BCAJ | Bombay Chartered Accountant Journal

GAPs in GAAP — Revenue — Gross vs. Net of Taxes

The gross v. net presentation of taxes is very important for many companies as revenue is a key performance indicator. Further some companies have to pay licence fees or have a revenue sharing arrangement and hence the amount disclosed as revenue becomes critical. There is substantial accounting literature in Indian GAAP that deals with these issues, albeit in various context.

In the ‘Guidance Note on Terms used in Financial Statements’ of ICAI, the expression ‘sales turnover’ has been defined as: “The aggregate amount for which sales are effected or services rendered by an enterprise.” The term ‘gross turnover’ and ‘net turnover’ (or ‘gross sale’ and ‘net sales’) are sometimes used to distinguish the sale aggregate before and after deduction of returns and trade discounts”

The Guide to Company Audit issued by the Institute while discussing ‘sales’, states as follows:

“Total turnover, that is, the aggregate amount for which sales

are effected by the Company, giving the amount of sales in respect of each class of goods dealt with by the company and indicating the quantities of such sale for each class separately.

The term ‘turnover’ would mean the total sales after deducting therefrom goods returned, price adjustments, trade discount and cancellation of bills for the period of audit, if any. Adjustments which do not relate to turnover should not be made e.g., writing off bad debts, royalty, etc. Where excise duty is included in turnover, the corresponding amount should be distinctly shown as a debit item in the profit and loss account.”

The ‘Statement on the Amendments to Schedule VI to the Companies Act, 1956’ issued by the ICAI while discussing the disclosure requirement relating to ‘turnover’ states as follows:

“As regards the value of turnover, a question which may arise is with reference to various extra and ancillary charges. The invoices may involve various extra and ancillary charges such as those relating to packing, freight, forwarding, interest, commission, etc. It is suggested that ordinarily the value of turnover should be disclosed exclusive of such ancillary and extra charges, except in those cases where because of the accounting system followed by the company, separate demarcation of such charges is not possible from the accounts or where the company’s billing procedure involves a composite charge inclusive of various services rather than a separate charge for each service.

In the case of invoices containing composite charges, it would not ordinarily be proper to attempt a demarcation of ancillary charges on a proportionate or estimated basis. For example, if a company makes a composite charge to its customer, inclusive of freight and despatch, the charge so made should accordingly be treated as part of the turnover for purpose of this section. It would not be proper to reduce the value of the turnover with reference to the approximate value of the service relating to freight and despatch. On the other hand if the company makes a separate charge for freight and despatch and for other similar services, it would be quite proper to ignore such charges when computing the value of the turnover to be disclosed in the Profit and Loss Account. In other words, the disclosure may well be determined by reference to the company’s invoicing and accounting policy and may thereby vary from company to company. For reasons of consistency as far as possible, a company should adhere to the same basic policy from year to year and if there is any change in the policy the effect of that change may need to be disclosed if it is material, so that a comparison of the turnover figures from year to year does not become misleading.”

The Statement on the Companies (Auditors’ Report) Order 2003 issued by the Institute in April 2004, while discussing the term ‘turnover’ states as follows: The term ‘turnover’ has not been defined by the order. Part II of Schedule VI to the Act, however, defines the term ‘turnover’ as the aggregate amount for which sales are effected by the company. It may be noted that the ‘sales effected’ would include sale of goods as well as services rendered by the company. In an agency relationship, turnover is the amount of commission earned by the agent and not the aggregate amount for which sales are effected or services are rendered. The term ‘turnover’ is a commercial term and it should be construed in accordance with the method of accounting regularly employed by the company.

As per the ‘Guidance Note on Tax Audit’ — “The term turnover for the purposes of this clause may be interpreted to mean the aggregate amount for which sales are effected or services rendered by an enterprise. If sales tax and excise duty are included in the sale price, no adjustment in respect thereof should be made for considering the quantum of turnover. Trade discounts can be deducted from sales, but not the commission allowed to third parties. If, however the excise duty and/ or sales tax recovered are credited separately to excise duty or sales tax account (being separate accounts) and payments to the authority are debited in the same account, they would not be included in the turnover. However, sales of scrap shown separately under the heading ‘miscellaneous income’ will have to be included in turnover.”

As per explanation to paragraph 10 of AS-9 Revenue Recognition, “The amount of revenue from sales transactions (turnover) should be disclosed in the following manner on the face of the statement of profit and loss:

Turnover (Gross)   XX
Less: Excise Duty   XX
Turnover (Net)   XX

The amount of excise duty to be deducted from the turnover should be the total excise duty for the year except the excise duty related to the difference between the closing stock and opening stock. The excise duty related to the difference between the closing stock and opening stock should be recognized separately in the statement of profit and loss, with an explanatory note in the notes to accounts to explain the nature of the two amounts of excise duty.” AS-9 clearly sets out the requirement with respect to presentation of revenue and excise duty.

With respect to VAT the Guidance Note on Value Added Tax issued by ICAI states that “VAT is collected from the customers on behalf of the VAT authorities and, therefore, its collection from the customers is not an economic benefit for the enterprise and it does not result in any increase in the equity of the enterprise”. Accordingly, VAT should not be recorded as revenue of the enterprise. Correspondingly, the payment of VAT is also not treated as an expense. The Guidance Note on VAT further states, “Where the enterprise has not charged VAT separately but has made a composite charge, it should segregate the portion of sales which is attributable to tax and should credit the same to ‘VAT Payable Account’ at periodic intervals”. Currently most companies follow this guidance, though some entities have presented revenue gross of VAT and correspondingly treated VAT as an expense.

With respect to sales tax and service tax, the Guidance Note on revised Schedule VI states that such taxes are generally collected from the customer on behalf of the Government in majority of the cases. However, it adds that this may not hold true in all cases and it is possible that a company may be acting as principal rather than as an agent in collecting these taxes. 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. Strangely under the Guidance Note on revised Schedule VI, this concept of principal and agent is to be applied only with respect to sales tax and service tax, but not on excise duty which is covered under AS-9 and VAT which is covered by the GN on VAT.

Author’s view

Sellers of goods and services may enter into different arrangements with respect to indirect taxes. Some contracts clearly require the customer to pay the seller whatever tax is finally paid to the Government; in other words the seller acts as an agent between the Government and the customer. In other cases, the seller charges one all inclusive lump-sum amount for the entire sale contract including taxes.

The seller then pays to the Government whatever taxes are due, shouldering the risks of changes in tax rate or tax legislations. The tax burden on the seller would be the amount paid to the Government less any amount of input credit that is available to him. The tax burden could vary significantly under different scenarios, and this would determine the ultimate profit the seller makes on the lump- sum contract. In such cases, it could be said that the seller acts as a principal with respect to these taxes and hence should present revenue on a gross basis and the indirect tax as an expenditure. This example highlights a quagmire that companies have to face due to conflicting literature. On the one hand the guidance note on VAT requires a net presentation; whereas the guidance note on revised Schedule VI with respect to sales tax and service tax requires an assessment of principal and agent relationship which in this example would translate into a gross presentation.

The end result is that “what is good for the goose is not good for the gander” and absent a uniform principle for presentation of revenue and indirect taxes significant disparity in the disclosures would continue to arise in the future.

In the author’s view, the ICAI should commission a project to deal comprehensively with the presentation of various indirect taxes paid in India. Whether these taxes are presented gross or net, would depend on the nature of the indirect tax and the contractual arrangements between the seller and the buyer. It may be noted that under International Financial Reporting Standards, the evaluation of gross v. net presentation is done on the basis of principal agent relationship.

Nirav Shah

Don’t Underestimate India’s Consumers

Accountant Abroad

“Don’t Underestimate India’s Consumers”,
says John Lee
who is a fellow at the Centre for Independent Studies, Australia and visiting
fellow at Washington’s Hudson Institute. He has authored the book ‘Will China
Fail?’ His analysis of the distinction of current domestic market push in China
and India makes interesting reading.

Western multinationals are often attracted to China’s size,
but they’re bypassing Asia’s true shopping powerhouse

The scale of China has always fascinated merchants. In 19th
century England, spinning-mill owners were convinced they would reap profits
beyond their dreams if they could just get every Chinese to buy one
handkerchief. Alas, the one man one handkerchief plan never took off, and for
multinationals hoping to tap China’s masses, the country continues to
disappoint. Since the global economic crisis, Beijing has constructed a way
around a slump. Roads, ports, railways: Name it, and China is building it. But
its consumers aren’t pitching in. As a percentage of the gross domestic product,
Chinese consumption is the lowest of any major economy at less than one-third.
Almost all the country’s growth this year has come from infrastructure spending
or speculation in domestic assets.

Western multinationals should consider fantasizing about
India instead. The momentum for its bounce back comes from Indians, including
the poor, buying their way to growth. The demand for handbags, air travel, and
fine dining in Mumbai may have eased, but domestic consumption accounts for
two-thirds of the Indian economy — twice China’s level!

China’s problem is that its top-down, state-led model of
development (not to mention its artificial suppression of the Yuan) structurally
impairs domestic spending. According to Minxin Pei, director of the Keck Center
for International & Strategic Studies, three-quarters of China’s capital goes to
the 120,000 odd state-controlled entities and their many subsidiaries, leaving
40 million plus privately owned businesses to fight for scraps. The upshot:
Business profits tend to end up in state coffers, not Chinese wallets. Wage and
income growth, even for China’s urban residents, hovers at about half the level
of GDP growth over the past 15 years.

India’s bottom-up private sector model, for all its chaos and
bureaucracy, provides a stark contrast. While the nation badly needs
infrastructure, its consumers are in a far better position to spend. India can
now boast of an overwhelmingly independent middle class about 300 million
strong, as against China’s 100 – 200 million, depending on the parameters.
Profits from India’s businesses, large and small, go into Indian pockets rather
than the state coffers.

The contrast sharpens outside these two nations’ cities. Half
of China and two-thirds of India live in rural areas. That’s about 700 million
people in each. The rural half of China is falling behind. Back in the
mid-1980s, the mainland’s urban-rural income ratio was 1.8. It now stands at
about 3.5. Although per-capita incomes have risen, an estimated 400 million of
mainly rural residents have seen net incomes stall or decline over the past
decade. Yasheng Huang, a professor at the Massachusetts Institute of
Technology’s Sloan School of Management, estimates that China’s absolute levels
of poverty and illiteracy have doubled since 2000! In India, they’ve been
halved. The urban-rural income gap has steadily declined since the early ‘90s.
Over the past decade, economic growth in rural India has outpaced growth in
urban areas by almost 40%. Rural India now accounts for half the country’s GDP,
up from 41% in 1982. World Bank studies show that rural China accounts for only
a third of GDP and generates just 15% of China’s growth. Meanwhile, rural India
is chipping in about two-thirds of the overall growth.

Jagmohan S. Raju of the University of Pennsylvania’s Wharton
School points out that every major Indian consumer company knows it can’t
succeed without reaching the villages. That’s why Indian companies arguably lead
the world in innovative low-income products. Telecom provider Bharti offers the
world’s lowest call rates; Tata Motors sells the world’s cheapest car. And the
push for the villages has led to a well-developed consumer marketplace
throughout India.

For Western brands chasing the luxury market, both China and
India offer abundant opportunities. But when what you sell is suited to — and
scaled to — millions of city and country dwellers, it makes sense to aim your
ef¬forts at India — at least for now.

(Source :
Bloomberg BusinessWeek,
February 1 & 8, 2010)

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Nirav Shah

Auditing Companies’ Ethics

Accountant Abroad

Questions have been raised about the conduct of business on
the back of the global market collapse. Is the profession ready to be called
upon to audit companies’ ethics ? Michelle Perry reflects on this question in an
article published in Accountancy magazine (February 2009).

As the bewildering number of strands to the present global
financial crisis unfolds and new precedents are set daily, the role of the
accountancy profession in the financial meltdown is under review.

In the wake of the corporate collapses that began with Enron,
the finger was pointed keenly at auditors, who were demonised to such an extent
that lawmakers in Europe and America were kept so busy drafting new accounting
rules and regulations that any real in-depth analysis of the causes of those
corporate disasters didn’t happen until long after new rules were already in
place. But the rules did not prevent Madoff’s giant Ponzi scheme — at this
stage, it isn’t clear whether any of the audit firms should have known about the
scheme when they performed, for example, due diligence work for clients and
funds that lent him the money. And upon reflection of PricewaterhouseCooper’s
statement that its audits of Satyam were conducted ‘in accordance with
applicable auditing standards and were supported by appropriate audit
evidence’, it becomes apparent that the rules did not stop senior financial
executives from producing fictitious numbers.

Authorities aren’t making those same mistakes this time
round. So far, regulatory muscles haven’t been flexed in terms of drafting reams
of new rules, but questions are being asked again about whether auditors could
have done more to mitigate the current corporate collapses in this financial
crisis.

No more rules :

Although the profession says there are lessons to be learnt
from this current crisis, for now it doesn’t support the creation of any new
rules. ‘It’s wrong to say this is all about unethical behaviour by companies. We
would be very nervous about new standards,’ says Steve Maslin, Grant Thornton’s
head of external professional affairs. ‘What comes out of the analysis of this
financial crisis isn’t that we need new standards but that they are better
policed.’ Nina Barakzai, an ethics expert who sits on IFAC’s ethics standards
board, supports this view : ‘We don’t need to change any regulations until we
know why we are changing them and how that will impact on other things . . . It
becomes more important to stick with principles now in the current climate.’ To
ensure better policing of the existing rules, Maslin suggests companies could do
more to regularly check the composition of the executive and non-executive
boards to see if they are ‘fit for purpose’.

