Category: Accounting Standards

Scoping – Ind AS 18 or Ind AS 11?

Under
IFRS, IFRIC Interpretation 15 Agreements for the Construction of Real
Estate deals with accounting of real estate contracts. Determining
whether an agreement for the construction of real estate is within the
scope of IAS 11 (Ind AS 11) Construction Contracts or IAS 18 (Ind AS 18)
Revenue depends on the terms of the agreement and all the surrounding
facts and circumstances. Such a determination requires judgement with
respect to each agreement.

IAS 11 applies when the agreement
meets the definition of a construction contract set out in paragraph 3
of IAS 11: ‘a contract specifically negotiated for the construction of
an asset or a combination of assets …’ An agreement for the construction
of real estate meets the definition of a construction contract when the
buyer is able to specify the major structural elements of the design of
the real estate before construction begins and/or specify major
structural changes once construction is in progress (whether or not it
exercises that ability). Thus, a customer may ask a real estate
contractor to construct a villa (a) on a land owned by the customer and
(b) as per design and specification approved by the customer. The
customer controls the work-in-progress on an ongoing basis, and can
generally sack the contractor (albeit by payment of penalty) and hire a
new contractor. In situations such as this, the contractor will have to
apply IAS 11.

In contrast, an agreement for the construction of
real estate in which buyers have only limited ability to influence the
design of the real estate, e.g. to select a design from a range of
options specified by the entity, or to specify only minor variations to
the basic design, is an agreement for the sale of goods within the scope
of IAS 18. The entity may transfer to the buyer control and the
significant risks and rewards of ownership of the work in progress in
its current state as construction progresses. In this case, if all the
criteria in paragraph 14 of IAS 18 are met continuously as construction
progresses, the entity shall recognise revenue by reference to the stage
of completion using the percentage of completion method. The
requirements of IAS 11 are generally applicable to the recognition of
revenue and the associated expenses for such a transaction. The entity
may transfer to the buyer control and the significant risks and rewards
of ownership of the real estate in its entirety at a single time (e.g.
at completion, upon or after delivery). In this case, the entity shall
recognise revenue only when all the criteria in paragraph 14 of IAS 18
are satisfied. Thus, consider a scenario where a real estate developer
own a piece of land in which it constructs a building with about 100
flats. In this scenario, the risk and rewards are transferred to the 100
customers, when the building construction is complete and the flats are
ultimately delivered to the customers. It is inconceivable that the
risk and rewards are transferred to the 100 customers on an ongoing
basis. If that was the case, each customer would own the work in
progress and have the ability to hire another contractor to construct
his/her individual flat. That is neither legally nor practically
possible, for example, it is not possible that 100 different contractors
representing 100 different customers could possibly complete the
construction of the building.

In the Indian situation,
considering the demand of the real estate developers the standard
setters decided to carve out IFRIC 15. Further, a real estate contract
was specifically scoped in Ind AS 11. In accordance with Ind AS 11
Construction Contracts, the standard would apply to accounting in the
financial statements of contractors including the financial statements
of real estate developers. The definition of construction contracts in
Ind AS 11 also includes agreement of real estate development to provide
services together with construction material in order to perform
contractual obligation to deliver the real estate to the buyer.

Thus,
real estate construction contracts would be accounted for in accordance
with Ind AS 11, like any other construction contract. Therefore, in the
above example, the sale of 100 flats would be treated like a
construction contract to be accounted for using the percentage of
completion method (POCM) rather than accounting for them as sale of
goods, wherein, revenue is recognised when the completed flat is
ultimately delivered to the customer.

The carve in to Ind AS 11
is somewhat nebulously drafted. As per this carve in, Ind AS 11 would
apply to accounting in the financial statements of contractors including
the financial statements of real estate developers. Does that mean Ind
AS 11 would apply to contractors other than real estate contractors
also? For example, it is not absolutely clear, whether Ind AS 11 or Ind
AS 18 would apply to construction of a standard equipment such as a ship
or aircraft or windmill. The author believes that Ind AS 18 should
apply to these items, since the buyer is unable to specify the major
structural elements of the design of the equipment before construction
begins and/ or specify major structural changes once construction is in
progress whether or not it exercises that ability. In other words, the
author believes that the above items should be treated like a sale of
goods. This can also be supported by the intention of the ICAI to allow
construction contract accounting to real estate development only.

Ind AS 11 vs Guidance Note on Accounting for Real Estate Transactions (Revised 2012)

On
account of the diverse practices under Indian GAAP, the ICAI felt it
necessary to issue a revised Guidance Note titled Guidance Note on
Accounting for Real Estate Transactions (Revised 2012) to harmonise the
accounting practices followed by real estate companies in India. Under
Ind AS 11, accounting for real estate development would be accounted for
as a construction contract in accordance with Ind AS 11. An interesting
point to note is that the requirements of Ind AS 11, may or may not be
the same as those contained in the Guidance Note. This section deals
with some critical areas of similarities and differences that exist
between Ind AS 11 and the Guidance Note. Under both Ind AS 11 and the
Guidance Note, completed contract method would be prohibited. However,
there are significant dissimilarities in the way POC method is applied.

Question 1: Is the scope of the Guidance Note and Ind AS 11 the same?

The
revised Guidance Note would apply to any enterprise dealing in real
estate as sellers or developers. The term ‘real estate’ refers to land
as well as buildings and rights in relation thereto. The Guidance Note
provides an illustrative list of transactions which are in scope. The
Guidance Note applies not only to development and sale of residential
and commercial units, row houses, independent houses, with or without an
undivided share in land, but to many other real estate transactions.
These are sale of plots of land with or without any development. The
development may be in the form of common facilities like laying of
roads, drainage lines, water pipelines, electrical lines, sewage tanks,
water storage tanks, club house, landscaping etc. The sale of plots of
land, include long term sale type leases. What is a long term sale type
lease is not defined. Typically a 99 year lease would generally fulfill
the definition of a sale type lease. However, whether a 50 year lease
would be a sale type lease is a matter of conjecture and judgment will
have to be applied. However, the principles that would be used to apply
the judgment are not contained in the Guidance Note. In the author’s
view, conditions that establish whether a lease is a finance lease or
operating lease may serve as a good basis for making that decision. For
example, in the case of a 99 year lease, if the present value of the
minimum lease payments is atleast 90% or higher of the fair value of the
land, it could be construed, subject to other requirements that the
lease in substance is a sale type lease. Another example, which may be
construed as a sale type lease is a 50 year lease of land, where the
ownership is transferred to the lessee at the end of the lease period.
Whether a lease is a sale type lease or not, will have a significant
impact on the accounting. In the case of a lease, the revenue is
recognised over the lease period; whereas in a sale type lease the
revenue is accounted for when the sale type lease is executed.

The
revised Guidance Note also scopes in the acquisition, utilisation and
transfer of development rights, redevelopment of existing buildings and
structures and joint development agreements for real estate activities.

Other
than scoping in joint development agreements, the revised Guidance Note
does not provide any guidance on how to account for such agreements.
Real estate transactions of the nature covered by Accounting Standard
(AS) 10, Accounting for Fixed Assets, Accounting Standard (AS) 12,
Accounting for Government Grants, Accounting Standard (AS) 19, Leases,
and Accounting Standard (AS) 26, Intangible Assets, are outside the
scope of the Guidance Note. For example if a real estate contract was
being constructed for own administrative use, AS-10 principles rather
than this Guidance Note would apply. Similarly short-term leasing of
real estate would be covered by AS-19; however, a long term sale type
lease would be covered under the Guidance Note.

