminologies may also be considered wherein the movements can be continued to be provided as in the case of the past for the current year as well as for the previous year.

Cash and Cash Equivalents

As per the Revised Schedule VI, Cash and Cash Equivalents have to be presented separately on the face of the Balance Sheet. Further, the term Cash and Cash Equivalents have been defined to include balance with banks, cheques and drafts on hand, cash on hand and others. However, the term cash and cash equivalent has been defined differently under AS-3 as per which, cash comprises cash on hand and demand deposits with banks and cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash and that are subject to an insignificant risk of changes in value. In addition, the deposits can be considered as Cash Equivalent only when the original maturity period for the same is less than 3 months. Since the Revised Schedule VI clearly indicates that in the case of conflict, an Accounting Standard would prevail over the Schedule, there is a need for using the definition as per the AS-3 for Cash and Cash Equivalents with suitable disclosures for the other component which would imply suitable modification of the terminologies used in the Balance Sheet for presenting the Cash and Bank Balances. This view has been confirmed by the Guidance Note on Revised Schedule VI issued by the ICAI as well.

Another view could also be taken that the term Cash and Cash Equivalents defined as per AS-3 is applicable only for Cash Flow Statement preparation purposes and not necessarily for other purposes, which would imply that the reporting requirements as the per Revised Schedule VI may be presented as intended in the Revised Schedule VI with a suitable disclosure relating to the break-up of the Cash and Cash Equivalents as per AS-3 (for cash flow tie up purposes) and other items.

Issues relating to interpretation of concepts/ terms

Identification of Current Element

The Balance Sheet format in the Revised Schedule VI has been designed on the basis of classified Balance Sheet approach and hence requires all assets and liabilities to be categorised into current and non- current. One has to remember that while doing the categorisation, the term current will also include the current portion of the long-term assets and liabilities. Further, categorisations of employee benefit-related liabilities, provisions as current and non-current would pose practical difficulties and the same need to be planned upfront.

As part of this exercise of categorisation of the Balance Sheet, while applying the concept of operating cycle, identification poses practical challenges. In general, the term operating cycle is considered as the time required between the acquisition of assets for processing and their realisation in cash or cash equivalents. If a company has different operating cycles for different parts of the business, then the classification of an asset as current is based on the normal operating cycle that is relevant to that particular asset. In cases where the normal operating cycle cannot be identified, it is assumed to have duration of 12 months.

Materiality threshold for disclosure

As per the Revised Schedule VI, separate disclosure is required on the face of the Statement of Profit and Loss for (i) cost of materials consumed, (ii) purchases of stock-in- trade and (iii) change in inventories of finished goods, work-in-progress and stock-in-trade. In this regard, details of consumption of raw materials, purchases and work-in- progress are required to be given under ‘broad heads’.

The term ‘broad heads’ has not been defined under the Revised Schedule and the same needs to be decided taking into account the concept of materiality and presentation of a true and fair view of the financial statements. Such identification of broad heads requires careful consideration and exercise of professional judgment. Considering the general practice, application of a threshold of 10% of total value of purchases of stock- in-trade, work-in-progress and consumption of raw materials can be considered as acceptable for determination of broad heads. However, nothing prevents a company in applying any other threshold as well, duly considering the concept of materiality and presentation of a true and fair view of the financial statements. This position has also been reiterated by the ICAI in its Guidance Note on Revised Schedule VI in Para 10.7.

Identification of Other Operating Revenue

Revised Schedule VI requires specific classification of revenue into sale of products, sale of services and other operating revenue. Interpretation of the term Other Operating Revenue as required under the Revised Schedule VI would pose challenges to companies. This has to be carefully identified and differentiated from Other Income. Whether a particular income constitutes ‘Other Operating Revenue’ or ‘Other Income’ is to be decided based on the facts of each case and a detailed understanding of the company’s activities.

The term Other Operating Revenue would include revenue arising from the company’s operating activities, i.e., either its principal or ancillary revenue-generating activities, but which is not revenue arising from the sale of products or rendering of services.

Goods in transit for individual inventory items
Revised Schedule VI stipulates that the items of inventories of goods in transit need to be disclosed separately for each and every item of the inventory such as raw material, work -in-progress, finished goods, etc. (if any).

Other issues

Impact on ratios calculated for banking arrangements

The definitions for the terms current assets and current liabilities as per the Revised Schedule VI could lead to redefining the current ratios computed by the management and submitted for various banking and other arrangements. Similarly, the extent of cash and cash equivalents as per the Revised Schedule VI could be different from the liquid assets computed for various other purposes.

I GAAP v. Ind AS

Though the Revised Schedule VI is not expecting any change in the measurement yardstick used for accounting and reporting the financial results, there could be practical challenges in dealing with some of the disclosure aspects as per the Revised Schedule VI. For example, the stock options cost charged to the Statement of Profit and Loss needs to be disclosed separately as per the Revised Schedule VI; however, at present there is no accounting standard which deals with the accounting aspects of stock options. However, the ICAI has issued a guidance note on the subject. This poses challenges since basic accounting for stock options cost is not mandatory, whereas the disclosure requirements relating to the same are made mandatory through the Revised Schedule VI. This confusion would continue till the relevant Ind AS dealing with the accounting aspects of stock options becomes mandatory. Similar issues could arise with respect to other items as well where there is no accounting standard governing the basic accounting aspects but there is a disclosure requirement in the Revised Schedule VI.

Change in accounting policy for dividend income received from subsidiaries

As per the old Schedule VI, the parent company had to recognise dividends declared by subsidiary companies even after the date of the Balance Sheet if it pertains to the period ending on or before the Balance Sheet date. However, there is no such requirement as per the Revised Schedule VI. Hence, in line with the Accounting Standard 9 on Revenue Recognition such dividends will have to be recognised now as income only when the right to receive dividends is established.

This would also require a suitable disclosure in the financial statements regarding the change in the accounting policy followed by the company with respect to recognition of such dividend income from subsidiaries.

It is worth noting that though the Revised Schedule VI requires the disclosure of the proposed dividend as part of the notes, in view of the specific provisions of AS-4 ‘Contingencies and Events Occurring After the Balance Sheet date’ which specifically requires adjustment of the proposed dividend in the Balance Sheet, companies need to continue to adjust the proposed dividend in the Balance Sheet, though the declaration by the shareholders is pending. Till such time AS-4 is amended, this position would continue in view of the supremacy of the accounting standards over the Revised Schedule VI which has been stated specifically in the Revised Schedule VI itself.

Position regarding AS-30/31/32

As per the current position AS-30, 31, 32 on Financial Instruments have not been notified under the Companies (Accounting Standards) Rules, 2006; hence, early application of these standards by a company is encouraged only subject to compliance of the of the other notified Accounting Standards such as AS-11, AS-13 and other applicable regulatory requirements which would prevail over AS-30, 31 and 32. If a company has early adopted Accounting Standards AS-30, 31 and 32, it could have challenges in presenting the financial statements as per the Revised Schedule VI.

For example, for an entity which has early adopted AS-30, 31, and 32, presentation of preference shares and determination of its status as liability or equity based on the economic substance could be an issue for dealing with the presentation requirements of Revised Schedule VI. This has been clarified by the ICAI vide its Guidance Note on Revised Schedule VI (Para 8.1.1.4) that since Accounting Standards AS-30 Financial Instruments: Recognition and Measurement, AS-31 and AS- 32 Financial Instruments: Disclosures are yet to be notified and section 85(1) of the Act refers to Preference Shares as a kind of share capital, Preference Shares will have to be classified as Share Capital.

Considering the above and the legal status of Accounting Standards AS-30, 31 and 32 which is recommendatory pending Notification by the Government, careful consideration has to be given with respect to the conflicts, if any, in the presentation between the same and the Revised Schedule VI which is part of the Companies Act, 1956.

Dealing with the requirements from other statutes
If there are any disclosure requirements which emanate from other statutes, the same needs to be provided in addition to the other disclosure requirements stipulated under Revised Schedule VI. For example, the disclosure requirements related to outstanding dues to micro small and medium enterprises should be disclosed in accordance with the Micro Small and Medium Enterprises Development Act, 2006. The same position would continue in the case of disclosures required under the Listing Agreements with the stock exchanges.

Conclusion

Introduction of the Revised Schedule VI is a path-breaking initiative for the Indian corporate world in the era of globalisation. The changes brought out in the financial reporting through the Revised Schedule VI cannot be considered as a simple exercise of representation of numbers in a different format, but requires careful consideration of various factors duly reflecting the business considerations and the investor expectations. There is no doubt that application of the Revised Schedule VI is intended to bring the disclosure requirements of the Indian corporate financial statements in line with the prevailing international practice. The Indian corporates are in the process of responding to the expectations of the Regulators swiftly by gearing themselves to adapt to the new environment of financial disclosures. In this process, there are bound to be various challenges and implementation issues and hence would naturally lead to enhanced learning/experience. By way of properly planning and navigating the financial reporting exercise with utmost care and attention, and taking best use of the available guidance, the implementation challenges can be well managed.

Nirav Shah

Ind AS 40 – Investment Property

Background

Current Indian GAAP provides limited guidance on accounting for investment properties under AS 13 Accounting for Investments. In order to converge the Indian Accounting Standards (Ind AS) with those under the International Financial Reporting Standards (IFRS), Ind AS 40 has been issued. Ind AS 40 will become applicable as and when Ind AS are notified.

Scope and definitions

Ind AS 40 provides guidance with respect to recognition, measurement and disclosure of investment property. It also provides detailed guidance on transfer to/from and disposals of investment property. Ind AS 40 specifically excludes below mentioned assets from its scope, as the relevant guidance relating to these assets is covered under other accounting standards:

• Biological assets (Ind AS 41 – Agriculture)

• Mineral rights and mineral reserves such as oil, natural gas and similar non-regenerative resources. This standard could be applied to measurement in lessee’s or lessor’s financial statements depending on certain specified conditions.

But Ind AS 40 does not deal with matters covered under Ind AS 17 – Leases like classification of leases, recognition of lease income, accounting for sale and leaseback transactions etc. Definitions Investment property is property (land or a building— or part of a building—or both) held (by the owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both, rather than for:

(a) use in the production or supply of goods or services or for administrative purposes; or

(b) sale in the ordinary course of business. Thus the classification depends on the use of the property. Owner-occupied property is property held (by the owner or by the lessee under a finance lease) for use in the production or supply of goods or services or for administrative purposes. Recognition Investment property is recognised as an asset only when both the following conditions are met:

• It is probable that the future economic benefits that are associated with the investment property will flow to the entity; and

• the cost of the investment property can be measured reliably. The above criteria are applied to all properties irrespective of whether the costs are incurred towards the property in the initial phase or subsequent phases. Measurement Initial measurement An investment property shall be measured initially at cost. Transaction costs which are directly attributable for preparing the asset for its intended use will form part of its initial cost. For example, property taxes, legal fees etc.

The principles are same as would be applied to determine the cost of asset under Ind AS 16 Property, Plant and Equipment (PPE). Maintaining consistency with Ind AS 16, abnormal amounts of inefficiencies incurred and initial operating losses incurred will not form part of the cost of the asset and will be expensed off as incurred. In case of acquisition of investment property on deferred payment terms, the investment property would be recognised, based on its current cash price equivalent. The difference between the current cash price equivalent and the deferred payment terms would be recognised as finance cost over the term of the deferred payment term.

Borrowing costs directly attributable to the acquisition, construction or development of an investment property that is a qualifying asset shall be capitalised in accordance with Ind AS 23 Borrowing Costs. The initial cost of a property interest held under a lease and classified as an investment property shall be as prescribed for a finance lease under paragraph 20 of Ind AS 17, i.e., the asset shall be recognised at the lower of the fair value of the property and the present value of the minimum lease payments. An equivalent amount shall be recognised as a liability as prescribed under Ind AS 17.

Subsequent measurement

Unlike IAS 40 which permits both cost and fair value model after initial recognition, Ind AS 40 does not provide such an accounting policy choice after initial recognition under Ind AS 40. Ind AS 40 permits application of only the cost model.

The cost model is similar to that prescribed under Ind AS 16 for Property, Plant and Equipment i.e. at cost less accumulated depreciation less accumulated impairment losses. Only if the asset is classified as held for sale, the same would be valued in accordance with Ind AS 105 Non-current Assets Held for Sale and Discontinued Operations i.e. at fair value. While initial recognition and subsequent measurement is at cost, an entity is required to disclose the fair value of the investment property.

Fair value determination

Fair value is the price at which the investment property could be exchanged between knowledgeable, willing parties in an arm’s length transaction. It should reflect the market conditions at the end of the reporting period and does not consider any transaction costs it may incur on sale or disposal. It also does not reflect future capital expenditure that will improve or enhance the value of the property.

It is best evidenced by current prices in an active market for similar properties in the same location and subject to similar terms of the contract. If information pertaining to similar term contracts is not available, then the value of such properties should be adjusted to reflect the differences in the contracts.

Transfers

Although an entity’s business model plays a key role in the initial classification of property, the subsequent reclassification of property is based on an actual change in use rather than on changes in an entity’s intentions. Transfers to and from investment property can be made only when there is change in use which has to be evidenced by:

• commencement of owner-occupation, for a transfer from investment property to owner-occupied property;

• commencement of development with a view to sell, for a transfer from investment property to inventories;

• end of owner-occupation, for a transfer from owner-occupied property to investment property; or

• commencement of an operating lease to another party, for a transfer from inventories to investment property.

As such, the subsequent reclassification is based on actual change in use and not just the intentions of the entity.

For example, Company S owns a site that is an investment property. S decides to modernise the site and sell it. The investment property is transferred to inventory at the date of commencement of the redevelopment of the site that evidences the change in use. However, a decision to dispose of an investment property without redevelopment does not result in it being reclassified as inventory. The property continues to be classified as investment property until the time of disposal unless it is classified as held for sale.
Let us take another example where Company G which previously classified a property as an investment property has now decided to use the property as its administrative headquarters due to an expansion of its business, and commences redevelopment for own use in February 2013 (e.g. builders are on site carrying out the construction work on G’s behalf). In this case, the redevelopment of the property for future use for administrative purposes effectively constitutes owner occupation. Therefore, G should reclassify the property to owner occupied property on commencement of the redevelopment in February 2013.

Transfers between investment property, owner-occupied property and inventories do not change the carrying amount of the property transferred and they do not change the cost of that property for measurement or disclosure purposes. In other words, transfers happen at the carrying amount. For example, if an investment property of Rs. 100,000 depreciated @ 10% SLM is transferred to inventory at the end of 3 years, the same will be transferred to inventory at Rs. 70,000 i.e., the carrying amount of investment property at the end of 3 years.

Disposals
The investment property shall be derecognised i.e. eliminated from the financial statements on disposal, providing an asset under finance lease or when it is permanently withdrawn from use and no future economic benefits are expected from its disposal. The criteria and guidance given in Ind AS 18 Revenue would be applied to determine the date of disposal, whereas Ind AS 17 would be applied in case the disposal is by way of finance lease or sale and leaseback.