One issue that keeps resurfacing is the role of auditors in
assessing business ethics, and whether it is possible to accurately measure a
company’s ethics. The profession has always been supportive of increased
disclosure and narrative reporting, breaking ground with the development of the
operating and financial review (OFR), or the Business Review. Narrative
disclosure has increased significantly over the past decade and continues to
rise, but assurance of this for the most part is not widespread, and anyway its
currently unclear as to whether any existing assurance in this sphere did
anything to prevent the present financial crisis.

The question remains, is it possible to assess and measure
the business ethics of people and are auditors the best placed to do it ? There
are issues of conflict to seriously consider. Accountants may have the most
appropriate skills but aren’t often independent enough to do this kind of
reporting. You won’t get the equivalent of audit report on financial statements
by way of an audit opinion on business ethics.

Like many in the profession, Maslin is concerned that we
ended up forcing companies to report on so many different items that already
weighty financial reports have become even longer. Accountants nonetheless have
a role to play in fostering ethical behaviour in business.

‘In terms of measuring business ethics, we are really in our
nappies,’ says Leo Martin, Director and co-founder of Good Corporation, which
has developed a standard to measure companies’ business ethics. Martin points to
the Siemens corruption scandal, currently in the courts, as an example of how
difficult it would be to catch such unethical behaviour in an audit : Siemens
agreed to pay a record $ 1.34 bn (£ 970 m) in fines in December 2008 after being
investigated for serious bribery involving top executives and management board
members. The inquiry revealed questionable payments of roughly $ 1.9 bn between
2002 and 2006, leading to investigations in Germany and the US.

‘Most auditors would never catch that behaviour because it
didn’t appear in the accounts. That requires a different kind of auditing and
whistle-blowing,’ Martin adds. Auditors are already working closely with
anti-corruption and fraud organisations like Transparency International to
develop controls to combat corporate corruption, and research what role they can
play in detecting corruption.

Laurence Cockcroft, former Chairman of Transparency
International, says management attitudes have changed considerably since the mid
1990s in a positive way and there’s greater awareness now. We are in a new era,
but there’s a long way to go,’ he says.

Independence is integral :

What is certain is that any assurance or auditing of business
ethics must remain unquestionably independent, and more importantly be perceived
to be independent too. Credibility is vital in the current market.

The AIU – Audit Inspection Unit, part of the Professional Oversight Board, found the top seven audit firms’ methods of conducting audit to be generally acceptable, but the report also pinpointed a number of problem areas, expressing concerns over independence and ethical behaviour at several of the firms it reviewed. Accountants are keenly aware of the need to highlight their credibility and that objectivity is where auditors have to avoid compromising. There is general agreement the problem lies in the fact that there are vast questions of judgment involved. Normally these are discussed and mutually resolved; however, behind-the-scenes debate between auditors and boards isn’t appreciated as much as it should be.

Firms must work to allay any concerns the regulators and investors have and heed their suggestions to help restore credibility in the financial systems. No one knows what will happen next in terms of the global economy but economists and business experts predict worse is still to come, which means that the profession will need to illustrate its robustness.

Excerpted from article by Michelle Perry in Accountancy [ICAEW – UK] February 2009.

Nirav Shah

Singapore Spells Out Six Tenets of Regulation

Accountant abroad

Post-crisis world requires high regulatory standards, while
also allowing for innovation and risk-taking

The recent global financial crisis, which resulted in the
failure of complex financial products and the collapse of several foreign banks
elsewhere, has led to calls here (in Singapore) and globally for tougher
regulation of financial institutions.

In a treatise released on June 8, the Monetary Authority of
Singapore (MAS) shed light on its own position, saying that regulations must not
become too stringent in an attempt to prevent any kind of company shortcoming or
failure. At the same time, it also warned that Singapore’s regulatory regime
should not swing too far in the opposite direction, with an overly dynamic
approach adopted at the expense of a stable financial system. Setting out what
it calls six ‘tenets of effective regulation’, it says it has to tread a middle
ground that sees high standards of regulation, while allowing well-managed
risk-taking and innovation.

Its so-called monograph comes at a time when international
regulatory standards are being reviewed and tightened worldwide by
policy-makers. Among other things, new capital rules — dubbed Basel III — are on
course to be implemented by major financial jurisdictions, including Singapore.
MAS said that while new international regulatory standards will mean some
tightening here, the shift will not be dramatic. It will use its tenets to
design regulation in the post-crisis world and help ensure its approach is
relevant and effective in achieving what it calls a sound and progressive
financial services sector.

In releasing the monograph, MAS said it is looking to foster
shared understanding and ‘shared ownership’ of its approach and objectives with
industry players. The six tenets that will be used to guide its actions are :

outcome focussed;

shared responsibility;

risk appropriate;

responsive to change and
cycles;

impact sensitive; and

clear and consistent.

These six tenets or principles are seen as being at the heart
of MAS’ approach to regulation.

The ‘outcome focussed’ tenet is evident, for example,
in housing loan rules which serve to encourage prudent lending and proper credit
assessment by financial institutions. This is in line with MAS’ financial
stability objectives and the Government’s policy of promoting a stable and
sustainable property market. To meet these goals, MAS has put in place property
lending limits. The 80% loan-to-value regulatory limit, for example, requires
banks to maintain a ‘prudent buffer’ in their housing loan portfolios, and
encourages property buyers to be more circumspect when making purchases. The
‘shared responsibility’ tenet is demonstrated through the MAS guidelines on
fair dealing issued last year. They spell out the responsibilities of the boards
of directors and senior managements of financial institutions for delivering
fair dealing outcomes to customers.

In underlining its six tenets, MAS stressed that a balanced
regulatory approach was needed, with effective regulation guided by a range of
considerations. These include transparency and clarity, the balance of costs and
benefits, and meeting international standards while remaining appropriate in the
local context.

MAS’ monograph has met with a broadly positive industry
response. Barclays Capital economist Leong Wai Ho said that Singapore “was one
of the well-managed economies” with a sound
banking

system, and added
that the ‘mission statements’ were “really about MAS facing up to an evolving
landscape”. “Market players must play their part and share the responsibility to
ensconce a level playing field,” said Mr. Robson Lee, a partner at investment
banker Shook Lin & Bok.

And MAS deputy managing director Teo Swee Lian noted in a statement that success
in achieving effective regulation “requires more than MAS setting demanding
standards of itself”. He noted that the industry played a key role in the
implementation of regulation. They should not rely on the Government to
prescribe or legislate in a knee-jerk response whenever there are adverse market
developments. “Industry has a critical role to play by taking shared
responsibility for and ownership of the regulatory objectives, as well as
instituting high standards of governance and controls for itself.”

(Source : The Straits Times, Money Supplement, 9-6-2010)

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Nirav Shah

Lehman’s illegal gimmicks

Accountant Abroad

A court-appointed United
States bankruptcy examiner has concluded there are grounds for legal claims
against top Lehman Brothers bosses and auditor for signing off misleading
accounting statements in the run-up to the collapse of the Wall Street bank in
2008, which sparked the worst financial crisis since the Great Depression. A
judge this week released a 2200-page forensic report by expert Anton Valukis
into Lehman’s collapse that includes scathing criticism of accounting ‘gimmicks’
used by the failing bank to buy itself time. These included a contentious technique known as ‘Repo 105’ which temporarily boosted the bank’s balance sheet
by as much as $ 50 billion.

The exhaustive account
reveals that Barclays, which bought Lehman’s US businesses out of bankruptcy,
got equipment and assets it was not entitled to. And it reveals that during
Lehman’s final few hours, chief executive Dick Fuld tried to get British Prime
Minister Gordon Brown involved to overrule Britain’s Financial Services
Authority (FSA) when it refused to fast-track a rescue by Barclays. With Wall
Street shaken by the demise of Bear Stearns in March 2008, Valukis said
confidence in Lehman had been eroded : “To buy itself more time, to maintain
that critical confidence, Lehman painted a misleading picture of its financial
condition.” The examiner’s report found evidence to support ‘colorable claims’,
meaning plausible claims, against Fuld and three successive chief financial
officers.

Valukis said the bank tried
to lower its leverage ratio, a key measure for credit-rating agencies, with Repo
105 — through which it temporarily sold assets, with an obligation to repurchase
them days later, at the end of financial quarters, in order to get a temporary
influx of cash. Lehman’s own financial staff described this as an ‘accounting
gimmick’ and a ‘lazy way’ to meet balance-sheet targets. A senior Lehman
vice-president, Matthew Lee, tried to blow the whistle by alerting top
management and the
auditors. But the auditing firm ‘took virtually no
action to investigate’.

During the bank’s final
hours in September 2008, Fuld tried desperately to strike a rescue deal with
Barclays, but the FSA would not allow the British bank an exemption from seeking
time-consuming shareholder approval. The British finance minister, Alistair
Darling, declined to intervene and Fuld
appealed to the US treasury secretary, Henry
Paulson, to call Prime Minister Gordon Brown, but
Paulson said he could not do that,” says the
examiner’s report.

“Fuld asked Paulson to ask
(then US) President George Bush to call Brown, but Paulson said he was working
on other ideas. In a ‘brainstorming’ session, Fuld then suggested getting the
president’s brother, Jeb Bush, who was a Lehman adviser, to get the White House
to lean on Downing Street.

Barclays eventually bought
the remnants of Lehman’s Wall Street operation from receivership for $ 1,75
billion — a sum that has enraged some bankruptcy creditors who believe it was a
windfall for the British bank.

The examiner’s report finds
grounds for claims against Barclays for taking assets it was not entitled to,
including office equipment and client records belonging to a Lehman affiliate,
although it says these were not of material value to the deal — the equipment
was worth less than $ 10 million.

The report into the bank’s
demise revealed last week a similar addiction to accounting hallucinogens like
those seen in the Enron case. Until now, the big mystery was how the Wall Street
giant could have been reporting healthy profits right up until the
moment it keeled over and died — bringing most of the Western economy down with
it. But the latest investigation reveals financial transactions known as Repo
105 and Repo 108, used to remove temporarily tens of billions of dollars of debt
from the bank’s balance sheet at the end of every accounting period. As the
banking crisis grew, so did Lehman’s addiction to such trickery. Executives even
referred to Repo 105 as “another drug we’re on” in emails uncovered by the
report.

A lawyer for Fuld has
rejected the examiner’s findings. Patricia Hynes of the law firm Allen & Overy,
said Fuld did not structure or negotiate the Repo 105 transactions, nor was he
aware of their accounting treatment. She added that Fuld “throughout his career
faithfully and diligently worked in the interests of Lehman and its
stakeholders”. A spokesman for the London-headquartered auditors of Lehman told
Reuters the firm had no immediate comment because it was yet to review the
findings.

The capacity for Lehman to
continue to shock after a year of books and revelations is itself a shock. But
the biggest surprise is how little has changed since Enron and the scams of the
last financial bubble. Regulators like to caution against simply addressing the
specific causes of past scandals when trying to prevent future ones, but it is
as if all the Wall Street rules introduced to clean up accounting have only
encouraged finance directors to study the history books more closely for
inspiration.

Edited version of the article
by Andrew Clark

(Source : Mail &
Guardian Online, 23-3-2010

Web address : http://www.mg.co.za

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Nirav Shah

Consolidation – redefining control and reflecting true net worth Part-2

In the previous article, we discussed the principles of control defined in the IFRS consolidation standards, the impact of rights available with non controlling interests, accounting for step-up acquisitions, accounting for dilution of stake with or without losing control and consolidation of special purpose entities.

Continuing with the topic of consolidation, in this article we will cover certain implementation issues and other differences which will have a significant impact on Indian companies.

Key differences and implications:

Concept of de facto control:

In the earlier article we discussed that control is defined as the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. This definition of control under IFRS gives rise to another perspective, which is the’ defacto’ control model. De facto control arises when an entity holding a significant minority interest can control another entity without legal arrangements that would give it majority voting power. De facto control exists if the balance of holdings in an entity with other shareholders is dispersed and the other shareholders have not organised their interests in such a way that they commonly exercise more votes than the significant minority shareholder.

Under a de facto control model the power to govern an entity through a majority of the voting rights or other legal means is not essential for consolidation. Rather, the ability in practice to control (e.g., by casting a majority of the votes actually cast) in the absence of legal control may be sufficient if no other party has the power to govern. Under this approach, de facto control is evaluated based on all evidence available. Presence of de facto control can result in consolidation by the significant minority shareholder.

Both the ‘power to govern’ and ‘de facto’ control models meet the principles of control under IAS 27 – Consolidated financial statements. Accordingly, an entity has an accounting policy choice on assessing control and consolidation i.e. whether to assess as per the power to govern model or the de facto control model. This policy choice needs to be followed consistently and disclosed in the financial statements.