Ind AS 11 would
apply to accounting in the financial statements of contractors including
the financial statements of real estate developers. Under Ind AS 11,
there is no definition of what constitutes a real estate developer or
real estate development. Generally, the guidance in the Guidance Note
with respect to scoping may be used for Ind AS 11 purposes.

Question 2: How are transactions which are in substance delivery of goods accounted for under Ind AS and the Guidance Note?

Requirement under the Guidance Note

In
respect of transactions of real estate which are in substance similar
to delivery of goods, principles enunciated in Accounting Standard (AS)
9, Revenue Recognition, are applied. For example, sale of plots of land
without any development would be covered by the principles of AS-9.
These transactions are treated similar to delivery of goods where the
revenues, costs and profits are recognised when the revenue process is
completed. For recognition of revenue in case of real estate sales, it
is necessary that the conditions specified in paragraph 10 and 11 of
AS-9 are satisfied. Those conditions are enumerated below.

10.
Revenue from sales or service transactions should be recognised when the
requirements as to performance set out in paragraphs 11 ……. are
satisfied, provided that at the time of performance it is not
unreasonable to expect ultimate collection. If at the time of raising of
any claim it is unreasonable to expect ultimate collection, revenue
recognition should be postponed.

11. In a transaction involving
the sale of goods, performance should be regarded as being achieved when
the following conditions have been fulfilled:

i. the seller of
goods has transferred to the buyer the property in the goods for a price
or all significant risks and rewards of ownership have been transferred
to the buyer and the seller retains no effective control of the goods
transferred to a degree usually associated with ownership; and

ii.
no significant uncertainty exists regarding the amount of the
consideration that will be derived from the sale of the goods.

In
accordance with the above, the point of time at which all significant
risks and rewards of ownership can be considered as transferred, is
required to be determined on the basis of the terms and conditions of
the agreement for sale. The completion of the revenue recognition
process is usually identified when the following conditions are
satisfied:

(a) The seller has transferred to the buyer all
significant risks and rewards of ownership and the seller retains no
effective control of the real estate to a degree usually associated with
ownership;

(b) The seller has effectively handed over possession of the real estate unit to the buyer forming part of the transaction;

(c) No significant uncertainty exists regarding the amount of consideration that will be derived from the real estate sales; and

(d) It is not unreasonable to expect ultimate collection of revenue from buyers.

Revenue
from sale of lands or plots without any development is recognised when
the above conditions are satisfied. In the case of sale of developed
plots, where the development activity is significant, these would be
treated as transactions which are in substance construction type
contracts and accounted for accordingly. The Guidance Note does not
elaborate further as to when development activity would be treated as
significant or insignificant. This may have a material impact on revenue
recognition in some cases. Consider an example, where at the end of
reporting period a company sells plots of land, which will entail start
and completion of development activity subsequent to the reporting
period. If the development activity is considered significant, entire
revenue will be recognised in the subsequent reporting period, because
the 25% threshold criterion in the Guidance Note for revenue recognition
under POCM will be met only in the subsequent reporting period. If the
development activity is considered insignificant, revenue on the plot
will be recognised in the current reporting period, and revenue on the
development (to be allocated on market value basis) will be recognised
in the following reporting period. Requirement under Ind AS 18/Ind AS 11
Revenue from sale of lands or plots without any development is
recognised like a sale of goods under Ind AS 18. This is similar to the
requirement in the Guidance Note. In the case of sale of developed
plots, where the development activity is significant, these may be
treated in accordance with the Guidance Note which is to treat them as
construction type contracts. However it is questionable whether the 25%
revenue recognition threshold criterion in the Guidance Note would apply
under Ind AS. The author believes that the 25% threshold in the
Guidance Note is not relevant under Ind AS and entities will have to
apply judgement to assess whether the general revenue recognition
criteria are fulfilled.

Question 3: What are in substance
construction type contracts and how are they accounted for under the
Guidance Note and Ind AS?

Requirement in the Guidance Note

In
the case of real estate transaction which has the same economic
substance as construction contracts, the Guidance Note draws upon the
principles enunciated in Accounting Standard (AS) 7, Construction
Contracts and Accounting Standard (AS) 9, Revenue Recognition. Some
indicators of construction type contracts are:

(a) The duration
of such projects is beyond 12 months and the project commencement date
and project completion date fall into different accounting periods.

(b)
Most features of the project are common to construction contracts,
viz., land development, structural engineering, architectural design,
construction, etc.

(c) While individual units of the project are
contracted to be delivered to different buyers these are interdependent
upon or interrelated to completion of a number of common activities
and/or provision of common amenities.

(d) The construction or development activities form a significant proportion of the project activity.

For
example, construction and sale of units in a residential complex would
be covered by the principles of AS-7 and AS-9. The
construction/development of commercial and residential units has all
features of a construction contract – land development, structural
engineering, architectural design and construction are all present. The
natures of these activities are such that often the date when the
activity is commenced and the date when the activity is completed
usually fall into different accounting periods.

In case of real
estate sales, which are in substance construction type contracts, a two
step approach is followed for accounting purposes. Firstly, it is
assessed whether significant risks and rewards are transferred to the
buyer. The seller usually enters into an agreement for sale with the
buyer at initial stages of construction. This agreement for sale is also
considered to have the effect of transferring all significant risks and
rewards of ownership to the buyer provided the agreement is legally
enforceable and subject to the satisfaction of conditions which signify
transferring of significant risks and rewards even though the legal
title is not transferred or the possession of the real estate is not
given to the buyer. After satisfaction of step one, the second step is
applied, which involves the application of the POCM method. Once the
seller has transferred all the significant risks and rewards to the
buyer, any acts on the real estate performed by the seller are, in
substance, performed on behalf of the buyer in the manner similar to a
contractor. Accordingly, revenue in such cases is recognized by applying
the POCM method on the basis of the broad methodology explained in AS
7, Construction Contracts and detailed in the Guidance Note.

Paragraph
3.3 of the 2012 Guidance Note states as follows: “The point of time at
which all significant risks and rewards of ownership can be considered
as transferred, is required to be determined on the basis of the terms
and conditions of the agreement for sale. In the case of real estate
sales, the seller usually enters into an agreement for sale with the
buyer at initial stages of construction. This agreement for sale is also
considered to have the effect of transferring all significant risks and
rewards of ownership to the buyer provided the agreement is legally
enforceable and subject to the satisfaction of conditions which signify
transferring of significant risks and rewards even though the legal
title is not transferred or the possession of the real estate is not
given to the buyer.”

The 2012 Guidance note contains an
anti-abuse clause to prevent companies from recognising revenue in
certain circumstances. Paragraph 3.4 of the Guidance Note states that
“The application of the methods described above requires a careful
analysis of the elements of the transaction, agreement, understanding
and conduct of the parties to the transaction to determine the economic
substance of the transaction. The economic substance of the transaction
is not influenced or affected by the structure and/or legal form of the
transaction or agreement.” Though this appears to be an anti-abuse
clause the full meaning of this paragraph is not clear and hence,
judgement would be required in many situations.