Gains or losses resulting from difference in net sales proceeds and the carrying value of investment property will be recognised in profit or loss in the period in which the property is disposed or retired. In case the sales proceeds are deferred, the consideration receivable will have to be discounted to its present value and the difference would be recognised as finance income over the period of credit.

Practical issues

Classification issues
Determining what is or what is not investment property may raise practical issues, some examples of which are given below:

Subsequent cost
Subsequent costs of day-to-day servicing and maintaining a property are expensed as incurred and cannot be capitalised. But where statutory/fregulatory approvals are required to be obtained and any expenses incurred during the period required to get such approvals shall be capitalised as the property cannot be put to intended use till such time that the approvals are obtained.

Equipments and furnishings
Equipments and furniture and fittings that are physically attached to the building will be considered as integral part of the building and will not be accounted for separately. For example, lifts, escalators, air conditioning units etc., will all be considered as part of investment property. In case of movable property, the same would get accounted separately as PPE in accordance with Ind AS 16. In such cases, care must be taken while disclosing the fair value of the investment property, so that it does not include the fair value of moveable property that has been accounted for separately, otherwise it will be misleading.

Inventory vs. Investment Property
The entity’s intention regarding the property is a primary criteria for classification. Property held for short-term sale would be classified as inventory whereas the one held for long-term purposes would generally get classified under investment property. For example, if a builder acquires bare land with intention to construct buildings and sell them, the land would be classified as inventory because it is an asset held in the process of production for sale. However, if the company has brought land with no specific use in mind, then it gets classified as investment property. (Eg: Financial institution acquires a property as full and final settlement of loan given and is uncertain about its intention). In case a developer of the property holds a completed developed property and intends to rent the same, he could classify the same as investment property instead of classifying it as inventory.

Consolidated and separate financial statements
A property may also get classified differently in consolidated and separate financial statements of an entity. For example, when a holding company leases building to its subsidiary which uses the same as its administrative office, the property could be classified as investment property in the books of the holding company but would be classified as PPE in the Consolidated Financial Statements (CFS).

Dual-use property
Wherein a property could be used for dual purposes, say for own use and other for renting out, a portion of dual property can be classified as investment property, only if the portion could be sold separately. When a portion of the property can not be sold separately, the entire property is classified as investment property only if the portion of the property held for own use is insignificant. For example, Company X owns an office block and uses 3 floors as its own office; the remaining 12 floors are leased out to tenants on operating lease. Under the local laws, X could sell legal title to the 12 floors, while retaining legal title to the other 3 floors. In this case, the 12 floors would be classified as investment property.

Ancillary services
In case where the owner of the property provides ancillary services, the key factor in determining whether the same should be classified as investment property is its relative insignificance to the entire arrangement.

But in case of hotels, ancillary services would be considered as significant part and an owner-managed hotel would be regarded as owner-occupied property instead of investment property, as the property is used to a significant extent for the supply of goods and services. In case where the owner of the hotel is just a passive investor and the management function and provision of services is carried out by a third party and the owner is not exposed to variations in cash flow from the operations of the hotel, the same will be treated as investment property. As such, judgment is required in determining the classification of the property in case of different scenarios. An entity should assess on a case-to-case basis whether the arrangement is more like an example of owner-managed hotel (not investment property) or an example of office building with security services provided by the owner (investment property).

Even in case of classification of business centres, some of them which provide high level services such as secretarial support, teleconferencing and other computer facilities and where tenants sign relatively short term leases, the facilities provided are more in the nature of owner-managed hotel and hence should not be classified as investment property. In other cases where the owner provides just the basic furnishing and users are required to sign up for a minimum period, the same could be treated as investment property.

Disclosures
An entity is required to disclose the following:
•   accounting policy for measurement.
•   when classification is difficult, the criteria it uses to distinguish investment property from owner-occupied property and from property held for sale in the ordinary course of business.
•   the methods and significant assumptions applied in determining the fair value of investment property.
•   the extent to which FV is based on valuation by professional independent valuer; if not, such fact should be disclosed.
•   amounts recognised in profit or loss for rental income, direct operating expenses that generated as well as those that did not generate rental income.
•   the existence and amounts of restrictions on the realisability of investment property or the remittance of income and proceeds of disposal.
•   contractual obligations to purchase, construct or develop investment property or for repairs, maintenance or enhancements.
•   Depreciation method and useful life or rate of depreciation.
•   Gross carrying amount and accumulated depreciation at beginning and end of reporting period.
•   Reconciliation of carrying amount of investment property at the beginning and end of the period.
•   Impairment losses recognised or reversed.
•   Exchange differences.
•   Transfers to and from inventories and owner-occupied property.
•   Assets classified as held for sale.
•   Other changes.

Conclusion
This accounting standard prescribes accounting for investment property and the related disclosure requirements. It gives detailed guidance on the classification, recognition and measurement of investment properties. The guidance requires the measurement of the investment property using the cost model similar to measurement of PPE under Ind AS 16. It also gives guidance on transfers to and from investment property and states that these can be made only when there has been a change in the use of the property.

Judgment would be required on case to case basis to classify the property as investment property especially in cases of ancillary use or dual-use of the property.

Nirav Shah

Financial Statement Disclo sures — How Much is Too Much

Now that the IASB and the FASB’s joint projects are making steady progress in addressing key accounting areas, the two Boards are spending more time at the conceptual issues such as the presentation and disclosure in the financial statements. Earlier this year, the IASB hosted a public forum to brainstorm the topic while the FASB discussed a summary of the responses to its discussion paper on the disclosure framework.

Over the last five years, the size of annual reports of companies has increased substantially. One of the reasons attributed to the global financial crisis was the off-balance sheet exposures and the lack of adequate disclosures in the financial statements relating to these exposures by the companies. This pushed regulators, standard-setters, auditors, preparers and users of the financial statements alike in working overtime to bulge the size of companies’ annual reports without much deliberation around the usefulness of enhanced disclosures or their potential implications on loss of more relevant information among the resultant disclosure ‘noise’ in the financial statements.

Soon after, the solution began to emerge itself as a problem as preparers and auditors started feeling the burden of complying with these additional reporting requirements. Many organisations were forced to expand their financial reporting teams manifold to cope with the exhaustive data collection and analyses and to upgrade their financial reporting systems. This strain pushed forward the momentum around the Boards’ respective projects addressing the presentation and disclosure and is now creating a lot of traction among those affected.

As the participants from Africa, Asia, Europe and North America continue to debate possible solutions to the issue through the IASB and FASB forums, a message that has come out loud and clear is that while the preparers think there is too much required to disclose, users, on the other side, are suffering from information indigestion. There is a lot served, but of that there is very little that’s palatable. Much of the relevant information intended to address the needs of the key stakeholders is lost in this disclosure overload. However, if the constitution of the participants is to go by, the message is crystal clear that it’s the preparers who see this as a larger issue than users of the financial statements.

There are several ideas being mulled to achieve disclosure effectiveness, as there is also a scepticism around the practicability of these ideas. Some of these are:

• Materiality – How can this be applied to qualitative disclosures

• Principles-based guidance – Is it possible to have a single source of principles-based guidance providing conceptual framework for all disclosures

• Purpose and relevance – Is it possible to provide a ‘one-size-fits-all’ definition of purpose and/or relevance of the disclosure requirements

• Offer flexibility – Move away from the words such as ‘shall’ or ‘at a minimum’ from the disclosure requirements in the existing standards; let the preparers use discretion in deciding what’s relevant for their business

• Avoid overlap – There are areas requiring disclosures in the Management Discussion & Analysis (the front half) and also within the financial statements (the back half) of an annual report. A cross-reference mechanism may be developed to avoid repetition.

There is a high degree of engagement on this issue indicating wider approval to the disclosure framework project but a near unanimous view is that there isn’t going to be an easy fix to the disclosure problem.

The key challenges expected at this stage are:

• Finding the right balance to cater to all users with different needs

• Alignment with the overall financial statement conceptual framework

• Legal, institutional barriers

• Disclose more, not less – the cost of a disclosure failure is high

The debate continues but things seem to be moving in the right direction. The problem has been diagnosed; a solution will follow in due course. Standard-setters will need to work with regulators and other bodies who have a say in imposing the disclosure requirements and expand their outreach efforts to be able to cut the clutter effectively from financial statements without losing relevance and effectiveness from the disclosures. Let’s do our bit by getting involved in these discussions and work towards achieving a better world of financial reporting.

Thought to munch – There are so many of us who cannot find enough time to read an interesting book that’s more than 200 pages long. For an annual report with more than 200 pages!! Any takers?

levitra

Nirav Shah

REVISED REPORTING REQUIREMENTS FOR AUDIT OF FINANCIAL STATEMENTS

Introduction

An audit report is an opinion of an auditor regarding entity’s financial statements. It is the conclusion of an audit of financial statements is the audit report. It is only through the audit report that the statutory auditor communicates about the audit procedures followed, the auditing framework followed and whether the financial statements on which the report is given depicts a ‘True and Fair’ view.

The Institute of Chartered Accountants of India (ICAI) has promulgated several standards for the conduct of audit and reporting. The SAs are divided into 2 groups:

a) Standards on Quality Control (SQC) (which apply at the firm level) and

b) Standards on Audit (SA) which apply to audits of historical financial information. SAs are further categorised as standards dealing with:

i) G eneral principles and responsibilities (issued under 200 series);

ii) Risk assessment and response to assessed risks (issued under 300 and 400 series);

iii) Audit evidence (issued under 500 series);

iv) Using work of others (issued under 600 series);

v) Audit conclusions and reporting (issued under 700 series) and

vi) Specialised areas (issued under 800 series).

ICAI had issued a new set of SAs (under 700 series) which were to be applied for audits for financial statements for the period on or after 1st April 2011. However, in view of inadequate dissemination of information about the applicability of the series 700 SAs and consequent unawareness of the same, the applicability was postponed by ICAI for audits for financial statements for the period on or after 1st April 2012. Thus, audit reports for audits conducted for the financial year 2012-13 would be the first year of applicability of the series 700 SAs. ICAI has also issued “Implementation guide on Reporting Standards” to address the concerns, apprehensions and difficulties in relation to implementation of the new reporting standards.

This article discusses the Standards on Audit Conclusions and Reporting issued under 700 series.

The new SAs are listed as under:

SAs apply to audits of general purpose financial statements (GPFS). They do not apply to engagements other than audits, where the procedures performed are ‘reviews’ or ‘compilations’ or ‘agreedupon- procedures’. GPFS generally consist of balance sheet, statement of profit and loss (or income statement), cash flow statement, significant accounting policies and notes and where applicable, statement of changes in equity.

GPFS are Financial Statements are FS prepared in accordance with a Financial Reporting Framework (FRF) and is designed to meet common financial information needs of a wide range of users. The FRF may be a ‘fair presentation framework’ or a ‘compliance framework’. Broad differences between these two frameworks are given in the Table 1.

A question which arises is that apart from audit reports of companies, whether these SAs would also apply to reports issued under the Income Tax Act, 1961 (e.g. tax audit report issued in Form 3CB)? As mentioned in 6 above, SAs apply to audits of GPFS – hence if the financial statements for which the report is issued in Form 3CB, are GPFS, then these SAs would also apply for such reporting. Para 3.4 of the Preface to the Statements of Accounting Standards issued by ICAI in 2004 states that “the term ‘General Purpose Financial Statements’ includes balance sheet, statement of profit and loss, 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…”

Further, footnote 9 to SA 800 ‘Special Considerations – Audits of Financial Statements Prepared in accordance with Special Purpose Frameworks’ states that “In India, financial statements prepared for filing with income tax authorities are considered to be general purpose financial statements”.

In view of this specific assertion from ICAI, the audit report format prescribed by SA 700(R), SA 705, SA 706 and SA 710(R) would also apply to reports issued in Form 3CB under the Income Tax Act, 1961.

The ‘Financial Reporting Framework’ (FRF) is not defined in SA 700(R). However, para 22 of SA 700 (AAS 28) mentions: “Paragraph 3 of “Framework of Statements on Standard Auditing Practices and Guidance Notes on Related Services”, issued by the ICAI, discusses the financial reporting framework. It states: “ ….Thus, FS need to be prepared in accordance with one, or a combination of:

(a) Relevant statutory requirements, e.g., the Companies Act, 1956,

(b) Accounting Standards issued by ICAI; and

(c) Other recognised accounting principles and practices, e.g., those recommended in the Guidance Notes issued by the ICAI” (emphasis supplied)

The above Framework issued in 2001 has been withdrawn pursuant to the revised “Framework for Assurance Engagements” applicable from April 1, 2008. The revised framework does not define ‘Financial Reporting Framework’. Due to this, does it imply that the other recognised accounting principles and practices, e.g., those recommended in the Guidance Notes (GN) issued by the ICAI will not form part of FRF? ICAI needs to clarify this, since, if the GNs issued by ICAI do not form part of FRF, the very mandatory nature of these GN for members of ICAI comes in doubt.

SA 700(R) requires an auditor to form an opinion on whether the FS are prepared in all material respects in accordance with the applicable FRF. To form that opinion, the auditor has to conclude, whether reasonable assurance has been obtained that the FS as a whole are free from material misstatement, whether due to fraud or error. In order to come to such conclusion the auditor shall need to take into account the following:

i) whether Sufficient Appropriate Audit Evidence (SAAE) has been obtained in accordance with SA 330 ‘Standard on the Auditor’s Responses to Assessed Risks’;

ii) whether uncorrected misstatements are material, individually or in aggregate in accordance with SA 450 ‘Standard on Evaluation of mis-statements identified during the Audit’;

iii) other required evaluations related to selection, consistent application and disclosure of the significant accounting policies and reasonability of accounting estimates by management; and

iv) In case of fair presentation framework, evaluation to also include whether FS achieve fair presentation.

SA 700(R) requires that the auditor expresses an unmodified opinion if he concludes that the FS are prepared, in all material respects, in accordance with the applicable FRF. The auditor has to, however, give a modified opinion in two situations:

i) When the auditor has obtained SAAE but he concludes that the FS taken as a whole are not free from material misstatement(s); or

ii) When he is unable to obtain SAAE.

In either of the above situations the auditor must give a modified opinion as per SA 705.

In case of reporting under fair presentation frame-work, if the auditor concludes that the fair presentation is not achieved, he should discuss the matter with the management to resolve the issue and based on the outcome, decide whether he should give a modified opinion or not.

As per the SA 700(R), the auditor’s report has to be in writing and should include the following:

Title

The title of an auditor’s report should clearly indicate that it is the report of an independent auditor like “Independent Auditor’s Report”. Unlike the earlier title ‘Auditor’s Report’ this title makes it very implicit that independence is one of the important considerations while doing the audit.

Addressee

The report should be addressed to those for whom it is prepared in line with the existing requirement. Typically, it is addressed to ‘the shareholders’ or ‘the members’ in case of the statutory audit under the Companies Act, 1956 or to the Board of Directors in case of Consolidated Financial Statements (CFS).