Accounting for joint ventures:

Currently, accounting for joint ventures under IFRS is not very different from accounting under Indian GAAP i.e. AS 27 – ‘Financial reporting of interests in joint ventures’. However, IAS 31- ‘Reporting interests in joint ventures’ gives the venturer a choice to account for a jointly controlled entity using either the proportionate consolidation method or the equity method in its consolidated financial statements. Interestingly, as part of the IASB/FASB convergence project, the exposure draft ED-9 on ‘Joint Arrangements’ issued by the IASB in September 2007 proposes to prohibit the proportionate consolidation method. Hence, once this ED becomes an effective IFRS, venturers would account for jointly controlled entities only as per the equity method of accounting in their consolidated financial statements.

The basis for such a change has been stated by the IASB as follows – ‘When a party to an arrangement has joint control of an entity, it shares control of the activities of the entity. It does not, however, control each asset nor does it have a present obligation for each liability of the jointly controlled entity. Rather, each party has control over its investment in the entity. Recognising a proportionate share of each asset and liability of an entity is not consistent with the Framework, which defines assets in terms of exclusive control and liabilities in terms of present obligations.’ Hence the equity method of accounting is more representative of the interests of a venturer in the joint venture. Going forward, this change would most impact the reported consolidated revenue of such venturers.

Accounting for associates:

The principles of accounting for associate entities in the consolidated financial statements of an investor under IFRS are the same as under Indian CAAP. Unlike Indian CAAP, IFRS considers potential voting rights that currently are exercisable in assessing significant influence, for example convertible debentures held by the investor.

Deferred taxes on consolidation:

Under Indian CAAP, deferred taxes in the consolidated financial statements are quite simply the summation of deferred taxes in each of the individual group companies. Unlike IFRS, the Indian CAAP accounting framework does not require any adjustments to be made to deferred taxes on consolidation. Under IFRS, the important adjustments that are required to be made to arrive at the consolidated deferred taxes and resultant profit after tax are as below:

Elimination of deferred taxes on inter company transactions/stock reserves:

In determining tax expense in consolidated financial statements, temporary differences arising from elimination of unrealised profits and losses resulting from intra-group transactions should be considered. Consider an example: Parent company sells goods to its subsidiary company worth Rs. 1000. Parent company’s profit on this transaction is Rs. 100. At the year end, these goods remain unsold by the subsidiary and are hence lying in its inventory. On consolidation an adjustment to eliminate the unrealised profit of Rs. 100 is made in the consolidated financial statements of the Parent company. Hence the accounting base of the inventory in the consolidated books has now become Rs.900 whereas the tax base of the same inventory still remains Rs. 1000. This gives rise to deductible temporary difference which should be recognised as a deferred tax asset in the consolidated financial statements.

Now the question that arises is at what tax rate should this deferred tax asset be recognised – at the seller’s (parent company’s tax rate) or the buyer’s (subsidiary company’s tax rate). IAS 12 states that an entity recognises deferred tax assets only when it is probable that taxable profits will be available against which the deductible temporary differences can be utilised/Since the reversal of the difference would result in lower current taxes in the buyer’s books, the recognition of this deferred tax asset is made on the buyer’s rate keeping into consideration whether the buyer would have sufficient taxable profits in the future to utilise this deferred tax asset.

Recognition of deferred taxes on undistributed profits of joint ventures and associates:

Currently under Indian CAAP, profits of subsidiaries, branches, associates and joint ventures (‘investee companies’) are included in consolidated profits of the Parent company. The consolidated performance results and net worth are accordingly reported to the shareholders of the Parent under Indian CAAP. However one important aspect that is not reported is the impact of tax leakage when the profit earned by the investee companies will be transferred to the Parent. Accordingly the consolidated profit and the net worth reported under Indian CAAP is over-stated to that extent, since the overall tax impact on the consolidated profit available to the Parent company is not completely recorded in the books of account. Such deferred tax impact is accounted for in the consolidated financial statements under IFRS.

For example: Parent Company P consolidates undistributed profits of Rs. 100 crores of Subsidiary company S in its consolidated financial statements of which Rs 15 crores is post acquisition profits. P plans to draw dividends of Rs.20 crores from S in 18 months’ time; P estimates that Rs.15 crores of that amount will relate to post-acquisition earnings already recognised in the financial statements. The dividend distribution tax rate in S’s jurisdiction is 15%. In this case, P should recognise a deferred tax liability of Rs.2.25 crores (at a rate of 15% on Rs.15 crores) in its consolidated financial statements.

Thus as explained above, undistributed profits of certain investee companies result in a taxable temporary difference in the consolidated books of accounts. However, as per Para 39 of IAS 12, taxable temporary differences in respect of investments in subsidiaries, branches, associates and joint ventures are not recognised if :

the investor is able to control the timing of the reversal of the temporary difference; and

it is probable that the temporary difference will not reverse in the foreseeable future.

Since an entity controls an investment in a subsidiary or branch, the entity may be exempt for recognising deferred tax liability on undistributed profits, if it can demonstrate that it controls the timing of the reversal of a taxable temporary difference and the temporary difference will reverse in the foreseeable future. The term ‘foreseeable future’ is not defined in the standard; generally it is necessary to consider in detail a period of 12 months from the reporting date, and also to take into account any transactions that are planned for a reasonable period after that date.

Since deferred tax assets and liabilities are measured based on the expected manner of recovery (asset) or settlement (liability); deferred taxes on undistributed profits of subsidiaries, joint ventures or associates could be recognised either based on the applicable dividend distribution tax or the capital gains tax rate depending on the expected manner of recovery of such profits.

In case where the difference is assumed to be reversed though capital gains i.e. on sale of investments deferred tax liability is created on the effective capital gain tax rate on the difference between the net assets attributable to the Parent’s share less the indexed cost of acquisition.

In the above example, consider that P plans to dispose of the investment in 15 months and the capital gains tax rate applicable to it is 30%. The excess of the net assets of S over the cost of acquisition is Rs.15 crores and the indexation benefit is assumed to be 3 crores. In this case, P would recognise a deferred tax liability of Rs.3.6 crores [(15-3)*30%]in its current consolidated financial statements.

In situations where the entity does not account for the aforesaid deferred tax liability in accordance with Para 39, a disclosure to that extent is required in the financial statements reporting the amount of deferred tax liability not accounted for in the books.

An investor does not control an associate or a joint venture and therefore is not in a position to control the associate/joint venture’s dividend policy. Therefore a deferred tax liability must be recognised unless the associate/joint venture has agreed that profits will not be distributed in the foreseeable future or the Parent company’s approval is mandatory for dividend distribution (as a protective right).

Uniform accounting policies:

Para 24 of IAS 27 states that ‘consolidated financial statements shall be prepared using uniform accounting policies for like transactions and other events in similar circumstances.’ Therefore, if a subsidiary, associate or joint venture uses different accounting policies from those applied in the consolidated financial statements, then appropriate consolidation adjustments to align accounting policies should be made when preparing those consolidated financial statements. In practice, this can often pose challenges, particularly in case of associates and joint ventures, where the parent entity has no control over the accounting policies considered by the investee companies for their separate financial statements.

Impact of business combination ‘fair value’ accounting on ongoing consolidation:

In the earlier article on IFRS 3 – Business Combinations (refer BCA Journal, June 2009 edition), we discussed the purchase method of accounting for all business combinations and in particular, acquisition of a subsidiary, which results in accounting for all assets and liabilities acquired at fair values. Since there is no option of push down accounting under IFRS, the subsidiary continues to carry the same assets and liabilities at their book values (or as per the IFRS accounting policy adopted by it for each asset and liability) in its stand alone books of ac-count. Whereas in the consolidated books of accounts, the assets and liabilities at acquisition date are continued to be carried at fair values as on that date. This results in the following additional adjust-ments that are required to be carried out as part of the consolidation procedure at every reporting period:

Restate the recognised assets and liabilities in the subsidiary’s books as on acquisition date to their fair values and accordingly make adjustments for depreciation or amortisation

Recognise intangibles identified as on the acquisition date at their fair values and accordingly make adjustments for amortisation or impairment

Recognise deferred taxes as on the acquisition date and accordingly make adjustments for reversals in the future periods.

Effectively, the acquired subsidiary would have to maintain two sets of financial statements:

Separate financial statements as per IFRS book values or the accounting policies applied

Financial statements for consolidation purposes as per the fair values on acquisition date with appropriate adjustments.

IAS 28 – ‘Investment in associates’ requires that on acquisition of the investment the excess between the cost of the investment and the investor’s share of the net fair value of the associate’s identifiable assets and liabilities should be accounted for as goodwill and included in the carrying amount of investments or any deficit arising on the same basis should be included as income in the period in which the investment is acquired. In either case, initial accounting requires the identification of the fair value of net assets of the investee as on the acquisition date. Consequently, appropriate adjustments the investor’s share of the associate’s profits or losses after acquisition are also made to account for the subsequent measurement of these initial fair values. For example, depreciation of the assets would be based on their fair values at the acquisition date. Hence, separate set of accounts of associates would also have to be maintained for consolidation purposes.

Conclusion:

Consolidated financial statements are considered as the primary set of accounts under IFRS. The differences highlighted in the earlier and the present article have far reaching effects on the procedures of consolidation and the resultant impact on various performance matrices. The goal under IFRS is to move towards more transparent and consistent reporting that reflects the true net worth of the group.

Nirav Shah

LWSPRMS Act – Let Wall Street Pay for the Restoration of Main Street Act

Financial transactions tax : Recipe for disaster ?

Wall Street is widely blamed for causing the current economic mess in the US, so why not let it pay for it ? The idea is to impose a 0.25% tax on the value of stock transactions, and on a variety of derivative transactions. Indeed, a Bill introduced last week in the US House of Representatives is called the “Let Wall Street Pay for the Restoration of Main Street Act”. Proponents of this Bill believe the legislation could raise $ 150 billion per year.

A small increase in trading costs would, according to supporters, be a manageable burden, and it will be borne by the speculators who the Bill’s authors apparently believe (to judge by the Bill’s name) created the financial mess. Across the Atlantic, Prime Minister Gordon Brown of Britain has supported the idea as a way to take the burden off taxpayers during a time of financial crisis. In reality, the tax would deal a poorly-timed blow to long-term investors everywhere.

Proponents of a transactions tax misunderstand the way markets work. The bubble in home prices in the US was not caused by the rapid buying and selling of individual family homes. The financial crisis was primarily a liquidity crisis and a credit crunch, and the major problem with collateralised mortgage- backed bonds was that they declined significantly in value and became illiquid. A transactions tax that would have reduced trading and made repurchase agreements more costly could have made the problem even worse. Moreover, the Wall Street would not actually foot the bill for the presumed $ 150 billion tax as the authors of the Bill believe. In fact, the tax would simply be added to the cost of doing business, burdening all investors; not just the speculators. Some argue that high-frequency traders, who reportedly execute 70% of the equity market trades, would pick up the lion’s share of the Bill. But high-frequency traders are not villains — they play an important role in improving market efficiency.

Often mischaracterised as speculators, high-frequency traders scour markets for minor mispricings and arbitrage trading opportunities. They buy and sell stocks in an instant, hoping to earn pennies on a trade. Far from destabilising or creating volatility in the market, their actions significantly increase trading volume, reduce spreads, promote price-discovery, and ultimately reduce transaction costs for long-term investors. Such trades might not be doing God’s work, but they are socially useful.

Transaction costs have declined significantly over the past ten years, thanks to the many structural changes in equity markets, including trading in decimals instead of eighths, the proliferation of scores of trading venues that function as exchanges, and an explosion of high-frequency trading. US-based investment management company Vanguard has estimated that total transaction costs on an average trade have fallen by at least 50%, resulting in approximately $ 1 billion of annual savings to its investors. When magnified across the whole investment industry, investors have probably saved tens of billions of dollars in transaction costs.

Transactions taxes would make most current high-frequency trades unprofitable since they depend on the thinnest of profit margins. Trading volume would collapse, and there would be a dramatic shortfall in the tax dollars actually collected by the government. Market liquidity would decline, bid-offer spreads would widen, and all investors would pay significantly higher costs on their trades.

A tax on financial transactions would have to be imposed internationally to prevent a particular national market from being disadvantaged. It would be very difficult to achieve universal international consensus regarding the details of such a tax. In our environment of global capital markets, it would be virtually impossible to enforce it reliably.

Article by Burton Malkiel and George Sauter

(Source : Wall Street Journal — Edited excerpts published in Mint / December 10, 2009)

Nirav Shah

Ponzi scheme

Accountant Abroad

Chapter Eight

Ponzi’s Ghost

All scams are basically the same,

and the people running them are typically not very bright,

but they’re brighter than their victims,

which is all they need to be.

— David Marchant, investigative journalist

Carlos Bianchi left Italy in the waning hours of the
nineteenth century, arriving in the New World to change his name from Carlos to
Charles and from Bianchi to Ponsi. By the end of World War I, he’d not only
served time in a Montreal jail for cheque forging, he’d changed his name again,
this time from Ponsi to Ponzi.

Around 1919, looking for greener pastures, Ponzi left Canada
for Boston where, one day, he received a letter from someone in Italy containing
an international postal reply coupon. Still in existence today, it’s a simple
method of paying for postage in one country with the currency of another — if
you will, the global answer to self-addressed stamped envelopes. Because someone
in, say, Glasgow, can’t buy stamps to pay for return postage for his
correspondent in, say, Vancouver, Canada, he buys one of these coupons from his
local post office. Worth a fixed amount, the fellow in Glasgow sends it to his
correspondent in Vancouver who exchanges it at his local post office for a stamp
which covers the postage back to Glasgow.