The anti-abuse
clause was more clearly spelt out in paragraph 9 of the 2006 Guidance
Note which required the nature and extent of continuing involvement of
the seller to be assessed to determine whether the seller retains
effective control. In some cases, real estate may be sold with a degree
of continuing involvement by the seller such that the risks and rewards
of ownership are not transferred; for example, this may happen in the
case of a sale and repurchase agreements which include put and call
options, and agreements whereby the seller guarantees occupancy of the
property for a specified period. The anti-abuse clause in the 2012
Guidance Note is more broadly drafted and some may argue that it
encompasses many other situations. For example, a real estate company
may be precluded from considering real estate sales made to related
parties that are not genuine for the purposes of determining whether it
has satisfied the various threshold limits prescribed in the Guidance
Note for recognising revenue.

Paragraph 4.3 of the 2012 Guidance
Note sets out a very interesting perspective on the linkage between the
transfer of a legal title and the transfer of risks and rewards of
ownership. Paragraph 4.3 states “Where transfer of legal title is a
condition precedent to the buyer taking on the significant risks and
rewards of ownership and accepting significant completion of the
seller’s obligation, revenue should not be recognised till such time
legal title is validly transferred to the buyer”. For example, a real
estate company may have entered into a sale contract with a customer, of
a flat in a building that would take two years to complete. The
customer prefers to register the contract and pay stamp duty after two
years at the time of receiving possession of the flat to postpone the
cash outflow and thereby save on interest. On the other hand, another
customer that is availing a bank loan may have to register the sale
deed, pay stamp duty and obtain legal title immediately on entering into
the contract. In the former case, just because the customer is
obtaining legal title only at the time of possession, should not
preclude revenue recognition in the books of the real estate company. In
many cases, legal title would be deemed to be transferred to the
customer on entering into an agreement for sale, and registration with
the local authority may be seen as a formality that could be completed
at a later date. What is important is the agreement for sale, has to be
legally enforceable. In addition to selling to end users, real estate
companies often sell units to investors. In such cases, real estate
companies should be able to recognise revenue as long as there is a
legally enforceable contract between the real estate company and the
investor and the real estate company has no obligation to buy back the
unit or provide any other form of guarantee.

Requirement under Ind AS 11

The
above guidance may be applied under Ind AS 11, as it may not be
inconsistent with the intention of the ICAI. The Guidance Note applies
to projects where the duration of such projects is beyond 12 months and
the project commencement date and project completion date fall into
different accounting periods. There is no such restriction under Ind AS
11, and even projects below 12 months duration may qualify for
“construction type contracts”.

Question 4: For applying POCM how is “project” defined under Ind AS 11 and the Guidance Note?

Requirement under the Guidance Note

Project
is the smallest group of units/plots/saleable spaces which are linked
with a common set of amenities in such a manner that unless the common
amenities are made available and functional, these units/plots /
saleable spaces cannot be put to their intended effective use. The
definition of a project is very critical under the Guidance Note,
because that determines when the threshold for recognising revenue is
achieved and also the manner in which the POCM is applied. In other
words, the manner in which the project is defined by a company may have a
significant impact on the revenue, cost and profit that is recognised.
If the entire township is considered as a project then it is likely that
the threshold limit for recognising revenue is achieved much later as
compared to when each building in the township is identified as a
project.

Consider an example where two buildings are being
constructed adjacent to each other. Both these buildings would have a
common underground water tank that will supply water to the two
buildings. As either of the building cannot be put to effective use
without the water tank, the project would be the two buildings together
(including the water tank). Consider another example, where each of
those two buildings have their own underground water tank and other
facilities and are not dependant on any common facilities. In this
example, the two buildings would be treated as two different projects.
Consider a third variation to the example, where each of those two
buildings has their own facilities, and the only common facility is a
swimming pool. In this example, judgment would be required, as to how
critical the swimming pool is, to make the buildings ready for their
intended use. If it is concluded that the swimming pool is not critical
to the occupancy of either of those two buildings, then each of those
two buildings would be separate projects. Where it is concluded that the
swimming pool is critical to put the two buildings to its intended
effective use, the two buildings together would constitute a project.

The
definition of the term ‘project’ in the Guidance Note is somewhat
nebulous. Firstly, it is defined as a smallest group of dependant units.
This is followed by the following sentence in the Guidance Note “A
larger venture can be split into smaller projects if the basic
conditions as set out above are fulfilled. For example, a project may
comprise a cluster of towers or each tower can also be designated as a
project. Similarly a complete township can be a project or it can be
broken down into smaller projects.” Once the term ‘project’ is defined
as the smallest group of dependant units, it is not clear why the word
‘can’ is used instead of ‘should’. Does it mean that there is a
limitation on how small a project can be, but no limitation on how big a
project could be? In the example, where two buildings are being
constructed adjacently, and each have their own independent facilities
and are not dependant on common facilities, there is a choice to cut
this as either a project comprising two buildings or two projects
comprising one building each. If this is indeed the case, the manner in
which this choice is exercised is not a matter of an accounting policy
choice but rather a choice that is exercised on a project by project
basis.

Requirement under Ind AS 11

The requirement under
Ind AS 11 with respect to combining or separating contracts for
accounting purposes is irrelevant in the context of accounting for real
estate. For example, under Ind AS 11, two contracts need to be combined
together for accounting purposes if they are negotiated as a single
package; the contracts are so closely interrelated that they are, in
effect, part of a single project with an overall profit margin; and the
contracts are performed concurrently or in a continuous sequence. This
guidance is inapplicable to real estate development as they involve
multiple customers. Therefore the definition of the term “project” under
the Guidance Note may well be applied under Ind AS 11.

Question 5: For applying POCM how is “project cost” defined under Ind AS 11 and the Guidance Note?

Requirement
under the Guidance Note Project cost includes cost of land,
construction costs and borrowing costs. Cost of land may include cost of
land itself or development rights and other related costs such as stamp
duty, registration and brokerage. It also includes rehabilitation
costs. For example, when land is acquired, companies have an obligation
towards rehabilitating the displaced people by providing alternative
property and/or incurring various other social obligations.

Construction
and development costs include costs that are related directly to a
specific project such as cost of designing, labour, material, equipment
hiring or depreciation costs, but would exclude depreciation of idle
plant and equipment. It would include site supervision and site
administration costs and cost of obtaining municipal sanction or
building permissions, but would exclude head office general
administration costs. Construction costs would include expected warranty
costs/provisions, that may be incurred during or post the completion of
the construction. It may be noted that real estate companies were
accounting for warranties in numerous ways. By treating warranties as
any other input cost, this Guidance Note will bring consistency in the
treatment of warranty costs. Costs that may be attributable to a project
activity in general and can be allocated are also included as
construction and development costs; for example, insurance, cost of the
technical, architecture or supervision department, construction or
development overheads, etc. Such costs are allocated using methods that
are systematic and rational and are applied consistently to all costs
having similar characteristics. Construction overheads include costs
such as the preparation and processing of construction personnel
payroll. The allocation is based on the normal level of project
activity, similar to overhead absorption in the case of inventories.
Therefore in periods of low activity, not all of the general
construction overheads would be absorbed on the fewer projects that may
be in progress.