Introductory Paragraph

In this paragraph apart from identifying the entity, the title of each statements comprised in the FS and the period covered by each of the statements, a specific reference has to be made to the summary of significant accounting policies and other explanatory information given in the FS. The following illustration is given in the Appendix of the Standard:
“We have audited the accompanying financial statements of ABC Ltd, which comprise the Balance Sheet as at March 31, 20XX, and the Statement of Profit and Loss for the year then ended, and a summary of significant accounting policies and other explanatory information”.

Management’s Responsibility Paragraph

The SA requires the Auditor to describe, under a separate paragraph with heading ‘Management’s Responsibility for the financial statements’ that the management (or those charged with governance) is responsible:

• for the preparation of FS in accordance with the applicable FRF; and

• for the design, implementation and maintenance of the internal controls relevant to the preparation of FS which are free from material misstatement, whether due to fraud or error.

In cases where FS are prepared in accordance with a fair presentation framework, the report should refer to “the preparation and fair presentation of these FS” or “the preparation of FS that give a true and fair view”.

Auditor’s Responsibility Paragraph

The SA requires the report to state the following:

i) that the responsibility of the auditor is to express an opinion on the FS based on the audit;

ii) that audit was conducted in accordance with Standards on Auditing issued by ICAI and that these SAs require the auditor to:

• Comply with ethical requirements;

• Plan and perform the audit to obtain reasonable assurance about whether the FS are free from material misstatement.

The report should also describe an audit by stating that:

• An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the FS;

• The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the FS, whether due to fraud or error.

• In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation of the financial statements in order to design audit procedures that are appropriate in the circumstances,

An audit also includes evaluation of Appropriateness of accounting policies used and Reasonableness of management’s accounting estimates; and

Overall presentation of FS

i) Where the FS are prepared in accordance with a fair presentation framework, the description of the audit in the auditor’s report shall refer to “the entity’s preparation of FS that give True & Fair view”

ii) The auditor’s report should also state whether the auditor believes that he has obtained SAAE to provide a basis for his opinion.

Auditor’s Opinion Paragraph

The SA requires the expression of opinion as under:

Unmodified opinion expressed

In case of Fair Presentation framework:

FS present fairly, in all material respects, in accordance with {applicable FRF}

FS give a True & Fair view of in accordance with [applicable FRF]

The SA gives an illustration of an unmodified opinion in case of fair presentation framework under Companies Act, 1956 as under:

“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 Companies Act, 1956, in the manner so required and give a true & fair view of the financial position of ABC Ltd. As at March 31, 20xx and of its financial performance and its cash flows for the year then ended, in accordance with accounting standards referred to in section 211(3C) of the said Act”.

In case of Compliance framework:

FS are prepared, in all material respects, in accordance with [applicable FRF]

Other Reporting Responsibilities Paragraph

The SA mentions that sometimes the auditor is also required to report on other matters that are supplementary to the auditor’s responsibility to report on the financial statements. For example, report on additional specified procedures or to express an opinion on specific matters or under the relevant law or regulation. The SA provides that if the auditor addresses other reporting responsibilities in the auditor’s report on the FS that are in addition to the auditor’s responsibility under the SAs to report on the FS, they shall be addressed in a separate section in the auditor’s report that shall be sub-titled “Report on Other Legal and Regulatory Requirements,” or otherwise as appropriate to the content of the section. For e.g. reporting under CARO or for NBFCs as required by RBI, etc.. Unlike the current practice where different practices were being followed with reference to such reporting, SA 700(R) requires the same to be reported under a specific heading.

Signature

The Audit Report has to be signed in the auditor’s personal name and where a firm is appointed as auditor, report shall be signed in personal name and in name of audit firm. The report has to also mention membership number issued by ICAI and wherever applicable, the registration number of the firm, allotted by the ICAI.

Though it apparently appears from the SA that the signatures need to be in individual as well as in the name of the firm, the implementation guide to SA 700(R) issued by ICAI in Question 21 mentions that “the intention of the SA is not to have 2 separate signatures, one in personal name and one in firm name, but that the partner signing should sign in his personal name for and on behalf of the firm which has been appointed as the auditor with the name and registration number of the firm also mentioned as signatory”.

Date of Auditor’s Report

The SA mentions that the audit report cannot be dated earlier than the date on which auditor has obtained SAAE on which the auditor’s opinion is based. This is to inform users of the FS that the auditor has considered effect of events and transactions that have occurred upto that date.

Place of Signature

The SA requires that the auditor’s report has to specify location, which is ordinarily the city where the audit report is signed. Thus, in a case where the report is signed in a city other that the one where the Board has adopted the FS, the name of the city where the directors sign would be different from that where the auditor signs the report.

The SA mentions that the wording of an auditor’s report may sometimes be prescribed by the law or regulation applicable to the client. If the prescribed terms are significantly different from the requirements of SAs, SA 210 ‘Agreeing the Terms of Audit Engagement’ requires the auditor to evaluate:

• whether users might misunderstand the assurance obtained from the audit, and if so,

• whether providing additional explanation in the auditor’s report can mitigate such misunderstanding.

SA 705 – Modifications to the opinion in the Independent Auditor’s Report

SA 705 deals with the auditor’s responsibility to issue an appropriate report in circumstances when, in forming an opinion in accordance with SA 700(R), the auditor concludes that a modification to the auditor’s opinion on the financial statements is necessary.

SA 705 describes 3 types of modified opinions: (i) Qualified Opinion, (ii) Adverse Opinion and (iii) Disclaimer of Opinion

The decision on which type of modified opinion is appropriate depends on:

a) Nature of matter giving rise to the modification i.e. whether the FS are materially misstated or in case of inability to obtain SAAE maybe materially misstated; and

b) Auditor’s judgement about the pervasiveness of the effects or possible effects of the matter on the FS.

The SA mentions the circumstances when modification to opinion is required. It states that if the auditor concludes that based on the audit evidence obtained, the FS as a whole are not free from mate-rial misstatement, he can issued a modified report. This may be due to:

• Inappropriateness of the selected accounting policies:

Accounting Policies not consistent with applicable FRF;

FS do not represent underlying transactions and events in a manner that achieves fair presentation;

• Inappropriateness of adequacy of disclosures in FS

FS do not include all disclosures required by applicable FRF;

Disclosures not presented as per applicable FRF;

FS do not contain disclosures necessary to achieve fair presentation

• Inability to obtain SAAE

Circumstances beyond control of entity; (e.g. records destroyed or seized by authorities)

Circumstances relating to nature of timing of auditor’s work; (e.g. timing such that physical inventory cannot be taken )

Limitations imposed by management (e.g. auditors prevented from obtaining external confirmations, etc.)

SA 705 lays down as under the criteria for deter-mining the type of modification which are given in Table 2:

The SA mentions that ‘pervasive’ effects are those that, in the auditor’s judgment:

• Are not confined to specific elements, accounts or items of the FS;

• If so confined, represent or could represent a substantial proportion of the FS

• In relation to disclosures, are fundamental to users’ understanding of the FS.

The SA requires the auditor to disclaim an opinion when, in extremely rare circumstances involving multiple uncertainties, the auditor concludes that, notwithstanding having obtained SAAE regarding each of the individual uncertainties, it is not possible to form an opinion on the FS due to the potential interaction of the uncertainties and their possible cumulative effect on the FS.

SA 705 also gives the form and content of Auditor’s Report in case of Modified Opinion. It requires that

i) In addition to other elements as per SA 700(R), the Auditor’s Responsibility statement is to be amended to provide description of matter giving rise to modification;

ii) The placement of the same is immediately before the Opinion para with the heading “Basis for Modified Opinion”

iii) The contents of the ‘Basis of Modification Para’ dependon the cause of modification.. The same are given in Table 3

SA 705 requires a Qualified Opinion to be given as:

“Except for the effects of the matter(s) described in the ‘Basis for qualified opinion para’’

• In case of Fair Presentation framework:

The FS present fairly, in all material respects (or give a true and fair view) in accordance with the [applicable FRF]

• In case of Compliance framework:

The FS have been prepared, in all material respects in accordance with the {applicable FRF}”.

SA 705 requires an Adverse Opinion to be given as:

“In the auditor’s opinion, because of the significance of the matter(s) described in the ‘Basis of Adverse Opinion para’,

• In case of Fair Presentation framework: “The FS do not present fairly, in all material respects (or give a true and fair view) in accordance with the [applicable FRF]”.

• In case of Compliance framework: “The FS have not been prepared, in all material respects in accordance with the [applicable FRF]”.

SA 705 requires a Disclaimer of Opinion to be given as:

“Because of the significance of the matter(s) described in the ‘Basis for Disclaimer of Opinion para’, the auditor has not been able to obtain SAAE to provide a basis for an audit opinion and accordingly, the auditor does not express an opinion on the FS.”

The SA also requires description of auditor’s responsibility to be amended when the auditor expresses a qualified or adverse opinion. In such cases, the description of the auditor’s responsibility has to be amended to state that the auditor believes that he has obtained SAAE to provide a basis for his modified audit opinion.

In case, the auditor has disclaimed an Opinion, he has to amend the introductory paragraph of the auditor’s report to state that he was engaged to audit the FS and amend the description of the auditor’s responsibility. The same should be as under:

“Because of the matter(s) described in the Basis for Disclaimer of Opinion paragraph, we were not able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion”

SA 706 – Emphasis of Matter (EOM) paragraph and Other Matter (OM) paragraph in the Independent Auditor’s Report

SA 706 deals with additional communication in the Auditor’s Report when auditor considers necessary to draw user’s attention to:

• Matter(s) presented or disclosed in FS are of such importance that they are fundamental to user’s understanding of FS

• Matter(s) other than those presented or disclosed in FS that are relevant to user’s understanding of audit or auditor’s responsibilities or audit report

SA 706 has laid down the following requirements with respect to EOM para:

• Auditor should obtain SAAE evidence that the matter is not materially misstated in the FS;

• EOM para shall refer only to information presented or disclosed in the FS;

• Widespread use of EOM para diminishes the effectiveness of the auditor’s communication of such matters, by implying that matter has not been appropriately presented or disclosed in FS;

• It is to be placed immediately after Opinion para.

The SA requires that the EOM para must include a clear reference to the matter being emphasized, where the relevant disclosures that fully describe the matter can be found in FS and indicate that the audit opinion is not modified in respect of matter emphasized. An EOM para is to be included in the Auditor’s Report in the following circumstances:

• An uncertainty relating to the future outcome of an exceptional litigation or regulatory action;

• Early application (where permitted) of a new accounting standard that has a pervasive effect on the FS in advance of its effective date;

• A major catastrophe that has had, or continues to have, a significant effect on the entity’s financial position.

As per the SA, if the auditor considers it necessary to communicate a matter other than those that are presented or disclosed in the FS that, in the auditor’s judgment, is relevant to users’ understanding of the audit, the auditor’s responsibilities or the auditor’s report and this is not prohibited by law or regulation, he shall do so in a paragraph in the auditor’s report, with the heading “Other Matter”, or other appropriate heading. This paragraph is placed immediately after the Opinion paragraph and any EOM paragraph.

SA 710(R) – Comparative Information – Corresponding Figures and Comparative Financial Statements

SA 710(R) deals with the auditor’s responsibilities regarding comparative information in an audit of financial statements. The nature of the comparative information that is presented in an entity’s FS depends on the requirements of the applicable FRF.

SA 710(R) mentions that there are two broad approaches to the auditor’s reporting responsibilities in respect of comparative information: (a) Corresponding Figures; and (b) Comparative Financial Statements.

The approach to be adopted is often specified by law or regulation or in the terms of engagement. SA710 (R) addresses separately the auditor’s reporting requirements for each approach.

SA 710(R) requires the auditor to determine whether FS include the comparative information required by the applicable FRF and whether such information is appropriately classified. For this purpose, the auditor has to evaluate whether:

a) The comparative information agrees with the amounts and other disclosures presented in the prior period; and
b) The accounting policies reflected in the comparative information are consistent with those applied in the current period or, if there have been changes in accounting policies, whether those changes have been properly accounted for and adequately presented and disclosed.

If the auditor becomes aware of a possible material misstatement in the comparative information while performing the current period audit, the auditor has to perform such additional audit procedures as are necessary in the circumstances to obtain SAAE evidence to determine whether a material misstatement exists.

The SA requires that when corresponding figures are presented, the auditor’s opinion shall not refer to the corresponding figures except in the circumstances described as under:

i) If the auditor’s report on the prior period, as previously issued, included a qualified opinion, a disclaimer of opinion, or an adverse opinion and the matter which gave rise to the modification is unresolved, the auditor shall modify the auditor’s opinion on the current period’s financial statements. In such cases, in the ‘Basis for Modification’ paragraph in the auditor’s report, the auditor shall either:

• Refer to both the current period’s figures and the corresponding figures in the description of the matter giving rise to the modification when the effects or possible effects of the matter on the current period’s figures are material;

• In other cases, explain that the audit opinion has been modified because of the effects or possible effects of the unresolved matter on the comparability of the current period’s figures and the corresponding figures

ii) If the auditor obtains audit evidence that a material misstatement exists in the prior period FS on which an unmodified opinion has been previously issued, the auditor has to verify whether the misstatement has been dealt with as required under the applicable FRF and, if that is not the case, the auditor shall express a qualified opinion or an adverse opinion in the auditor’s report on the current period FS, modified with respect to the corresponding figures included therein.

iii) If FS of prior period were audited by a predecessor auditor, and the auditor is allowed and decides to refer to the predecessor auditor’s report for the corresponding figures, then the auditor shall state in an OM para that the FS of the prior period were audited by the predecessor auditor, the type of opinion expressed by him along with the reasons for the same and the date of that report.

iv) If the FS of prior period were not audited, the auditor has to state in an OM para that the corresponding figures are unaudited. However, it will not relieve the auditor from obtaining SAAE that the opening balances do not contain material misstatements that materially affect current period’s FS.

The SA also requires that when comparative financial statements are presented, the auditor’s opinion shall refer to each period for which financial statements are presented and on which an audit opinion is expressed.

As per the SA, when reporting on prior period FS in connection with the current period’s audit, if the auditor’s opinion on such prior period FS differs from the opinion the auditor previously expressed, the auditor will have to disclose the substantive reasons for the different opinion in an OM paragraph in accordance with SA 706. In case, however, the FS of prior period were audited by a predecessor auditor, the requirements as prescribed above in point 39 (iii) will apply, whereas if the FS of prior period were not audited, the requirements as prescribed above in point 40(iv) will apply.

What’s new in the revised audit report formats? The revised formats of audit reports given in the SAsare very specific formats for issuing unmodified reports [SA 700(R)], modified reports (SA 705) and giving Emphasis of Matter paragraphs in the audit reports (SA 706). Unlike current audit reports, where diverse practices were being followed in giving modified reports or giving emphasis of matter, the positioning of the various paras are also specifically mentioned in these SAs. This would make audit reports uniform across different audit firms and also achieve better comparability.