What caught Ponzi’s eye was that the coupon he received from
Italy had been purchased in Spain. He soon learned that while international
postal reply coupons were priced at fixed rates of exchange, actual currency
rates fluctuated to the point where this particular coupon had cost only about
15% of the value of the US stamps he could buy with it. In other words, coupons
bought in Spain and cashed in the States represented an instant profit of nearly
660%. So Charles Ponzi promptly announced his entry into the international
postal reply coupon business.

However, instead of funding the venture himself, which might
have been legal and would have been profitable, he invited investors to join
him. As he outlined the plan, he would personally travel to Spain to buy tens of
thousands of coupons, bring them back to the States where he would exchange them
for stamps, and then wholesale the stamps to businesses. Promising 40% profits
in just 90 days, he reinforced investor confidence with the old trick of forming
a corporation with a legitimate-sounding name: ‘The Securities and Exchange
Company’, which, of course, abbreviated to ‘S.E.C.’

For the first few months, money trickled in slowly but
steadily. It’s when he upped the promise to 100% profits that the flood-gates
opened and, on good days, hundreds of thousands of dollars arrived at his S.E.C.
In fact, he got so rich so quickly that, within six months, he purchased a large
stake in a New York bank and a Boston import-export firm. The only problem was,
his fortune wasn’t based on postal reply coupons, he was simply spending his
investors’ money.

Towards the middle of 1920, the Boston Post newspaper
began asking questions. Reporters canvassed post offices all over town, only to
discover that Ponzi couldn’t possibly be buying as many coupons as he claimed,
because that many coupons hadn’t been cashed in. The newspaper articles brought
investors to Ponzi’s front door demanding their money back. While fervently
praising the scheme, he obligingly returned investors’ money, plus interest,
paying them with the money sent in by new investors. Robbing Peter to pay Paul
worked for a while, but by August, the Boston Post was claiming that Ponzi was
millions of dollars in debt.

Maintaining a calm and reassuring exterior, Ponzi did what
conmen typically do when faced with the truth — he sued the messenger. He filed
a $ 5 million claim for damages against the Post and then, in the next
breath, announced a $ 100 million international investment syndicate. Before he
could get it off the ground, the Massachusetts State Banking Commission closed
down his bank. Newspapers across the country jumped on the bandwagon, reminding
the public of Ponzi’s earlier scuffles with the Canadian authorities, while
auditors fine-tooth-combed his S.E.C.’s books. They quickly discovered that
legitimate transactions were negligible. In fact, the grand total was a mere
$ 30. It meant that Ponzi never even bothered with his international postal
reply coupon idea.

His house of cards crumbled to the tune of $ 3 million. Ponzi
went to jail for a few years in Massachusetts, was allowed out on parole,
skipped and headed for Florida where he set up a real estate scam which earned
him another trip to prison. At the time he admitted, ‘Only a fool would have
trusted a crook like me.’ Around 1930-31, he was deported home to Italy. From
there he made his way to Brazil, where, eventually, he died penniless. His
legacy is the ‘Ponzi scheme’, and his ghost blithely lives on.

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Nirav Shah

Bring back substance

Accountant Abroad

When ‘true and fair’ accounts disclose either favourable
results that are factually unsupportable, or a position much worse than
warranted due to an ‘accounting quirk’, with no bearing on actual performance,
we are bound to wonder what is going on.

Arbitrary losses may arise when a company is forced to
separate its foreign exchange credits from the transactions that they cover,
even when inventory is costed at the FE rate for all decision-making purposes.
Or results may be burdened with the ‘value’ of options granted to a company’s
directors, when all we ever wanted was a note on the options granted, their
pricing, and how much they made when exercised. Worse, if the company cancels
the options, the grant cost allocable to future years becomes an immediate
revenue hit, even though it will never actually be paid.

A deferred tax ‘liability’ arises with virtually every ‘fair
value’ revaluation (even when there is no intention to sell), despite deferred
tax not being a liability at all under the International Accounting Standards
Board’s own definition.

The requirement to split land and buildings in property
revaluations, to calculate deferred tax on only the building portion of the
revaluation, then split that portion between ‘recover through use’ and
‘recover through sale’ and apply different tax rates over different time
horizons, is enough to convince you that we are dealing with the ramblings of an
unhinged mind.

Little wonder that we come across instances of exasperated
non-compliance.

A note in the accounts of one public company: ‘In view of
the size of the property portfolio, and the complexity of determining the
residual value and anticipated sale dates of these properties, and the fact that
any deferred tax liability raised will be offset by deferred tax assets,
management believe that an exercise to determine the requisite amounts would
require expenditure well in excess of any expected benefit.’

Arbitrary and indiscriminate :

The reverse effect can arise too. British Telecom’s pension
fund deficit doubled to £ 5.8 bn in the second quarter of 2009. Yet its IAS 19,
Employee Benefits, ‘mark-to-market’ measure of liabilities showed a £1 bn
improvement ! Said a spokesman : ‘While BT is obliged to report the IAS
19 figure each quarter, it has no relevance to the funding of the
scheme.’ To what, pray, does it have relevance ?

Banks continue to be the main beneficiaries of
‘compliance-generated’ profits. Years ago Enron showed that the most deceitful
words in the accounting lexicon are ‘off balance sheet’, yet banks still dodge
toxic asset impairment recognition by using credit derivatives held in
off-balance sheet vehicles.

General Electric in the US agreed in July to pay a settlement
of $ 50m (£ 30m) without admitting or denying wrongdoing following Securities
and Exchange Commission allegations that it fiddled its accounting repeatedly,
to preserve its reputation for ‘making the numbers’.

The SEC refers to discoveries by inhouse accountants of
misstatements that more senior executives ordered them to ignore. Two (out of
four) violations descended to the level of fraud, including an Enron-type scheme
to inflate profits by booking phony sales. In none of these cases has there been
a breach of standards or a murmur from the auditors. Yet giving such accounts
the true and fair imprimatur insults readers’ intelligence. The abiding
principle of preferring substance to rule-based form has all but been abandoned.

Our accounting rules have descended into farce and do not
lack mirth; however, they utterly lack commonsense.

Excerpted from an article by Emile Woolf
(Source : Accountancy, October 2009)

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Nirav Shah

GAPS in GAAP – Amalgamation after the Balance Sheet Date

Accounting Standards

Paragraph 27 of AS-14
‘Accounting for Amalgamations’ states as follows :

When an amalgamation is effected
after the balance sheet date but before the issuance of the financial statements
of either party to the amalgamation, disclosure is made in accordance with AS-4,
‘Contingencies and Events Occurring After the Balance Sheet Date’, but the
amalgamation is not incorporated in the financial statements. In certain
circumstances, the amalgamation may also provide additional information
affecting the financial statements themselves, for instance, by allowing the
going concern assumption to be maintained.

It has been noticed that there
is a mixed accounting practice with regards to High Court orders for
amalgamation received after the balance sheet date but before the issuance of
the financial statements. Many companies incorporate them in the financial
statements, a few have not. The mixed practice has arisen because the term
effected after the balance sheet date can be interpreted in more than
one way. This can be explained with the help of a simple example.

Query :

Big Ltd. has a year end 31
December 2007. It had earlier filed an application with the High Court for
merging Small Ltd. with itself with an appointed date of 1 January 2006. The
High Court passed the merger order on 4 January 2008, and the same was
filed on the same day with the ROC at which point in time it became
effective. Accounts for the year ended 31 December 2007 were signed on 15
January 2008. Should Big Ltd. consider the merger in its financial statements
for the year ended 31 December 2007 ?

Response :

View 1 :

No. The effective date of
amalgamation is the date when the amalgamation order is filed with ROC, which in
this case is, 4 January 2008. Therefore, the amalgamation has become effective
after the balance sheet date. Hence, in the 31 December, 2007 financial
statements, appropriate disclosures are made but the amalgamation is not
incorporated in the financial statements.

View 2 :

Yes.
The reference to effective date in AS-14 could be interpreted to mean the
appointed date. In this case the High Court has passed an order for merger with
an effective date of 1 January 2006.

From a plain reading of AS-14 it
appears that View 1 is a more appropriate answer. AS-14, paragraph 27 when
applied in this case, seems to suggest that the merger event is an event after
the balance sheet date and hence should be recorded after the balance sheet
date. The actual merger takes place only when the order is passed by the High
Court and filed with the ROC. Those significant events (High Court order
and filing with the ROC) had not happened before or at the balance sheet date.

However practice seems to
suggest that View 2 is more prevalent. This is probably for the reason that the
effective date is interpreted to be the appointed date. Moreover, as the event
(High Court order and filing with ROC) has already happened prior to issuance of
financial statements, it would not be prudent not to incorporate them in the
financial statements merely because the order was passed and filed with ROC
after the balance sheet date. The disadvantage with View 2 is companies may
arbitrarily choose to time the issuance of the financial statements to either
account or ignore the amalgamation transaction in the financial statements.

The author believes that whilst the technically
right answer is View 1, at the present moment and in the absence of any contrary
opinion from the ICAI, both views may be sustainable.

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Nirav Shah

Gaps in GAAP – Guidance Note on Accounting for Employee Share-based Payments

Accounting Standards

The Guidance Note allows either the fair value method or the
intrinsic method to account for employee share-based payments. The manner in
which the Guidance Note is drafted is based on the fair valuation principle
(more or less on the basis of IFRS). The intrinsic method is inadequately
covered by a sweeping paragraph (see below), without thought to the unintended
consequences that it may cause.

“Accounting for employee share-based payment plans dealt with
heretobefore is based on the fair value method. There is another method known as
the ‘Intrinsic Value Method’ for valuation of employee share-based payment
plans. Intrinsic value, in the case of a listed company, is the amount by which
the quoted market price of the underlying share exceeds the exercise price of an
option. For example, an option with an exercise price of Rs.100 on an equity
share whose current quoted market price is Rs.125, has an intrinsic value of
Rs.25 per share on the date of its valuation. If the quoted market price is not
available on the grant date, then the share price nearest to that date is taken.
In the case of a non-listed company, since the shares are not quoted on a stock
exchange, value of its shares is determined on the basis of a valuation report
from an independent valuer. For accounting for employee share-based payment
plans, the intrinsic value may be used, mutatis mutandis, in place of the
fair value.” (paragraph 40 of the Guidance Note)

When the above oversimplified paragraph is applied in the
context of some aspects of ESOP, it could result in certain unexpected results.
Let’s explain this with the help of a small example where a share settlement is
changed to cash settlement on vesting.

Now, let’s say one ESOP is granted that will vest at the end
of 3 years at an exercise price of Rs.90. At the date of grant the fair value of
the share is also Rs.90. The value of the option is estimated to be Rs.30. In
this example, if the fair value model is applied, Rs.10 will be charged in each
of the next three years. If the intrinsic model is applied, there will be no
charge.

So far so good, but now things will get a little complicated
as we move from a share-settled ESOP scheme to a cash-settled ESOP scheme. As
per the Guidance Note, “if an enterprise settles in cash, vested shares or stock
options, the payment made to the employee should be accounted for as a deduction
from the relevant equity account (e.g., Stock Options Outstanding
Account) except to the extent that the payment exceeds the fair value of the
shares or stock options, measured at the settlement date. Any such excess
should be recognised as an expense.” (paragraph 28 of the Guidance Note)

Assume in the above example, the share price is Rs.150 at
vesting date (end of the third year). The Company collects exercise price Rs.90
from the employee and pays Rs.150 (cash settlement). As already discussed above,
for accounting of employee share-based payment plans, the intrinsic value may be
used, mutatis mutandis, in place of the fair value. The requirement of
the Guidance Note will be changed as follows (if intrinsic rather than fair
value method is used) : “if an enterprise settles in cash, vested shares or
stock options, the payment made to the employee should be accounted for as a
deduction from the relevant equity account (e.g., Stock Options
Outstanding Account) except to the extent that the payment exceeds the intrinsic
value of the shares or stock options, measured at the settlement date.
Any such excess should be recognised as an expense.”

The payment of Rs.150 does not exceed the intrinsic value of
the shares at the settlement date, i.e. Rs.150. Hence the strange
conclusion is that there is no excess which needs to be recognised as an
expense.

This is strange because had the ESOP been a cash-settled
employee share-based payment plan from inception, the Company would have
charged Rs.60 as per the Guidance Note over 3 years of the scheme (see Appendix
IV of the Guidance Note). However, it appears that if a company has a
share-based plan to start with, but is then eventually settled in cash, no
charge is required in the profit and loss account.

The above dichotomy has arisen primarily because of an
unintended interplay between paragraph 28 and paragraph 40 of the Guidance Note,
which was predominantly written to provide guidance on fair value accounting of
ESOP, with the intrinsic method being inadequately addressed by a sweeping
paragraph (paragraph 40), which has caused a GAP in GAAP.

This issue needs to be immediately addressed by the Institute of Chartered
Accountants of India.

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Nirav Shah

GAPs in GAAP – Accounting for carbon credits

Accounting Standards

A number of Indian companies generate carbon credit under the
Clean Development Mechanisms (CDM). The amount involved is material enough to
the overall viability of a project.