Borrowing costs are capitalized in accordance
with AS-16 Borrowing Costs. The borrowing costs incurred towards
purchase of land forming part of construction of a commercial or
residential project are eligible for capitalisation since it does not
represent an asset in itself, but forms part of the project, which
requires substantial period of time to get ready for its intended use or
sale. However, borrowing costs incurred while land acquired for
building purposes is held without any associated development activity do
not qualify for capitalisation [Para 16 of AS 16]. Interest
capitalisation will be based on utilisation of funds, i.e., on the basis
of actual cash flow, and not on the accrual of liability. Thus,
warranty expenses that are included as project cost would be excluded
for the purposes of borrowing cost capitalisation, unless it involved an
actual cash flow. Sometimes real estate companies have to place
security deposits for the purposes of securing land or development
rights. EAC has opined that borrowing cost on the cash outflow on
security deposit cannot be capitalised, as the security deposit is not
part of the project cost.

Certain costs should not be considered
as part of the project cost, such as selling costs, costs of unconsumed
or uninstalled material delivered at site; and payment made to
sub-contractors in advance of work performed. Payment made to
sub-contractors for work performed will be considered as part of the
project cost. Further, accrual made for work done by sub-contractor will
also be considered as part of the project cost, but will be excluded
for the purposes of borrowing cost capitalisation, unless it results in
actual cash flows.

Requirement under Ind AS 11

The
above requirements of the Guidance Note would generally apply to Ind AS
11 as well. However, there is a significant difference. Under the
Guidance Note, the EAC had opined that borrowing cost on security
deposit paid for securing land cannot be capitalised. Under Ind AS,
security amount paid for land by the contractor is an advance
consideration for land. If the security amount was paid out of borrowed
funds, then borrowing cost should be capitalised provided the
construction on that land is taking place.

Question 6: How is Percentage of completion method (POCM) applied under Ind AS 11 and the Guidance Note?

Requirement under the Guidance Note

POCM
method is applied when the outcome of a real estate project can be
estimated reliably and when all the following conditions are satisfied:

(a) total project revenues can be estimated reliably;

(b) it is probable that the economic benefits associated with the project will flow to the enterprise;

(c)
the project costs to complete the project and the stage of project
completion at the reporting date can be measured reliably; and

(d)
the project costs attributable to the project can be clearly identified
and measured reliably so that actual project costs incurred can be
compared with prior estimates. Further to the above conditions, there is
a rebuttable presumption that the outcome of a real estate project can
be estimated reliably and that revenue should be recognized under the
POCM method only when the following events are completed:

• All
  critical approvals necessary for commencement of the project have been
  obtained; for example, environmental and other clearances, approval of
  plans, designs, etc., title to land or other rights to development/
  construction and change in land use

• When the stage
  of completion of the project reaches a reasonable level of development.
  A reasonable level of development is not achieved if the expenditure
  incurred on construction and development costs is less than 25 % of the
  construction and development costs. Such costs would exclude land cost
  but include borrowing costs.
• Atleast 25% of the saleable project area is secured by contracts or agreements with buyers.
• Atleast
  10 % of the total revenue as per the agreements of sale or any other
  legally enforceable documents are realised at the reporting date in
  respect of each of the contracts and it is reasonable to expect that the
  parties to such contracts will comply with the payment terms as defined
  in the contracts.

When POCM is applied, project revenue
and project costs associated with the real estate project should be
recognised as revenue and expenses by reference to the stage of
completion of the project activity at the reporting date. For
computation of revenue the stage of completion is arrived at with
reference to the entire project costs incurred including land costs,
borrowing costs and construction and development costs. Interestingly,
land cost is not included to determine whether the threshold for
recognizing revenue is reached. But once the threshold is reached land
cost is included for the purposes of determining the stage of completion
and is included in revenue and costs accordingly. As mentioned earlier,
costs incurred that relate to future activity on the project and
payments made to sub-contractors in advance of work performed under the
sub-contract are excluded and matched with revenues when the activity or
work is performed. The recognition of project revenue by reference to
the stage of completion of the project activity should not at any point
exceed the estimated total revenues from ‘eligible contracts’/other
legally enforceable agreements for sale. ‘Eligible contracts’ means
contracts/ agreements where at least 10% of the contracted amounts have
been realised and there are no outstanding defaults of the payment terms
in such contracts. To illustrate – if there are 10 Agreements of sale
and 10 % of gross amount is realised in case of 8 agreements, revenue
can be recognised with respect to these 8 agreements.

The
Guidance Note does not prohibit other methods of determination of stage
of completion, e.g., surveys of work done, technical estimation, etc.
However, computation of revenue with reference to other methods of
determination of stage of completion should not, in any case, exceed the
revenue computed with reference to the ‘project costs incurred’ method.
When it is probable that total project costs will exceed total eligible
project revenues, the expected loss should be recognised as an expense
immediately. The amount of such a loss is determined irrespective of
commencement of project work; or the stage of completion of project
activity.

The percentage of completion method is applied on a
cumulative basis in each reporting period to the current estimates of
project revenues and project costs. Therefore, the effect of a change in
the estimate of project costs, or the effect of a change in the
estimate of the outcome of a project, is accounted for as a change in
accounting estimate. The changed estimates are used in determination of
the amount of revenue and expenses recognised in the statement of profit
and loss in the period in which the change is made and in subsequent
periods. The changes to estimates include changes arising out of
cancellation of contracts and cases where the property or part thereof
is subsequently earmarked for own use or for rental purposes. In such
cases any revenues attributable to such contracts previously recognized
should be reversed and the costs in relation thereto shall be carried
forward and accounted in accordance with AS 10, Accounting for Fixed
Assets. A contract that was an eligible contract (10% of the contract
value is realised and there are no outstanding defaults) may become an
ineligible contract on subsequent default in payment by the customer.
The Guidance Note does not prescribe any requirements with respect to
the same. However, it appears logical that the guidance contained above
of treating the same as a change in accounting estimate is applied.
Thus, revenue recognized previously is reversed, and the associated
costs are transferred to inventory.

Requirement under Ind AS 11

When
the outcome of a construction contract can be estimated reliably,
contract revenue and contract costs associated with the construction
contract should be recognised as revenue and expenses respectively by
reference to the stage of completion of the contract activity at the
balance sheet date. An expected loss on the construction contract should
be recognised as an expense immediately. In the case of a fixed price
contract, the outcome of a construction contract can be estimated
reliably when all the following conditions are satisfied:

• total contract revenue can be measured reliably;
• it is probable that the economic benefits associated with the contract will flow to the enterprise;
• both
  the contract costs to complete the contract and the stage of contract
  completion at the balance sheet date can be measured reliably; and
• the
  contract costs attributable to the contract can be clearly identified
  and measured reliably so that actual contract costs incurred can be
  compared with prior estimates. In making a judgment about reliability of
  measurement, the following requirements under the Guidance Note may
  appear consistent with the overall Ind AS framework:
• All
  critical approvals necessary for commencement of the project have been
  obtained; for example, environmental and other clearances, approval of
  plans, designs, etc., title to land or other rights to development/
  construction and change in land use. However the following requirement
  in the Guidance Note appears inconsistent with the overall Ind AS
  framework:
• When the stage of completion of the project
  reaches a reasonable level of development. A reasonable level of
  development is not achieved if the expenditure incurred on construction
  and development costs is less than 25 % of the construction and
  development costs. Such costs would exclude land cost but include
  borrowing costs.

This requirement appears inconsistent
with Ind AS because a threshold of 25% for a real estate company that
routinely constructs real estate appears very arbitrary. Real estate
entities therefore should make their own judgment based on the
particular facts and circumstances.