Conclusion

As can be seen from the above, the audit report will undergo a substantial change for audits for periods beginning on or after April 1, 2012. The new format of the report is very different from the old format and will require auditors to spend more time in redrafting their reports to be in line with SA 700(R), SA 705, SA 706 and SA 710(R). The specific elements as required by the revised report, should also, hope-fully, make reading and understanding reports easier for shareholders and analysts and have a better appreciate the role of auditors.

Nirav Shah

External Confirmations – Proving Existence with External Evidence?

Audit evidence is considered to be more reliable when obtained in a documented form directly by the auditor from sources independent of the entity being audited. The higher the auditors’ assessment of risk of material misstatement (including risk of fraud or error), the greater would be the need to obtain persuasive evidence to address those risks. Unless, there exists reasons to conclude otherwise, the auditor would usually place a higher reliance on evidence obtained directly from third parties or corroborating evidence obtained from independent sources. SA 505 provides guidance on the auditor’s use of external confirmation procedures to obtain audit evidence.

‘External confirmations’ is a process of obtaining audit evidence through direct written communication from a third party in response to a request for information about a particular financial item in the financial statements. For certain financial captions, circularising and obtaining independent external confirmations, is one of the most reliable substantive audit procedures, to assist auditors to obtain sufficient appropriate audit evidence to validate the assertion of ‘existence’. Robust confirmation procedures can also serve as an effective tool to respond to fraud risks.

Confirmation requests are generally of two types:

a. Positive confirmation request—through this request, the confirming party responds directly to the auditor indicating whether the party agrees or disagrees with the information requested, or providing the requested information.

b. Negative confirmation request—the confirming party responds directly to the auditor only if the confirming party disagrees with the information provided in the request.

Usually, negative confirmations are used where there are a large number of small balances and the risk of material misstatement is assessed as low. A good example where negative confirmation can be used is for confirming vendor registration status under the Micro, Small and Medium Enterprises Development Act, 2006 (MSMED Act, 2006). Negative confirmation requests may be sent to vendors requesting them to confirm within a stipulated time, whether they are registered enterprises under the MSMED Act, 2006, failing which these would be considered as ‘nonregistered’ enterprises. Where detection risk is high, or the materiality of the account balance is high, positive confirmation will be needed to provide substantive evidence.

In common parlance, external confirmations are understood to be restricted to only bank balances, accounts receivables and payables. External confirmations could also be circularised for investments, borrowings, related party transactions, inventory in custody of third parties, loans and advances, property title deeds mortgaged, guarantees, contingent items, litigation and claims or items that are significant or outside the normal course of business.

External confirmations may also be used to confirm terms of agreements, contracts, or transactions between an entity and other parties or the absence thereof. For example, a request for confirmation of bank balances could also include the bank to confirm whether there exists any other exposure in respect of any other facilities availed by the enterprise. These could be in the nature of letters of credit, derivative contracts, forward contracts outstanding, bank guarantees provided, etc. All these could have implications for accounting and/or disclosures in the financial statements.

Generally, enterprises from whom external confirmation is sought are likely to be independent, ensuring that the evidence is reliable. However, the auditor needs to exercise greater professional scepticism and diligence in cases of related parties or where the confirming party might be economically dependent on the entity.

General reluctance to confirm is more likely due to misunderstanding of the purpose of the request. Debtors may misinterpret the confirmation as a demand for payment. Other parties may fear that confirmation might be binding if they should subsequently discover an error in their own records. Some respondents disclaim responsibility should their response be in error. This is usually the case with bank confirmations. However, this does not necessarily compromise the reliability of the confirmation. It is also pertinent to note that confirming parties may be more likely to respond indicating their disagreement with a confirmation request when the information in the request is not in their favour, and less likely to respond otherwise.

It is interesting to note that SA 505 provides guidance on audit procedures to be followed where an enterprise uses a third party to co-ordinate and provide responses to confirmation requests. Though not prevalent in India, this is a practice widely used in the US. In fact, certain financial institutions including banks in the US have taken the position not to respond to confirmation requests that are mailed or faxed, but accept audit confirmation requests sent only through Capital Confirmation, Inc. (CCI or Confirmation.com), a third party service provider which provides secure electronic confirmation services for auditors and their shared clients. The auditor in such cases would need to consider controls over the information sent by the entity to the service provider, the controls applied on processing of the data and controls over preparation and sending of the confirmation response to the auditor.

Let us now examine the practical application of SA 505 with a case study.

Case Study
ABC Limited is in the business of manufacturing and selling of chemical products. Sales are made to various dealers across the country. The usual credit period is 90 days. The sales for the year ended 31st March 20X0 aggregated Rs. 200 crore and debtors as at 31st March 20X0 amounted to Rs. 75 crore. The debtors listing comprised 350 customers. The management does not follow the practice of obtaining balance confirmations from its debtors.

The auditors of ABC are M/s. PQR & Co (PQR).Roger Smith, Assistant Manager with PQR, was the audit in-charge posted at ABC for the yearend audit. Roger selected 30 high value debtors having debit balances aggregating to Rs. 25 crore for circularisation. In respect of one customer – Genuine Chemicals Limited (GCL), from whom the outstanding was Rs. 10 crore (a material amount outstanding beyond the due date), the management refused to allow Roger to send the confirmation request as the management represented that currently there were ongoing negotiations with GCL, the resolution of which would get impacted by an untimely confirmation request. The mailing addresses for 27 parties were obtained by Roger from ABC’s sales account manager. Since the audit was currently under progress and Roger was posted at ABC’s office premises, Roger decided to courier the physical letters through the courier agency whose services were usually availed by ABC. The proof of dispatch (POD) had to be retained by the dispatch section of ABC as supporting evidence for payment of courier charges billed by the agency. The sales manager informed Roger that in respect of the remaining 2 parties, the business operations had moved to a new location and the new mailing address was not available. Hence for these parties, he requested that e-mails be sent by Roger for balance confirmation which were sent accordingly. For both the physical and the e-mail confirmation requests, the confirmation format used was as prescribed in PQR’s audit documentation standard. Further, return self-addressed envelopes were also enclosed with the physical confirmations couriered. Roger maintained a photocopy of all the confirmation requests circularised.

The debtors ledger for the year ended 31st March 20X0 was finalised by 10th April 20X0 and confirmations were sent by Roger on 15th April 20X0. The accounts were to be cleared by 5th May 20X0 as the board meeting to approve the accounts was scheduled for 10th May 20X0.

Responses were received from only 6 debtors (out of 29 circularised) as per details below.

On enquiry with the sales account manager, Roger was explained that even in the past when balances were circularised, the response received was abysmal. The customer pattern of ABC comprised a large pool of customers with small value balances. As such, the circularisation was not done with adequate rigour. Further, given the short time period between the date of circularisation and the date of accounts finalisation, the sales account manager informed that it was quite likely that some responses could be received post audit closure. For customers from whom no response was received, Roger verified subsequent payments, to the extent these were received until the date of audit. For customers from whom responses were received, Roger compared the confirmations received with the photocopies that he had retained in his file. He believed that the confirmations were in order. In respect of amount due to Genuine Chemicals Limited, Roger felt that given the sensitivity surrounding the pending negotiations, it would be appropriate not to send a confirmation request. Roger concluded on the work paper file that adequate work was done to comply with the requirements of SA505. Was Roger right in his conclusion?

Case Study analysis with the requirements of SA 505.

Design and dispatch of confirmation requests

• There was no management’s authorisation or encouragement to the customers selected for confirmation to respond to PQR’s request. Response rate to confirmation requests sent by auditors, particularly in case of debtors, is to a large extent driven by management’s intent and the degree of follow-up.

• Only high value positive balances were selected for circularisation. Roger should have built in an element of unpredictability by selecting even credit balances, if any, in the sample. Further, some debtors with low value amounts could also have been selected.

• For circularising balance confirmation in respect of Genuine Chemicals Limited, the management’s refusal to send a confirmation request should have been a trigger to evaluate its implication on the assessment of risk of material misstatement, including risk of fraud and whether such a refusal results in a scope limitation. Roger should have corroborated the explanations provided by the management by examining correspondence, if any, that ABC had with the customer evidencing the impending negotiations. He should have by enquiry or by performing procedures such as verifying lawyers’ confirmations/invoices deduced whether any legal case was filed against Genuine Chemicals. Further, given that the amount was material and outstanding beyond the due date, the auditor should have determined the implication of the non-recovery on the financial statements as well as on the audit opinion. This would also need to be communicated to those charged with governance at ABC.

• SA 505 requires the auditor to determine that the requests are properly addressed including testing the validity of some or all of the addresses on confirmation requests before these are sent out. Roger merely took the addresses as furnished by the sales account manager and did not perform procedures to verify the authenticity of the addresses provided.

• It is pertinent to note that for administrative convenience, the courier agency usually employed by ABC was used by the auditor. SA 505 stipulates that the auditor needs to maintain control over confirmation requests sent. Use of client courier may preclude maintenance of independence and control over requests sent. Where the requests are sent under the control of the auditor, he is better positioned to track the status of deliveries. As the client courier was used, proof of dispatches and deliveries was not maintained as evidence of circularisation. Reputed courier enterprises provide an online-tracking status of confirmations couriered together with delivery status. Roger should have also enquired into the status of delivery of confirmations couriered and whether there were any undelivered returns.

• The general practice is to circularise confirmations for year-end or quarter-end balances, but given the short period of time available post year-end for audit closure, Roger could have considered circularising confirmations for balances as at 28th February 20X0 in the month of March 20X0 and then performing roll-forward procedures performed from 28th February 20X0 until 31st March 20X0.

• SA 505 mandates the auditor to send out additional confirmation request where a reply to the previous request has not been received. There were no second/third reminders sent by Roger in the instant case.

Results of External Confirmation procedures

Roger compared the original responses received with the photocopies of the confirmations that he had retained in the file to ensure that there were no alterations made to the confirmations sent originally. This was a good verification procedure followed for testing the authenticity of responses.

Now, let us evaluate whether the response received for each of the six confirmation requests were in order.

1 Universal Chemicals

The confirmation had an exception being the difference of Rs. 3 lakh in the amount confirmed. Roger did not merely rely on the explanation provided by the sales account manager that the difference was on account of delay in accounting by Universal Chemicals. He rightly performed additional procedures to corroborate the same. He obtained confirmation over a telephonic call and further backed it up with a reconciliation explaining the difference from the customer. He also tested year-end sales to Universal Chemicals for further corroborative support.

2 Cosmos Traders

The very fact that the revised confirmation did not have any difference as against a difference of Rs. 32 lakh (in the original confirmation) should have lead Roger to use more professional scepticism and consider performing additional work like testing the transactions with Cosmos and understanding the reasons for the difference and how the same was reconciled.

3 Jupiter Chemicals

The confirmation provided was signed by the purchase executive of Jupiter. Roger should have evaluated whether reliance should be placed on the person authorising the confirmation, the purchase executive in this case. Usually depending on the size and set -up of an enterprise, one would expect accounts staff with appropriate authority to authorise the confirmation. Further, the confirmation was delivered at ABC’s address as against PQR’s office. The auditor should have insisted that the confirming party send the confirmation directly to him duly authorised by a person responsible to do so.

4 Neptune Chemicals

The confirmation was provided by Neptune Dye-Stuff, a Neptune Chemicals affiliate, i.e., not by the original intended confirming party. Such a confir-mation should have raised doubts over reliability of the response received. Further, this would also have implications on the auditor’s assessment of risk of material misstatement (including fraud risk) requiring Roger to modify the nature, timing and extent of other planned audit procedures.

5 Star Traders

This response was received electronically through an Internet email account and has a risk of reliability because proof of origin and authority of the respondent may be difficult to establish, and alterations may be difficult to detect. In this case, the confirmation was sent from an Internet e-mail account and not from the own domain of the confirming party. In such instances, it would be difficult to validate/corroborate the identity of the sender. In case of e-mail confirmations, the auditor needs to consider whether the mail was encrypted, signed electronically using digital signatures, and apply procedures to verify website authenticity. The auditor may also telephone the confirming party to determine whether the confirming party did, in fact, send the response.

6 Mars Chemitech Private Limited

Given the fact that MCPL has been making losses, Roger should have applied greater professional scepticism in evaluating MCPL’s ability to pay the debtor balance due rather than mere reliance on the confirmation provided by it directly.

Roger should have performed adequate alternate audit procedures to mitigate the risk of low response. Fewer responses to confirmation requests than anticipated may indicate a previously unidentified fraud risk factor that requires evaluation in accordance with SA 240.

Concluding remarks

One of the prominent reasons for genesis of frauds which corporate India has witnessed is the ineffectiveness in implementation of external confirmation procedures.

Obtaining external confirmations is a basic audit procedure which has been in audit theory for years but has not been practiced with the rigor that it deserves. To a large extent, the success of these procedures is driven by management’s rigour and follow -up with the confirming party to respond to the auditor which brings back the question of management’s intention to reflect a true and fair position of the enterprise’s affairs. SA 505 sets out the procedures that need to be performed for external confirmations to be an effective audit procedure which auditors should bear in mind while discharging their duties.

Nirav Shah

Proposed Accounting for Leases – Will it Impact Business Operating Models?

On 16th May 2013, the IASB issued an exposure draft (ED) on Leases. This is the second exposure draft issued after much internal and external deliberation by the IASB.

The leases project is one of the joint projects between the FASB and IASB which has been a focus area for the boards. The ED proposes fundamental changes to the existing lease accounting and is aimed to bring most leases on balance sheet for lessees. The first exposure draft was issued in September 2010 and since then, there have been various IASB meetings and public consultations. The second exposure draft is open for comments until September 2013. It introduces a dual-model approach for lease accounting, which would have a significant impact on the classification of leases, as well as the pattern and presentation of lease expense and income.

In this article, we will discuss some of the fundamental changes that are proposed in the Leases exposure draft.

Identification of leases
The ED defines a lease as “a contract that conveys the right to use an asset (the underlying asset) for a period of time in exchange for consideration”. An entity would determine whether a contract contains or is a lease by assessing whether:

(a) fulfillment of the contract depends on the use of an identified asset; and
(b) the contract conveys the right to control the use of the identified asset for a period of time in exchange for consideration.

A contract conveys the right to control the use of an identified asset if the customer has both the ability to direct the use and receive the benefits from use of the identified asset throughout the term of This definition encompasses the embedded leases concept currently under IFRIC 4. Hence arrangements which are not structured as leases but include an identified asset where the customer can direct the use and receive benefits will be considered leases. However, the ED puts a greater focus on the customer’s ability to direct the use of the underlying asset which means that contracts in which the customer uses substantially all of the output of an asset, but does not control its operations may not fall under the lease definition.