Under IFRS, the International Accounting Standards Board (IASB)
had issued an interpretation IFRIC 3 Emission Rights, which was withdrawn
in June 2005. Thus, the IASB is still debating on an appropriate treatment for
CERs (Carbon Emission Reduction). Under IFRS most entities generating CERs
treat the same as government grant covered under IAS 20 Accounting
for Government Grants and Disclosure of Government Assistance. This is
because an international agency grants the same. Accordingly, based on IAS 20
requirements, a generating entity recognises CERs as asset once there is a
reasonable assurance that it will comply with conditions attached and CERs will
be received.

IAS 20 gives an option to measure such grant either at
fair value or nominal value. Most entities will measure the CERs at fair
value to ensure appropriate matching with the costs incurred. They will
recognise the same in the income statement in the same period as the related
cost which the grant is intended to compensate. The corresponding debit will
be to intangible assets in accordance with IAS 38 Intangible Assets.

No guidance is currently available under Indian GAAP;
consequently various practices exist (a) income from sale of CERs is recognised
upon execution of a firm sale contract for the eligible credits, since prior to
that there is no certainty of the amount to be realised (b) income from CERs is
recognised at estimated realisable value on their confirmation by the concerned
authorities (c) income from CER is recognised on an entitlement basis based on
reasonable certainty after making adjustments for expected deductions.

The Accounting Standards Board (ASB) of the Institute of
Chartered Accountants of India (ICAI) has issued an Exposure Draft (ED) of the
Guidance Note on Accounting for Self-generated Certified Emission Reductions.
The ED proposes to lay down the manner of applying accounting principles to CERs
generated by an entity.

As per the ED the generating entity should recognise CERs as
asset only after receipt of communication for credit from UNFCCC and provided it
is probable that future benefits associated with CERs will flow to the entity
and costs to generate CERs can be measured reliably. Further, such assets meet
the definition of the term ‘inventory’ given under AS-2 Valuation of
Inventories and hence are valued at lower of cost and net realisable value.
Only the costs incurred for the certification of CERs bring the CERs into
existence and, therefore, only those costs should be included in the cost of
inventory. All other costs are either not directly relevant in bringing the
inventory to its present location and condition or they are incurred before CERs
come into existence as per the prescribed criteria. Thus, those costs cannot be
inventorised.

The ED will result in significant cost and revenue
mismatch in the financial statements. This is because entities would need to
expense most of their costs as soon as incurred (with an insignificant amount
being capitalised as inventory), but will recognise revenue arising from CERs
only when these are actually sold. Clearly the accounting recommended by the
ICAI is very different from existing practices under Indian GAAP, and hence
every company that has significant revenue from carbon credits will have to
consider the impact of the ED very carefully.

The treatment prescribed in the ED appears to be inconsistent
with the existing Indian GAAP literature in more than one regard. The ED
requirement to recognise CERs as asset only when these are credited by UNFCCC in
a manner to be unconditionally available is contrary to the principles currently
followed for recognition of an asset. In most cases, recognition of an asset is
based on criteria of probability/reasonable assurance as against absolute
certainty prescribed in ED. For example, both under AS-9 Revenue Recognition
and AS-12 Accounting for Government Grants, recognition of income is
based on the criteria of reasonable assurance.

The ED is also inconsistent with an Expert Advisory
Committee’s (EAC) opinion on export incentives. As per the EAC opinion DEPB
credit should be recognised in the year in which the export was made, without
waiting for its actual credit in the subsequent year, provided there are no
insignificant uncertainties of ultimate collection. The EAC opinion is based on
the application of the existing accounting principles, including definition of
the term ‘asset’ given in the Framework, which is based on the
probability theory.

In the authors view, the ED should not have been issued since
it clearly conflicts with the existing requirement and practices under both
Indian GAAP and IFRS and is contrary to the definition of an asset in the
Framework. As India is adopting IFRS and the guidance in these areas is
being developed under IFRS, issuing India-specific guidance is duplicating the
effort and creating more differences in how the 2 GAAPs are applied, which will
have to be then taken care of in 2011, which is the transition date for adopting
IFRS.

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Nirav Shah

GAPs in GAAP – Accounting for amalgamation

Accounting Standards

AS-14 — ‘Accounting for
Amalgamations’ defines amalgamations in the nature of merger and in the nature
of purchase (acquisition). The classification is important because in the case
of amalgamation in the nature of merger, the difference between the equity of
the transferor company and the equity issued to the shareholders of the
transferor company is adjusted against reserves of the amalgamated (transferee)
company. This accounting is usually known as the pooling method. In the case of
amalgamation in the nature of acquisition, the difference is reflected as
goodwill, which is then amortised in the income statement of the amalgamated
company over a period of 3-5 years. This method is usually known as acquisition
accounting.

Under AS-14 for an
amalgamation to qualify as being in the nature of merger it should satisfy all
the following conditions :

(a) All the assets and
liabilities of the transferor company become, after amalgamation, the assets
and liabilities of the transferee company.

(b) Shareholders holding
not less than 90% of the face value of the equity shares of the transferor
company (other than the equity shares already held therein, immediately
before the amalgamation, by the transferee company or its subsidiaries or
their nominees) become equity shareholders of the transferee company by
virtue of the amalgamation.

(c) The consideration
for the amalgamation receivable by those equity shareholders of the
transferor company who agree to become equity shareholders of the transferee
company is discharged by the transferee company wholly by the issue of
equity shares in the transferee company, except that cash may be paid in
respect of any fractional shares.

(d) The business of the
transferor company is intended to be carried on, after the amalgamation, by
the transferee company.

(e) No adjustment is
intended to be made to the book values of the assets and liabilities of the
transferor company when they are incorporated in the financial statements of
the transferee company, except to ensure uniformity of accounting policies.

Amalgamation in the nature
of purchase is an amalgamation which does not satisfy any one or more of the
conditions specified above.

Assuming conditions (a), (d)
and (e) are fulfilled, a question arises that in the case of an amalgamation of
a wholly-owned subsidiary into the parent company, whether the same would
qualify as being in the nature of merger and would require to apply pooling
method or in the nature of purchase and hence would need to apply acquisition
accounting.

The question arises because
it is not clear whether conditions (b) and (c) are fulfilled. For example,
condition (c) requires the parent company to discharge its obligation by issuing
shares to the shareholders of the wholly-owned subsidiary. In the given case,
that is not possible since the amalgamation would involve cancellation of the
existing shares (100%) of the parent company in the subsidiary, rather than the
parent issuing new shares to the shareholders (own self) of the subsidiary.

In the author’s view, in the
case of an amalgamation with a 100% subsidiary, conditions (b) and (c) are not
applicable at all, rather than unfulfilled. Therefore it is possible to apply
pooling method in the case of an amalgamation with a 100% subsidiary. This is
also in line with IFRS which requires the pooling method to be applied in the
case of common control transactions, i.e., restructuring or amalgamation
transactions within the group.

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Nirav Shah

Gaps in GAAP – Reverse acquisitions

Accounting Standards

In some business combinations, commonly referred to as
reverse acquisitions, the acquirer is the entity whose equity interests have
been acquired and the issuing entity is the acquiree. This might be the case
when, for example, a private entity arranges to have itself ‘acquired’ by a
smaller public entity as a means of obtaining a stock exchange listing. Although
legally the issuing public entity is regarded as the parent and the private
entity is regarded as the subsidiary, the legal subsidiary is the acquirer if it
has the power to govern the financial and operating policies of the legal parent
so as to obtain benefits from its activities. Commonly the acquirer is the
larger entity.

Example :

A Ltd. a big private company wants to become a public entity,
but does not want to register its equity shares. In order to accomplish that, A
Ltd. gets itself acquired by B Ltd., a smaller public entity.

A Ltd.	B Ltd.
Private company Legal subsidiary Accounting acquirer	Public company Legal holding Accounting acquiree

Under International Financial Reporting Standard-3, in a
reverse acquisition, the cost of the business combination is deemed to have been
incurred by the legal subsidiary (i.e., the acquirer for accounting
purposes) in the form of equity instruments issued to the owners of the legal
parent (i.e., the acquiree for accounting purposes). If the published
price of the equity instruments of the legal subsidiary is used to determine the
cost of the combination, a calculation shall be made to determine the number of
equity instruments the legal subsidiary would have had to issue to provide the
same percentage ownership interest of the combined entity to the owners of the
legal parent as they have in the combined entity as a result of the reverse
acquisition. The fair value of the number of equity instruments so calculated
shall be used as the cost of the combination.

Example

Balance sheet before business combination

C (CU) D (CU)

Net
Assets 1,100 2,000

Total 1,100 2,000

Equity 100 shares 300

60 Shares 600

Retained Earning 800 1,400

Total 1,100 2,000

C issues 2.5 shares in exchange for each ordinary share of D.
Therefore C issues 150 shares in exchange of all 60 shares of D. Therefore,
legally C is the acquirer. However, C is in substance an accounting acquiree
(assume). Fair value of one equity share of D at date of acquisition is Currency
Units (CU) 50. Fair value of C’s identifiable net assets as at date of
acquisition is CU1,300.

Response :

In the exchange, D’s shareholders own 60% of the combined entity (150/250).

If the business combination would have taken place in the form of D issuing equity to shareholders of C, in the same exchange ratio, it would have issued 40 shares (i.e., 100/2.5).

Thus, cost of business combination would be CU2000 (40 X CU50).

Goodwill = CU2000 — CU1300, i.e., CU700.

Consolidated Balance sheet of C Limited & Group after the acquisition:

Consolidated financial statements prepared following a reverse acquisition shall be issued under the name of the legal parent, but described in the notes as a continuation of the financial statements of the legal subsidiary (i.e., the acquirer for accounting purposes). Because such consolidated financial statements represent a continuation of the financial statements of the legal subsidiary:

(a) the assets and liabilities of the legal subsidiary shall be recognised and measured in those consolidated financial statements at their pre-combination carrying amounts.

(b) the retained earnings and other equity balances recognised in those consolidated financial statements shall be the retained earnings and other equity balances of the legal subsidiary immediately before the business combination.

(c) the amount recognised as issued equity instruments in those consolidated financial statements shall be determined by adding to the issued equity of the legal subsidiary immediately before the business combination the cost of the combination. However, the equity structure appearing in those consolidated financial statements (i.e., the number and type of equity instruments issued) shall reflect the equity structure of the legal parent, including the equity instruments issued by the legal parent to effect the combination.

(d) comparative information presented in those consolidated financial statements shall be that of the legal subsidiary.

As can be seen from the above, the accounting for reverse acquisition under IFRS is based on identifying the true acquirer. Goodwill is determined on the basis that the accounting acquiree is fair valued, considering the accounting acquirer has paid the consideration. Indian GAAP does not recognise the concept of reverse acquisition at all, and hence it is high time that Indian GAAP adopts IFRS-3 standard on business combination.

Nirav Shah

GAPs in GAAP – Accounting for SMEs

Accounting Standards

The publication of a simplified form of IFRS for private
entities has been long awaited by national standard setters and small and
medium-sized entities, which have been required to apply full IFRS in the past.
The International Accounting Standards Board (IASB) has issued its International
Financial Reporting Standard for Small and Medium-sized Entities (IFRS for SMEs).

The standard consists of 230 pages of text, arranged into 35
chapters that cover all of the recognition, measurement, presentation and
disclosure requirements for SMEs. There is no cross reference to other IFRS
(with one exception relating to financial instruments discussed below). This
underscores the fact that IFRS for SMEs is viewed by the standard setter as
independent from the full IFRS.

The standard is intended for use by SMEs. SMEs are defined in
the standard as small and medium-sized entities that do not have public
accountability and which also publish general-purpose financial statements for
external users. An entity has public accountability if its debt or equity
instruments are traded in a public market, or it holds assets in a fiduciary
capacity for a broad group of outsiders.

While this definition is necessary for an understanding of
the entities to which IFRS for SMEs is applicable, the preface to the standard
indicates that the decision as to which entities are required or permitted to
apply the standard will lie with the regulatory and legislative authorities in
each jurisdiction. However, if a publicly accountable entity uses the standard,
it may not claim that the financial statements conform to IFRS for SMEs even if
its application is permitted or required in that jurisdiction, as the entity
would not meet the definition of an SME.

In India, various regulatory authorities such as the Ministry
of Corporate Affairs, RBI, IRDA, SEBI, etc will have to define the term SME.
Considering the manner in which the term SME is defined in the standard, these
would include entities other than listed companies, banks, financial
institutions, insurance companies, etc.

IFRS for SMEs is based on the fundamental principles of full
IFRS, but in many cases, it has been simplified to make the accounting
requirements less complex and to reduce the cost and effort required to produce
the financial statements. To achieve this, IASB has removed a number of
accounting options available under full IFRS and attempted to simplify
accounting for SMEs in certain areas.

For example in the case of share based payments, the fair
value of shares in equity-settled share-based payment transactions can be
measured using the directors’ best estimate of fair value if observable market
prices are not available. Another example of simplification is investment
property which can be accounted as fixed assets, if fair valuing them involves
undue cost or effort or does not provide a reliable measure.

The IFRS for SMEs includes a set of illustrative financial
statements and a presentation and disclosure checklist to assist entities with
preparing their financial statements. The application of this standard is
expected to reduce the compliance costs for many smaller entities and help make
the financial statements of such entities less complex.

As the standard is very much principles-based, interpretation
issues are likely to arise, which will require a globally consistent resolution.
In order to ensure this standard achieves international consistency and
comparability of financial reporting, it is important that interpretations are
not developed by each jurisdiction. It would appear logical that the
International Financial Reporting Interpretations Committee (IFRIC) could be
approached to provide any interpretative guidance that users may require.