In accordance with the
Guidance Note, a real estate developer will start recognising revenue
from constructiontype contracts only after it satisfies the prescribed
criteria, e.g., the project has reached a reasonable level of
development and minimum 25% of the estimated revenues are secured by
contracts. Apparently, Ind AS 11 does not allow deferral of revenue in
this manner. Rather, it requires a company to start recognising revenue
from a construction contract immediately. In cases where the outcome of
the contract cannot be estimated reliably, the recognition of revenue is
restricted to the extent of costs incurred, which are probable of
recovery.

An interesting question that is often asked is the
treatment of land in a real estate construction contract. Some may argue
that under Ind AS 11 the cost of land does not represent “contract
activity” or “work performed” and therefore is not to be considered in
determining the stage of completion. In addition, when the percentage of
completion is based on physical inspection, no activity will be
measured if land has been acquired but the actual construction has not
yet commenced. In the Guidance Note, land is included as an input cost
and in the application of the POCM method for recognizing revenue, costs
and profits. However, land cost is not included to determine if the 25%
threshold is reached to start applying the POCM method.

Question 7: How are multiple elements accounted for under the Guidance Note and Ind AS 11?

Requirement
under the Guidance Note An enterprise may contract with a buyer to
deliver goods or services in addition to the construction/development of
real estate [e.g. property management services, sale of decorative
fittings (excluding fittings which are an integral part of the unit to
be delivered), rental in lieu of unoccupied premises, etc]. In such
cases, the contract consideration should be split into separately
identifiable components including one for the construction and delivery
of real estate units. For example, a real estate company in addition to
the consideration on the flat, charges for property maintenance services
for a period of two years, after occupancy. Such revenue is accounted
for separately and over the two year period of providing the maintenance
services. The consideration received or receivable for the contract
should be allocated to each component on the basis of the fair market
value of each component. Such a split-up may or may not be available in
the agreements, and even when available may or may not be at fair value.
When the fair market value of all the components is greater than the
total consideration on the contract, the Guidance Note does not specify
how the discount is allocated to the various components. Under the
proposed revenue recognition standard Ind AS 115, the allocation is done
on a proportion of the relative market value.

Requirement under Ind AS 11

The above guidance is generally not inconsistent with the requirements of Ind AS.

Illustration : Guidance Note vs Ind AS

Example under Guidance Note Relevant Details of a project are as below:

Scenario 1

At
the end of the reporting period the enterprise will not be able to
recognise any revenue as reasonable level of construction, which is 25%
of the total construction cost, has not been achieved, though 10% of the
agreement amount has been realised. Scenario 2 Apparently, the company
meets all the criteria for revenue recognition from the project. It
therefore recognised revenue arising from the contract using the POCM.
However, revenue recognised should not exceed estimated total revenue
from legally binding contracts. The revenue recognition and profits will
be as under:

Analysis of Scenario 1

• It is questionable
  whether the 25% threshold under
  the Guidance Note for revenue recognition will apply under Ind AS. The
  real estate entity may conclude that the 20% threshold is reasonable and
  thereby start recognising revenue.
• Even if the real estate
  entity believes that the threshold of revenue recognition has not been
  reached, revenue will have to be recognised. The recognition of revenue
  is restricted to the extent of costs incurred, which are probable of
  recovery. Analysis of Scenario 2
• Some may argue that under
  Ind AS 11 the cost of land does not represent “contract activity” or
  “work performed” and therefore is not to be considered in determining
  the stage of completion. Therefore percentage completion is not 65% but
  is 30%.

Overall Conclusion

The ICAI should address all the above issues and preferably
come out with a Revised Guidance Note to deal with
Real Estate Accounting under Ind AS.

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

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

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

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

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

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

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

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

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

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

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

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

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

Case study I – Size and nature

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

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

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

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

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

Analysis

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

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

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

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

Case study II – Selection of benchmark

Background

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

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

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

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

Analysis (a)

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

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

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

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

•     The relative volatility of the benchmark.

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

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

Analysis (b)

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

Analysis (c)

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

Analysis (d)

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

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

Closing remarks

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

Technical perspective
Arguments against this carve out are as follows:

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

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

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

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

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

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

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

Ind-AS
103 requires business combinations under common control to be
mandatorily accounted using the pooling method. The application of this
method requires the following:

(i) The assets and liabilities of the combining entities are reflected at their carrying amounts.
(ii)
No adjustments are made to reflect fair values, or recognise any new
assets or liabilities. The only adjustments that are made are to
harmonize the accounting policies.
(iii) The financial information
in the financial statements in respect of prior periods have to be
restated as if the combination had occurred from the beginning of the
earliest period presented in the financial statements, irrespective of
the actual date of the combination.
(iv) Ind-AS 103 originally
hosted on the MCA website required that excess of the amount recorded as
share capital issued plus any additional consideration in form of cash
or other assets given by the transferee entity over the amount of share
capital of the transferor company is recognised as goodwill.

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

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

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

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

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

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

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

SA 570 lays down the auditor’s responsibility with respect to the management’s use of going concern assumption in the preparation of financial statements.

General purpose financial statements are prepared on a going concern basis, unless the management either intends to liquidate the entity or to cease operations, or has no realistic alternative but to do so. When the use of the going concern assumption is appropriate, assets and liabilities are recorded on the basis that the entity will be able to realise its assets and discharge its liabilities in the normal course of business.

An enterprise may be required by either the reporting framework or by statute to specifically state that the financial statements have been drawn up on a ‘going concern basis’. Eg., in the Indian context, directors are required to specifically assert in the directors’ report that the financial statements of the company are prepared on going concern basis. Where reporting framework does not contain an explicit requirement to assess ‘going concern’, management’s responsibility for the preparation and presentation of the financial statements nevertheless includes such a responsibility. The minimum period over which such assessment is to be made is normally one year (12 months).

The auditor is required to obtain sufficient appropriate audit evidence about the appropriateness of management’s use of the going concern assumption.A Based on this evidence, the auditor should evaluate management’s assessment of the entity’s ability to continue as a going concern. SA 570 envisages two scenarios:

a. Use of going concern assumption is appropriate but a material uncertainty exists

b. Use of going concern assumption is inappropriate

Under scenario (a), the auditor would need to evaluate whether a material uncertainty exists relating to events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern, including evaluating mitigating factors, if any. A material uncertainty exists when the magnitude of its potential impact and the likelihood of its occurrence is such that, in the auditor’s judgment, appropriate disclosure of the nature and the implications of the uncertainty is necessary for a fair presentation of the financial statements. The disclosure would also include a statement to the effect that the entity may be unable to realise its assets and discharge its liabilities in the normal course of business. Where adequate disclosures have been made, the auditor would need to express an unmodified opinion and include an Emphasis of Matter paragraph to highlight the material uncertainty which casts a doubt on the entity’s ability to continue as a going concern. In cases where adequate disclosures have not been made, the audit report would need to be qualified.

Under scenario (b), if the auditor concludes that going concern assumption is inappropriate, the accounts cannot be prepared on a going concern basis. If these are in any case prepared on agoing concern basis, the auditor would need to express an adverse opinion.

A tabular presentation of the approach is given below:

Material uncertainty arises from conditions which cast doubt about the going concern assumption and such conditions could be financial, operational or statutory in nature. We will try to understand some of these conditions with examples.