Lease term
The determination of the lease term is based on the non-cancellable period of the lease, together with any optional renewal periods which the lessee has a significant economic incentive to exercise and periods covered by a termination option, if the lessee has a significant economic incentive not to terminate. The proposals include many factors for an entity to consider which are contract-based, asset-based, entitybased and market-based such as the amount of lease payments in the secondary period, location of the asset, financial consequences of termination, market rentals, etc for determination of the lease term. Again, there are no bright lines for the term ‘significant economic incentive’.

These proposals are a significant change as the lease term is a crucial estimate in determining the classification and accounting for the lease.

Classification – Type A and Type B leases
The ED identifies two types of leases – Type A and Type B. These are in some ways akin to current finance lease and operating lease models under IAS 17 Leases. The classification criteria would be based on the nature of the underlying asset and the extent to which the asset is consumed by the lessee over the lease term.

If the underlying asset is not property (i.e. not land and/or a building), it is classified as a Type A lease, unless the lease term is for an insignificant part of the total economic life of the underlying asset or the present value of the lease payments is insignificant relative to the fair value of the underlying asset. An underlying asset that is property (i.e. land and/or a building), is classified as a Type B lease, unless the lease term is for the major part of the remaining economic life of the underlying asset or the present value of the lease payments accounts for substantially all of the fair value of the underlying asset.

However, in all cases, if the lessee has a significant economic incentive to exercise an option within the lease to purchase the underlying asset, then the lease is classified as a Type A lease.

The terms ‘insignificant’, ‘major part’ and ‘significant economic incentive’ are not defined in the ED and there are no explicit bright lines or threshold percentages to make this assessment.

In effect, most leases other than property would be Type A leases and most leases of property would be Type B leases unless the above presumptions are rebutted.

Example
Company A enters into a 2-year lease contract for an item of equipment which has a total economic life of 10 years. The lease does not contain any renewal, purchase, or termination options. The lease payments of Rs. 1000 per year are made at the end of the period, their present value is calculated at Rs. 1,735 using a discount rate of 10%. The fair value of the equipment is Rs. 5,500 at the date of inception of the lease.

This lease would be classified as a Type A lease since it is not property and the lease term is considered more than an insignificant part of the total economic life (20%) and the present value of lease payments is more than insignificant relative to the fair value of the equipment (31.5%).

This lease would have been classified as an operating lease under the existing principles of IAS 17. However, the Type A classification will lead to much different accounting under the ED proposals.

Accounting by lessee
In a Type A lease, the lessee would recognise a lease liability, initially measured at the present value of future lease payments, and also a right-of-use (ROU) asset measured at the amount of initial measurement of lease liability plus any initial direct costs and payments made at or before the commencement date less any lease incentives received. Subsequently, the lessee would measure the lease liability at amortised cost using the effective interest rate method and the ROU asset at cost less accumulated amortisation – generally on a straightline basis. The lessee would present amortisation of the ROU asset and interest expense on the lease liability as separate expenses on the statement of profit or loss. The ROU asset will be presented under property, plant and equipment as a separate category (bifurcated further between Type A and Type B leases residual assets).

Continuing the example above, the lessee would have recognised a lease liability and a ROU asset of Rs. 1,735. In year 1, the amortisation expense would be Rs. 867 (1735/2) and interest expense of Rs. 174 (1735*10%). In year 2, the amortisation expense would be Rs. 867 and interest expense of Rs. 91 ((1735+174- 1000)*10%). The cash outflow of Rs. 1000 will be reduced from the lease liability. Thus, under the Type A model, the lessee would see a front loading of the lease expense.

In a Type B lease, the lessee would follow the approach for Type A leases for initial measurement. Subsequently, the lessee would calculate amortisation of the ROU asset as a balancing figure, such that the total lease cost would be recognised on a straight-line basis over the lease term and would be presented as total lease cost (amortisation plus interest expense) as a single line item in the income statement. Hence, considering the example above, under the Type B model, in year 1, the lessee would record a total expense of 1000 split between interest expense of Rs. 174 and ROU amortisation of Rs. 826. This will effectively result in a straight-line recognition of the lease expense over the lease period.

Accounting by lessor
In a type A lease, on commencement, the lessor would derecognise the underlying asset and recognise a lease receivable, representing its right to receive lease payments as well as a residual asset, representing its interest in the underlying asset at the end of the lease term. The total profit i.e. difference between the fair value of the asset and the carrying amount of the asset (if any) will be divided between upfront profit and unearned profit. Upfront profit will be recognised at the lease commencement and is calculated as total profit multiplied to the proportion that the present value of the lease payments divided by the fair value of the underlying asset.

The lease receivable would initially be measured at the present value of future lease payments. The lessor would measure the lease receivable at amortised cost using the effective interest rate method. In addition, the lease receivable will be tested for impairment under IAS 39 Financial Instruments: Recognition and Measurement. The lessor would also be required to re measure the lease receivable to reflect any changes to the lease payments or to the discount rate. Such re measurement may be triggered due to a change in lease term, lessee having or no longer having a significant economic incentive to exercise purchase option, etc .

The residual asset would be measured at the present value of the amount that the lessor expects to derive from the underlying asset at the end of the lease term, discounted at the rate that the lessor charges the lessee adjusted for the present value of expected variable lease payments. In the balance sheet, the residual asset is presented as net residual asset after reducing the unearned profit. Subsequently the residual asset will be accreted with interest over the lease period. Also, this residual asset is subject to impairment provisions under IAS 36.

This accounting under Type A leases for the lessor is much more complex than the existing finance lease accounting model.

Continuing the example above, consider the following additional facts: the carrying amount of the equipment in lessor’s books is Rs. 5,000 on the inception of the lease. The lessor estimates that the future value of the equipment at the end of the lease term would be Rs 4,555 (the present value using 10% discount rate would be Rs. 3,765). The following entry would be recorded in the lessor’s books at commencement:

Lease receivable Dr. 1,735
Gross residual asset Dr. 3,765*
Equipment Cr. 5,000
Unearned profit Cr. 342
(500-158)
Gain on lease of equipment Cr. 158
((5500-5000)*(1735/5500))

*Rs. 3423 (3765-342) is the net residual asset to be presented in the balance sheet.

In Year 1, lessor would receive a cash flow of Rs. 1000 of which Rs. 174 (1735*10%) would be recorded as interest income and Rs. 826 would be reduced from the lease receivable. Also, the lessor will book interest income on accretion of the residual asset Rs. 375 (3765 x10%).

For Type B leases, the lessor would follow an accounting model similar to that of an operating lease per existing IAS 17 and would continue to recognise the underlying asset in its balance sheet and recognise the lease income on a straight line basis over the lease term. However, there are proposed additional disclosures requirements for lessors’ of Type B leases compared to current GAAP.

Exemption for Short-term leases

The ED gives the option to entities to elect not to apply the new accounting model to short-term leases. A short-term lease is a lease that has a maximum possible term under the contract including any renewal options of less than 12 months and does not contain any purchase options for the lessee to buy the underlying asset. Under this option, lessees and lessors would only recognise lease expense/income on a straight line basis.

Impact

The new proposals will have a significant impact on the future of lease accounting. Entities will need to reexamine lease identification and classification as per new proposals. Moreover, recognising new assets and liabilities will impact key financial performance metrics. Management will need to make new estimates and judgments. Some of these estimates and judgments need to be reassessed at each balance sheet date giving rise to volatility in the balance sheet. The new proposals may also impact the way lease contracts are structured. This ED does not propose an effective date but it is unlikely to be effective before 1st January 2017.

Nirav Shah

Integrated Reporting

If we think that it’s only financial reporting that has seen substantial changes in the last 5 years, initiatives around better, more effective communication about an organisation’s sustainability and value creation through corporate reporting weren’t left far behind. As accountants, our professional responsibility primarily revolves around preparation, review and analysis of financial information. The management of an entity has even greater responsibility when it comes to communicating with shareholders and other stakeholders about how they are managing the business, how they are using the resources available to them and, above all, how they are creating value not just for its shareholders but for the environment at large in which it operates.

In this direction, a major milestone was achieved in April this year. The International Integrated Reporting Council (IIRC) issued a consultation draft of the International Integrated Reporting Framework (the ‘Framework’). The IIRC is a global coalition of companies, investors, regulators, standard setters and other key stakeholders. The main aim of the IIRC is to create a globally accepted integrated reporting framework and to make integrated reporting a globally accepted corporate reporting norm.

The Integrated Reporting (or IR) Framework sets out the purpose, provides guidance and outlines how businesses can better explain how they create, sustain and increase their value in the short, medium and long term. The aim is also to enhance accountability and stewardship and support integrated thinking and decision making in the wake of increasing challenges to traditional business models.

What is IR?
IR is defined as a process that results in communication by an organisation, most visibly a periodic integrated report, about value creation over time. It aims to communicate the ‘integrated thinking’ through which management applies a collective understanding of the full complexity of value creation to investors and other stakeholders. An integrated report is a concise communication about how an organization’s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value over the short, medium and long term. The length of these time frames will be decided by each the organisation differently with reference to its business strategy, investment cycles, and its stakeholders’ needs and expectations. Accordingly, there is no set answer for establishing the length for each term.

IR is intended to be a continuous process and to be most effective should connect with other elements of an organisation’s external communication, e.g. financial statements or sustainability report.

IIRC identifies those charged with governance as having the ultimate responsibility of the IR. On the other side, key audience is the providers of financial capital. At the same time, it is accepted that IR benefits all external parties interested in an organisation’s ability to create value over time, including employees, customers, suppliers, business partners, local communities, legislators, regulators, and policy-makers. It is important to note that the purpose of an integrated report is not to measure the value of an organisation or of all the capitals, but rather to provide information that enables the intended report users to assess the ability of the organisation to create value over time.

To lend further credibility to the IR process, organisations may seek independent, external assurance to enhance the credibility of their reports. The Framework provides reporting criteria against which organisations and assurance providers assess a report’s adherence; it does not yet provide the protocols for performing assurance engagements.

IR Framework
The purpose of the Framework is to assist organisations with the process of IR. In particular, the Framework establishes Guiding Principles and Content Elements that govern the overall content of an integrated report, helping organisations determine how best to express their unique value creation story in a meaningful and transparent way.

The Framework sets out six guiding principles to help preparers determine the structure of the integrated report.

These are:

• Strategic focus and future orientation
• Connectivity of information
• Stakeholder responsiveness
• Materiality and conciseness
• Reliability and completeness
• Consistency and comparability

An integrated report is structured by answering the following questions for each of its seven content elements:

• Organizational overview and external environment: What does the organisation do and what are the circumstances under which it operates?

• Governance: How does the organisation’s governance structure support its ability to create value in the short, medium and long term?

• Opportunities and risks: What are the specific opportunities and risks that affect the organization’s ability to create value over the short, medium and long term and how is the organization dealing with them?

• Strategy and resource allocation: Where does the organisation want to go and how does it intend to get there?

• Business model: What is the organisation’s business model and to what extent is it resilient?

• Performance: To what extent has the organisation achieved its strategic objectives and what are its outcomes in terms of effects on the capital?

• Future outlook: What challenges and uncertainties is the organisation likely to encounter in pursuing its strategy, and what are the potential implications for its business model and its future performance?

Pilot Programme

IR is a new concept and is in its formative stage. The IIRC acknowledges this fact. Accordingly, in order to construct and test its thoughts around the Framework, the IIRC began a Pilot Programme in October 2011. This programme was soon joined in by over 90 businesses and 30 investor organisations from around the globe. Some of the business network participants are Tata Steel, Kirloskar Brothers Limited, Unilever, The Coca- Cola Company, HSBC, Microsoft Corporation, and Prudential Financial among others. [Source: www.theiirc.org]. Version 1.0 of the Framework is expected to be published in December 2013, much before the end of the Programme in September 2014, thereby allowing participants time to test the Framework during their following reporting cycle. This will also enable the IIRC to assess IR outcomes and complete its work.

IR is still a voluntary initiative so why bother now?

Well, the key results of the Pilot Programme speak for themselves. 95% of participants find that integrated reporting provides a clearer view of the business model and increases board focus on the right KPIs; 93% feel it leads to the better data quality collection, greater focus on sustainability issues, development of improved cross-functional working processes and breaking down silos between teams; and 88% agreed that IR leads to improvements in business decision making.

Currently, the industry participation is led by financial services, while more than 50% of the geographical spread is accounted for by Europe as these were the worst affected during the financial crisis. Sustainability concerns may have sowed the seeds of the IR on a global scale, but the trends emerging from the Pilot Programme provide enough evidence of much wider benefits to the organisations and their stakeholders – now and in the future.

Let’s prepare for a world of valued corporate reporting!

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Nirav Shah

GAP in GAAP – Accounting for Associates

Background: An entity is an investor in an associate in accordance with AS 23 Accounting for Investments in Associates in Consolidated Financial Statements. The investor accounts for its interest in the associate using the equity method in AS 23. The investor enters into a lease agreement with the associate, classified as a finance lease under AS 19 Leases. The gain on the lease transaction exceeds the carrying amount of the investor’s investment in the associate.

The author notes two views for the accounting for the gain elimination:

View A: The gain from the transaction is eliminated only to the extent that it does not exceed the carrying amount of the investor’s interest in the associate. This view is by analogy to AS 23.18 where an entity’s share of losses of an associate ceases to be recognised when the investment carrying amount is reduced to zero. Paragraph 18 of AS 23 states “If, under the equity method, an investor’s share of losses of an associate equals or exceeds the carrying amount of the investment, the investor ordinarily discontinues recognising the share of further losses and the investment is reported at nil value.”

View B: All the investor’s share of the gain is eliminated. This view is supported by AS 23.13, which states that gains/losses from transactions are recognised only to the extent of the unrelated investors’ interests in the associate. Paragraph 13 states “In using equity method for accounting for investment in an associate, unrealised profits and losses resulting from transactions between the investor and the associate should be eliminated to the extent of the investor’s interest in the associate.”

Author supports View B. The second question therefore is – how should the gains to be eliminated, in excess of the carrying amount of the interest in the associate? Two methods are identified:

Method 1: As deferred income

Method 2: As a deduction from the related asset recognised by the investor.

Author supports Method 1, because ‘deferred income’ shows the nature of the eliminated gains and it would enable users to readily obtain information about the amount of eliminated gains in excess of the investors interest in the associate.

Author’s Recommendation: Author considers that AS 23 lacks guidance on the accounting for the elimination of any gain in excess of the carrying amount of the investment. The Institute of Chartered Accountants of India may consider amending AS 23 via a narrow-scope amendment to add specific guidance on how to account for the corresponding entry for the eliminated gain in excess of the carrying amount of the investor’s interest in the associate.

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Nirav Shah

IFRS Conceptual Framework – Time to Revise

In July 2013, the International Accounting Standards Board (IASB) issued a discussion paper on review of the Conceptual Framework for financial reporting for comment only. Comments on this paper need to be given by 14th January, 2014.

The IASB’s discussion paper on the Conceptual Framework provides a welcome opportunity to set out the fundamental principles of accounting necessary to develop robust and consistent standards. Although this is not an immediate project, it would set the tone for the future direction of accounting.