In India, one major criticism against the full implementation
of IFRS was that they would impose an unnecessary burden and hardship on SMEs.
With the issuance of the SME standard, one of the major hurdles for the
implementation of IFRS in India has been removed. The ICAI and the Ministry of
Corporate Affairs (MCA) should now take appropriate and swift measures to
legalize the adoption of full IFRS by public interest entities and IFRS for SMEs
by SMEs from 2011. As a first step, the ICAI and other regulatory bodies should
define an SME. Also, it is desirable that all regulatory agencies define SME in
a consistent manner to the extent practicable.

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Nirav Shah

IFRS : The ‘Balance Sheet Approach’ to Deferred Tax

Article

January 2010 brought a firm assertion from the Ministry of
Corporate Affairs (MCA) indicating International Financial Reporting Standards
(IFRS) is the only way forward — but companies may reach the destination in a
phased manner starting 2011. One year hence, news is in the air that based on
several representations from India Inc, the Ministry is likely to postpone the
convergence. On the other hand, India will have to rethink whether it wants to
go back on its word given to the G20. Hence, to balance the mounting global
pressure and India Inc’s demands, the Ministry is said to be contemplating
making it optional.

In the meantime, the Institute of Chartered Accountants of
India (ICAI) has already issued near-final IFRS-equivalent Indian Accounting
Standards (Ind-AS), pending approval of the Ministry.

Now, for India Inc, the most vital step is to be ready for
Ind-AS as is, and wait and watch for any further bumps (amendments) on this
roller-coaster ride.

One of the standards that will make your ride bumpier is Ind-AS
12 Income Taxes. For almost every adjustment that it is made to comply
with IFRS, there will be a deferred tax impact staring right back at you.

Bridging the gap between the income statement approach under
Indian GAAP and the balance sheet approach under IFRS itself is intimidating to
many. This article makes an attempt at simplifying the new concepts IAS 12
brings.

To understand the impact of deferred taxes, it is imperative
to understand why deferred tax is required in the first place. The example below
explains why deferred taxes are accounted for.

Company X purchases a machine costing Rs.100 million having a
useful life of two years. As per the tax laws, 100% depreciation is allowed in
the first year itself. Profit before depreciation and tax was Rs.200 million.
The profits of the Company X, without considering the deferred tax impact is as
shown in Table I.

Notes :

(1) The effective tax rate is different from the actual tax
rate in both the years.

(2) Although the profits and the tax rate for both the
years remain unchanged, the tax expense is different and consequently the
profit after tax is different.

Is this accounting in line with our basic concepts ?

1. Accrual concept :

As per the accrual concept, tax should be accounted for in
the books of accounts as and when it accrues. However, current tax is provided
based on taxation laws.

2. Matching concept :

Taxes should be accounted for in the same period as the
related incomes and expenses are accrued.

Hence, to prepare the books of accounts in line with the
above-mentioned concepts, we account for ‘deferred taxes’.

What is deferred tax ?

Deferred tax is the tax on:

income earned/accrued but not taxed as per the taxation laws of the country,
or

income not earned/accrued but taxed as per the taxation laws of the country.

In simple terms, deferred tax is a tax (book entry) on the
gap between the books of account and the tax books.

Income statement approach :

Accounting Standard (AS) 22 Taxes on Income advocates
income statement approach. Under this approach, profit as per books is compared
with profit as per tax. Then, deferred tax is created on all timing differences.
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. No deferred tax is created on
permanent differences.

Under this approach, deferred tax is created on only those
items that have an impact on the income statement. In other words, ‘income
statement approach’ assumes that all the incomes are accrued in the income
statement. However, items like gain on revaluation of fixed assets (i.e.,
revaluation reserve) are not considered for deferred tax purposes. Also, in
insurance companies and banks, investments are marked to market and the gain
thereon is parked in a reserve till it is realised. Although the income is
earned in the above cases deferred tax on the same is not recognised as the
transactions don’t impact the income statement directly.

Hence, IASB, in 1996, came up with the concept of temporary
differences/balance sheet approach.

Balance sheet approach :

‘Temporary difference’ is wider in scope as compared to
‘timing difference’. It also covers those differences that originate in the
books of accounts in one period and are capable of reversal in the same books,
of accounts in one or more subsequent periods. For example, gain on revaluation
arises in books of accounts and reverses in the same books by way of higher
depreciation charge. Now, many argue that the revaluation gain is a notional
gain and does not give rise to any tax in future periods. To understand the
logic behind the balance sheet approach, it is important to go back to the
definition of an asset. An asset is a resource controlled by the entity as a
result of past events and from which future economic benefits are expected to
flow to the entity. For example, when an asset costing Rs.100 is valued at
Rs.120, it means that the asset owner will receive future economic benefit of
Rs.120. Since the asset owner has paid just Rs.100 to get a benefit of Rs.120,
the upfront benefit of Rs.20 (120-100) is considered for deferred tax. In short,
it is based on an assumption that the recovery of all assets and settlement of
all liabilities have tax consequences and these consequences can be estimated
reliably and cannot be avoided.

Temporary Difference is defined as a difference
between the carrying amount of an asset or liability and its tax base, where
tax base is the amount that will be deductible for tax purposes.
Where the economic benefits are not taxable or expense not deductible, the tax
base of the asset is equal to its carrying amount.

In simple terms, an entity will have to draw a tax balance sheet. The numbers appearing in the tax balance sheet is termed as ‘tax base’. This tax base will be compared with the carrying amount of assets and liabilities in the books of accounts. Deferred tax will be calculated on the difference so calculated. For example — if interest expense is allowed on cash basis under tax laws, no expense would have been booked. Hence, no corresponding liability would exist as per tax books i.e., tax base is nil. On the other hand, a liability for the interest will be recorded in the books of accounts. The difference in carrying the amount of the liability is regarded as a temporary difference under the balance sheet approach.

To better understand the concept of ‘tax base’, a few examples have been given below:

1)A machine costs Rs.100. For tax purposes, depreciation of Rs.30 has already been deducted in the current and prior periods and the remaining cost will be deductible in future periods, either as depreciation or through a deduction on disposal. The tax base of the machine is Rs.70.
2)Dividends receivable from a subsidiary of Rs.100. The dividends are not taxable. Thus, the tax base of the dividends receivable is 100. (Note: If the economic benefits will not be taxable, the tax base of the asset is equal to its carrying amount.)
3) Similarly, a loan receivable has a carrying amount of Rs.100. The repayment of the loan will have no tax consequences. The tax base of the loan is Rs.100.
4) Current liabilities include interest revenue received in advance of Rs.100. The related interest revenue was taxed on a cash basis. The tax base of the interest received in advance is nil.

Temporary differences are of two types:

1) Taxable temporary differences (Deferred tax liability):

Taxable temporary differences are temporary differences that will result in taxable amounts in determining taxable profit/loss of future periods when the carrying amount of the asset or liability is recovered or settled. For example — incomes accrued as per books of accounts (fair value of financial instruments) but taxable on receipt basis and lower depreciation charge in books of accounts.

In simple words, where the carrying value of assets is more as per books of accounts or carrying value of liability is less as per books of accounts when compared to tax base, it results in taxable temporary differences.

2)Deductible temporary differences (Deferred tax assets):

Deductible temporary differences are temporary differences that will result in amounts that are deductible in determining taxable profit/loss of future periods when the carrying amount of the asset or liability is recovered or settled. For ex-ample — higher depreciation charge in books of accounts. In simple words, where the carrying value of assets is less as per books of accounts or carrying value of liability is more as per books of accounts when compared to tax base, it results in deductible temporary differences.

Deferred tax on items recognised outside profit or loss:
Current tax and deferred tax shall be recognised outside profit or loss if the tax relates to items that are recognised, in the same or a different period, outside profit or loss. Therefore, current tax and deferred tax that relate to items that are recognised, in the same or a different period:

a) in other comprehensive income, shall be recognised in other comprehensive income (OCI)
b) directly in equity, shall be recognised directly in equity i.e., in the Statement of Changes in Equity (SOCIE).

For example, deferred tax on revaluation of as-sets should be recognised in revaluation reserve in OCI. Hence, there will not be any charge to profit or loss.

Deferred tax on revaluation of assets:

IFRSs permit or require certain assets to be carried at fair value or to be revalued (for example, IAS 16 Property, Plant and Equipment, IAS 38 Intangible Assets, IAS 39 Financial Instruments: Recognition and Measurement and IAS 40 Investment Property). However, as per the tax laws, revaluation of assets is not considered while computing the taxable income. Consequently, the tax base of the asset is not adjusted. Nevertheless, the future recovery of the carrying amount (on sale or otherwise) will result in a taxable flow of economic benefits to the entity and the amount that will be deductible for tax purposes will differ from the amount of those economic benefits. The difference between the carrying amount of a revalued asset and its tax base is a temporary difference and gives rise to a deferred tax liability or asset. This is true even if:

a) the entity does not intend to dispose of the asset. In such cases, the revalued carrying amount of the asset will be recovered through use and this will generate taxable income which exceeds the depreciation that will be allowable for tax purposes in future periods; or

b) tax on capital gains is deferred if the proceeds of the disposal of the asset are invested in similar assets. In such cases, the tax will ultimately become payable on sale or use of the similar assets.

For example, Company A buys an asset worth Rs.100 on 1st April, 2010. The useful life of the asset is five years and the tax laws allow it to be depreciated over four years. One year later, on 31st March, 2011, the Company revalues the asset to Rs.120. In such a case the temproary difference will be as shown in Table 2.

In the above case, the deferred tax liability created on revaluation on 31st March, 2011, of Rs.45 reverses in the subsequent periods. The accounting entry for the year 2011 would be:

Revaluation reserve A/c Dr. 45
To Deferred tax liability A/c 45

Suppose on 31st March, 2013, the Company decides to sell the asset at Rs.70. In this case, there would be a gain of Rs.10 as per the books of accounts. However, the tax books will show a gain of Rs.45, thus offsetting the temporary difference of Rs.35.

Indian GAAP:

Accounting Standard (AS) 22 Taxes on income does not permit creation of deferred tax on the excess depreciation charged on the revalued portion. It is not considered as a timing difference, but a permanent one. The underlying reason is that, under the income statement approach, a deferred tax liability is not created on the date of revaluation (since it does not have an effect on the income statement). Thus, deferred tax assets (reversal of deferred tax liability) cannot be recorded on the excess depreciation charged.

Deferred tax on business combination:

IFRS 3 Business Combinations require the identifiable assets acquired and liabilities assumed in a business combination to be recognised at their fair values at the acquisition date. Temporary differences arise when the tax bases of the identifiable assets acquired and liabilities assumed are not affected by the business combination or are affected differently. For example, when the carrying amount of an asset is increased to fair value but the tax base of the asset remains at cost to the previous owner, a taxable temporary difference arises which results in a deferred tax liability. The resulting deferred tax liability affects goodwill.

For example, Company A merges Company B with itself. In the process it acquires net assets of Rs.1,000 crore (fair value Rs.1,200 crore) for Rs.1,500 crore. Goodwill being the difference between the consideration paid and fair value was Rs.300 crore (1,500 — 1,200 crore). Now, Company A will have to calculate the deferred tax on the fair valued por-tion of Rs.200 crore (1,200 — 1,000 crore), the tax base being the cost to previous owner of Rs.1,000 crore as compared to the revised carrying amount of Rs.1,200 crore. The deferred tax would hence be 100 crore (assuming tax rate of 50%). These Rs. 100 crore will be added to goodwill and the total goodwill will be Rs.400 crore (300 + 100 crore). The accounting entry would be:

Goodwill A/c Dr. 100
To Deferred tax liability A/c 100

Indian GAAP:

As per Accounting Standard Interpretation (ASI) 11* Accounting for Taxes on Income in case of an Amalgamation, deferred tax on such differences should not be recognised as this constitutes a permanent difference. The consequent differences between the amounts of depreciation for accounting purposes and tax purposes in respect of such assets in subsequent years would also be permanent differences.

It may be noted that ASI 11 has been issued by the ICAI but has not been incorporated in the standards notified under the Companies (Accounting Standards) Rules, 2006. Hence, ASI 11 is not applicable to companies. However, it is generally noted that companies treat such difference as permanent difference and do not create any deferred tax on the same.

Deferred tax on consolidation:

IAS 12 requires re- calculation of deferred tax at consolidated level. In effect, an entity will have to calculate deferred tax impact on inter-company transactions.

For example — Company H, the holding company, sells goods costing Rs.1,000 to Company S, the subsidiary company, for Rs.1,200. The goods are lying in the closing stock of Company S. Assume tax rate 0f 50%. Then entry in the consolidated

books is as follows:
Deferred tax asset A/c Dr. 60

To Deferred tax expense A/c 60

[(1,200-1,000)*50%]

Here, the deferred tax asset is created because the profit element of Rs.200 (1,200 — 1,000) is not eliminated in the tax books i.e., the consolidated books has an inventory of Rs.1,000 but the tax books of Company S has an inventory of Rs.1,200.

Please note: the tax rate used in this case would be the rate applicable to the Company S, since the deduction will be available to Company S.