Financial condition resulting in material uncertainty

Case Study 1
ABC Limited (‘ABC’) is a company incorporated in India and is a wholly owned subsidiary of PQR Investment Ltd (‘PQR’), an investment company based in Mauritius. ABC Limited is engaged in the business of process research and development and analytical services. As at 31st March 20X0, ABC has accumulated losses aggregating to Rs. 600 lakh as against paid-up capital of Rs. 250 lakh. The accumulated losses have exceeded the net worth of the Company. The current assets of the company as at 31st March 20X0 stand at Rs. 120 crore, whereas the current liabilities due for payment over the next one year are Rs. 100 crore, i.e. ABC does not have a net current liability position. Management contends that it has no intentions of discontinuing business operations and believes that the Company will be able to continue to operate as a going concern and meet all its liabilities as they fall due for payment based on support from PQR. Management provided a confirmation to this effect letter from PQR Investment Limited to the auditors as evidence of support. The accounts of ABC were prepared on a going concern basis. Was this basis appropriate per requirements of SA 570?

Analysis
The existence of accumulated losses exceeding the net worth represents a financial condition of material uncertainty. In the instant case, PQR, the parent company provided a confirmation extending financial support to ABC to enable it to continue as a going concern. While SA 570 requires auditor to obtain written confirmation from the parent confirming the support, it also makes it incumbent upon auditors to evaluate the parent company’s ability to provide the requisite financial support. It is pertinent to note that PQR is an investment company. In such a case, the auditors would need to consider additional factors like whether PQR has the necessary wherewithal to provide financial support and if PQR was a mere investment vehicle then evaluating whether the shareholders of PQR have the ability to provide support and if yes, consider obtaining confirmation from the shareholders to that effect. Mere reliance on the confirmation would not suffice. Management would need to make detailed disclosures stating that the accounts have been prepared on going concern on the basis of financial support guaranteed by the parent company would be required to be made in the financial statements. The auditor would need to include in his audit report, a Matter of Emphasis highlighting this condition. Alternatively, where the auditor is satisfied with the appropriateness of the going concern assumption, he would not be required to include a Matter of Emphasis in his audit report.

Case Study 2
XYZ Winds Limited (‘XYZ”) is in the business of manufacturing windmills. XYZ has a paid up capital and reserves of Rs. 200 crore as at 31st March 20X5. XYZ has been incurring losses for the last three years however the Company has a positive net worth as at 31st March 20X5. XYZ had borrowed funds aggregating to Rs. 150 crore by way of foreign currency convertible bonds (FCCBs) on 1st April 20X0 which were due for repayment on 1st January 20X5. In view of continuing losses, XYZ was unable to repay the FCCBs on the due date. The Company also has overdue amounts payable to creditors and certain other lenders as at 31st March 2013. The current liabilities as at 31st March 20X5 amount to Rs. 800 crore whereas current assets stand at Rs. 550 crore. The Company is in negotiations with the FCCB holders and is working on various solutions with them to ensure settlement of their dues. The Company is also taking various steps to reduce costs and improve efficiencies to make its operations profitable. The final outcome of the negotiations is pending as on the date the financial  statements  are  approved  by  the  Board. Does  this
 situation  trigger  a
 material
 uncertainty
leading  to  the  going  concern
 assumption  being challenged?

Analysis
The fixed term borrowings are overdue for pay- ment. The given situation
also represents a net liability or net
current liability position. The Com- pany’s ability to continue as a going concern
is  in part dependent on the successful
outcome of the discussions with the FCCB holders as well its ability to
generate/source additional cash flows to
repay its liabilities in the short-term. An assess- ment covering qualitative
and judgmental aspects needs to
be made, an illustrative
inventory of which could include:

• Whether management has a history of success- fully refinancing or renewing the entity’s debt obligations as they come due
 

• Whether management has made sufficient progress in negotiating with planned funding source(s), if any and whether management has provided evidence to support its assertions rela- tive to progress

• Whether the uncommitted funding amount is significant or insignificant relative to the total funding need
 
• Ability and willingness of the owners to provide additional capital to fund the liquidity crisis.

If based on additional procedures performed, auditors are satisfied with the appropriateness of the going concern assumption, the auditor would need to include a matter of emphasis in their re- port highlighting the fact that the accounts have been prepared on a going concern basis despite the material uncertainty. Management would need to make enhanced disclosures about the material uncertainty as well as mitigating factors. Where the auditor is not satisfied with the appropriate- ness of the going concern assumption, he would need to issue an adverse opinion.

Case Study 3

Moon Metals Limited (MML) is in the business of manufacturing of hot rolled steel plates. The paid up  capital  of  MML  as  at  31st  March  20X0  is  Rs. 2,000  crore  as  against  accumulated  losses  of  Rs. 2,250 crore. Due to the sluggish market conditions in  the  steel  industry,  high  rates  of  interest  and short tenure of loans taken, MML was unable to repay  significant  portion  of  loans  from  financial institutions/banks as per the repayment schedule. The overdue amount of such loans including over- due  interest,  as  at  31st  March  20X0  aggregates to  Rs.  1,000  crore.  Further,  loans  aggregating  to Rs.  500  crore  are  due  for  repayment  within  one year from the Balance Sheet date. The aggregate loans outstanding as  at 31st March 20X0  amount to  Rs.  4,000  crore.

In  view  of  the  deterioration  in  the  steel  market conditions, the management of MML submitted a omprehensive Financial Restructuring Plan (CFRP) in April 20X0 to the Corporate Debt Restructuring Group (CDR) consisting of all the secured lenders of the company. The CFRP, inter alia, provides for conversion  of  promoter  loans  into  equity,  buy- back  of  certain  unsecured  loans  at  a  discount, additional equity infusion by promoters, enhanced cash flow projections through cost rationalisation, operational efficiencies, renegotiation of contracts and other cost control measures to improve Com- pany’s operating results; all these factors ultimately resulting in improvement of the company’s net worth. The CFRP is under consideration by the CDR as on the date of approval of the accounts,
i.e.  30th  June  20X0.

The  liabilities  due  for  repayment  amount  to  ap- proximately Rs. 2,500 crore, which is greater than the  currently  expected  cash  flows  from  business and any committed or contracted sources of funds of the Company.   The Company’s ability to repay its  loan  and  related  liabilities  falling  due  up  to 31st  March  20X1  is  dependent  on  the  Company being  able  to  successfully  implement  the  actions proposed  in  the  CFRP.  What  factors  need  to  be reckoned, if the accounts for the year ended 31st March  20X0  were  prepared  on  a  going  concern basis  in  the  above  case?

Analysis

In this case study, the Company has been admit- ted  to  CDR  whereby  management  has  provided commitments in lieu of the CDR restructuring the loans and waiving off existing events of defaults/ penal interest and provision of further finance. In addition  to  the  factors  explained  in  the  analysis to  Case  Study  2  above,  the  auditors  would  need to  evaluate  the  following  aspects:

• Analysing and determining the reliability of cash flow, sales, profit and other relevant forecasts prepared by the management, the auditor may consider consulting corporate finance experts to validate these assumptions.

• Considering historical evidence of growth and profitability of the entity as well as the industry in which the entity operates

• Considering apparent feasibility of plans to reduce overhead (e.g. existence of labor agree- ment restrictions) or administrative expendi- tures, to postpone maintenance or research and development projects, or to lease rather than purchase assets

• Whether the company’s financial health has de- teriorated significantly or its operations changed significantly since the reporting date

• Assessing the ability and intent of the promot- ers to fulfill the funding commitment, assess- ing whether the commitment is sufficient and enforceable The time horizon over which the evaluation of the mitigating factors in this case would transcend beyond one year.