Need for a review of the Conceptual Framework

In recent times, there have been many discussions regarding the extent of fair value accounting under IFRS, the measurement of performance, keeping assets on or off balance sheet etc. which raise questions on the fundamentals of accounting under IFRS. In the aftermath of the global financial crisis, as the accounting complexities increase, the IASB’s thinking about some of these fundamentals has also evolved. This gave rise to the need for a revised Conceptual Framework which reflects the recent changes in accounting and provides a backbone for future changes.

This discussion paper is designed to obtain initial views and comments on a number of matters, and focuses on areas that have caused problems in practice for standard setters as well as companies. It also sets out the IASB’s preliminary views on some of the topics under discussion.

Key changes envisaged

Revised definitions of assets and liabilities

The revised Conceptual Framework proposes to clarify the existing definitions of assets and liabilities. Rather than the focus of the current definition on inflow or outflow of resources, the proposals suggest that the focus should be on underlying resources or obligations as the basis for determining the recognition of an asset or liability. Given below are the proposed definitions:

(a) an asset is a present economic resource controlled by the entity as a result of past events.

(b) a liability is a present obligation of the entity to transfer an economic resource as a result of past events.

Additional guidance on applying the definitions of assets and liabilities

The IASB proposes to provide additional guidance on the meaning of economic resource, control, transfer of economic resource, constructive obligations and present obligation. Additional guidance would be provided also on reporting the substance of contractual rights and contractual obligations and executory contracts. These would be helpful to support the proposed new definitions of asset and liability explained above.

Revised guidance on when assets and liabilities should be recognised

The IASB’s preliminary view on recognition is that an entity should recognise all its assets and liabilities unless the IASB decides when developing or revising a particular standard that an entity need not, or should not, recognise an asset or a liability either because of cost benefit considerations or that such recognition would not be a faithful representation.

New guidance on when assets and liabilities should be derecognised

The existing Conceptual Framework does not address derecognition in a comprehensive manner. The IASB’s preliminary view is that an entity should derecognise an asset or a liability when it no longer meets the recognition criteria. However, for cases in which an entity retains a component of an asset or a liability, the IASB should determine, when developing or revising the standards, how the entity would best portray the changes that resulted from the transaction. This could be achieved by way of enhanced presentation or disclosure or continuing to recognise the original asset or liability and treating the proceeds received or paid for the transfer as a loan received or granted.

New way to present information about equity claims against the reporting entity

Financial statements currently do not clearly show how equity instruments with prior claims against the entity affect possible future cash flows to investors. Also, the IASB proposes to address the distinction between equity and liability, specifically the problems of applying the definition of liability consistently within IFRS.

Measurement requirements

This section of the discussion paper provides guidance to assist the IASB in developing measurement requirements in new or revised standards. The proposals state that there are different bases of measurement i.e cost, market prices including fair value and other cash flow based measurements. These bases should be applied based on their relevance, cost benefit analysis and their impact on the profit and loss/other comprehensive income (OCI) statement.

Principles for distinguishing profit or loss from OCI

The extant Framework does not provide guidance on presentation and disclosure. The reporting of financial performance (including the use of OCI and recycling) is a key topic that needs to be addressed. Further, the IASB proposes to provide more guidance in the area of materiality.

This Discussion Paper incorporates the views received through the IASB’s public consultation carried out in 2011. It has detailed discussions around the key topics mentioned above and other topics where different views have been deliberated and the IASB’s preliminary views have been stated out for comment. This is an important project for the IASB as it not only addresses concerns around the fundamental areas as they exist today but also set the principles for standards to be developed in the future.

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Nirav Shah

GAP in GAAP— Fair Value of Revenue

Background

Company A sells handsets—either for upfront cash or for payment in installments. Until recently, its pricing was:

• Rs. 810 for upfront cash; or
• 36 monthly installments of Rs. 25 (total Rs. 900), implying an interest rate of 7% pa on the cash price of Rs. 810.

New competitors that sell handsets for cash but not on credit have entered the market—this has led to a drop in the cash sale price to Rs. 621 but A still makes most of its sales on credit on the same terms as before (i.e. Rs. 25 a month for 36 months).

This gives an imputed interest rate of 29% pa on the installment contract relative to the new cash price of Rs. 621. A believes this implied interest rate is unreasonably high. It sells some receivables on a non-recourse basis at yields approximating 7-8% pa.

How should A measure its revenues from handsets?

Options under Indian GAAP

View 1-The fair value of the consideration is the cash sale price (i.e. Revenue Rs. 621)

Since the handsets sold have a cash alternative price that is clearly determinable, revenue should be recognised at this price. In addition, even if the fair value of the consideration were higher than the cash sale price, this premium represents a payment for services to be received (financing services) that should be recognised over the service period as part of finance income rather than immediately as part of revenue from selling the handset.

The support for this view can be found in AS-9 itself. As per the illustration in AS 9 Revenue Recognition, “When the consideration is receivable in installments, revenue attributable to the sales price exclusive of interest should be recognised at the date of sale. The interest element should be recognised as revenue, proportionately to the unpaid balance due to the seller.” Though this paragraph supports the discounting of the installments, it does not provide any guidance on how the interest is determined. Therefore it is possible to determine the cash sale price based on an observable market and to treat the residue as interest, though that interest amount is much higher than the market.

View 2-The fair value of the consideration is the price derived by discounting the installment payments using market-based interest rates (i.e. Revenue Rs. 810)

The support for this view can be found in AS-9 itself. As per the illustration in AS 9 Revenue Recognition, “When the consideration is receivable in installments, revenue attributable to the sales price exclusive of interest should be recognised at the date of sale. The interest element should be recognised as revenue, proportionately to the unpaid balance due to the seller.” Though this paragraph supports the discounting of the installments, it does not provide any guidance on how the interest is determined. Therefore, it is possible to determine the cash sale price by discounting the installments at the market yield of 7% p.a.

In addition, Paragraph 47 of AS 30 Financial Instruments Recognition and Measurement (not yet mandatory) states that the initial measurement of financial assets should be based on their fair value and the receivables are the consideration being valued. Therefore, under this view the fair value of the consideration should be derived by discounting the future cash flows using market-related interest rates.

View 3–No discounting (i.e. Revenue Rs. 900)
The illustration in AS-9 requires discounting in the case of installment sales. If the fact pattern was somewhat different, so that the payment was not based on installments, but the sales were on deferred payment terms, then discounting may not be required. For example, sale was made at Rs. 900 but entire payment of Rs. 900 is collected after six months. In such a case, it may be argued that the illustration in AS-9 which applies to installment sales does not apply in this case. This may be particularly true in schemes where a customer paying upfront or a customer paying over a short period, say 6 months, ends up paying the same amount. In other words, there is no interest amount to be imputed or the interest amount is immaterial. An interesting point to note is that under IAS 18 Revenue, revenue is always recognised at fair value of the consideration, and hence discounting is mandatory unless immaterial. Unlike IAS 18, under AS-9 there is no requirement to recognise revenue at fair value. The illustration in AS 9 to discount and separate revenue and finance income is only applicable when the sales are made purely on an installment payment scheme.

View 4-Accounting policy choice
In the absence of any detailed guidance, the author believes that either of the views above can be accepted. I suggest that the Institute should provide guidance as the object of an accounting standard is to eliminate diverse accounting practices.

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Nirav Shah

GAP in GAAP Accounting for Warranty Obligations

In the case of construction companies, the issue of
accounting for revenue and warranty obligations subjects itself to
multiple possibilities. Consider a construction company that executes a
long term contract, which takes 2 years to complete and which comes with
a warranty period of 2 years. The question is, how does the contractor
account for revenue and warranty costs in accordance with (AS) 7,
‘Construction Contracts’ and other accounting standards. Let us take an
example. The total contract value is 120.

View 1

Paragraph
11 and 14 of Accounting Standard (AS) 29, ‘Provisions, Contingent
Liabilities and Contingent Assets’, states as follows:

“11. 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.”

“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

If these conditions are not met, no provision should be recognised.”

In
the extant case, let us further assume that the contractor is bound to
rectify, rework and compensate any defects, short supplies, operational
problems of the individual equipment already supplied/ work already done
under construction contracts. In other words, the contractual
obligation in respect of warranty coexists from the date of first supply
and not from the date of completion of contract. Thus, there exists a
contractual/customary present obligation in respect of warranty service,
which will require out-flow of resources embodying economic benefits to
settle the obligation. Therefore a provision in respect of warranty
service should be recognised.

As far as timing of recognition of
provision is concerned, the following relevant paragraphs 15, 16 and 21
of AS 7, are reproduced below:

“15. Contract costs should comprise:

(a) costs that relate directly to the specific contract; …

16. Costs that relate directly to a specific contract include: …

(g) the estimated costs of rectification and guarantee work, including expected warranty costs; and …”

“21.
When the outcome of a construction contract can be estimated reliably,
contract revenue and contract costs associated with the construction
contract should be recognised as revenue and expenses respectively by
reference to the stage of completion of the contract activity at the
reporting date. …”

Based on the above, it may be argued that the
estimated warranty cost is a contract cost which is directly related to
the specific contract. When the outcome of a construction contract can
be estimated reliably, contract revenue and contract costs associated
with the construction contract should be recognised as revenue and
expenses respectively by reference to the stage of completion of the
contract activity at the balance sheet date. Accordingly, following the
percentage of completion method, the contract costs, including provision
for expected warranty costs should be recognised by reference to stage
of completion of the contract activity at the reporting date. Thus, the
present obligation in respect of contractual warranty as per the
provisions of AS 29 arises from the performance of a contract activity
in respect of which contract cost is recognised even during the progress
of the contract and as such, the proportionate warranty cost can be
included as ‘cost incurred’ to determine the stage of completion for
recognition of revenue as per the principles of AS 7.

This view
is also aligned to the current practice with respect to sale of goods
which contains a warranty obligation. The current practice is to
recognise the entire revenue when the goods are sold, and make a
provision with respect to warranty costs.

View 2

It
is questionable whether the warranty on the project commences as each
equipment in the project is installed. Generally the warranty is on the
entire project, and it commences on the handover of the project to the
customer. The activities involved in ensuring that the equipments are in
working condition during the construction of the project are more in
the nature of a project activity rather than a warranty activity. If
this be the case, then the warranty provisions and the corresponding
revenue would be recognised at the end of Year 2. Therefore the only
difference in view 1 and 2 is the timing of the recognition of the
warranty provisions and the corresponding revenue.

View 3

Paragraph
26 of AS 7 states as follows, “A contractor may have incurred contract
costs that relate to future activity on the contract. Such contract
costs are recognised as an asset provided it is probable that they will
be recovered. Such costs represent an amount due from the customer and
are often classified as contract work in progress”.

Since the
warranty activity is a future activity, any provision for the
contractual obligation on the warranty should also be correspondingly
recognised as an asset. However, no revenues/costs are recognised when
the contract is in progress with regards to warranty. Once the project
is commissioned and the warranty commences, revenue and cost with
respect to warranty is recognised. For sake of simplicity, the margins
on the contract activity and warranty activity in the above example have
been maintained at the same level. However, in practice the margins may
differ.

Conclusion

The author believes that each of the above views may be tenable under current Indian accounting standards.

Nirav Shah

Should Gains be Recognised due to ‘Own’ Credit Deterioration

Since the start of the global financial crisis in 2008, the credit risk of counter parties has become increasingly important. Globally, the financial environment has been very volatile and has created a lot of uncertainty in the minds of stakeholders as well as prospective investors.

Volatility in credit worthiness of entities, not only has a significant impact on the business of these entities (ability to raise funds and capital at attractive rates), but has also resulted in a unique accounting implications.

This implication arises from provisions relating to gains/ losses due to ‘changes in fair value of financial liability due to changes in ‘own’ credit risk’ in certain cases.

The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board’s (FASB) inclusion of own credit risk in liability measurement has proved controversial over the years. Several media articles have focused on the fact that due to EU accounting rules, banks may have systematically overstated their net assets and distributed non-existent profits as dividends and bonuses.

Let us take an example to understand how change in own credit risk, results in reflecting a better performance and increases the net assets for entities.

Balance sheet for Bank XYZ

*Measured at fair value through profit or loss account Keeping all other external parameters constant, if the creditworthiness of Bank XYZ decreases, it will result in an increase in its credit spreads (as the cost of funds for a more risky instrument will be higher). This in turn will result in a reduction in the fair value of the underlying instruments issued by the Bank. The revised balance sheet of XYZ may be as under (fair value is presumed to be Rs 800)

Balance sheet for Bank XYZ (Rs)

This reduction in the financial liability by Rs 200 is recorded as a gain in the income statement and has a favourable impact on reported PAT and EPS of the Bank.

Relevant accounting literature under IFRS supporting the aforesaid accounting treatment

IAS 39 “Financial Instruments: Recognition and Measurement” permits an entity to classify any financial liability into the category of “Fair value through profit or loss (FVTPL)” when:

• It is acquired or incurred principally for the purpose of selling or repurchasing it in the near term

• Part of a portfolio managed together and evident by recent pattern of short term profit taking

• It contains more than one embedded derivatives.

Generally derivative liabilities, structured financial products etc are recognised by entities at fair value.

IAS 39 requires an entity to reflect credit quality in determining the fair value of financial instruments and related changes in fair value are accounted in the profit and loss account.

Impact on results

During 2011, a number of international banks reported positive earnings in spite of increasing credit spreads i.e., declining credit worthiness. This outcome was due to own-credit-risk adjustments allowed in terms of IAS 39 (referred above) and similar guidance under US GAAP laid down in FASB Standard No. 159 “Fair Value Option for Financial Assets and Financial Liabilities”. Own-credit risk adjustments can result in unrealised losses as well when banks’ creditworthiness improves.

Below is a summary of the impact, this provision had on the performance results of a few large banks

One can logically argue that it is misleading for an entity to report a gain on its liabilities as a direct result of its own creditworthiness deteriorating, particularly as the entity would not be able to realise this gain unless it repurchases its debt at current market prices. However, there is another view in support of fair valuation, which is based on the principle of “increase in shareholder value”. As per this view increase in shareholder value resulting from a credit downgrade is based on differing contractual claims of shareholders and bondholders. Under this approach wealth is transferred from the existing bondholders, who have already committed to a lower interest rate and thus bear the risk of changes in interest rates, to the shareholders. If bondholders had waited to purchase the obligations they may well have received a higher interest rate. Thus, the gain is attributable to the lower interest rate that the entity enjoys in the current period as compared to the market interest rate (for another entity with the present (deteriorated) credit rating).

In India, The Ministry of Corporate Affair (MCA) has issued accounting standards which are aligned to IFRS (known as “Ind AS’), to be notified at a future date. Ind AS 39 “Financial Instruments: Recognition and Measurement” prescribes that in determining fair value of a financial liability, which on initial recognition is designated at fair value through profit or loss, any change in fair value consequent to changes in the company’s own credit risk should be ignored. This was a concious difference from IFRS incorporated under Ind AS. This difference was because Indian standard setters were not comfortable with companies recognising ‘gains’ in the financial statements just because their credit worthiness has deteriorated.