Indian GAAP:

Under Indian GAAP, the practice followed is to consolidate the books by adding line-by-line items. Deferred tax is also calculated in the consolidated books as a summation of deferred tax appearing in the individual books of accounts.

Deferred tax on undistributed profits:

As per IAS 28 Investments in Associates, an entity is required to account for its investment in associates as per equity method in the consolidated financial statements. Under the equity method, the investment in an associate is initially recognised at cost and the carrying amount is increased or decreased to recognise the investor’s share of the profit or loss of the investee after the date of acquisition, reduced by distributions received. On the other hand, its tax base will remain the cost of investment. The difference between the books of accounts and tax base is investor’s share of undistributed reserves of the investee entity. In simple terms, an entity will have to provide for deferred tax on its share of undistributed reserves of the investee company in its consolidated books.

Similar is the treatment under IAS 31 Interests in Joint Ventures where an entity elects equity method of accounting.

Nevertheless, an entity is exempted from the above requirement if the following conditions are satisfied:
a) the investor/venturer is able to control the timing of the reversal of the temporary difference; and

b) it is probable that the temporary difference will not reverse in the foreseeable future.

However, an investor in an associate/a venturer in a joint venture, generally, does not control that entity and is usually not in a position to determine its dividend policy. Therefore, in the absence of an agreement requiring that the profits of the associate/venturer will not be distributed in the foreseeable future, an investor/venturer recognises a deferred tax liability arising from taxable temporary differences associated with its investment in the associate/joint venture.

Deferred tax on land:

The Income-tax Act, 1961 provides for indexation of cost of non-depreciable assets like land, when computing the capital gain/loss on sale. This indexed cost of land (i.e., its tax base) will exceed the book value of land by the indexation benefit provided. Hence, a deferred tax asset will have to be created on this difference.

Indian GAAP:

Since the indexation benefit neither affects the current year’s tax profit, nor the profit as per books, deferred tax is not provided as per Indian GAAP.

Carried forward business losses and unabsorbed depreciation:
A deferred tax asset shall be recognised for the carried forward business losses and unabsorbed depreciation to the extent that it is probable that future taxable profit will be available against which such losses and depreciation can be utilised.

Although the term ‘probable’ is not defined by the standard, probable in general terms is ‘more likely than not’.

Indian GAAP:

AS 22 mandates virtual certainty for recognition of deferred tax assets in case of carried forward business losses and unabsorbed depreciation.

As per ASI 9 Virtual certainty supported by convincing evidence, virtual certainty is not a matter of perception. It should be supported by convincing evidence. Evidence is matter of fact. Virtual certainty refers to the extent of certainty, which, for all practical purposes, can be considered certain. Keeping in view ‘virtual certainty’ as against ‘probable certainty’ it seems that Indian GAAP is more conservative on the matter of recognition of deferred tax asset.

Exceptions:

There continues to remain certain items over which the standard does not permit creation of deferred taxes, as below:

1) Initial recognition of goodwill:

Para 21 of IAS 12 Income Taxes prohibits recognition of deferred tax liability on initial recognition of goodwill, because goodwill is measured as a residual and the recognition of the deferred tax liability would increase the carrying amount of goodwill.

2) Initial recognition of an asset or liability in a transaction which:

i) is not a business combination, and

ii) at the time of transaction, affects neither accounting profit nor taxable profit/loss.

For example, a penalty was paid in the process of bringing an asset to its working condition as intended by the management and hence, it was capitalised. As per taxation laws, penalty is not allowed as an expense. Now, this penalty affects neither accounting profit nor taxable profits. Hence, as per the above said exception, no deferred tax shall be created on this difference.

Re-assessment:

At the end of each reporting period, an entity reassesses unrecognised deferred tax assets. The entity recognises a previously unrecognised deferred tax asset to the extent that it has become probable that future taxable profit will allow the deferred tax asset to be recovered. For example, an improvement in trading conditions may make it more probable that the entity will be able to generate sufficient taxable profit in the future for the deferred tax
asset to meet the recognition criteria.

Discounting:

The principles of IFRS require long-term assets and liabilities to be discounted to the present value. In most cases detailed scheduling of the timing of the reversal of each temporary difference is impracticable and highly complex for the purpose of reliable determination of deferred tax assets and liabilities on a discounted basis. Therefore, the deferred tax assets and liabilities shall not be discounted.

Current/Non-current:

IAS 1 Presentation of financial statements requires an entity to present current and non-current assets, and current and non-current liabilities, as separate classifications in its statement of financial position. However, an entity shall not classify deferred tax assets/liabilities as current assets/ liabilities, i.e., deferred taxes shall always be clas-sified as non-current.

Takeaways:

As mentioned above, deferred taxes will impact almost all IFRS adjustments. One will have to consider all IFRS adjustments like fair valuation, use of effective interest rates, derivative and hedge accounting to calculate accurate deferred taxes.

To conclude, there are three important takeaways:
1) An entity will have to calculate the tax base for each asset and liability and compare the same with the financial statements,
2) Items that were earlier considered as permanent difference as per Indian GAAP may have to be considered as temporary difference as per IFRS, and

3) Deferred taxes, for certain items, will be rec-ognised outside profit or loss i.e., in OCI or SOCIE.

Nirav Shah

Finding the Sweet Spot

Accounting Standards

Accounting standards are becoming increasingly complicated.
Though the standard-setters have their heart in the right place, and would want
to simplify the standards, the end result is that accounting standards are
becoming incomprehensible. The more the standard-setters try to simplify, the
worse it gets. One reason may very well be that businesses are getting
complicated, and transactions are not as simple as they used to be. A few years
ago, Indian GAAP had only 15 accounting standards; now that number has more than
doubled. Even International Financial Reporting Standards (IFRSs) would soon
cross 3000 plus pages.

Indian standards are inspired by IFRS. Therefore it would be
more appropriate to look at the development of IFRSs. These standards were
written over several years and with the assistance of different national
standard-setters. Consequently the lay out of the standards, the manner of
drafting and the use of English differ substantially. Recent IFRSs are drafted
more methodically, with a clear segregation of scope, definitions, recognition
and measurement, measurement after recognition, retirement and disposal,
disclosures, basis of conclusion, implementation guidance, etc. Therefore it is
of utmost importance that all old IFRS be drafted afresh, to make them
consistent with the recently issued standards.

There are a number of terms (see box) that have been used
frequently throughout the standards, which could mean different things to
different people; particularly given the fact that IFRSs would be used worldwide
and English in different countries is influenced by local culture. Therefore, a
term such as ‘may be accounted for in the following manner’ may be
interpreted in India as providing an alternative, though that may not be the
intention of the standard-setters. So also terms such as near term, current
period, short term, foreseeable future, long term, etc. or probable terms such
as probable of recovery, possible that it would be recovered, likely that it
would be recovered, highly unlikely that it would not be recovered, certain that
it would be recovered, etc. can create confusion. Firstly, these terms should be
reduced to a few standard terms and they should be used consistently across the
standards. Also, it would be more preferable to put some mathematical threshold
to these terms so that when it is being said that it is probable of recovery, it
should be known whether a 51%, 75% or 95% chance of recovery is applicable. In
India, we have already struggled with these terms, a prime example being the
requirement of virtual certainty with regards to recognition of deferred tax
assets in situations of unabsorbed losses and unabsorbed depreciation. Quite
clearly there is a lot that can be done in this area to clear the clutter.

Another debate is whether standards should be principle-based
or rule-based. It may be noted that though US GAAP is called rule-based
standards, it has a number of principles which are not translated
into detailed rules. So also though IFRS are principle-based, standards on
financial instruments almost read like a detailed rule book. In my view, the
whole argument of whether standards should be rule-based or principle-based is
futile. What we need is to hit that sweet spot where standards can be understood
easily and consistently.

Easier said than done, but with some hard work this can be achieved. Take for example, the accounting of multiple element contracts. Consider an example, where along with sale of software licence, post-contract customer support (PCS) will be provided over the next 6 months to a customer under a single contract. There are many accounting possibilities in this case. If there is price evidence for PCS, the price for software licence could be derived. This is known as the residual method. Alternatively, if there is price evidence for the software licence, the price for the PCS could be derived. This is known as the reverse residual method. Alternatively, the price for both elements may be known, and consequently the over-all discount on the contract may be allocated to the two elements, based on their relative fair values. A fourth possibility is the determination of revenue for the two elements by adding a uniform margin on their respective cost. The fifth possibility would be to keep the margin on the two elements different, to reflect their relative value and pricing in the market place. As can be seen, IFRS lends itself to multiple interpretations. Under US CAAP, the only method that is permitted is the residual method. Therefore under US CAAP, if there is no vendor-specific objective evidence (VSOE) of the undelivered element (in this case the PCS), no revenue can be recognised on the sale of licence. In such circumstances, the entire licence fee revenue is recognised ratably over the period during which the PCS is to be provided, rather than on delivery of the licence. As can be seen from the above example, US CAAP is very harsh and extensively rules-driven in this area. IFRS, takes the other extreme, is nebulous and lends itself to multiple interpretations. Quite clearly, this is an example where the sweet spot can be found and a common ground found between the two extreme approaches. US CAAP’s rule-based approach is founded by the fear that there would be abuse of standards if they are not fairly detailed. However, experience suggests otherwise – those who want to abuse the standards, would abuse them irrespective of whether those are based on principles or rules. Besides in many cases it is easier to abuse rules, by structuring the transaction in a desired manner. This is clearly seen in the area of leases, where lessees structure deals to escape finance lease classification. Another area which needs serious attention is the availability of too many accounting choices under IFRS. For example, fixed assets, intangibles, investment properties can be accounted using either the fair value model or cost model, actuarial differences in the case of employee benefits can be accounted for in a number of ways. Similarly choices are available in the case of government grants, impairment, financial instruments, etc. Too many choices result in inconsistency, lack of comparability and put to question the ability of standard-setters to make up their mind on the appropriate basis of accounting. Accounting is an art, not a pure science, and it should remain that way. Therefore, what is being suggested is not the elimination of judgment in the application of the standards. Nor is it being suggested that standards should be reading like rule books with too many bright line tests. What is being suggested is the use of appropriate and standard terminologies that should be used consistently, the removal of too many accounting choices, and principles that are not only easily understood, but tell you how the accounting should be done.

Adios to the Abyss.

Nirav Shah

GAPs in GAAP — IFRS Convergence Roadmap

Accounting standards

There are numerous matters
on the IFRS convergence roadmap that still remain to be effected upon or need
clarification. More importantly, the standards are not yet notified under the
Companies Act. So no one knows what the final standards will actually look like.
Nor has the requisite amendment to the Companies Act been made, to amend the
relevant provisions that are in conflict with IFRS, such as S. 78, S. 391, S.
394, Schedule VI, Schedule XIV, etc. In this article, we take a look at some of
the issues relating to applicability of the roadmap itself.

The Ministry of Corporate
Affairs (MCA) roadmap set out is as follows.

The first set of Accounting
Standards (i.e., converged accounting standards) will be applied to specified
class of companies in phases :

(a) Phase-I :

The following categories of
companies will convert their opening balance sheets as at 1st April, 2011, if
the financial year commences on or after 1st April, 2011 in compliance with the
notified accounting standards which are convergent with IFRS. These companies
are :

(a) Companies which are
part of NSE — Nifty 50

(b) Companies which are
part of BSE — Sensex 30

(c) Companies whose shares
or other securities are listed on stock exchanges outside India

(d) Companies, whether
listed or not, which have a net worth in excess of Rs.1,000 crores.

(b) Phase-II :

The companies, whether
listed or not, having a net worth exceeding Rs.500 crores, but not exceeding
Rs.1,000 crores will convert their opening balance sheet as at 1st April, 2013,
if the financial year commences on or after 1st April, 2013 in compliance with
the notified accounting standards which are convergent with IFRS.

(c) Phase-III :

Listed companies which have
a net worth of Rs.500 crores or less will convert their opening balance sheet as
at 1st April, 2014, if the financial year commences on or after 1st April, 2014,
whichever is later, in compliance with the notified accounting standards which
are convergent with IFRS.

In a subsequent
clarification from the MCA it was clarified that the date for determination of
the criteria is the balance sheet at 31st March, 2009 or the first balance sheet
prepared thereafter when the accounting year ends on another date. The
clarification has resolved some questions, but unfortunately has raised many
other questions.

We take a look at some
unanswered questions.

A company gets listed at 1st
April, 2009. 31st March, 2009 it had a networth of Rs.450 crores. At 31st March,
2010 it has a networth of Rs.550 crores which is likely to grow substantially in
following years. How would such a company comply with IFRS ?

Technically, based on MCA
clarification, such a company never applies IFRS since at 31st March, 2009 it
was unlisted and had a networth of less than Rs.500 crores. However this
conclusion seems counterintuitive. In the author’s view, the 31st March, 2009
date should be seen as a dynamic date rather than a static one. Since at 31st
March, 2010, the company was listed and had a networth of greater than Rs.500
crores, in the author’s view, it should be included in phase II of IFRS
implementation.

A listed company has a
networth of Rs.990 crores and Rs.1020 crores at 31st March, 2009 and 31st March,
2010, respectively. Should such a company be included in phase I or II of IFRS
implementation ?

For reasons mentioned above,
the 31st March, 2009 should not be seen as a static, but as a dynamic date. On
that basis the company should be included in phase I of IFRS implementation, as
it has a networth of greater than Rs.1000 crores at 31st March, 2010.