Depending on the status of approval of the CRPF and consideration of the factors listed above, the auditor would need to perform additional proce- dures to evaluate management’s assessment of going concern. Where in the auditor’s evaluation, the going concern assumption is appropriate, he would need to include a matter of emphasis in the audit report and ensure that detailed disclosures are made in the financial statements. Where the auditor is not satisfied with the appropriateness of the going concern assumption, he would need to issue an adverse opinion.

Operational condition resulting in material uncertainty

An operational condition may arise where an en- terprise is formed for achieving a stated objective and the objective is either achieved or becomes infructuous. For e.g. a project office that was constituted to execute the contract for construc- tion of a power plant for a power generating company would get annulled on completion of the project or where the contract with the power company gets cancelled.

Legal condition resulting in material uncertainty

A going concern issue may also arise where the operation of an enterprise is subject to licensing by statutory authorities and such license is with- drawn or cancelled thereby entailing a cessation to the enterprise’s existence. In the Indian con- text, a recent example of the applicability of the legal condition resulting in material uncertainty of an enterprise to continue as a going concern  is the cancellation of telecom licenses of certain operators by the telecom regulatory authorities leading to termination of business operations for those operators.

It is easier to evaluate going concern for enterprises operating in a mature industry experiencing turbulent times. However, for enterprises that operate in nascent or niche environments, this evaluation could pose difficulties. Consider the case of a company which is engaged in drug discovery and whose net worth is completely eroded. For such cases, the auditors would need to apply heightened professional skepticism to conclude appropriateness of going concern assumption, as this would involve evaluating factors such as fu- ture cash flows from development of molecules, success in clinical trials, ability to sell the product at development stage or engage a partner for further development, outsourcing of development of molecules etc.

In the Indian context, companies operating in the aviation industry have been encountering going concern issues. The operating results of these companies continue to be materially affected mostly by extraneous factors such as high aircraft fuel costs, significant depreciation in the value of currency, declining passenger traffic and general economic slowdown. Some of these companies have continued to prepare the financial statements based on their ability to explore various options to raise finance to meet short-term and long-term obligations, promoter commitment to provide op- erational and financial support and amendments to FDI policy which may improve investor sentiment towards the aviation industry.

Concluding remarks

As the world deals with the cascading impacts of the financial crisis, which continue to this day, the global economy has had to find a course through uncharted waters. The growing complexi- ties in companies’ balance sheets due to the global economic crisis and foreign exchange volatility have triggered a debate over one of the basic premises of financial accounting — every company is a ‘going concern’ that will not go out of busi- ness or liquidate in the foreseeable future. Going concern issues have significant ramifications for companies such as market capitalisation, ability to raise resources, employee retention, protection of stakeholders interests, investor confidence and so on. The significance of the going concern concept is also evident in the valuation of the assets of the business as ‘going concern’ also forms one of the basis on which businesses are valued.

Where going concern assumption is no longer appropriate, the financial statements would need to be prepared under the liquidation basis of ac- counting whereby the carrying values of all assets (including fixed assets) are presented at their estimated realisable value and all liabilities are presented at their estimated settlement amounts.

In  fact,  a  going  concern  assumption  being  invali- dated  post  the  balance  sheet  date  is  considered to be an adjusting event.   Accounting Standard 4 requires  assets  and  liabilities  should  be  adjusted for events occurring after the balance sheet date that  indicate  that  the  fundamental  accounting assumption  of  going  concern  is  not  appropriate. The  Companies  (Auditor’s  Report)  Order,  2003 specifically requires the statutory auditor to report whether  disposal  of  a  substantial  part  of  the  as- sets has affected the going concern of a company. Similarly,  the  reporting  requirement  under  CARO 2003  with  respect  to  erosion  of  net  worth  and incurrence of cash losses is also aimed at assessing the  financial  health  and  as  a  corollary,  the  going concern  of  a  company.

In practice, evaluating the appropriateness of a going concern assumption can be highly judgmental and SA 570 provides adequate guidance for an auditor to make this assessment.

1. The Companies Act requires that every company with net worth of Rs. 500 crore or more, or turnover of Rs. 1,000 crore or more or a net profit of Rs. 5 crore or more during any financial year will constitute a CSR committee.

2. The CSR committee will consist of three or more directors, out of which at least one director will be an independent director.

3. The CSR committee will:

(a) Formulate and recommend to the board, a CSR policy, which will indicate the activities to be undertaken by the company.

(b) Recommend the amount of expenditure to be incurred on the activities referred to in the CSR policy.

(c) Monitor CSR policy from time to time.

4. The board will ensure that company spends, in every financial year, at least 2% of its average net profits made during the three immediately preceding financial years. For this purpose, the average net profit will be calculated in accordance with the clause 198.

5. The company will give preference to local areas around where it operates, for spending the amount earmarked for CSR activities.

6. The board will approve the CSR policy and disclose its contents in the board report and place it on the company’s website.

7. If a company fails to spend such amount, the board will, in its report specify the reasons for not spending the amount.

8. Schedule VII of the Act sets out the activities, which may be included by companies in their CSR policies. These activities relate to (a) eradicating extreme hunger and poverty (b) promotion of education (c) promoting gender equality and empowering women (d) reducing child mortality and improving maternal health (e) combating HIV, AIDs, malaria and other diseases (f) ensuring environmental sustainability (g) employment enhancing vocational skills (h) social business projects (i) contribution to certain funds and other matters.

Naming and Shaming

The Companies Act does not prescribe any penal provision if a company fails to spend the amount prescribed on CSR activities. The board will need to explain reasons for non-compliance in its report. Thus many believe that there is no legal obligation to incur CSR expenditure. Creating a legal obligation under the Companies Act to incur CSR expenditure, would have created constitutional hurdles for the regulator. Hence the Government has chosen a path of applying moral pressure, by requiring disclosure of CSR expenditure. As there is no legal obligation to incur CSR expenditure, there would be no legal obligation to make good short spends of previous years or prohibition on taking credit in future years for excess amount spent on CSR.

The draft rules clarify that CSR is not charity or mere donations. CSR is the process by which an organisation thinks about and evolves its relationships with stakeholders for the common good, and demonstrates its commitment in this regard by adoption of appropriate business processes and strategies. CSR is a way of conducting business, by which corporate entities contribute to the social good. Socially responsible companies do not limit themselves to using resources to engage in activities that increase only their profits. They use CSR to integrate economic, environmental and social objectives with the company’s operations and growth.

From the draft rules, it is clear that CSR is based on shared values and should be a part of a company’s business strategy. It should not be seen as a discretionary expenditure. Certainly reputed companies can ill afford not to have CSR as part of their business strategy and spend the legislated amount on CSR. Hence, these companies would have, if not a legal obligation, atleast a constructive obligation to incur the CSR expenditure. The same cannot be said of companies that do not care about CSR or have cash flow problems and hence would not pursue CSR.

In a nutshell, as a result of the Companies Act 2013, for companies that meet the threshold, there may or may not be a constructive obligation. It is a company specific analysis that will have to be made.

Accounting of CSR expenditure

Assume, Company A meets one of the thresholds, and hence CSR is applicable to it. There are three scenarios with respect to CSR expenditure.