Even Basel III rules, require banks to “derecognise in the calculation of Common Equity Tier 1, all unrealised gains and losses that have resulted from changes in the fair value of liabilities that are due to changes in the bank’s own credit risk.” This rule ensures that an increase in credit risk of a bank does not lead to a reduction in the value of its liabilities, and thereby an increase in its common equity.

Given the ongoing volatility in the economic environment, this is an area which needs to be closely monitored, particularly due to the implications on reported financial performance and capital adequacy considerations.

Nirav Shah

Section A: AS 29: Disclosures regarding provision for potential civil and criminal liability

Section A: AS 29: Disclosures regarding provision for potential civil and criminal liability

Ranbaxy Laboratories Ltd Year ended 31-12-2011

From Notes to Accounts (Rupees in millions)

On 20th December 2011, the Company agreed to enter into a Consent Decree with the Food and Drug Administration (“FDA”) of United States of America (“USA”) to resolve the existing administrative actions taken by FDA against the Company’s Paonta Sahib and Dewas facilities. The Consent Decree was approved by the United States District Court for the District of Maryland on 26th January 2012. The Consent Decree establishes certain requirements intended to further strengthen the Company’s procedures for ensuring the integrity of data in its US applications and good manufacturing practices at its Paonta Sahib and Dewas facilities. Successful compliance with the terms of the Consent Decree is required for the company to resume supply of products from the Dewas and Paonta Sahib facilities to USA.

Further, the Company is negotiating towards a settlement with the Department of Justice (“DOJ”) of USA for resolution of potential civil and criminal allegations by DOJ. Accordingly, the Company has recorded a provision of Rs. 26,480 million ($500 million) which the Company believes will be sufficient to resolve all potential civil and criminal liability.

From Auditor’s Report

Without qualifying our opinion, we draw attention to note 2 of schedule 24 of the financial statements, wherein it has been stated that the management is negotiating towards a settlement with the Department of Justice (“DOJ”) of the United States of America for resolution of potential civil and criminal allegations by the DOJ. Accordingly, a provision of Rs. 26,480 million has been recorded which the management believes will be sufficient to resolve all potential civil and criminal liability.

From CARO report
According to the information and explanations given to us, the provisions created for FDA/DOJ for Rs. 26,480 million (as explained in Note 2 of Schedule 24) by the Company has resulted into long-term funds being lower by Rs. 21,754.09 million compared to long-term assets as at 31st December 2011. Accordingly, on an overall examination of the balance sheet of the Company as at 31st December 2011, it appears that short term funds of Rs. 21,754.09 million have been used for long-term purposes during the current year (without considering the impact of excess remuneration paid to Chief Executive Officer and Managing Director as explained in paragraph (d) of the audit report). As represented to us by the management, the shortfall is temporary in nature, hence resulting in long-term funds being lower.

From Directors’ Report

With regard to qualifications contained in the auditors’ report, explanations are given below:

i) Long term funds lower than long term assetsnote no. 2 of Schedule 24 to the financial statements.

The Company has made a provision of Rs. 26,480 million for settlement with the Department of Justice (DoJ) of U.S.A., which the Company believes will be sufficient to resolve all potential civil and criminal liability. This has resulted into long-term funds being lower by Rs. 21,754.09 million compared to long-term assets as at 31st December 2011. The Company believes that the abovementioned shortfall is temporary in nature.

From Management Discussions and Analysis statement

Regulators across the world have become stricter, in respect of compliance to requirements with even more severe consequences for non-compliance.

Ranbaxy signed a Consent Decree (“CD”) with the United States Food & Drug Administration (“US FDA”) in December 2011 to resolve the existing administrative actions taken by the US FDA against the Company’s Poanta Sahib, Dewas and Gloversville facilities. The CD was subsequently approved by the United States District Court for the Court of Maryland on 25th January, 2012. The CD establishes certain requirements intended to further strengthen the Company’s procedures for ensuring the integrity of data in the US applications and good manufacturing practices at its Poanta Sahib and Dewas facilities.

Specifically, the CD requires that Ranbaxy comply with detailed data integrity provisions before FDA will resume reviewing drug applications containing data or other information from the afore-mentioned plants. These provisions include:

1. Hire a third party expert to conduct a thorough review at the facilities and audit applications containing data from affected plants;

2. Implement procedures and controls sufficient to ensure data integrity in the Company’s drug applications; and

3. Withdraw any applications found to contain untrue statements of material fact and/or a pattern or practice of data irregularities that could affect approval of the application.

The Company will have to relinquish 180 days exclusivity for 3 pending generic drug applications. This will not have material impact on the performance of the Company. The Company could also be liable for liquidated damages to cover potential violations of the law and CD. The implementation of CD, is expected to put to rest the legacy issue that impacted Ranbaxy, and requires strict adherence.

The Company separately announced a provision of $500 Mn in connection with the investigation of the Department of Justice, which the Company believes will be sufficient to resolve all potential civil and criminal liabilities. The Company has taken corrective actions to address the CD concerns and is confident of working together with the regulators towards its satisfactory closure.

Ranbaxy Laboratories Ltd Year ended 31-12-2012

From Notes to Accounts (Rupees in millions)

The Company is negotiating towards a settlement with the Department of Justice (“DOJ”) of the USA for resolution of potential civil and criminal allegations by DOJ. Accordingly, the Company had recorded a provision of Rs 26,480 ($500 Million) in the year ended 31st December 2011, which on a consideration of the progress in the matter so far, the Company believes will be sufficient to resolve all potential civil and criminal liability. The Company and its subsidiaries are in the process of negotiations which will conclusively pave the way for a Comprehensive DOJ Settlement. The settlement of this liability is expected to be made by the Company in compliance with the terms of settlement, once concluded and subject to other regulatory/statutory provisions.

From Auditor’s Report
No mention

From CARO Report

Clause 10

The accumulated losses of the Company at the end of the year are not less than fifty percent of its net worth (without adjusting accumulated losses). As explained to us, these are primarily due to provision created for settlement with the Department of Justice (DOJ) of the United States of America for resolution of potential civil and criminal allegations by the DOJ (refer to note 8 of the financial statements). The Company has not incurred cash losses in the current financial year though it had incurred cash losses in the immediately preceding financial year.

Clause 17

According to the information and explanations given to us, the provision created for settlement with the DOJ amounting to Rs. 26,480 million (refer to note 8 of the financial statements) by the Company in the previous accounting year have resulted in long-term funds being lower by Rs. 5,558.22 million compared to long-term assets as at 31st December 2012. Accordingly, on an overall examination of the Balance Sheet of the Company as at 31st December 2012, it appears that short term funds of Rs. 5,558.22 million have been used for long-term purposes. As represented to us by the management, the shortfall is temporary in nature and action is being taken to have long term funds within a short period of the amount being actually paid.

From Directors’ Report
In continuation of signing of the Consent Decree with the USFDA, the Company is in the final stage of settlement with the U.S. Department of Justice (DOJ) to resolve civil and criminal liabilities.

With regard to comments contained in the Auditors’ Report, explanations are given below:

i) The accumulated losses of the Company at the end of the year are not less than fifty percent of its net worth:

The accumulated losses are primarily due to provision of Rs. 26,480 million created by the Company in the year ended 31st December, 2011 for settlement with the DOJ for resolution of potential civil and criminal allegations by the DOJ.

ii) Short term funds used for long term purposes:

The Company had made a provision of Rs. 26,480 million in the previous accounting year for settlement with the DOJ. This has resulted into long-term funds being lower by Rs. 5,558.22 million compared to long-term assets as at 31st December, 2012. Accordingly, short-term funds of Rs. 5,558.22 million have been used for long-term purposes which are temporary in nature.

Nirav Shah

SA 240 (Revised): A Practical Insight

In our professional practice, how often do we come across defences such as:

“Whatever I did was in the interest of the organisation without any intention of personal gratification whatsoever”.

“You need to pay bribes to get your work done, there is no other way”.

“If the senior executives can have their fat bonuses, then why can’t I have my piece of cake?”

“Cooking the books or creative accounting is not fraud; it is just bending the rules”.

These are the usual defences which one puts forth when faced with the prospect of being held answerable or responsible for fraud (or even potential fraud). But let us examine the auditor’s duty and responsibility relating to fraud in an audit of financial statements.

SA 240 (Revised) (which is effective for audits of financial statements for periods beginning on or after 1st April 2009) deals with “the auditor’s responsibility to consider fraud and error in an audit of financial statements” and defines fraud as “an intentional act by one or more individuals among management, those charged with governance, employees or third party, involving the use of deception to obtain an unjust or illegal advantage”. The distinction between ‘fraud’ and ‘error’ is whether the underlying action resulting in misstatements is intentional (i.e. fraud) or unintentional.

Let us understand the application of SA 240 (Revised) with the following two case studies. These cases represent ‘frauds’ as they were intentionally committed by the management/employees to gain an illegal advantage resulting in misstatement in financial statements resulting either from misappropriation of assets (cash in the first case) or fraudulent financial reporting (misstatement of inventories in the second case).

Case 1

Background
ABC Ltd. was engaged in the manufacturing of hot rolled steel plates. The manufacturing process involves melting iron ore and converting the molten ore into iron sheets of required size(s). During the course of production, a given proportion of ore had to be scrapped. The scrap generated was measurable in terms of standard yield and was also dependent on the quality of ore used. The scrap generated was sold to two scrap dealers at an agreed upon price. Scrap sales as a percentage of total income were insignificant. The entire process of scrap sales was handled by the CFO under the direct supervision of the Managing Director. The documentation maintained by the CFO for scrap sales included the quantity sold, the price charged and the quotations supporting the price charged as well payment of statutory levies such as excise and VAT. The realisation of scrap sales was never an issue as scrap was always sold on the basis of ‘advance payment by cheque’. From an audit standpoint, given that scrap sales (as recorded in the books) did not constitute a material amount, the auditors’ verification was restricted to ensuring compliance with excise and VAT rules and performing an overall analytical review.

The real situation was quite different. The actual quantity of scrap generated was much higher than that recorded in the books. The actual price realisation was also significantly higher with the difference between the amount disclosed in the books and actual price being received in cash. The cash was used to make facilitation payments (‘bribes’) to secure favours/approvals from various authorities in relation to day-to-day business operations. The actual scenario came to light when the business with the scrap dealer was discontinued on account of dispute and the scrap dealer informed the board of directors of the arrangement.

Analysis with respect to SA 240 (Revised)

Responsibility of management and those charged with governance

Per SA 240 (Revised), the primary responsibility to ensure prevention and detection of fraud and error rests with the management and those charged with governance. Since senior management was involved in the fraud, it was imperative that those charged with governance exercised much greater control and supervision over management function. They should have, using their authority of management oversight, ensured that this aspect of the company’s operation was reviewed independently and reported.

? Understanding the entity’s internal controls— The entire process of scrap sales was being managed by the CFO who had the authority to negotiate the rates with the scrap dealer, was responsible for dispatch of scrap and was also responsible for ultimate collection. There was no segregation of duties resulting in one individual being able to initiate and complete the entire transaction singlehandedly. There was an absence of an independent check of the overall reconciliation of materials consumed and goods produced. There was no independent verification of the quotes obtained to support the prices charged. This could have been mitigated by establishing a process of selection of scrap dealers such as tendering or by formulating a scrap negotiation committee comprising operational/functional heads responsible for negotiating terms with scrap dealers.

? Deterrents to improper conduct by management— The arrangement was being managed by the CFO with the knowledge of the Managing Director leading to management override of controls. Establishing a ‘code of conduct’ mandating compliance by one and all and stipulating disciplinary action (including termination and legal recourse) for non-compliance could have acted as a deterrent in fraud prevention/detection.

? Independent review by internal audit function reporting directly to those charged with governance could also have assisted in fraud detection/prevention. In situations where the entity has an internal audit function, the auditor can make enquiries of the internal auditor about any specific procedures performed to detect fraud and whether satisfactory responses were received from management to any findings resulting from those procedures.

? Whistle-blower mechanism—In terms of SA 315, responsibilities of those charged with governance include oversight of the design and effective operation of whistle blower procedures, establishment of these procedures could act as a ‘deterrent’.

Auditors’ Responsibilities
Per SA 240 (Revised), owing to the inherent limitations in an audit, the auditor cannot obtain absolute assurance that the material misstatements in the financial statements (either because of fraud or error) will be detected. The auditor has to, however, obtain reasonable assurance that the financial statements as a whole are free from material misstatement and should therefore ensure that they have followed the auditing procedures in accordance with the auditing standards generally accepted in India. However, the auditor could be held responsible where the misstatements due to fraud or error remained undetected due to nonapplication of the required audit procedures and professional scepticism.

In this regard it is important to note that the risk of not detecting a material misstatement due to fraud is greater than that arising from an error, since fraud may involve a sophisticated modus operandi, and could include collusion, forgery and intentional misrepresentation. This risk increases with management fraud since they are in a position to manipulate records and override controls.

In the given case, applying the guidance given in SA 240 (Revised) and SA 200 (Revised) Overall Objectives of the Independent Auditor and the Conduct of an Audit in accordance with Standards on Auditing, the auditors should have considered the following factors while auditing scrap sales:

Identify and assess fraud risk—the auditor should have designated scrap sales as an area susceptible to fraud in view of the fact that scrap sales were controlled entirely by the CFO and the Managing Director.

Understanding of the entity’s business and maintaining professional scepticism—the auditors should have considered obtaining deeper understanding of the manufacturing process, understood the relationship of scrap generated with quantity produced and enquired into reasons why the quantity of scrap generated as recorded in the books was low in relation to finished goods produced. The auditors could also have considered the usual quantum of scrap generated in similar/like industries and related this to the scrap quantity recorded in the company’s books. The auditors should have compared the rates charged to scrap dealers with independent sources such as market prices of steel scrap.

Understanding of internal control environment—There was no segregation of duties as the entire function was being performed by the CFO and MD. Further, as senior management was involved, there existed the risk of management override of controls. The auditor should have communicated these deficiencies in internal controls to those charged with governance and should also have formally enquired whether the governance body has any knowledge of actual, suspected or alleged fraud relating to scrap sales.

Respond appropriately to identified (or suspected) fraud—The auditors should have given due consideration to controls over scrap sales while reporting on internal controls in the Companies (Auditor’s Report)
Order, 2003 (‘CARO’) report. Post identification of the fraud, the auditor would have to appropriately modify the reporting relating to paragraph 4(xxi) of the CARO report.

As such, applying analytical procedures alone on the consideration that scrap income was insignificant to the overall financial statements was not appropriate and would not constitute sufficient appropriate audit evidence.