A company with a small
networth of Rs.200 crores, has listed its FCCB on a foreign exchange. Other than
that, the company’s securities are neither listed in India nor abroad. On 1st
April, 2009 the company delists its FCCB. Assume that the company’s networth
will not grow significantly in the future. Should such a company be included in
phase I of IFRS implementation ?

If the testing date of 31st
March, 2009 is seen as static, then the company is included in phase I of IFRS
implementation. However, if the testing date of 31st March, 2009 is seen as
dynamic, then the company is not covered in any of the phases of IFRS
implementation. More importantly it would be counterintuitive to include such
companies for IFRS implementation, as they are neither significant, nor listed
in India or abroad subsequent to the testing date of 31st March, 2009.

It is important that the MCA
provides answers to the above questions to facilitate smooth transition to IFRS.
In the absence of any clarification forthcoming from the MCA, companies are
advised to apply a ‘better safe than sorry’ policy and interpret the
requirements of the roadmap conservatively. A point to be noted is that the
roadmap allows earlier adoption of IFRS voluntarily. Where companies are
reluctant to do so, they should seek a conclusive response from MCA in all
borderline cases discussed above before taking any position on this matter.

levitra

Nirav Shah

GAPs in GAAP – Accounting for joint ventures Proportionate consolidation v. equity method

Accounting Standards

Under Indian GAAP (AS-27 Financial Reporting of Interests
in Joint Ventures), an interest in a joint venture (jointly controlled
entity — JCE) is accounted for using the proportionate consolidation method.
Under this method the venturers report their respective proportion of the JCE’s
assets, liabilities, income and expenses in its consolidated financial
statements.

Under IFRS, IAS-31 requires the application of proportionate
consolidation method for joint ventures but also allows the application of
equity method as an alternative method. Under the equity method an interest in a
JCE is initially recorded at cost and adjusted thereafter for the
post-acquisition change in the venturer’s share of net assets of the JCE. The
profit or loss of the venturer includes the venturer’s share of the profit or
loss of the JCE.

The International Accounting Standards Board (IASB) issued an
Exposure Draft (ED) 9 Joint Arrangements which is intended to replace
current IAS-31. Unlike IAS-31, the ED proposes that a joint venture shall be
accounted using the equity method only. In other words, proportionate
consolidation method which is the preferred method under current IAS-31 will no
longer be available and the alternative method, i.e., equity method in
current IAS-31 becomes the only method to be followed.

The IASB is of the view that the removal of options from IFRS
will reduce the possibility of similar transactions being accounted for in
different ways. Further, the IASB believes that the proportionate consolidation
method has certain technical flaws and is not consistent with the Framework
for the Preparation and Presentation of Financial Statements. When a party
to an arrangement has joint control of an entity, it shares control of the
activities of the entity. It does not, however, control each asset, nor does it
have a present obligation for each liability of the JCE. Rather, each party has
control over its investment in the entity. If the party uses proportionate
consolidation to account for its interest in a JCE, it recognises as assets and
liabilities a proportion of items that it does not control or for which it has
no obligation. These supposed assets and liabilities do not meet the definition
of assets and liabilities in the Framework.

A number of respondents to the ED have questioned the IASB’s
decision to require only equity method for joint ventures. At the time of
issuance of current IAS-31, the same Framework was applicable. At that
time, the IASB has clearly recognised that proportionate consolidation better
reflects the substance and economic reality of a venturer’s interest in a JCE.
Against this background, the ED does not offer any compelling arguments for
removal of proportionate consolidation method.

While the IASB has indicated that proportionate consolidation
has technical flaws and is not consistent with the Framework, it does not
explain as to why the equity method is considered more appropriate to account
for interests in a JCE ? How does the application of the equity method enhance
the faithful representation of joint ventures in the financial statements of the
venturer ? Further, the removal of proportionate consolidation will lead to the
same accounting treatment for ‘joint control’ and ‘significant influence,’ which
is inappropriate.

Significant impact on Indian entities :

In India, a number of entities in sectors such as real
estate, infrastructure development, oil and gas, etc. carry out significant
activities through joint ventures. For example, KSK Power or GMR Infrastructure
carry out significant activities through joint ventures. If such entities need
to apply equity method to their interests in joint ventures, it is possible that
their financial statements will not reflect any significant economic activity.
If equity accounting is to be used, the infrastructure holding company will not
be able to present proportionately the activities and revenues of its various
joint ventures. This may have several consequential implications on matters such
as borrowing capacity, satisfaction of debt covenants, performance evaluation of
key executives, key ratios, explaining performance to investors and analysts,
etc. In certain cases, these entities may even have to reconsider their overall
business strategy and significant contracts.

IASB’s view is that the enhanced disclosure requirements of
the proposed IFRS would provide better information about the assets and
liabilities of a joint venture than is provided by using proportionate
consolidation. The exposure draft proposes the disclosure of summarised
financial information for all individually material joint ventures to help meet
the needs of users of financial statements. In the author’s view, this line of
argument is inappropriate and disclosures cannot justify equity accounting of
joint venture. Besides in many cases, disclosures on their own may not provide
any solution, for example, in the case of project bidding where qualification
requirements are linked to the revenues recorded in the financial statements of
the bidding entity.

As IFRS would eventually apply to Indian entities, it is high
time that Indian companies and local standard-setters started paying more
attention to IFRS exposure drafts. Companies that would be significantly
impacted should make suitable representations to the IASB along with the local
standard-setters.

levitra

Nirav Shah

Gaps in GAAP – Multiple Element Contract

Accounting Standards

Recently the ICAI issued an Exposure Draft of Monograph on
‘Revenue Recognition for Arrangements with Multiple Deliverables’ inviting
comments. The author is pleased to respond to the Exposure Draft.

Overall, the author does not agree with the issuance of the
proposed Monograph for the following summary reasons :

1. After having made a public announcement of convergence with International Financial Reporting Standards (IFRS) effective April 1, 2011, the Institute of Chartered Accountants of India (ICAI) or any of its committees should not take any action which may go against the spirit of the said announcement.

2. As hereinafter discussed, certain requirements of the Monograph may not be in compliance with IFRS.

IAS 18 contains guidance with regard to multiple element
contracts, which provides that ‘Recognition criteria are usually applied
separately to each transaction. However, in certain circumstances, it is
necessary to apply the recognition criteria to the separately identifiable
components of a single transaction in order to reflect the substance of the
transaction. For example, when the selling price of a product includes an
identifiable amount for subsequent servicing, that amount is deferred and
recognised as revenue over the period during which the service is performed.’
International Financial Reporting Interpretations Committee (IFRIC), at its
November 2006 meeting, has considered that the multiple element issue was wide
and complicated, needing a full scope debate and amendment of IAS 18, rather
than an interpretation, and therefore decided not to take this item onto its
agenda. Therefore, issuance of the proposed Monograph in India is not
recommended since it may conflict with the outcome of the said project.

The Monograph is an adaptation of ‘EITF 00-21 : Revenue
Arrangements with Multiple Deliverables’ under US GAAP. Since US GAAP
follows rule-based approach as compared to principle-based approach under IFRS,
application of the Monograph based on US GAAP requirements will significantly
reduce scope of judgment by the preparers and limit flexibility available under
IFRS. In addition, some of these requirements may be contrary to IFRS. The
following are a few examples in this regard :

(i) As per the Monograph, if there is objective and reliable evidence of fair value, i.e., Specific Objective Evidence (SOE) for all units of accounting in an arrangement, the arrangement consideration should be allocated to the separate units of accounting based on their relative fair values (the relative fair value method). In cases, where there is objective reliable evidence for undelivered elements only, then the residual method is used to allocate the arrangement consideration.

This implies that if there is no objective evidence of fair value, for either delivered or undelivered element, then no revenue can be recognised until all elements are delivered. Take for instance, a company selling version V1 of a product, plus an entitlement to receive updated version V2, due to be released in the next one year. As there is no SOE of fair value of V2, since it has not been sold separately, as it has not yet been released, under the Monograph, sales cannot be recognised on despatch of V1.

Paragraph 13 of IAS 18 and paragraph 11 of the Appendix to IAS 18 provide guidance on the accounting treatment of multiple elements under IFRS. Paragraph 13 states that “in certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction”. As per paragraph 11 of the Appendix to IAS 18, “when the selling price includes an identifiable amount for subsequent servicing, that amount is deferred and recognised as revenue over the period during which the service is performed. The amount deferred is that which will cover the expected costs of the services under the agreement, together with a reasonable profit on those services”.

While IAS 18 does not provide any specific guidance on how that allocation should be determined, it does not require SOE of fair values; rather, cost of services plus reasonable profit may be an indicator of fair value. An entity may also estimate fair value based on a statistical approach or market practice. We believe that in cases where revenue recognition has been deferred under the Monograph due to a lack of SOE of fair value, it would be unreasonable to conclude that no fair value can be established under IFRS, just because SOE of fair value is not available.

(ii) As it is evident from (i) above, the Monograph gives precedence to the relative fair value method over the residual method; whereas there is no such preference under IFRS. As part of issuance of IFRIC 13, IFRIC has examined this issue and noted that IAS 18 does not specify which of these methods should be applied, or in what circumstances. The IFRIC decided that the interpretation should not be more prescriptive than IAS 18(refer Basis for Conclusions paragraph BC 14 to IFRIC 13). Under IFRS, therefore either method or other methods such as cost methods or management estimates would be acceptable.

(iii) The Monograph requires that under the residual method, the amount of consideration allocated to the delivered item(s) equals the total arrangement consideration less the aggregate fair value of the undelivered item(s). The residual method therefore has the effect of allocating all discounts to the delivered element, rather than apportioning the discount among all elements. For example, a company sells one product for INR 10 million with one year’s post-sale services (PSS) and a renewal rate of PSS has been fixed at INR 2 million (20%) at the end of the first year (giving a fair value of INR 2 million for the PSS element). Under the residual method, the company will be able to recognise INR 8 million when the licence is delivered (total contract price of 10 million less 2 million being fair value of the undelivered element).

Under IFRS,while the above may be an acceptable method of recognising revenue on delivered element; one could question the allocation of entire discount to the delivered element. Under IFRS one may allocate the discount to both the delivered and undelivered element, for example, in proportion of the fair value of the undelivered elements and of the residual amount determined for the delivered element. In the example above, this would have the consequence of allocating the discount both on the delivered licence element and on the undelivered PSS element, for example, 84% of it allocated to the delivered licence element and 16% allocated to the PSS. Thus, applying the residual method and then apportioning the discount among delivered and undelivered elements would result in recognition of INR 8.4 million of revenue on delivery of the product software, whereas the residual method alone would restrict the amount of revenue recognised upon delivery of the licence to INR 8 million.

For the above reasons, the author does not believe that the Research Committee should pursue this Monograph till the time further guidance is provided by the IASB. Any such action by the Committee may put a question mark over ICAI’s commitment to converge with IFRS.

Nirav Shah

GAPs in GAAP – Accounting of Treasury Shares

Accounting standards

Companies may have invested
in their own shares for a number of reasons, for example, treasury shares are
created at the time of mergers and acquisitions of a group company or any other
company. When a company sells its own shares, the shares are transferred from
one set of owners to another set of owners. Under International Financial
Reporting Standards (IFRS), no gain or loss is recognised on the acquisition or
sale of treasury shares, because they are considered as fresh capital issuances
leading to an increase or decrease in share capital rather than an income or an
expense. The acquisition or subsequent resale by an entity of its own equity
instruments represents a transfer between those holders of equity instruments
who have given up their equity interest and those who continue to hold an equity
instrument and hence no gain or loss is recognised.

IAS 32, Financial
Instruments : Presentation sets out the requirements very clearly in paragraphs 33 and 34.

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

34 The amount of
treasury shares held is disclosed separately either in the statement of
financial position or in the notes, in accordance with IAS 1 Presentation
of Financial Statements. An entity provides disclosure in accordance
with IAS 24 Related Party Disclosures if the entity reacquires its
own equity instruments from related parties.

However, under current
Indian accounting standards, in the absence of any specific guidance, there are
disparate practices, though it is common to find companies recognising profit on
sale of treasury shares. This is acceptable under current Indian accounting
standards. However, as already mentioned, the same would not be acceptable under
IFRS. This would provide companies with an accounting arbitrage prior to their
IFRS transition date. For example, a company may sell the treasury shares prior
to the IFRS transition date and thereby recognise gains under Indian GAAP. If
the company sells these shares after adoption of IFRS, it cannot recognise any
gain/loss. As IFRS is being adopted in phases, the accounting arbitrage will
continue for entities that adopt IFRS in later phases or are not required to
apply IFRS.

It may be noted that in
accordance with the directives of SEBI, the stock exchange listing agreements
were amended to require all listed companies to comply with accounting standards
in the case of any merger, amalgamation or restructuring u/s.391 and u/s.394,
and that this would be evidenced by a certificate from the auditors of the
company. Consequently, this had the effect of pre-empting the rights of the High
Court in determining the accounting treatment u/s.391 and u/s. 394. If such a
scheme requires gain/loss to be recognised on sale of treasury shares, then the
auditors will not be able to qualify the certificate with regards to compliance
with accounting standards.

The absence of a standard in India with
regards to accounting of treasury shares is a gap that will be filled
when IFRS kicks in.

levitra

Nirav Shah

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