1. Company A spends 2% (determined in accordance with the Act) each year.

2. Company A spends nothing or less than 2% each year.

3. Company A spends more than 2% in one year, and may or may not take credit for the excess spend in future years

Scenario 1 is fairly straight-forward. Scenario 3 is not dealt with in this article. This article focusses on Scenario 2. How does Company A account for CSR expenditure in Scenario 2?

Author’s Response
To answer this question, one will have to answer three questions. Is there a legal obligation to spend on CSR? If there is no legal obligation, has the company created a constructive obligation for itself? How are constructive obligations accounted for under AS 29 – Provisions, Contingent Liabilities and Contingent Assets?

Based on discussions above, the author believes that there is no legal obligation to incur CSR expenditure. However, companies are advised to seek legal clarity on this matter. The answer to the second question, whether or not there is a constructive obligation, would depend on facts and circumstances of each case.

Paragraph 11 of AS 29 provides some insight on constructive obligation. It states “An obligation is a duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner.”

Whether or not there is a constructive obligation, will be clear from facts and circumstances of each case. Infact the requirement of Companies Act 2013, could throw some light on whether constructive obligation exists in a given fact pattern. As per the Act, the CSR committee will: (a) Formulate and recommend to the board, a CSR policy, which will indicate the activities to be undertaken by the company (b) Recommend the amount of expenditure to be incurred on the activities referred to in the CSR policy (c) Monitor CSR policy from time to time. Further, the board will approve the CSR policy and disclose its contents in the board report and place it on the company’s website. The above disclosures should throw adequate light on whether or not there is constructive obligation in a given fact pattern.

Now the million dollar question. Assuming there is constructive obligation in a given fact pattern, would a company require to make provision for the short or nil spends, on the basis that the short or nil spends will be made good in the future years. The response of the standard setters on this issue has been very confusing.

Constructive obligations should be provided

The requirements in Indian GAAP, suggesting constructive obligations should be provided for are:

(a) AS 29 defines ‘obligating event’ as an event that creates an obligation that results in an enterprise having no realistic alternative in settling that obligation. This definition is capable of being interpreted as requiring a provision based on constructive obligation criteria rather than merely on legal criteria.

(b) Paragraph 11 of AS 29 describes obligation at a constructive level rather than on a legal basis. Paragraph 11 describes obligation as follows: “An obligation is a duty or responsibility to act or perform in a certain way. Obligations may be legally enforceable as a consequence of a binding contract or statutory requirement. Obligations also arise from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner”.

(c) In the case of refund by retail stores, AS 29 requires a provision based on constructive obligation criteria and not on the basis of a legal obligation.  The example contained in AS 29 is reproduced below.

Illustration 4: Refunds Policy

A retail store has a policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. Its policy of making refunds is generally known. Present obligation as a result of a past obligating event – The obligating event is the sale of the product, which gives rise to an obligation because obligations also arise from normal business practice, custom and a desire to maintain good business relations or act in an equitable manner. An outflow of resources embodying economic benefits in settlement – Probable, a proportion of goods are returned for refund (see paragraph 23).

Conclusion – A provision is recognised for the best estimate of the costs of refunds (see paragraphs 11, 14 and 23).

(d)Paragraph 3 of AS 15  Employee Benefits  states that “The employee benefits to which this Standard applies include those provided:……(c) by those informal practices that give rise to an obligation. Informal practices give rise to an obligation where the enterprise has no realistic alternative but to pay employee benefits. An example of such an obligation is where a change in the enterprise’s informal practices would cause unacceptable damage to its relationship with employees.”  In the Indian context, bonus, increments, etc. are provided for based on constructive obligation rather than on the basis of a legal obligation. This is in accordance with AS-15.  Thus the concept of constructive obligation is not an alien concept and is recognized not only in AS-29, but also other Indian standards such as AS-15. (e) AS 25 – ‘Interim Financial Reporting’, requires the constructive obligation criteria to be applied in making provision for bonus in interim periods. As per AS 25, “a bonus is anticipated for interim reporting purposes, if, and only if, (a) the bonus is a legal obligation or an obligation arising from past practice for which the enterprise has no realistic alternative but to make the payments, and (b) a reliable estimate can be made.”

Only legal obligations are provided, constructive obligations are not provided The requirements in Indian GAAP, suggesting constructive obligations should not be provided for are:

1. The view that constructive obligation should not be provided for is clearly confirmed in two EAC opinions.  In a recent opinion published in The Chartered Accountant of July 2013, the EAC opined “Since as per Department of Public Enterprises Guidelines, there is no such obligation on the enterprise, provision should not be recognised. Accordingly, the Committee is of the view that the requirement in the DPE Guidelines for creation of a CSR budget can be met through creation of a reserve as an appropriation of profits rather than creating a provision as per AS 29.  On the basis of the above, the Committee is of the view that in the extant case, it is not appropriate to recognise a provision in respect of unspent expenditure on CSR activities. However, a CSR reserve may be created as an appropriation of profits.”

    Another opinion is contained in Volume 28, Query no 26.  In this query EAC opined “A published environmental policy of the company by itself does not create a legal or contractual obligation. From the Facts of the Case and copies of documents furnished by the querist, it is not clear as to whether there is any legal or contractual bligation for afforestation, compensatory afforestation, soil conservation and reforestation towards forest land. In case there is any legal or contractual obligation, compensatory afforestation, felling of existing trees or even acquisition of land could be the obligating event depending on the provisions of law or the terms of the contract.”

2.  AS 29 has rejected the concept of constructive  obligation in regard to provision for restructuring costs (e.g. voluntary retirement cost), which is required to be provided for based on a legal obligation rather than when there is an announcement of a formal and detail plan of restructuring.

3. The draft Ind-AS ED corresponding to IAS 37 Provisions, Contingent Liabilities, and Contingent Assets, identifies constructive obligation as a difference between Ind-AS and AS-29.  
This is reproduced below.

   Major Differences between the Draft of AS 29 (Revised 20xx), Provisions, Contingent Liabilities and Contingent Assets, and Existing AS 29 (issued 2003)

    1. Unlike the existing AS 29, the Exposure Draft of AS 29(Revised 20XX) requires creation of provisions in respect of constructive obligations also. [However, the existing standard requires creation of provision arising out of normal business practices, custom and a desire to maintain good business relations or to act in an equitable manner]. This has resulted in some consequential changes also. For example, definition of provision and obligating event have been revised in the Exposure Draft of AS 29 (Revised 20XX), while the terms ‘legal obligation’ and ‘constructive obligation’ have been inserted and defined in the Exposure Draft of AS 29(Revised 20XX). Similarly, the portion of existing AS 29 pertaining to restructuring provisions has been revised in the Exposure Draft of AS 29 (Revised 20XX).

    Conclusion

     Apparently, there are internal inconsistencies in AS 29. While some requirements of AS 29 require creation of provision toward constructive obligation; other aspects may be read as if the same may not be required. Overall, it appears that the ICAI does not favour creation of a provision with respect to constructive obligation. This is particularly clear from the two EAC opinions. However, it is unclear, how the EAC opinions can override some of the requirement under AS-29 which require a provision to be created for constructive obligation. This creates a huge anomaly; one that can be resolved only by suitably amending AS-29 to bring it completely in line with the intentions of the standard setters.  The author does concede that at this stage, it may not be advisable to amend Indian GAAP. Rather it would be advisable to take swift steps to adopt IFRS/Ind-AS, and leave the past behind.