CASE 2

Background

XYZ Ltd. was engaged in the business of manufacturing gypsum boards, the primary raw material for which is natural gypsum. Gypsum was purchased in huge quantities in rock form in uneven size and shape. Given the quantity, size and shape, gypsum had to be stored in open spaces resulting in gypsum being exposed to the external environment. No physical verification was conducted during the year and at year-end, physical verification was not feasible given the huge quantum and uneven size/shape of the material in stock, the technical specifications (in terms of extent of exposure to light/air/water) as well as inability to draw inference based on test check. The quantity in stock was therefore certified by an independent surveyor and the auditors’ relied on the surveyor’s report. The quantity reported by the surveyor was used by the company to account for stocks in the books at the year-end.

The actual scenario was far different than that disclosed in the books. The quantity of gypsum in stock reported by the independent surveyor was as instructed by the factory manager. The factory manager reported the desired results given the arrangement with the valuer and the auditor’s reliance on the valuer’s work. The fraud came to light when during the course of interim audit for the subsequent financial year, the auditor insisted on physical verification of the stock by weighment at a point in time when the quantity of gypsum in the warehouse was at the lowest level. The quantity weighed physically was far less than that shown in the books at the time of physical verification.

Analysis with respect to SA 240 (Revised)

Responsibility of management and those charged with governance

In the present case, the perpetrator of the fraud was a functional manager (factory employee) as against a member of senior management in Case
1. The responsibility for preventing and detecting fraud primarily rests with the management; however, the administration and monitoring of controls in Case 2 would be different. This could have been achieved by:
Management evaluation of the expertise of the independent valuer engaged by the factory manager including considering obtaining a separate valuation from another valuer (given the quantum of stocks involved). Management could also independently test the methodology applied and assumptions made by the valuer in arriving at the likely quantity of stocks lying in the open ware-house.

Mandating physical verification by physical weighment of stocks at least once in a year and reconciliation of physical balances with book records, and also considering increasing the frequency of verification (based on the significant value of such stocks).

Formulating a policy of rotation of valuers at appropriate intervals.

Employees performing functions having high susceptibility to fraud being made to compulsorily avail annual leave.

Monitoring control in the form of an over-all exercise reconciling quantity of gypsum purchased, expected gypsum consumption (relative to finished goods produced) and derived closing inventory of gypsum would have also revealed the overstatement of closing inventory as per books.

Establishing a ‘code of conduct’ mandating compliance by one and all and stipulating disciplinary action (including termination and legal recourse) for non-compliance could have acted as a deterrent in fraud prevention/detection.

Auditors’ Responsibilities

Per SA 240 (Revised), while performing risk assessment procedures to obtain an understanding of the entity and its environment, the auditor should perform procedures to identify material misstatements due to fraud which includes A 620—Using the Work of an Expert requires that an auditor ought to have satisfied himself as to the expert’s skills, competencies and objectivity. The auditor should have considered whether the source data used by the expert, the assumptions made and methodology used is reasonable having regard to the auditor’s knowledge of the client business.

incorporating an element of unpredictability in selecting the nature, timing and extent of audit procedures. Accordingly, the auditor could have mandated that management conduct actual physical verification of stocks at a time other than the year-end and the auditor being present at such count.

The auditor should have performed analytical procedures to deduce the expected quantity of gypsum that would be in closing inventory at the year-end considering the production and expected input-output yield.

The auditor would need to appropriately modify his opinion in relation to paragraph 4(ii) of the CARO report relating to physical verification of inventories. Consequent to the fraud being detected, the auditor would need to consider modifying the audit opinion as well as consider fraud reporting under paragraph 4(xxi) of CARO report.

As such, mere reliance on the expert’s work by the auditors could not be considered as sufficient audit evidence for the purpose of expressing an opinion.

Whom should the auditor communicate with when the fraud is detected?

On fraud being identified or where the auditor has obtained information that fraud exists, the auditor must inform the same to the appropriate level of management who are primarily responsible for the prevention and detection of fraud. If the auditor suspects the fraud involving management, the communication should be done to those charged with governance. In other cases it should be to the management, at least one level above the level at which the fraud is suspected.

Although the auditor’s professional duty to maintain the confidentiality of client information may preclude him from reporting to any outside entity, the auditor’s legal responsibilities may override his duty of confidentiality on certain occasions, for e.g., when an auditor is required to disclose information under any law or under a directive of a judicial body/court.

Management Representations

The auditor should obtain written representations from the management or those charged with governance which include acknowledging their responsibility for the design, implementation and maintaining internal controls to prevent and detect fraud, that they have disclosed to the auditor the results of management’s assessment of the risk that the financial statements may be misstated on account of fraud and their knowledge of actual, suspected or alleged fraud. However, the obtaining of mere representation does not absolve an auditor from the responsibilities cast upon him under SA 240.

Compatibility with the corresponding International Standards of Auditing-ISA 240

The application section of paragraph A6, A56 and A66 of ISA 240 specifically deals with the application of the requirement of ISA 240 to the audits of public sector entities. However, since SA 240 (Revised) applies to all entities irrespective of their form, nature and size, a specific reference to the applicability of the Standard to public sector entities has not been included.

However the spirit of the corresponding para-graphs in ISA 240 has been retained in SA 240 (Revised) as follows:

Para A6 has been retained such that in certain cases the auditor may be required by the legislature or the regulator to specifically report on the instances of the actual/ suspected fraud in the client entity.

Para A56 has been retained such that the auditors may not have an option to withdraw from the engagements in certain cases.

Para A66 has been retained such that the requirement for reporting fraud, whether or not discovered through the audit process, may be subject to the specific provisions of the audit mandate or related legislation or regulation.

Conclusion:

Considering the nature and characteristics of a fraudulent act and the responsibility cast upon the auditor, it is imperative that due professional scepticism is exercised throughout the audit and the requirements of SA 240 (Revised) are followed to assist the auditor in identifying and assessing the risk of material misstatement due to fraud and in designing procedures to detect such mis-statement.

Nirav Shah

Changing Face of the Auditor’s Report

Our July 2013 issue focused on accountability. There cannot be a more relevant backdrop to the recent global developments taking place in enhancing the role of audit and the auditor’s reporting model.

A concern we have often heard but has remained unaddressed over the decades is the ‘expectation gap’ between the role of an auditor as expected or perceived by the users of the financial statements and what the real role of an auditor is under the applicable laws and regulations. The primary reason for this gap is the lack of communicative value of the auditor’s report. Investors have often indicated that auditors, in the audit process, obtain and review critical information relating to the company, areas of significant impact on the company’s financial position and exercise of management judgement around these areas. These insights do not make it through to the auditor’s report creating a gap between the information that is available to the auditors and their appointers. Consequently, the primary purpose of the audit report has remained limited to opining on whether the financial statements pass or fail the ‘true and fair’ presentation test.

To address these concerns, regulators around the world have worked together and are proposing changes in what is seen as an overhaul of the auditor reporting model.

On 25th July 2013, the International Auditing and Assurance Standards Board (IAASB) issued an exposure draft (the ED) of Reporting on Audited Financial Statements: Proposed New and Revised International Standards on Auditing (ISAs). The ED revises a number of existing ISAs and proposes a new ISA. The new ISA (ISA 701) Communicating Key Audit Matters in the Independent Auditor’s Report introduces requirements to include ‘key audit matters’ (KAMs) in the auditor’s report of listed entities. KAMs are those matters that the auditor considers of most significance in the audit of the entity’s current period financial statements.

Other changes to the auditor’s report are proposed by revising other ISAs including ISA 700 Forming an Opinion and Reporting on Financial Statements.

In summary, key changes in the auditor’s report proposed are as follows:

• Reporting Key Audit Matters

• A new section on the auditor’s opinion on the management’s assessment and appropriateness of the use of going concern basis and whether the auditor has identified a material uncertainty casting significant doubt on the entity’s ability to continue as a going concern

• A statement of auditor’s independence and compliance with other ethical responsibilities under the applicable law and regulations

• An improved description of the auditor’s responsibilities

• Reporting on the auditor’s responsibilities relating to other information

• Engagement partner’s name in the auditor’s report of listed entities.

While the IAASB was working on these proposals, the regulator on the other side of the North Atlantic Ocean wasn’t far behind. Within a matter of few days, on 13 August 2013, the Public Company Accounting Oversight Board (PCAOB) issued its own new auditing standard The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion with related amendments for public comment. The objective of this new PCAOB standard is, in essence, the same as that of the IAASB’s, i.e., to make the auditor reporting model more informative and relevant to investors and other financial statement users.

In addition to the existing pass/fail opinion, key proposals of the new PCAOB auditing standard in the auditors’ report are as follows:

• Reporting Critical Audit Matters (CAMs) identified and addressed by the auditor during the audit of the current period’s financial statements.

• Enhance the current reporting language by including the phrase ‘whether due to error or fraud’ in the context of whether the financial statements are free of material misstatements

• A specific statement on the auditor tenure (i.e. the year since the auditor has been serving the company consecutively)

• A specific statement on the auditor independence and compliance with the United States federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission (“SEC”) and the PCAOB

• Communication related to other information in accordance with the new PCAOB auditing standard proposed concurrently—The Auditor’s Responsibilities Regarding Other Information in Certain Documents Containing Audited Financial Statements and the Related Auditor’s Report

Although the IAASB’s and the PCAOB’s proposals refer to the key reporting matters differently—key audit matters vs. critical audit matters—the guidance around how these matters will be determined by an auditor is similar. These are both identified as significant risks or areas involving significant auditor judgment; areas that posed significant difficulty in obtaining sufficient appropriate audit evidence or forming an opinion on the financial statements; and those that required an auditor to significantly change the planned audit approach. Under both sets of standards, these are matters of such importance that they are communicated by the auditors with those charged with governance, e.g. the audit committee.

In addition to the IAASB and the PCAOB proposals, the European Commission is also working on similar projects that will change the auditor reporting model through new/revised accounting and audit directives. The changes proposed by the IAASB and the PCAOB are expected to be effective from fiscal periods beginning on or after 15th December 2015. However, different countries may adopt a different timeline in implementing these changes in their version of the ISAs. For example, even ahead of the IAASB’s proposals, in June 2013, the Financial Reporting Council already revised ISA 700 (UK & Ireland) The Independent Auditor’s Report on Financial Statements and is effective from the periods commencing on or after 1st October 2012 for the companies reporting against the UK Corporate Governance Code. Some of the changes in the ISA 700 (UK & Ireland) are over and above those proposed by the IAASB. For example, the ISA (UK & Ireland) also requires the auditor to report on how the concept of materiality was applied in planning and performing an audit.

The way ahead
These changes seem distant and are still at the proposal stage. It should be borne in mind though that these are based on extensive outreach activities conducted by the international regulators and have closely followed each other’s projects. Therefore, these are quite likely to make their way through to the final standards.

As regards the impact on audit reporting in India is concerned, the global developments may put forward an interesting challenge to the regulators and standard-setters in India. Currently, paragraphs 4 and 5 of the Companies (Auditor’s Report) Order, 2003 already require reporting on specific items but these may not align with the definition of a key/ critical audit matter referred to in the IAASB and the PCAOB proposals. Also, there are proposals that do not currently exist in an auditor’s report under the Indian Companies Act. Accordingly, it will have to be seen whether Indian audit reports get even longer by bringing on board these additional sections to make it more consistent with the global reporting model or get a bit more concise by replacing/ removing some of the items reported on currently.

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Nirav Shah

GAP in GAAP— Accounting of Tax Effects on Dividends Received from Foreign Subsidiary

The Finance Act 2013 has amended section 115-O of the Income tax Act. As per this amendment, the dividend distribution tax (DDT) to be paid will be reduced, among other matters, by the amount of dividend, if any, received from its foreign subsidiary if the domestic/ recipient company has paid tax u/s. 115BBD on such dividend.

An illustration is provided below. A domestic company received dividend of Rs. 100 from its foreign subsidiary and paid tax u/s. 115BBD of the Act. Later, but within the same financial year, it is distributing dividend of Rs. 300 to its shareholders. For simplicity, it is assumed that tax rate applicable on both the distributions is 15%. Given below is an computation of DDT in pre and post Finance Act 2013 scenario:

Particulars

Pre-Finance

Post-Finance

Act 2013

Dividend received from for-

100

eign subsidiary

Tax u/s. 115BBD of the Act

@ 15%

Dividend distributed

300

Less: dividend received from

–

100

foreign subsidiary

Amount liable to DDT

300

200

DDT @15%

In the Pre-Finance Act 2013 scenario under Indian GAAP, companies charge tax paid u/s. 115BBD, being tax paid on dividend income, as current tax to the statement of profit and loss (P&L). DDT paid u/s. 115-O is charged to P&L Appropriation account.

Query

In the Post-Finance Act 2013 scenario, how should a company account for tax paid of Rs. 15 u/s. 115BBD of the Act? Is this a tax paid on foreign dividends received (and hence charged to P&L A/c as current tax) or it is a payment of DDT (and hence charged to P&L Appropriation A/c)?

Author’s Response
View 1

The first argument is that the company continues to pay tax u/s. 115BBD of the Act which is charged to P&L A/c. The offset allowed in the recent amendment results in lower DDT to be paid. Therefore, under this view, current tax charge would be Rs. 15 charged to P&L A/c and DDT to be adjusted against P&L Appropriation A/c would be Rs. 30.

View 2
The second argument is that through the offset mechanism, the company is entitled to claim refund of the tax paid u/s. 115BBD of the Act. Hence, if the company believes that it will be able to use the benefit of tax paid by reducing the DDT, it should not charge the same to P&L. Rather, it should recognise the same as a separate asset. The said asset will get realised at the time of dividend distribution to its shareholders. A company will be able to recognise such asset only if it can demonstrate that distribution of dividend is reasonably certain and it will be able to utilise the credit (under the Act the utilisation should happen within the same financial year). According to this view, the current tax charge would be Nil and DDT to be adjusted against P&L Appropriation A/c would be Rs. 45.

A strong argument in support of View 2 is that the intention of the law is to provide relief on the cascading effect of tax. The intention is to fix the income tax charge on the company based on the ultimate dividend outflow to the shareholders. Therefore per se there is no relief with regards to DDT, but the relief is with respect to dividend income earned by the company, provided they are in turn distributed to ultimate shareholders.

Conclusion

The author believes that the issue is debatable and that both views are possible, for the reasons mentioned above. When View 2 is applied, a note, drafted as follows, could be included in the financial statements: “Current tax charge excludes income-tax paid u/s. 115BBD of the Income-tax Act, since it has been used as a set-off against payment of DDT.”

To achieve the objective of comparability, the Institute should publish its’ view on AS 22 – Accounting to taxes on income.

Nirav Shah

Pantaloon Retail (India) Limited (30-6-2010)

New Page 1

Section A : Disclosures on Clause 21 of CARO, 2003 regarding
fraud noticed or reported on or by the company during the year

10. Pantaloon Retail (India) Limited (30-6-2010)

From Auditor’s Report :

To the best of our knowledge and belief and according to the
information and explanations given to us, no fraud on or by the Company has been
noticed or reported during the year, although there were some instances of fraud
on the Company by the Management, the amounts whereof were not material in the
context of the size of the Company and the nature of its business and the
amounts were adequately provided for.

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Nirav Shah

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